Making finance climate-consistent: how could the UK implement Article 2.1.c of the Paris Agreement?

It is almost three years since the Paris Agreement on climate change was adopted and the need to accelerate climate action is stronger than ever. The UK government has already announced it is exploring the implications of the Paris Agreement’s goal of holding temperature rise to well below 2°C – and ideally 1.5°C – for its own long-term emission reduction targets. These targets are contained in the 10-year old Climate Change Act and commit the UK to cutting greenhouse gas emissions by at least 80% by 2050 from 1990 levels. A recent review by the Grantham Research Institute concluded that the Act “will probably need supplementing by 2020, for instance by including a target for achieving ‘net zero’ emissions”.

But the Paris Agreement does not just commit countries to cut emissions. All countries also need to put in place a policy framework for climate-consistent finance, in order to fulfil the Paris goal contained in Article 2.1.c of “making financial flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development”.

The UK has a particular imperative to set out what climate-consistent finance looks like

The UK’s service-based economy is dominated by the finance sector and the Government has staked out its ambition to make the country a global pioneer in green finance. In March 2018, the government-appointed Green Finance Task Force published a set of 10 recommendations not just to respond to the threat of climate change but also to capture the strategic economic benefits from the growth in global markets in green finance. The Government’s response to the Task Force is due before the end of this year.

For all this, the UK does not yet have an explicit plan to make its financial flows consistent with both decarbonisation and climate resilience. Finance was missing from the Climate Change Act, an absence based largely on the assumption that real economy policies to price carbon and promote low-carbon solutions would be sufficient to attract the necessary capital. But the global financial crisis revealed the urgent need for complementary measures within the financial system itself to mobilise capital. The short-termism of the financial system was unable to appreciate existential threats like climate change – and prevailing incentive structures meant that insufficient capital was being channelled to critical sectors such as renewable energy infrastructure, resource-efficient real estate and clean-tech innovation.

Greening the financial rules of the game

Climate and other sustainability factors need to be incorporated into the rules of the game and institutional structure of finance if we are to overcome these problems. This is starting to happen. One reform was the launch of the Green Investment Bank, now privatised. Another was the inclusion of climate change in the Bank of England’s architecture for prudential regulation.

Intriguingly, the catalyst for these reforms occurred as an unintended result of the Climate Change Act. As part of the Act, the UK’s Department for Environment, Food and Rural Affairs (Defra) was given the power to request that key infrastructure operators and public bodies show how they are responding to current and future climate impacts, under the Adaptation Reporting Power (ARP). In 2014, Defra invited the Bank of England to prepare a report and, somewhat surprisingly, the Bank’s Prudential Regulatory Authority (PRA) accepted, with a focus on the insurance sector.

Defra’s approach came at a critical moment. Concern was growing in the City of London about the systemic threat of climate change both in terms of the value at risk from physical disruption and the prospect of ‘stranded assets’ in fossil fuel sectors. The Bank of England could easily have swatted away the request. But for its Governor Mark Carney, it provided the mandate he needed to explore what this emerging risk meant for the governance of the financial system.

The response came in September 2015, when Carney gave his now landmark ‘Breaking the tragedy of the horizon’ speech, arguing that entrenched myopia meant that by the time climate change became material for financiers, it would be too late to avoid its catastrophic impacts. The PRA’s adaptation report went far beyond a simple assessment of the exposure of the UK insurance sector to climate impacts: it set out an analytical framework for how finance could respond to the physical, transition and liability risks of climate change – a framework that is now used globally.

Further, the report provided the evidence base that Carney needed in his capacity as chair of the Financial Stability Board to develop a coordinated international response. This eventually became the Taskforce on Climate-related Financial Disclosures, which has quickly become the global touchstone not just for reporting but also for corporate and financial responses to climate.

On these foundations, the Bank has built a broader strategy around climate change management. A banking sector assessment report is expected before the end of 2018. The UK’s other financial regulators – the Financial Reporting Council, the Pensions Regulator and the Financial Conduct Authority – have started to explore what climate change means for them. And a government consultation on the future of the Adaptation Reporting Power has revealed support for making the entire financial sector comply. The Government has yet to set out how it expects this regulatory quartet to engage in the next round of adaptation reporting.

How could the UK lead on implementing Article 2.1.c?

The UK’s experience over the past five years shows just how quickly both financial institutions and regulators can respond to the challenge of climate change. But there is a way to go in order to respond fully to Article 2.1.c of the Paris Agreement.

The independent Committee on Climate Change’s 2018 Progress Report to Parliament underscored the need for a consistent policy framework to reduce investor risk and keep costs of capital low. In addition, recent reports on green finance from Parliament’s Environmental Audit Committee point to the consequences of a series of climate policy reversals, including a dramatic reduction in low-carbon investment: this fell by 56% in 2017, compared with a 7% contraction globally. More broadly, the UK and other countries lack a clear assessment of the ‘distance to target’ for making financial flows aligned with low-carbon and resilience goals.

With an absence of global guidance for implementing Article 2.1.c, the UK could take a leadership position by setting out how this complex task could be achieved. Building on the UK’s well established climate policy framework, four steps could be taken.

  1. Extend the mandate of the Committee on Climate Change (CCC) to assess and recommend measures needed to implement the Paris Agreement’s goals, including Article 2.1.c. This would provide an independent perspective, separate from implementing agencies such as the Bank of England – and it would be a natural fit with the CCC’s role of providing expert advice to policymakers.
  2. Start the process for implementing Article 2.1.c with an initial stock-take, led by the CCC, to establish how ‘financial consistency’ can best be interpreted. This would cover financial flows within the UK and between the UK and the rest of the world. It would need to cover flows in a) primary financing – by households, corporates, banks and investors in the real economy; and b) secondary financing – investments in listed equities, bonds and other financial products that indirectly support climate action. Both decarbonisation and resilience should be included. And it would need to measure the alignment of the UK’s financial system with the low-carbon and resilience goals of the Paris Agreement and then recommend the measures needed to close the gap.
  3. Bring forward and implement the necessary measures to align the UK financial system with Article 2.1.c.
  4. Add ‘financial consistency’ to the scope of the CCC’s regular advice on setting and meeting the UK’s climate targets as well as its annual progress report to Parliament.

To mobilise the capital at the speed and scale required to avoid ‘Hothouse Earth’, the UK and every other country needs to know whether its financial system is aligned with the goals of the Paris Agreement. The UK government has already indicated that once the Intergovernmental Panel on Climate Change’s Special Report – Global Warming of 1.5°C is published this October, it will be seeking advice from the CCC on the implications for its emissions targets. This provides an opportunity to include Article 2.1.c of the Paris Agreement as well in the UK’s climate policy architecture.

Nick Robins is Professor in Practice – Sustainable Finance at the Grantham Research Institute on Climate Change and the Environment. The views expressed in this commentary are those of the author and not necessarily those of the Grantham Research Institute.

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