Sustainable finance: investors have a taste for green stocks, but want firms to be transparent

European investors are choosing greener stocks even if it means lower returns, according to JRC research published today.

Investors are also considering transparency on environmental reporting when choosing where to invest.

The JRC experts identified a ‘greenness and transparency factor’ in stock prices and developed a tool to hedge against risks associated with the transition to a green economy, where stocks from greener and more transparent firms are likely to outperform others.

The tool and findings are released today in a special ‘climate risk’ issue of the Journal of Financial Stability. Another JRC article in the special issue investigates green bonds and bank lending.

Commissioner for Innovation, Research, Culture, Education and Youth, Mariya Gabriel said: “Science is at the heart of safeguarding a sustainable and prosperous future for all Europeans, ready to face the challenges that lie over the horizon. The Joint Research Centre provides evidence and tools to understand and mitigate the risks that climate change poses to our financial stability, as we build a green, digital and resilient recovery from the coronavirus pandemic”.

While the financial system has a key role to play in driving the transition needed to deliver on our European Green Deal, its actors are also directly concerned by the risks involved.

Climate change and the green transition pose two separate channels of risk to the financial system. Firstly, more frequent and severe climate-related natural disasters may ultimately affect financial institutions (‘physical risk’). A flood, for example, can affect thousands of households and businesses, whose losses would in turn be borne by their insurer (or by public authorities).

Secondly, the transition to a green economy requires transformative action from firms, especially those whose activities are carbon-intensive. Those firms unwilling to take action will be left with stranded assets in the wake of important changes to technologies, consumer preferences and policies that accompany the transition (‘transition risk’).

Financial stability and climate risk

The special issue includes ten articles, two authored by the JRC, assessing these channels of climate risk. Its insights and tools can help design resilience-enhancing policies as Europe seeks to invest in a green recovery from the coronavirus pandemic and reduce greenhouse gas emissions by at least 55% by 2030.

Specific issues addressed in the special issue include:

• scenarios under which climate-related financial risks are more severe, in order to identify them early on and take action to mitigate them;
• policy mixes through which the transition to a resilient and low-carbon economy can be achieved with minimum risks for the financial system, by fostering an early and orderly transition;
• the role of traditional financial instruments, like stocks and bonds, for the green transition and what this implies for the financial system – including new opportunities arising for investors such as the growing market of green bonds.

Carbon emissions and environmental disclosures

‘What greenium matters in the stock market?’ assesses European individual stock returns and finds evidence of a ‘greenium’ - a risk premium related to the greenness of a firm.

A negative greenium shows that European investors are willing to accept a lower return for holding greener stocks. However, this concept of ‘greenness’ is not limited to carbon emissions and includes firms' transparency on their environmental performance. If either carbon emissions or transparency are left out of the picture, evidence of this ‘green taste’ is not as strong or even disappears.

The findings suggest that investors, being well aware that firms may use ‘greenwashing’, favour those that provide more information to the public to back up their claims of low carbon emissions.

Green bonds: driving the green transition?

‘The pricing of green bonds: are financial institutions special?’ investigates whether green bonds are a cheaper source of finance for issuers and syndicated lending decisions by banks issuing green bonds.. It finds that banks getting finance on the green bond market reduce the share of lending going towards carbon-intensive sectors, when they act as the lead bank in a consortium.. this could suggest that, to some extent, both sides of banks’ balance sheets are becoming greener.

Such greening does not automatically change banks’ riskiness. By potentially contributing to the reduction of carbon emissions, this shift in lending may ultimately decrease physical risks. However, it will not necessarily reduce system-wide transition risks, because the liquidity of companies undertaking carbon-intensive activities might deteriorate if bank credit cannot be easily substituted. On the other hand, it provides a clear incentive for these companies to demonstrate that they are transitioning away from carbon-intensive activities towards green activities.

The European Commission’s policy action

Climate action is incorporated in the recovery plan for Europe, which has the European Green Deal at its core.

To finance the green recovery, the Commission will borrow up to €750 billion (in 2018 prices - €800 billion in current prices) under NextGenerationEU the EU’s instrument to achieve a green, digital and resilient recovery. The Commission intends to raise 30% of that amount through green bonds.

In this way, the EU will issue up to €250 billion of green bonds in the coming years, making the EU one of the biggest green bond issuers globally and reinforcing the EU’s policy and market leadership in sustainable finance.

Building on the 2018 Action Plan on financing sustainable growth, the renewed sustainable finance strategy will put forward a number of actions to ensure that financial markets support companies to invest in a rapid and orderly transition. To this end, it will aim at increasing private investment in sustainable activities, and to integrate climate, environmental, disaster risk reduction, social and governance considerations into our financial system rules.

The JRC’s findings indicate that EU legislation related to sustainability disclosures go in the right direction and provide investors with what they need and demand most: transparency. Such legislative action includes:

• The Corporate Sustainability Reporting Directive proposal, adopted in April.
• The sustainable finance disclosure Regulation;
• The taxonomy Regulation, with a delegated act on disclosures planned for adoption in June;
• Various articles in related regulations targeting banks and investment firms

A Commission proposal on an EU Green Bond Standard is also expected in July.