Why banks view renewable energy as a riskier investment than fossil fuels

The financial sector is one of the most heavily regulated industries in the world, and for good reason. Financial rules, which require banks to keep capital in reserve when making riskier investments, are designed to prevent financial crises. Other financial regulations, such as accounting rules, aim to provide investors with a credible valuation of their financial assets.

However, new research I conducted with my colleagues shows that some of these rules could have unintended consequences for the low-carbon transition.

Building renewable energy sources that will replace fossil fuels will require a lot of money. A large part of this sum will come from banks, among other investors. But some financial regulations affect banks’ behavior and lending choices.

By analyzing global accounting regulations using data on European banks, our team of researchers identified a structural bias in the financial models needed to assess and report risks.

We found that these models rely on historical information about companies’ creditworthiness to assess the risk of various investments. Alarmingly, they tend to view carbon-intensive assets as less risky than low-carbon ones.

Decarbonizing the world by 2050 could save £12 trillion (US$15 trillion) and avoid the worst effects of global warming. All barriers to this transition should be removed, including unintended benefits given to fossil fuels and other high-carbon projects by financial regulation.

Low or high carbon risk

We investigated whether financial risk assessment models inhibit the transition to carbon-intensive economic activities, using data from the European Banking Authority (EBA). We focused on the accounting rules of the International Financial Reporting Standard and their influence on the companies and sectors to which banks decide to lend.

The risk assessments carried out by banks on their investments directly affect their profitability. This in turn incentivizes banks to lend to certain activities over others. Our analysis showed that the average risk estimate among EU banks for high-carbon sectors of the economy was 1.8%, compared to 3.4% for low-carbon sectors (calculated in euros that a bank expects to lose for each loan unit).

One of the main factors contributing to the cost of renewable energy production is the initial cost of mobilizing investments. Banks tend to pair riskier investments with higher interest rates, and so these rules could make it more expensive to finance the construction of wind and solar farms.

Conversely, by estimating high-carbon activities as low risk, these models may discourage banks and other financial institutions from shedding their high-carbon assets and financing the green transition.

Retrospective models

Financial models may overestimate the risk of low-carbon investments by relying on historical trends that may no longer hold in the future, especially as renewable energy production becomes less expensive. This question probably goes beyond accounting rules. For example, capital requirements regulations use similar models and shape the economic incentives and behavior of financial institutions.

Without objective measures of financial risk, it is difficult to replace estimates based on historical observations. One solution could be to ensure that risk assessments use climate modeling scenarios to project the risk of high-carbon investments.

Policymakers around the world now face the challenge of meeting their carbon neutrality commitments, but our research suggests that the tools, models and regulations they use are not up to the task.