Banks may be our best hope in fighting climate change

Temperatures are rising and there is lots of work to do to avert disastrous outcomes. Europe is looking at one quick and easy avenue to make change happen: Go through banks.

Industry executives may not like it but banks are both an efficient way to raise the cost of carbon and to make sure that all companies properly disclose their emissions. Governments can make banks do the oversight work for them.

If that sounds like an outrageous demand, look at it another way. Banks are already used for political and social ends, most notably by the US money-laundering rules that have been beefed up dramatically in the past 20 years specifically to combat terrorist financing and to thwart the activities of politically undesirable or dangerous people and groups. Ask BNP Paribas SA what happens if you help process money for America's enemies. (The French bank was fined $9 billion in 2014 for running financial transactions for Sudan, Iran and Cuba.)

The simple fact is finance underlies everything and banks can be relatively easily controlled. The system is a single, efficient window into the economy and it is already closely monitored and regulated.

On the climate front, the idea is to make banks think much harder about what kind of companies they lend to and at what cost. Many banks have already stopped funding coal-fired power plants, but stress tests that involve climate-related risks and will lead to higher capital requirements can help create a rising scale of financing costs that should help support cleaner business activity and discourage dirtier practices across industries.

The European Banking Authority said this week it expects banks to take tighter environmental regulation seriously and start adding to their equity cushions, which help them absorb uncertain losses that result from climate-related risks. Upcoming stress tests in the eurozone should start to reveal how much pain climate risks could cause in loan books. Understanding this involves banks gathering and reporting much more information about their exposures.

It is a hard and costly problem for the industry, but it is inevitable. Why? Because governments have realised that acting through the financial system is both economically and politically expedient.

Voters don't like extra direct taxes on their cars, energy suppliers or on companies that lead to increases in the prices of the things they like to buy. And yet pollution and high fossil-fuel use have to be made more expensive to incentivise people to find alternative ways of doing things. Increasing the cost of funding and capital for activities that are worse for the environment is a good answer.

There is still a debate to be had. Some bankers prefer carbon pricing, which affects all industries and should hit the worst offenders with the biggest costs. Emissions Trading Schemes or Carbon Credits are among the ways to do this. They have a similar effect as taxes, but the rate or cost is set by markets, not governments. One drawback is that speculation can lead markets to misprice things, sometimes wildly. Governments would also have to keep tabs on companies to make sure they are using these tools correctly and bearing the right costs.

Beyond political convenience, banks need to understand and prepare for climate-related risks anyway. There are loans to businesses, homes and commercial property that face an increased risk of fire or flood for example. If consumer preferences change and shift to greener goods and services, what is the value of loans to established businesses that are left behind?

Bankers may grumble, but using their industry to fight climate change makes a lot of sense. Financial incentives work and getting banks to impose the costs is more efficient than waiting for politicians to make direct taxes somehow palatable.

Paul J Davies is a Bloomberg Opinion columnist covering banking and finance.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.