Nuno Fernandes is Professor of Finance at IESE Business School. He is also the Chairman of the Board of Auditors of Banco de Portugal, Non-Executive (Member of Audit Committee) at the European Investment Bank, and Research Associate of the European Corporate Governance Institute. His particular areas of interest are climate finance, mergers and acquisitions, corporate governance, banking, financial strategies, and corporate finance.
Nuno Fernandes regularly advises companies and financial institutions in Asia, Europe, Latin America, and the Middle East. He has delivered speeches and conducted workshops for well-known companies around the world.
A regular contributor to international media – including The Financial Times, Forbes, and The Wall Street Journal – Professor Fernandes is the author of several other books, including Finance for Executives: A Practical Guide for Managers (second edition), and The Value Killers: How Mergers and Acquisitions Cost Companies Billions—And How to Prevent It.
In the past, Nuno Fernandes was the Dean of Católica-Lisbon, and Professor of Finance at IMD in Switzerland. He has received numerous teaching and research awards and has been published in leading international academic journals, including the Journal of Financial Economics, Review of Financial Studies, and Harvard Business Review. In 2022, he won the “Outstanding Teacher” award, in The Case Centre’s Worldwide Competition, also known as “business education’s Oscars.” He earned his PhD in Management (Finance) from IESE Business School, and a degree in Economics from Universidade Católica Portuguesa.
In his interview with the International Finance Magazine, Nuno Fernandes shares his insights about his new book Climate Finance, Green Investing, M&As, climate risks, role of Central Banks in Climate Finance, and much more.
Q) Can you shed some light on your new book Climate Finance?
A) Three years ago, I started to work on this book, as I wanted more people to be aware of the massive impact that climate change can have on financial markets, and companies overall. Moreover, what could the finance world do to contribute to this massive global challenge.
Climate change is not a possible future risk. It has already started to impact human life and the worst effects are yet to come. Avoiding those extreme impacts represents an unprecedented challenge for humanity. A huge level of investment is required to meet the Paris Agreement goals. Given the magnitude of the challenge, it is clear that public investment alone will not be enough. Private sector funds need to be channelled into the new investment opportunities.
Climate change poses risks to companies, banks, governments, and investors, but also opens up opportunities. And my new book, Climate Finance, covers sustainable finance topics and climate-related frameworks, balancing investor and corporate needs.
Banks and financial investors can serve as enablers of a smooth transition and help properly allocate capital and risks. Every type of investor will be involved in different ways: by investing in private equity funds or directly in projects, buying bonds or equities, or investing in global funds that diversify their savings.
Several financial instruments are novel, and some aspects of their structure and best practices are still being developed. The book provides practical and applied concepts that are firmly grounded in reality, highlighting evidence from markets, academic research, and practical case studies featuring leading companies and investors.
Q) How is climate linked to finance? Can you elaborate?
A) Finance is about linking demand for capital (typically companies), to suppliers of capital (e.g. investors and financial institutions). Defined in this broad sense, Finance (including financial players such as shareholders, debtholders, capital markets, regulators/central banks, and boards) has an important role to play in tackling the challenges ahead.
Climate impacts Finance. For instance, climate change affects a company’s fundamentals, and thus markets overall. Climate change brings new risks and opportunities for companies, and this has obvious financial implications. And investors do care about these, and are engaging with companies so that they provide additional disclosures, stress tests, manage the exposure to stranded assets, or have clearer low-carbon transition strategies.
But Finance also impacts Climate. Calls for action to address the climate crisis come from company stakeholders (customers, employees, etc.), world leaders, regulators, and investors. These changes in consumption attitudes affect the way companies design their strategies, as they strive to meet the consumer demand for more responsible products. Consequently, large companies, such as automotive companies, are also asking their suppliers to be more environment-friendly. This leads to a higher demand for financial instruments related to climate change. Indeed, the different finance tools, new ESG metrics, and new financial instruments such as green bonds or sustainability-linked loans, all contribute towards companies taking concrete actions to reduce their carbon footprint, and thus help in the transition.
Therefore, it goes both ways. Climate impacts Finance. But Finance also impacts Climate.
Q) Why does climate finance matter?
A) Climate-related risks affect financial markets. Corporate fundamentals will change. The profitability change will vary from sector to sector. Some companies and industries are better positioned than others for a low-carbon economy. Not only because of policy/regulations regarding emissions or carbon taxes but repricing of assets is also another way in which climate change impacts investments, collateral values, and balance sheets throughout the world. As a consequence of shifts in risk perceptions and societal preferences, the price that investors are willing to pay for different assets is changing, and so is the risk they attribute to them.
The world’s largest investor, Larry Fink, Chief Executive Officer of BlackRock, has issued several warnings in his annual letters to shareholders. Many more long-term investors, including pension funds, sovereign funds, and others, are increasingly concerned that failure to act could endanger the long-term returns on their assets.
Besides, a big funding gap exists between what we have right now (the Paris Agreement signatures) and what we need to have in the future (the actual infrastructure, supply chains, and corporate frameworks to deliver on those agreements). Bridging this gap should now be the priority for executives, board members, and shareholders. Finance plays an important role in the development of instruments used to address this gap. By properly using tools such as green bonds or loans, companies introduce climate change in their long-run strategic portfolios, and thereby help them in their transition.
Corporate action will be crucial for obtaining the funds needed to fulfil the carbon neutrality goals, and most of the required investment will come from the private sector. Market-based finance is a key pillar in this process. Capital markets, the intermediary between savings and corporate investments, can be used to close the investment gap.
Q) How are companies responding to the stranded assets problem?
A) Stranded assets are assets that suffered premature write-downs, devaluations, or conversion into liabilities. In other words, stranded assets are assets that, despite being productive from a purely operational point of view, are no longer economically viable due to changing regulations and consumer tastes. They are particularly concentrated in some sectors, and they are important for countries that depend on commodity exports.
For instance, in the energy sector, given the global commitments to the reduction of CO2 emissions, there is a real possibility that the value of oil and some other carbon-related assets may become zero. In fact, achieving the Paris Agreement’s long-term temperature targets will certainly result in several billion barrels of reserves unutilized. Investors will tend to shift their capital away from carbon-intensive sectors and direct them to carbon-efficient companies, projects, and technologies.
However, the stranded assets problem can affect economies globally as economic and financial systems are interconnected. Stranded assets are not restricted to the fossil fuel sector. For instance, in the agriculture sector, land degradation, extreme weather events, and wildfires can destroy crops, affect livestock farming, and transform these assets into stranded assets. Also, agricultural assets can become stranded because of the greening of the supply chain, shifts in consumer behaviour or political changes, and environmental regulation. This is why this will also hit advanced economies through the interconnections of the global economy and through ownership and lending positions in the global financial system.
At the company level, assets on the balance sheets of companies operating in the fossil fuel industry (and others) are likely to become impaired. This means that companies will need to decrease the value of assets on the balance sheet and recognize an extraordinary loss in the income statement in that period. Erosion of assets from the balance sheet has capital structure implications, as the leverage ratios of the company will rise. If some highly leveraged firms were hit by losses due to stranded assets, they would be unable to service their debt obligations. For example, in early 2021, S&P downgraded the credit rating of three U.S. companies – Chevron Corporation, Exxon Mobil Corporation, and ConocoPhillips – mentioning “pressure to tackle climate change” among the causes.
Companies operating in highly polluting industries can reduce their environmental risks and mitigate stranded asset risk in a variety of ways:
Divesting old/polluting assets: An oil company can sell off old and obsolete assets such as refineries or oil wells and diversify its portfolio to include renewable energy.
Not reinvesting into the old business: A company can choose not to reinvest in old (and polluting) assets and favour new investments in sustainable assets. This can be done by investing a gradually smaller proportion of the earnings into sectors/products that are “at risk.”
Sourcing differently: A company can radically transform its supply chain and operating model, reduce its energy consumption, and switch to less carbon-intensive forms of energy supply.
Using M&As to transform their portfolio: By acquiring new technologies and pipelines of cleaner products, a company can sometimes transform its business faster than the organic rate of change.
Q) What is European Union’s contribution to international climate finance? How important has their contribution been?
A) Although finance (and the various financial actors) can play a role in mobilizing savings toward climate-related goals and investments, policies and regulations also play a role. The first step is to introduce a fiscal policy that incorporates the pricing of externalities, which is related to carbon taxes and fuel subsidies. It is important to recognize that political economy aspects are involved.
A priority in capital markets regulation is to clarify definitions related to sustainable finance. A lack of clarity as to what constitutes a green loan, green bond, and other green activities hinders banks, companies, and investors and increases the potential for greenwashing activities.
In the EU, the European Commission launched its Action Plan on Financing Sustainable Growth to meet the 2030 targets that it has committed to, in line with the Paris Agreement. This includes several policy initiatives to direct capital toward low-carbon projects, allow better management of the financial risks associated with climate change, and foster transparency in financial and economic activities. In March 2020, it published the Final Report, which details the following:
An EU classification system of sustainable activities (the EU Taxonomy): Provides a classification framework for sustainable economic activities. Its objective is to provide a common language and uniform criteria that corporates and investors can use to describe environment-friendly activities.
An EU Green Bond Standard: Represents the European guideline for green bond issuers, and complements the Green Bond Principles (by the International Capital Market Association). It aims to promote transparency and comparability in the green bond market, as well as support its growth.
Methodologies for EU climate benchmarks and disclosures for benchmarks.
Consistent labelling and disclosure of funds to enable investors to make informed choices.
Guidance for institutional investors on their disclosures, including how to factor in investor preferences and integrate ESG into their investment processes.
Guidance to improve corporate disclosure of climate-related information.
Q) Can you give your insights about Green Investing? Is investing in Green Bonds & Green Funds profitable for investors?
A) Several papers have examined whether companies with strong ESG credentials also have enhanced profitability and value, what is sometimes referred to as “doing well by doing good.” Also, there is some empirical research on the implications of climate risk and ESG in general for investors. Overall, the evidence is mixed, and it is difficult to establish causality, especially for issues such as climate change risks, for which very limited data time series are available.
I would like to highlight one thing. Despite anecdotal evidence provided by commentators, newspapers, and consultant reports, there is no scientific evidence suggesting superior performance by high-ESG funds in the long run. This does not mean that investors should not consider climate issues and sustainability in their investment decisions. Of course, they do, as it impacts cash flows, risk, and growth opportunities.
It is important to remember that firms with lower risk should have lower expected returns or cost of capital. However, during a transition period, we may observe high returns for sustainability-related strategies. Past returns do not predict future returns, and past average returns definitely do not necessarily imply strong expected returns in the future.
Finally, it is sometimes assumed that everyone (investors in particular) seeks to maximize performance or shareholder value. Some investors, however, have different utility functions. If the values and goals of these investors align with sustainability considerations, then they pursue these strategies even if they do not promise superior performance.
However, we should also not overestimate the objective of “doing good for the world” as a driving force of financial flows. It is important to realize that maximizing risk-adjusted returns is likely to remain the primary consideration for most investors.
Q) How can companies use M&As to improve their environmental performance?
A) Climate considerations are becoming increasingly important in M&As. Mergers can be used by companies to “green” their portfolio quickly, acquire cleaner technology, and better comply with the expectations of stakeholders, including regulators. Large players have been using mergers to close technological and business model gaps in their portfolios, and quickly become more environmentally conscious.
M&As will be especially important in certain sectors such as oil and gas, as producers need to invest in the transition from fossil fuel to cleaner energy sources. In other cases, the goal can be to acquire energy-saving or emission-reducing technologies, or to move the business toward other low-pollution sectors.
However, M&As pose significant challenges. Some of the more important of these are paying attention to overpayment, accountability in the integration, and communication with different stakeholders, including employees.
Overall, climate-risk factors can affect the likelihood of a deal being closed, and environmental due diligence is necessary for most mergers. Poor performance on environmental issues can negatively impact the valuation, and it can be used to negotiate the price down. However, in some cases, value and efficiency can be increased after the deal, by bringing the target assets to the same level of ESG performance as the acquirer. This requires the integration to focus on improving the ESG factors of the target and thus bring its poor ESG performance on par with that of the acquirer.
Q) What is the importance of climate risks for institutional investors?
A) Institutional investors are the largest holders of shares in publicly traded companies worldwide. They are also the majority holders of bonds (corporate and government). Therefore, it is obvious that they are key players in the low-carbon transition.
When we talk about institutional investors this includes asset managers, sovereign wealth funds, pension funds, and other types of investors. Many of these investors have a long-term orientation and are concerned about the long-term implications of climate change on their portfolios’ returns and risk.
Most institutional investors believe that climate risks have financial implications for their portfolio firms, and that these risks, especially regulatory risks, already have begun to materialize. Besides being a scientific reality, climate change is also an economic reality, and thus, it is a relevant investment issue. As a result, they are increasingly incorporating environmental information into their financial analysis and investment decisions.
There are different strategies used by these investors, such as screening, integration, exit or engagement. There is still limited empirical evidence on how different investors apply investment strategies, and their relative effectiveness. The little empirical evidence that exists suggests one has to be careful about greenwashing and initiatives on sustainability that are simply PR efforts without any concrete impact. The evidence also suggests that engagement seems to be more effective than divestment in achieving positive environmental results.
Q) What impact will Central Banks have on Climate Finance?
A) Central Banks are important players in financial markets. To begin with, they are responsible for implementing monetary policy, in which role they affect interest rates as we are seeing in the last few months. Importantly, Central Banks are also large buyers of financial products, namely, bonds for their portfolios. In addition, many of them are responsible for regulating the financial sector and ensuring financial stability.
In their different roles, they can use various tools to influence the climate transition. For instance, in bond purchase programs, Central Banks can use portfolio tilts, or exclusion lists, to direct their purchases toward greener assets. That is, while implementing bond purchase programs, Central Banks can influence the relative size, and rates, of different bond markets.
In supervising the financial sector, different operational tools can be used, including reserve requirements, collateral restrictions, and overall prudential regulation tools such as capital ratios and disclosures.
Further, many Central Banks are incorporating climate considerations internally. For instance, EU Central Banks agreed, in February 2021, on a standardized reporting of their own portfolio carbon footprint, along the lines of the TCFD.
However, it is important to consider that all these changes have consequences, costs, and distributional effects, and the availability of data that can justify future changes is a significant challenge. What Central Banks and financial regulators will do to support a smooth low-carbon transition will depend on what their mandate allows, how this is interpreted, and their willingness to act. Moreover, the mandates and policy tools differ significantly across countries.
Q) You claim that your book will be helpful for corporate managers, investors, executives, regulators and central bankers. What insights are you providing them?
A) This book provides an in-depth understanding of the various aspects of climate finance, from the risks and opportunities to the demand and supply of capital, to the impact of global policies. It presents frameworks to help readers better understand the sustainable finance field and the link between finance and climate. It allows the reader to assess their contributions, risks, opportunities and personal role in the coming transition. It also helps investors and companies make more informed capital allocation decisions by appropriately incorporating all risks.
If your work deals with finance, you must understand how the real-world impacts of climate change are reshaping stakeholders’ expectations. Businesses cannot sit back and be passive spectators of the government’s actions. Rather, they need to participate in efforts to combat climate change and contribute in different ways.
In addition to being a useful guide for finance leaders and practitioners, this book can also be used in business education (MBA, master’s, and executive education programs). It is based on many years of teaching and consulting with world-class corporations from all continents of the world.
Climate Finance will help you be part of the solution to the greatest challenge facing humankind today. The book will help you make the right choices and take meaningful action to protect the long-term interests of your organization against the financial threats posed by climate change.