Soaring energy prices, the war in Ukraine and further stark evidence from the IPCC on the severity of the climate threat requires sustainable finance to move into a new phase. Nick Robins sets out what financial policymakers, regulators and institutions can do to help resolve the great issues of our time.

Speeding the replacement of today’s fossil fuel energy system with one powered by clean energy is one of the central tasks of sustainable finance. The climate-driven imperative to phase out fossil fuels has become an increasingly mainstream financial issue. Russia’s illegal invasion of Ukraine is a brutal reminder that there has always been another reason to sever our dependence on coal, oil and gas: energy security.

Fossil fuels are doubly unsustainable, because of both their emissions and their finite, non-renewable nature. The war in Ukraine once again reveals the folly of reliance on fossil fuels with their trade structurally vulnerable to geopolitical manipulation, and their revenues frequently serving to facilitate corruption and empower authoritarian regimes. The disruptive consequences of this unholy mix have caused energy prices to spike and billions to suffer from the soaring cost of living, deepening the imperative of investing in a just transition for workers, communities and consumers.

Learning from the energy crises of the 1970s to confront today’s intersecting threats

The current crisis should prompt us to reflect on the fossil fuel shocks of 1973 and 1979, the first triggered by the Arab-Israeli conflict and the second by the Iranian Revolution. As well as causing stagflation, these events also spurred the first serious efforts to improve energy efficiency and develop renewable sources of energy – Vestas sold its first turbine in 1979, for example. In 1973, the UK hit its peak level of carbon dioxide emissions; in 1979 the European Union followed suit. Two decades before climate policy started to take off in the 1990s, it was wrenching supply-side energy crunches that put a cap on Europe’s carbon emissions.

But the 1970s also drove the search for new sources of hydrocarbons and dependence on fossil fuels continued, not least in emerging and developing economies such as China, India, Indonesia and South Africa. The result: most of the carbon dioxide from fossil fuels has been emitted since 1991 and according to the International Energy Agency, 2021 saw the highest ever level of carbon emissions from energy, despite pandemic lockdowns.

Governments must avoid being lured once more into boosting domestic coal, oil and gas production in reaction to crisis. The Intergovernmental Panel on Climate Change has made clear that global emissions need to peak between 2020 and 2025 to limit warming to 1.5°C. In the words of UN Secretary-General Antonio Guterres, “investing in new fossil fuel infrastructure is moral and economic madness” at a time when “cheaper renewable solutions provide green jobs, energy security and greater price stability”.

In Europe at least, the signs are that the crisis could help fast-forward the net-zero transition. Launching the REPowerEU package, two weeks after the initial Russian assault, the Commission’s Green New Deal Commissioner, Frans Timmermans, called for a “dash into renewable energy at lightning speed”. This needs to be matched by action to structurally eliminate fossil fuel demand, which will happen by improving energy efficiency, electrifying heat and transport and ramping up green hydrogen production.

Shaking up sustainable finance

Despite repeated warnings of fossil fuels’ capacity for deep turmoil, the world of finance has been caught off guard by the crises of 2022. The Ukraine conflict has moved key energy transition strategies such as divestment centre-stage as corporations and investors race to exit Russian assets. It has shown that fire-sale divestments in a time of crisis brings the ultimate crystallisation of stranded asset risk.

More profoundly, seasoned market watchers, such as Kingsmill Bond, argue that Russia’s invasion of Ukraine means that “global demand for fossil fuels has very likely peaked” and “investors should reduce their exposure to a sector facing structural decline”. BlackRock’s CEO Larry Fink believes “that recent events will actually accelerate the shift toward greener sources of energy in many parts of the world”.

To make this come about, sustainable finance needs to deliver a ‘double punch’ which confronts the twin sources of fossil fuel unsustainability – climate change and energy insecurity – and closes the green investment gap once and for all, most importantly in the Global South. Models show that annual net-zero investments must increase three- to six-fold by 2030, according to the IPCC. In developing countries, an even greater expansion of four to eight times is required, from less than $500 billion a year to potentially more than $3 trillion.

Net-zero commitments from business and finance have grown remarkably, but more than six years on from the Paris Agreement, progress in actually shifting investment flows is still far too slow. The latest net-zero benchmark from Climate Action 100+ found that net-zero alignment of capital expenditure plans from 166 of the highest carbon companies was “almost non-existent”. The overall result is a “persistent misallocation of capital” in the view of the IPCC. The crisis means that financial policy, the operations of financial institutions and the actions of central banks and regulators all need to work in a fully coordinated effort to reallocate capital across the financial system. This investment-led approach will not only help overcome the twin flaws of fossil fuels, but also drive a more attractive and inclusive development pathway.

Deploying the financial policy toolbox

Even with public balance sheets already stretched by COVID and interest rates rising, the case for an investment-led response to the crises remains strong. 2022 needs to be the year when the longstanding promise of $100 billion in climate finance for developing countries is not only met but exceeded, for both decarbonisation and resilience. Development banks need to de-risk private flows of capital into green assets, not least by reducing the elevated costs of capital in developing countries. Banks and investors want to allocate capital to net-zero in the Global South, but crucial market frameworks are still to be created. Alongside this positive mobilisation, finance ministers need to ensure that temporary relief for surging energy prices does not entrench tax incentives for fossil fuel production and consumption. Rather, the Ukraine crisis needs to be the prompt for finally eliminating the $400 billion a year in fossil fuel subsidies, complementing this with a one-off windfall tax on oil and gas to underpin emergency measures.

Governments could also tap into the growing investor demand for green assets by delivering a significant issuance of green, social and sustainability sovereign bonds. Climate bond guru Sean Kidney has highlighted the potential for a new generation of ‘freedom’ bonds – like the US Liberty bonds in WWII – to respond to the war in Ukraine and finance a green and inclusive recovery. Globally, the proceeds of these sovereign bonds and other fiscal measures could finance a series of ‘Just Energy Transition Partnerships’, building on the model being pioneered in South Africa, delivering a responsible retirement of fossil fuel assets in ways that leave no one behind.

Transition plans must rise to the challenge

To mobilise the assets of the global financial system, firm-level transition plans are an essential lever to show how capital will be reallocated. Through the Glasgow Finance Alliance for Net-Zero, over 450 financial institutions have committed to releasing net-zero plans. Worldwide in 2021, about one-third of over 13,000 companies disclosing through the CDP were developing transition plans. The practice remains in early stages, however, with fewer than 1% reporting on all aspects of a credible plans.

Clearly, the content of these plans has to reflect the added urgency to phase out fossil fuels and ramp up investment in clean energy solutions. Commitments for halting new investment in fossil fuels were already set to be one of the touchstones for these plans to bring them into line with climate science, as reflected in the IEA’s net-zero scenario. The onset of war has supercharged the pivotal role that transition plans have to play, from both real economy businesses and financial sector institutions. This makes it imperative that these plans rise to the challenge, showing clearly how investment portfolios, bank balance sheets and corporate CAPEX plans are credibly aligned with net-zero in the short, medium and long term. Ambitious plans to curb fossil fuels and expand clean energy in each of the next three years will be crucial if global emissions are to peak by 2025, accompanied by measures to ensure the transition is positive for workers and communities.

Strengthening the financial rules of the game

As guardians of the financial system, central banks and supervisors also need to raise their game to explicitly factor the instability of fossil fuels into their strategies alongside climate risks. At the European Central Bank Isabel Schnabel has usefully distinguished between the ‘fossilflation’ that lies at the root of the recent energy price spikes, ‘climateflation’ as physical shocks impact on production (of food, for example), and ‘greenflation’ as rising demand for clean energy solutions prompts supply chain bottlenecks (for example in critical minerals). All of these point to the need for further action to make sure that monetary policies are fully aligned with the goals of the Paris Agreement, by incorporating, for example, net-zero factors into collateral frameworks and asset purchases to counter price instability. Rising interest rates risk making the clean energy boost harder, so ensuring that costs of capital reflect the full risks of fossil fuels is essential.

Supervisors will also have a key role in evaluating transition plans from banks, insurers and investors, both to ensure that they reduce risks for individual institutions and also that they contribute to the stability of the system overall. The Banque de France’s François Villeroy de Galhau, for example, has argued that banks should be required to publish transition plans and that these should be assessed by supervisors, adding that if they identified a misalignment with climate policy targets, this could be seen as “an indication of material transition risk”, leading potentially to a capital add-on in terms of capital weights.

Always enough money, not yet in the right places

Sustainable finance has consistently advanced through successive crises over the past two decades. It needs to do so once more in the face of the military, economic, environmental and human crisis of 2022.

One of our greatest strengths is that “there is sufficient global capital and liquidity to close global investment gaps” as the IPCC confirmed this month. Another is that an increasing proportion of the high-level policies, rules and strategies that govern this finance is committed to net-zero. But one of the obstacles we face is conceptual. To date, the framing of sustainable finance for the energy transition has only been walking ‘on one leg’ by focusing on carbon to the exclusion of the unsustainability of fossil fuel supply. By bringing these two imperatives together and focusing on the needs of the billions now left behind by a fossil-dependent energy system, sustainable finance could once again contribute to resolving the great issues of our time.

The author would like to acknowledge feedback from Simon Dikau, Mike Hugman, Hans-Peter Lankes, Sabrina Muller and Simon Perham in the preparation of this commentary.

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