By Patrick Curran, policy analyst, Nicholas Stern, chair, and Nick Robins, professor in practice – sustainable finance, Grantham Research Institute on Climate Change the Environment

In raising ambition and accelerating action on climate change, there is one sector that can have an outsized impact on changing the trajectory: the finance sector. In this post for the Sustainable Finance Leadership Series, Patrick Curran, Nicholas Stern and Nick Robins set out why and how the finance sector should be encouraged to ramp up its focus on climate action.

The recently completed UN climate summit, COP25, has highlighted some of the tensions in acting on climate change and the challenges to raising ambition. While there was some positive progress at the COP, such as announcements from the Coalition on Finance Ministers, overall the frictions between countries continue and reaching consensus on technical issues remains elusive.

However, this does not mean there is no action happening. A recognition of the growth opportunities associated with action, realisation of the risks of breaching 1.5oC in global temperature rise, and pressure from young people are combining to drive action in some areas. The recently announced Green New Deal in the European Union is one example; others include the United Kingdom’s commitment to net-zero greenhouse gas emissions by 2050, and initiatives at the state and city level in the United States.

Yet annual global emissions of greenhouse gases continue to rise, albeit at a slower rate than in the past. Today the world’s emissions trajectory puts it on course for a temperature rise of 3oC by the end of the century. Currently we are on the wrong path.

Clearly there is an urgent need for more action from more countries, and for a raising of ambition to tackle the challenge. In 2020 both will have to be demonstrated. The COP26 summit, to be hosted by the UK in Glasgow, will be the principal forum for demonstrating ambition and communicating what has happened.

The role of the finance sector in leading action and raising ambition

In raising ambition and accelerating action, there is one sector that can have an outsized impact on changing the trajectory, and that is the finance sector. The finance sector interacts with all others: its activities and actions are dictated by a combination of governments, regulators and private actors.

The importance of the finance sector is articulated in the third goal of the Paris Agreement, Article 2.1(c): “Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.”

Realising Paris’s climate change goals requires strong, sustained action over the next decade with a focus on the long term. This requires investments now in long-lived assets (infrastructure) that avoid greenhouse gas emissions and are resilient to the physical impacts at 1oC of warming or more. It requires adapting business models and packages to support different approaches and activities. And it requires innovation and the deployment of new technologies. All of these require finance.

However, in recent decades the finance sector has become a dominant sector in and of itself. This is often referred to as ‘financialisation’ and is measured by a strong increase in credit as a portion of GDP. This process has diverted the sector from its ‘notional’ role of intermediation between savers and investors in the real economy, or its role in risk management for insurance, pensions and so on.

Instead, the actions of many of those in the sector have fostered asset bubbles and emboldened a focus on short-termism driven by profit maximisation. Short-termism in turn has placed pressure on investors or corporations to act without due consideration for the impacts of their operations on the environment or wider society.

When taken together, the dynamics within the financial system have resulted in an unwillingness for the private sector to take risks through innovation or investment that may have longer-term pay-offs. Short-termism has slowed vital action on climate change.

Actions to shift the finance sector to focus on climate change

The world is awash with savings seeking good returns and there are huge and attractive investment opportunities that exist in infrastructure investment. Climate-friendly investment in transport, cities, buildings and energy systems is required around the world. If this investment is designed optimally and structured correctly these assets can offer stable, long-term cash flows with attractive returns.

It also makes sense to reduce risks to these operations by making them zero-carbon or designed in a way that supports low-carbon activities. At the same time we should be ensuring that all investments are resilient to the current and future physical impacts of climate change so they can continue operations. The investments are not only about climate action, they are sensible in their own right when compared with the alternatives. In almost all cases low- or zero-carbon, resilient infrastructure does not need to cost more, and due to rapid falls in cost, this kind of infrastructure is now the commercially sound investment.

However, there is a significant gap in translating these opportunities into real projects. Risks remain and entrenched systems continue to favour the past approaches. By working together, policymakers, regulators, commercial banks, investment banks, asset managers (pension funds, insurance companies, sovereign wealth funds) and international finance institutions (multilateral development banks, development finance institutions) can lay the foundations through changes to their current actions. They can mitigate many of the risks and turn low-carbon opportunities into viable, investable prospects at scale.

From public policymakers, initiatives are required to establish the long-term policies that offer certainty and stability, lower the cost of capital and incentivise innovation. All public policy decisions and finance should be aligned with climate goals.

Carbon pricing is still one of the most important policies required

That only 29 countries have any form of carbon price, and that only six are in the range suggested by the Stern-Stiglitz commission, has to be improved upon. For those countries that do not yet have a price on carbon they should introduce one as a matter of urgency. For countries that already do, they should announce the pathways through which the pricing will reach the recommended levels and communicate this in their updated Nationally Determined Contributions (NDCs), to be submitted at COP26.

The revenues from carbon pricing can also be deployed to support investment in the ‘just transition’ to a zero-carbon economy. This is the agenda that sees measures to ensure that no one is left behind by the changes required to meet climate goals and by the interaction of these changes with other structural changes in economies such as the shift to services, new labour-saving technologies and globalisation. To support the just transition, there is the potential to utilise a combination of options to promote policy goals and objectives such as research and development, social protection, lifelong learning, or revenue recycling. To build trust and coalitions for action, carbon pricing should be designed to be fair and equitable. Recent experiences, such as the gilets jaunes protests in France, demonstrate how carbon pricing that does not consider the social dimensions of change can interact with existing social and political tensions.

Carbon pricing alone is not enough

To be effective carbon pricing has to be combined with changes to other incentives. The International Energy Agency calculated that in 2018 US$420 billion went directly towards subsidising fossil fuels; however, when including climate and air pollution costs that are not priced, the International Monetary Fund puts the subsidy at US$5.2 trillion per annum. Whether made directly, or the result of a failure to price externalities, all of these subsidies distort finance flows. Clear and decisive actions to phase out these subsidies must be taken urgently.

Regulations and standards set by public policymakers are also powerful tools. Working in conjunction with pricing, these instruments can target areas where pricing is more difficult or less likely to be as effective – areas including city design, public transport and air pollution. This combination has already proven to be successful in ramping up action, including in energy-efficient lighting or around building standards.

Finance ministries are instrumental to combining these instruments and creating the long-term, credible and coherent policy environment that supports investment. The Coalition of Finance Ministers for Climate Action’s ‘Santiago Action Plan’, launched at COP25 and including 51 countries covering 30 per cent of global GDP, is a positive signal, but more action and leadership are essential.

Regulators and central banks need to incorporate climate change into their areas of influence

The impacts of climate change present a systemic risk to the financial system. Mean temperature increases of 1.5oC are outside of human experience and 3oC above current levels has not been experienced for millions of years. These outcomes pose immense risks to people’s lives, livelihoods and ability to be productive.

Central banks should act to remove the obstacles to investment in green products by developing the rules that determine ‘green’ and ‘brown’ (a recent example of such rules comes from the High-Level Expert Group on Sustainable Finance), by requiring increases in transparency around disclosure, and by integrating climate change into their own asset allocations. While there is movement from some, led by the Bank of England, acting together should be prioritised. The Network for Greening the Financial Systems (NGFS) has released a comprehensive report on some of the options available. All central banks should join the network and aim for implementation of these recommendations by COP26.

Action by the private sector should consider entire portfolios

The private sector, including asset managers, institutional investors, infrastructure financers and commercial banks, should also take steps to align with the Paris Agreement. This action needs to move away from a focus on asset classes to consider entire portfolios. Signatories to the Net-Zero Asset Owner Alliance, with combined assets under management (AUM) of US$4 trillion, have committed to align their portfolios with 1.5oC by 2050. While a positive and vital step and demonstration of leadership, companies currently signed up to this commitment represent just 6 per cent of the AUM of the top 400 global asset managers.

Commitments are a first phase, but action and delivery should follow. Assessments of asset managers’ current portfolios exposure to climate change risk (physical and transitional) should be concluded as a matter of urgency. The results should be publicly disclosed as those that own the assets have a right to know where their investments lie and the risks they are exposed to.

Action should then be taken: the worst performing companies in terms of climate change should be sold and the reason why should be made public. The Swedish pension fund AP4 provides a good example of this approach.

Where investors continue to hold polluting assets, they should use their voices and votes to push companies to publicly disclose their exposure to the physical and transition risks in accordance with the Taskforce on Climate-related Financial Disclosures (TCFD). They should use their influence and oversight to ensure that companies develop and implement strategies for alignment of their activities with the Paris Agreement over the long term.

While existing portfolios should be rebalanced away from existing fossil fuels, investors should also commit to not investing or supporting any new fossil fuel-based projects or companies. Again, this is not just a climate decision but one that is financially prudent in its own right. There is an increasing body of evidence that demonstrates that socially and environmentally responsible investments consistently out-perform in many areas of the markets. However, worryingly, the Bank of England estimates that more than US$185 trillion (of equity and bonds) has been secured to support companies that will keep the world on a trajectory that sees temperatures rise by far more than 1.5oC.

Allocation of assets remains important

One asset class that has gained a lot of interest in the past decade is green bonds. Over this time total green bond issuance has exceeded US$800 billion but this is still only around 0.3 per cent of total outstanding debt securities.

There is significant potential for countries to lead through the issuance of more sovereign green bonds in the current low interest rate environment. Green sovereign bonds can be used to connect investors to the implementation and realisation of national and local climate policies. The proceeds can be used to achieve both the environmental and socioeconomic dimensions of the zero-carbon transition through investing in skills and training, regional infrastructure, or enterprise support. Increased issuance from national governments in the lead-up to COP26 will send the signals that there is commitment to action.

Development finance can support new technology deployment and help manage political risks

Development finance institutions (DFIs) can take investment opportunities through to viable investment prospects, particularly within developing countries. These institutions have the mandate, experience and tools available to manage the risks associated with large-scale infrastructure investments, supporting the deployment of new technologies and managing political risks. Working together with national and local governments, development finance can increase confidence, demonstrate potential and mobilise private sector investment at scale.

The multilateral development banks (MDBs) have been making a strong move in the right direction since the Paris Agreement was signed. The High Level MDB Statement on climate action of September 2019 is an important announcement. But the movement by many is still far too slow. As of 2017 only 29 per cent of annual finance from MDBs was associated with climate change action. To demonstrate the ambition required, the aim should be to have all investment aligned with the Paris Agreement target by the end of 2020.

If all countries were to move together, it should be possible to meet the political commitments around climate finance made in 2010 and reiterated in the Paris Agreement – the target for developed countries to mobilise US$100 billion a year for developing countries by 2020. While not enough on its own, the target is an important symbol for commitment to the international process and is vital to building trust among different parties.

Worryingly, the signs are that the finance target will be missed. The recent Green Climate Fund replenishment made in October 2019 provides further evidence: while some developed countries demonstrated leadership (led by many of those in the European Union) and doubled their contributions, the overall amount was only equivalent to that pledged in 2015. To meet, and exceed, the target requires a concerted push from bilateral donors, DFIs and MDBs over the next year. It should be a priority to announce that the target has been met by COP26.

Ambition depends on finance. Finance follows ambition

If we are to mobilise the ‘trillions’ required for climate action, the financial system will have to play a central part. It needs to be reoriented to pursue climate action. But we do not need to tear it all down and start again. It is possible to achieve this reorientation using the existing tools and with existing institutions – which we must do given the urgency we have to work with. Action on its own is itself highly attractive with real opportunities and benefits for all.

The shift can occur if climate change mitigation, adaptation and risk management are placed at the centre of decision-making. This will require national governments, regulators, development finance institutions and the private sector to work together and set the direction. The recommendations from the Eminent Persons Group on Global Financial Governance provide examples of how this could be achieved.

We already see the shoots of many of the policies, ambitions and discussions for this transformation, but progress is far too slow. To ramp it up requires leadership by finance ministries, central banks, development finance institutions and assets managers. Those that are willing to act must lead by their own actions and by working together.

Coalitions of the willing can work together to signal the direction of travel, shape markets and encourage others to join them along the way. By working together they can set off a virtuous cycle that demonstrates what is possible and raises the ambition at international negotiations.

Further delay pushes us further off course. Acceleration is partly dependent on the direction taken by those within the finance sector but the sector can play an outsize role in pushing others. Only urgent and ambitious action will be enough to avoid the immense risks from climate change and unlock the enormous opportunities of a zero-carbon world.

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

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