Researchers develop innovative finance approach to help banks fight global warming

An adjunct professor from the University of Cape Town’s (UCT) African Institute of Financial Markets and Risk Management (AIFMRM) has collaborated with other academics on a novel and easily-implementable way for banks and financial institutions to step up their role in driving sustainable finance and combating climate change.

Earlier this year, University College of London (UCL) mathematician, Dr Andrea Macrina, was busy cooking a birthday dinner for his wife when the phone rang. It was one of his collaborators, asking if he had a few minutes for a quick conversation about their research. Two hours later, he was still on the phone, and his wife had taken over the cooking of her own birthday dinner.

“I was very apologetic,” recalls Dr Macrina, who is also an adjunct professor at the African Institute of Financial Markets and Risk Management (AIFMRM) at the University of Cape Town (UCT). “It didn’t feel right at all, and my heart was very heavy. I had spoken to my wife about this research project, and she knew how excited we all were.” In fact, he and co-authors Chris Kenyon and Mourad Berrahoui worked through the Christmas and New Year period, taking very few breaks over the festive season, to complete their research to be put in the public domain in early 2022.

Their paper called the Transparency Principle for Carbon Emissions Drives Sustainable Finance has already drawn much interest from the financial services industry. It was presented publicly to academics, peers, and figures in the financial sector at the AIFMRM-QuantsSA Research Seminar on 10 March 2022.

“This research is very exciting,” explains AIFMRM Director Professor David Taylor. “The alignment of financial market incentives and carbon emissions disincentives is key to limiting global warming. This research provides a new way of designing financial instruments according to the enabled carbon flows and is compatible with existing bank systems. So, it does not call for new systems or software to be introduced.”

In layman’s terms, the researchers developed a new way to structure financial products, like loans, to include information about the enabled carbon emissions. This means adding a number quantifying the enabled carbon impact that institutions can use to calculate financial risk associated with carbon flows. By asking for more carbon-related disclosures and entering them in the terms sheets, banks can use these to compare cash flows and carbon flows and apply them to evaluate financial loans provided to fund projects, for example.

By accounting for the enabled carbon emissions of projects like new coal-fired power stations, disincentives could arise to build such power plants, encouraging more cost-effective and environmentally friendly alternatives or new designs that offset the carbon emissions. “Accounting for carbon emissions allows the banks to determine the financial requirements to balance costs arising from the enabled carbon flows which will radically change project costs, decreasing the risk that assets become stranded (unusable),” says Dr Macrina. This will lead to projects being restructured to include negative emissions technologies and, in their paper, the researchers offer new suggestions for mixed financial-physical solutions to minimise costs.

“Sustainability and the focus on climate change are key issues for financial market participants,” says Professor Taylor. “WWF International, among many other global organisations, has emphasised the crucial need for financial organisations and systems to play their part in reducing carbon emissions. Innovative research like this suggests actual and implementable ways in which financial institutions can play a bigger and more active role in reducing carbon emissions.”

With energy and power generation crises hitting not only South Africa but also various countries worldwide due to oil price uncertainty following Russia’s war in Ukraine, the approaches banks and financial institutions take toward financing future power plants have become even more relevant than ever before.

Dr Macrina and his co-authors in the paper introduce a carbon equivalence principle, which can be used to quantify how green a project is. Dr Macrina says they prefer not to use the term “green” as it is too narrow to describe emission impact. “We find labelling something as ‘green’ can be very limiting and inadequate as ‘green’ projects can still have a big carbon impact that is not acknowledged.” He explains, “A building may qualify as being ‘green’ due to certain building practices and materials used, but once you take into account the power sources it uses, you see its carbon emissions actually may no longer make it ‘green’.”

By considering instead enabled carbon emissions, a more accurate representation is gained. The researchers call this the Carbon Equivalence Principle (CEP) and they believe it enables greater incentive alignment between sustainability and normal financial management.

Dr Macrina says this also paves the way to cutting down on greenwashing, where organisations and activities claim to be environmentally friendly but do not accurately account for the carbon impact of their projects, products, or practices. Environmental organisation Greenpeace defines greenwashing as: “A PR tactic used to make a company or product appear environmentally friendly without meaningfully reducing its environmental impact.”

As pressures increase on organisations to be more ESG (environmentally, socially, and corporate governance) compliant, there have been calls on the financial services industry to adapt systems to more accurately reflect what the carbon footprint of a project, like a coal-fired power plant, will be. “Our paper talks about the transparency principle because it allows financial systems to truly reflect the environmental impact,” says Dr Macrina.

“Finance is the means by which so much is enabled and achieved. From construction to manufacturing, production and even service delivery. These must be financed and if we can innovate financial systems and find new ways to structure financial instruments, we can make a more meaningful contribution to the role finance plays in incentivising environmentally friendly practices and projects and how physical and financial risk is managed.”