Policies to support environmental risk management in investment decisions

Abstract

Investors are increasingly requiring assessments of environmental risks arising from climate change, natural resource scarcity and pollution. Improved environmental risk management also lowers the total cost of capital of firms, thus making them more attractive to investors. We illustrate this relationship by demonstrating how greater environmental risk may increase a firm's after-tax cost of capital. However, better environmental risk management by firms requires a range of complementary policies. The rules governing the financial system should support investment decision-making that takes into account environmental sources of risk and opportunity. Central banks can advance this objective by establishing environmental risk management and reporting requirements and adjusting capital provisioning to account for underpriced environmental threats. There is also a need to develop international guidelines and common policy and legal frameworks to support and streamline such initiatives. Developing such a policy strategy is likely to produce a self-reinforcing gain to firms, investors and society.