Financing the climate change triple jump: how to align capital with a 1.5°C world

Just as investors were starting to get the hang of climate change – the risks, the opportunities and their duties as stewards of the world’s savings – along comes another blockbuster UN report that makes clear that we need to do far more, far faster.

The special report from the Intergovernmental Panel on Climate Change (IPCC) on how to hold global warming to 1.5°C makes clear that we need “rapid and far-reaching transitions in energy, land, urban, infrastructure and industrial systems”. To make this happen, the world’s US$386 trillion financial system will also need to undertake its own transition. To start with, this means rethinking how finance manages fundamental questions of time and space.

Rethinking the relationship between finance, time and space

The time value of money is central to the way that finance is allocated and risk is managed, making assets available today worth more than those in the future. This common sense approach has, however, been turned into a pervasive short-termism that is coded into today’s market practice and regulatory conventions. It is crucial that we overcome this ‘tragedy of the horizon’ – to use the Bank of England’s Mark Carney’s apt phrase – if we are to minimise the catastrophic multi-century impacts of climate change. The introduction of climate scenarios by corporations, banks and investors, as recommended by the Task Force on Climate-Related financial Disclosures, is a first step towards making the long-term material.

If the challenge of time is increasingly recognised in the financial realm, the spatial disconnect between the world’s financial centres and the economic hinterland is only starting to be appreciated. As the EU’s recent High-Level Expert Group on Sustainable Finance observed, “for many, finance is seen as a sector concentrated in metropolitan hubs, remote from the priorities of growth, employment and environmental improvement that prevail in Europe’s rural and (former) industrial areas.”

This disconnect is global and ensuring that the financial system serves inclusive, place-based development is critical if we are to avoid stranded assets, workers and communities.

Rethinking the relationship between finance and time and space prepares the ground for the strategic actions that banks, capital markets, insurers and investors will need to take to ensure global warming is held to 1.5°C. Many changes are required, but three leaps can be identified, in what could be called the ‘climate change triple jump’ in terms of investment strategy, capital intensity and societal impact.

Leap 1: Investment strategy

The first leap will be to ensure that all financial decisions take place within the limits required for a secure, prosperous and resilient zero-carbon economy. According to the IPCC report (Figure SPM.3b), this means aligning financial flows with a world where carbon dioxide emissions have been cut by 45% from 2010 levels by 2030. Further out, it means designing financing pathways that enable the share of renewables in generating primary energy to increase by between 832% and 1,137% relative to 2010 levels by mid-century and, in parallel, to cut coal as a share by 73% to 97%.

Leap 2: Capital intensity

The second leap will be to increase the capital intensity of the global economy, boosting the rate of investment in assets that deliver both decarbonisation and resilience. Currently, gross fixed capital formation (GFCF – an estimate of net capital expenditure by both the public and private sectors) is about 24% of global GDP. The IPCC report (Chapter 4-88) estimates that limiting global warming to 1.5°C above pre-industrial levels requires an increase in upfront energy investment of 1.5% of the GFCF.

In absolute terms, 1.5% is a relatively small amount, but it will yield both substantial savings in energy consumption as well as financial returns from the investments that are made. This shift is also consistent with the broader need to move savings towards productive assets – and away from real estate, for example – thus making the 1.5°C transition highly attractive from a macroeconomic perspective. By extension, this boost to investment and redirection of savings will, of course, be a major strategic opportunity for the sector that manages these assets – in other words, finance.

Leap 3: Societal impact

The third financial leap is then to make sure that this capital reallocation also delivers positive societal impact in terms of broad-based sustainable development. The IPCC report is crystal clear that social justice and equity are core aspects of climate-resilient development pathways that aim to limit global warming to 1.5°C, particularly in addressing inevitable trade-offs and widening opportunities without making the poor and disadvantaged worse off.

The transition could bring a range of highly positive social benefits in terms of incomes, net job creation, health and community wellbeing, but these will not take place automatically. Here, investors are recognising the pivotal role they can play in supporting a ‘just transition’ in line with the goals of the Paris Agreement on climate change. To facilitate this process, the Grantham Research Institute and Harvard’s Initiative on Responsible Investment have prepared an investor guide in partnership with the UN-backed Principles for Responsible Investment and the International Trade Union Confederation. Financing a just transition is fast becoming the new frontier for responsible investors, for those motivated by fiduciary considerations and impact ambitions alike.

1.5 degrees is feasible but needs rapid action

The road to a 1.5°C economy can seem daunting. But what is now clear is that this remains both technologically and financially achievable. As Jim Skea, Co-Chair of IPCC Working Group III said at the launch of the special report, “Limiting warming to 1.5°C is possible within the laws of chemistry and physics but doing so would require unprecedented changes.” The mission for finance is to make sure that its own laws enable this shift to take place, fast.

The views in this commentary are those of the author and not necessarily those of the Grantham Research Institute.