Since the adoption of the Paris Accord in 2015, financial institutions have implemented different climate transition strategies to comply with global standards. The most common methodology has been to set some sort of emission target, which is a limit on the total emissions of a bank’s lending portfolio over time. Typically, a bank will set emission targets to measure how well its extension of credit aligns with its business strategy for financing decarbonization technologies.
Some regulatory authorities, such as the European Central Bank, believe that emission targets are not just business strategy or reporting resources but also essential risk management tools that help to protect a bank from climate transition risk—the risk that changes in climate policy, regulation or technology will increase the fundamental risks that a bank faces. Emission targets are also often interpreted as an important climate policy enforcement mechanism that uses the financial system to mandate decarbonization of businesses by depriving them of funding if they fail to transition sufficiently rapidly.
In this post, we argue that emission targets used as transition risk management tools or as climate policy enforcement mechanisms can produce damaging unintended consequences such as increased risks for individual banks, systemic risk in the financial system and reduced economic growth. Emission targets used as transition risk management tools can increase risk since they assume that transition risk can go only one way—towards more decarbonization. However, transition risk can go in either direction—towards more or less decarbonization—at different times and in different countries. Making the wrong assumption can lead to losses. If all banks are assuming that transition risk can only go in one direction, and transition risk goes in the opposite direction, transition risks will be correlated across banks, producing systemic risk. Banks should separate transition risk management from emission targets to avoid bearing these unintended risks.
The shift to net zero in as little as 25 years will require an unprecedented and gigantic shift in technology. The transition to a decarbonized economy is enormously complex, requiring intricate coordination between new technologies that must be selected to work effectively together. Treating emission targets as climate policy enforcement mechanisms can interfere with this delicate balance, reducing economic growth. To illustrate the coordination and selection issues concretely, we discuss a case study of the United Kingdom’s policy of converting to wind power generation. In this example, emission targets applied as limits would not help to solve the coordination and technology adoption problems, but could rather restrict credit to companies unnecessarily, effectively functioning as a permanently tight monetary policy that would slow economic growth.
Emission Targets Can Increase Transition Risks
The view that adherence to emission targets helps a bank control its climate transition risk rests crucially on the assumptions that 1) transition risk always goes in one direction, since the economy must continually decarbonize, and 2) the economy will transition at a decarbonization speed that is consistent with achieving net zero emissions by 2050. If both assumptions were true, i.e., we knew with certainty the pace and direction of the decarbonization of the economy, then a bank would indeed take on transition risk if its lending portfolio were misaligned with how the underlying economy is changing. Unfortunately, we do not know the direction or pace of decarbonization with certainty; adherence to transition targets could increase the risk of a bank’s lending portfolio if it is inconsistent with the actual, rather than the assumed, direction and pace of decarbonization
Transition Risk Can Go in Either Direction
From the point of view of economic theory, emissions are an externality in which some of the cost is imposed on the country responsible for the emissions and some of the cost is transferred to the rest of the world. The Paris Accord attempted to manage this externality by maintaining an international agreement in which all countries pledge to reduce emissions according to their Nationally Defined Contributions (NDC), plans and commitments to reduce emissions developed by each country. The Paris Accord is an example of an international policy coordination in which every country commits to decarbonize its economy. Does this mean that we know with certainty that every country will continue to decarbonize its economy—that transition risk will always go in the direction of increased decarbonization?
Any agreement that attempts to control an externality such as increases in temperature is plagued by the free rider problem: holding the behavior of every other country constant, every country has an incentive to depart from the agreement, because it can enjoy the benefits of an overall lower increase in temperature while not changing its own economy. If a country’s departure from the agreement has little effect on the outcome, it will be more incentivized to defect.
To measure the degree to which countries would be tempted to defect, we need to quantify the effect on the increase in temperature of a single country departing from a joint agreement to decarbonize. We will use hector[1], the open-source reduced complexity physical risk model, to project temperature increases to 2100. We run a series of scenarios using hector. The input to hector is a full scenario path over time of all the greenhouse gases. To represent the decarbonization scenario that all countries pledge to adhere to, we will use the scenario ssp126, which limits the global temperature increase to between 1.5°C and 2°C. If a country defects from the decarbonization agreement, we assume that its emissions are consistent with ssp245, which, if all countries were on that scenario, would produce a temperature increase of about 2.7°C. In the examples below, we assume that one country or set of countries departs from the agreement in 2025 and emits according to ssp245 while the remaining countries stick to the agreement and stay on an emission path consistent with ssp126. Figure 1 shows the results for major developed countries and groups of countries.
Figure 1
Figure 1 shows an immaterial temperature increase resulting from either the U.S. or the EU27 departing from the agreement, assuming no other country does. Figure 2 runs a series of examples assuming the BRICS countries all depart the agreement together[2], and assuming the larger BRICS countries depart the agreement separately. Figure 2 shows that the smaller BRICS countries, such as Russia and Brazil, would have an immaterial effect on the temperature increase if they decided to depart from the Paris Accord, assuming that no other country did. China would have a more significant effect if it departed, since it is the largest emitter in the world. Still, China’s effect on the temperature increase by 2100 is only 0.28°C. As a group, however, the BRICS countries have a significant effect if they all followed China and departed the agreement together: the temperature increase would end up by 2100 well above 2°C rather than well below it. The effect on temperature of all the BRICS countries departing together is not surprising, since they constitute about 50% of global emissions.
Figure 2
Figures 1 and 2 confirm that the free rider problem in any international policy commitment to constrain emissions is relatively significant. When we combine the free rider incentives for a country to depart with the lack of enforcement mechanism to prevent a country from departing as well as the inability to bind future governments to the policy commitments made today, we should expect a substantial probability that at least one and likely many countries would depart from the agreement at some unpredictable time. Moreover, the departure of even one major country or a few countries could cause the entire agreement to collapse.
In light of these incentives, a bank’s risk management department must assume that transition risk can go in either direction for any country or group of countries. A bank may have developed a plan to finance decarbonization technologies, which it monitors using emission metrics. But a prudent risk management department at the bank will not necessarily accept the business judgment that is codified in the emission metrics but will instead independently review transition risk exposure by country and by groups of countries. It will be important for the risk management department to carefully monitor the economic and political situation in countries for signs that decarbonization regulations and incentives might be slowed, eliminated or even reversed to limit the bank’s exposure to losses.
Systemic Transition Risk
Systemic transition risks could arise if many banks are simultaneously assuming that decarbonization policy is going in one direction only and therefore orient their lending portfolios to match that assumption, but then decarbonization policies change. This common bank behavior could be induced by a regulatory requirement, such as the ECB’s current expectation that banks, for transition risk management purposes, monitor the emissions of their portfolios over time to make sure they are declining at a rate consistent with a net zero scenario. The ECB’s policy assumes that decarbonization risk is unidirectional because of the current EU Climate Law and the EU’s Fit for 55 policy. However, Figure 2 showed that the temperature increase that results from the EU reversing these policies is negligible. With the continuing rise in populist political parties, the non-trivial chance that other countries will depart, and the fact that some serious economic models project that the European economy would ultimately benefit from climate change[3], it is by no means a sure thing that the European economy will continue to decarbonize at the pace required by the net zero by 2050 scenario. By mandating a coordinated assumption across banks that might be incorrect, the ECB’s regulatory expectations could be introducing systemic risk into the European financial system, a risk that could spread by contagion to the U.K. or U.S. financial systems.
Other Transition Risks
Banks can also face transition risks if they extend financing to businesses that are transitioning too fast relative to demand. Recently, for example, Germany’s residential solar panel industry contracted, producing defaults and job losses.[4] It is also possible to extend financing to a decarbonization technology that does not end up working out, producing risks to the bank. For example, various innovations in nuclear power are being developed to supply clean energy. Recently Google and Kairos Power signed an agreement to produce 500MW of electric power using the fluoride salt-cooled high temperature reactor.[5] Some companies are working on Small Modular Reactors, whose advantages potentially include lower costs, faster deployments, scalability and enhanced safety. France has shown a preference for deploying nuclear power to decarbonize its economy.[6] A car rental company that moves to quickly to electric cars when the customer demand does not justify such a move will mistakenly appear to the bank to have lowered transition risk, if the bank is only looking at emission targets. Similarly, the proposed innovations in nuclear technology will appear to reduce transition risk if the bank only looks at emissions targets and metrics. However, particular nuclear technologies might fail: they might end up being too expensive, turn out to be technically infeasible or be unable to secure regulatory approval.
To manage transition risks, a bank’s risk management department must carefully look at each proposed financing on a case-by-case basis, separate from business strategy decisions. Transition risks are not controlled by satisfying emission targets.
Emission Targets Can Damage the Economy
The goal of emission targets is to support the transition to a net zero economy. If emission targets are also used to enforce decarbonization policy, they can create harmful unintended consequences, including wasted resources, higher than necessary emissions and lower economic growth. We illustrate the issues with a case study.
Case Study: Wind Power Generation in the UK
The U.K. has developed an ambitious plan to expand wind power generation as part of its decarbonization policy. It plans to deploy 50GW of offshore wind power by 2030[7], which could provide a third of the U.K.’s electricity by that date.[8] Recently, the U.K. government has decided to double the use of onshore wind by 2030.[9]
The investment in wind power in the U.K. so far has run into some practical challenges, problems that are only expected to worsen if they are not resolved. The power transmission grid has not been sufficiently updated to handle the additional power capacity produced by the wind farms. Ironically, wind power operators are paid to turn off wind power generators on the windiest days while gas power operators are paid to turn their plants on. The National Grid uses a balancing mechanism that manages supply and demand on the power grid. When grid constraints prevent wind power from reaching the demand, “constraint payments” are made to the wind power generators to compensate them for the lost revenue resulting from turning off their plants. These payments to both wind and gas power operators are passed through to consumers in their energy bills.
These constraint payments cost U.K. consumers about £1 billion in 2024.[10] Moreover, when wind power generators are turned off, the energy is wasted. In 2022, the amount of wind energy wasted could have powered 1 million British households for one year.[11] When gas power is substituted for wind energy, the power generators emit greenhouse gases that would otherwise not have been emitted. In 2022, the extra emissions were estimated to be 1.3 Mton of C02 equivalent.[12] By 2030, if current trends continue, constraint payments could cost U.K. consumers £3.5 billion, and the wasted wind power would have been enough to power five million U.K. households per year. Extra emissions by 2030 are estimated to be 6.8 Mton of C02 equivalent, 45% of the expected power sector emissions in the U.K. in 2030.[13]
Thus, it is critically important to quickly solve the power grid congestion problems. Although laying new cable may not be possible in a short time frame, there are many promising technologies that can mitigate the congestion problem: 1) Temporary battery storage of wind power; 2) Grid Enhancing Technologies (GET) such as Dynamic Line Rating that can increase temporary capacity; 3) Offshore Transmission Grids that allow offshore wind power plants to share infrastructure; and 4) High Voltage Direct Current (HVDC) installed by wind power operators that allow more efficient long distance power transmission. To be implemented, these technologies require financing, some of which has already happened. The grid operator National Grid, plc, offered a £7 billion rights issue to raise additional capital, underwritten by a major British and major American bank.[14] But much more needs to be done.
If emission targets are treated as hard constraints or limits on bank financing in order to enforce decarbonization policies, they would tend to divert banks’ attention from helping to solve the critical underlying grid problems and would introduce perverse incentives instead. Emission targets are typically predicated on the assumption that it is possible to know exactly how the mix between fossil fuel-based and renewable energy will change with time to meet a net zero goal. If applied as limits or constraints on lending, emission targets would encourage restriction of lending to British companies that do not accomplish this assumed mix, even though it may not be possible for them to do so: British companies would be penalized by banks for not shifting to renewables fast enough, even if the reason may be that the power grid operator is paying wind power generators to shutter production and paying gas power operators to increase production. Instead of penalizing British companies with higher borrowing costs, banks should be financing grid enhancements.
If emission targets used as hard limits or constraints on bank lending are coordinated across banks by regulatory policy, they could have serious consequences for economic growth. A climate-motivated restriction of credit would be similar to the way tight monetary policy works through the credit restriction channel: it would be like having a relatively permanent policy of high interest rates that would put a brake on economic growth.
Conclusions and Recommendations
Current transition risk policies can produce the following unintended consequences:
- Emission targets that commit banks to a coordinated view of the direction and speed of decarbonization, whether motivated by the need to manage transition risk or to enforce climate policy, can increase risks for individual banks and could increase systemic risk in the financial system.
- Emission targets that function as limits or constraints on bank financing decisions to enforce government decarbonization policies can lead to wasted resources, unnecessarily increased emissions, and lower economic growth.
To avoid these problems, it is important to distinguish between emission targets and the management of transition risk. Emission targets should be used to keep track of strategic business goals while transition risk management should be used to identify, measure and mitigate transition risks that might materialize as financial risks. Regulatory policy should not equate transition risk management with emission targets. To reduce the risk of creating reputational or legal risks if emission targets are perceived as soft or hard limits when they are not intended to be, banks should consider carefully defining and differentiating the terms “commitment,” “binding commitment,” “aspiration” and “ambition” in their external communications.
[1] Hector is available at https://jgcri.github.io/hector/. To use the model, we built the command line version from the c++ source code under Windows.
[2]We include in BRICS the current official members: Brazil, Russia, India, China, South Africa, Iran, Egypt, Ethiopia and the United Arab Emirates.
[3] See Cruz, J and Ross-Hansberg, E. “The Economic Geography of Global Warming,” Review of Economic Studies, (2024)
[4] See Financial Times, “German solar sector in distress as consumer boom fizzles,” (2024), available at https://www.ft.com/content/83b927f7-db90-49de-8f2c-d0fd88631573
[5] See https://kairospower.com/external_updates/google-and-kairos-power-partner-to-deploy-500-mw-of-clean-electricity-generation/
[6] See https://www.france24.com/en/france/20240109-france-drops-renewables-targets-prioritises-nuclear-in-new-energy-bill
[7] See U.K. Government, “Offshore Wind Net Zero Investment Roadmap,” (2023), available at https://assets.publishing.service.gov.uk/media/64a54c674dd8b3000f7fa4c9/offshore-wind-investment-roadmap.pdf
[8] U.K. Government Press Release, “Offshore wind energy revolution to provide a third of all UK electricity by 2030,” (2019), available at https://www.gov.uk/government/news/offshore-wind-energy-revolution-to-provide-a-third-of-all-uk-electricity-by-2030
[9] U.K. Government, “Policy statement on onshore wind,” (2024), available at https://www.gov.uk/government/publications/policy-statement-on-onshore-wind/policy-statement-on-onshore-wind
[10] Bloomberg News, “UK Is Paying £1 Billion to Waste a Record Amount of Wind Power,” (2024), available at https://www.bloomberg.com/news/articles/2024-12-02/uk-is-paying-1-billion-to-waste-a-record-amount-of-wind-power
[11] Sani,L, “Gone with the Wind? Grid congestion and wind integration in Great Britain,” Carbon Tracker Analyst Report, (2023), available at https://carbontracker.org/reports/gone-with-the-wind/full-report/
[12] Ibid Sani, L
[13] Ibid Sani, L
[14] Morningstar News, “TOP NEWS: National Grid gets 90% acceptances for GBP7 billion raise,” (2024) available at https://www.morningstar.co.uk/uk/news/AN_1718178440223329200/top-news-national-grid-gets-90-acceptances-for-gbp7-billion-raise.aspx
