Time for finance to turn down the heat

As the financial system gears up for the COP26 UN climate summit in November, leaders of financial institutions will need to know the answer to two questions: what is your temperature score and how will you bring it down to 1.5°C as soon as possible? Nick Robins looks at the progress being made.

2020 needs to be the year when the financial system makes the irreversible shift towards alignment with the goals of the Paris Agreement. We now know that the last decade was the hottest on record and that this was caused by man-made carbon emissions. The world has already heated up by over 1°C, contributing to the rash of extreme events in terms of fire and flood. And scientists at the Intergovernmental Panel on Climate Change have laid out the evidence for why it is so important to hold further warming to the Paris objective of 1.5°C if truly catastrophic damage is to be avoided.

For banks and investors, new metrics are required that show how their balance sheets and portfolios compare with this strategic temperature target. Central banks and financial regulators also need to keep score so that they understand the positioning of individual institutions as well as the aggregate levels across the systems they supervise. The reason is clear: limiting global temperature rise to 1.5°C is the best way to secure the long-term financial stability that is at the core of their mandates.

Sobering reports to date but with cause for hope

According to research published by Mirova in 2018, the S&P 500 index was at that point compatible with warming of 4.9°C, and the MSCI World equity index with 5°C. This points to systemic problems as these indices are used to construct portfolios for the growing proportion of passive investments and also as performance benchmarks for active managers.

However, the pace of change does appear to be quickening. Axa, the France-based insurance group, announced in December 2019 that it would align its portfolio with 1.5°C by 2050. Axa estimates that the current ‘warming potential’ of its corporate and sovereign holdings stands at 3.3°C and 2.9°C respectively, below the broad market reference of 3.7°C. But some core assets such as US Treasuries remain far off the mark, carrying a potential for extreme warming of 5.5°C.

Rising pressures on finance

In the words of Mark Carney, outgoing Governor of the Bank of England, the results of these first assessments are not “comfortable reading”. But the pressures on finance to first assess the distance between their current positioning and climate goals, and then take steps to close the gap, are set to intensify. Individual savers and pension beneficiaries want to be confident that their money is being invested in line with global climate goals. Financial sector leaders need to be sure that their business models are proofed against future policy and technology shifts. And financial policymakers will increasingly require market participants to disclose their warming scores to mobilise capital for the transition and underpin system stability.

Establishing a temperature marker also allows financial sector leaders and central bank governors to better calibrate the growing array of proxy metrics used to measure progress on climate change. These include tracking allocations to ‘green’ and ‘brown’ assets (such as renewables and fossil fuels) and measuring portfolio carbon footprints. If carbon foot-printing tracks outputs, climate heat-printing measures outcomes.

Welcome steps forward

So far, the investor community has been in the vanguard. An 18-strong coalition holding over US$4 trillion in assets has now come together to align their portfolios with 1.5°C through the Net-Zero Asset Owner Alliance. Banks are also stepping up their commitments, with 33 lenders with balance sheets of  US$13tn pledging to align their portfolios to finance the low-carbon, climate-resilient economy that is required to limit global warming to well-below 2°C, while striving for 1.5°C. UK bank RBS, for example, has announced that it will at least halve the climate impact of its financing activity by 2030 and “do what is necessary” to achieve alignment with the 2015 Paris Agreement.

These welcome steps are set to be reinforced by regulatory requirement. As part of its forthcoming climate stress test in the UK, for example, the Bank of England is proposing that the banks and insurers it regulates have to estimate the increase in global temperatures implicit in their exposures, calculating the aggregate ‘temperature alignment’. Importantly, this exercise will also enable the Bank to assess the overall heat-print of the UK financial system.

The European Green Deal will also drive forward policies and regulations to make finance consistent with the Paris temperature target. Indeed, a number of measures have just been passed as part of the EU’s sustainable finance action plan and these provide key foundations. For example, the EU has updated its regulation on market benchmarks so that providers will have to show by 31 December 2021 how their methodology aligns with the target of carbon emission reductions or attains the objectives of the Paris Agreement.

All this means that we can look forward to a time in the not-too-distant future when a portfolio’s heat-print is routinely disclosed along with that of its benchmark, including for major passive fund managers (such as BlackRock, StateStreet and Vanguard). This will provide a further stimulus to reallocate capital.

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