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The impact of financial regulation on renewable energy investment
The financial sector is heavily regulated to ensure stability and faces challenges in supporting the low-carbon transition. Regulations meant to prevent crises and provide reliable asset valuations may unintentionally favor fossil fuel investments. A study conducted by a team of experts using data from European banks reveals structural biases in financial models that assess and report risks that could hinder the green transition.
Financial models traditionally rely on historical data to gauge a company’s creditworthiness. Surprisingly, these models view carbon-intensive assets as less risky compared to low-carbon alternatives. This discrepancy leads to higher interest rates and higher financing costs for renewable energy projects. As a result, banks may be hesitant to sell high-carbon assets in favor of green investments, slowing the transition to a sustainable economy.
Understanding low-carbon and high-carbon risk assessments
A detailed analysis of data from the European Banking Authority (EBA) reveals a significant difference in risk assessments between high-carbon and low-carbon sectors: the average risk estimate for high-carbon sectors is 1.8%, compared to 3.4% for low-carbon sectors. This difference has a direct impact on banks’ profitability and lending decisions, creating an incentive to prioritise high-carbon investments over greener options.
One of the biggest barriers to renewable energy production is the upfront cost of raising investment. Financial regulations that classify renewable energy projects as high risk drive up interest rates, increasing the cost of building wind and solar farms. Conversely, the lower risk estimates of high-carbon activities make them more attractive to banks, encouraging continued investment in fossil fuels.
Addressing backward-looking financial models
Financial models that rely on historical trends may not accurately reflect the evolving landscape of renewable energy. As renewable generation costs fall, these models may overestimate the risks associated with low-carbon investments. Capital requirement regulations such as Basel III/IV use similar backward-looking models, influencing economic incentives and financial behavior.
Adopting forward-looking models that incorporate climate scenarios can better align financial risk assessments with the goals of the low-carbon transition. These models can help to more accurately predict the risks associated with high-carbon investments and eliminate bias against green investments. Policymakers and financial regulators need to recognize the need for modern tools and regulations that support the net-zero carbon transition.
