What does Article 2.1(c) of the Paris Agreement mean for central banks?
Central banks and financial supervisors are essential enablers of ‘Article 2.1(c)’, which is about securing the finance for a low-emissions, resilient world. Joseph Feyertag and Nick Robins outline how these institutions can make progress on this important goal.
The significance of the finance goal of the Paris Agreement could not be more important for driving climate action. Article 2.1(c) calls on governments to ‘make financial flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development’. This is a pre-condition for achieving the Agreement’s adaptation and mitigation goals, including limiting global warming to 1.5°C above pre-industrial levels. After all, we cannot reduce greenhouse gas emissions or increase resilience to climate change without finance. By adopting Article 2.1(c), 196 countries around the world effectively agreed to completely overhaul their financial systems to support net zero and resilience.
Transforming the financial system
Despite its importance in tackling climate change, Article 2.1(c) remains poorly understood and has been difficult to implement. According to last year’s Sharm el-Sheikh Implementation Plan, no less than a “transformation of the financial system” is needed to mobilise the investments required for climate action. The UNFCCC’s response was to hold its first ever meeting on Article 2.1(c) in Bangkok last month, to explore new ways of achieving the alignment that’s needed.
Regular assessments of climate finance flows show that we are not yet channelling capital to the right places. Despite reaching an all-time high of $850–940 billion per year, global climate finance flows represent only a small fraction of what is needed by 2030, estimated at $3.5 trillion in emerging markets and developing economies alone. Meanwhile, $1 trillion in fossil fuel subsidies was provided by governments last year.
‘Making finance flows consistent’ with low emissions and resilience requires more than incremental changes to ‘scale up’ green finance flows or ‘scale down’ brown ones. Rather, the size of capital reallocation needed requires a rethink of the rules and processes that underpin everyday decisions across the nearly $500 trillion-worth of assets of the global financial system. As governors of those rules and as holders of nearly $44.1 trillion of those assets, central banks and financial supervisors are therefore essential enablers of Article 2.1(c).
Central banks start to set out their contribution to Article 2.1.c
In June, the secretariat of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) set out its views on Article 2.i(c) in a submission to the UNFCCC’s call for insights. The NGFS now consists of 127 members from across the world and the submission demonstrates that the central banking and financial supervisory community is starting to think about how they can bring together the longer-standing agenda of ‘greening the financial system’ and the newer agenda that articulates the goal of Article 2.1(c) – ‘making financial flows consistent’.
The NGFS’s submission highlights a key perspective to understanding and clarifying the scope of Article 2.1(c). Much confusion over this part of the Paris Agreement stems from a narrow perspective that it is only about the climate-consistency of public finance flows. Such an understanding is purely focussed on domestic public finance, such as calls to stop governments subsidising fossil fuels or permitting further oil and gas exploration. A slightly broader perspective incorporates the alignment of international public finance, such as financial resources committed by developed countries to assist developing countries as part of overseas development aid, or as part of climate finance under Article 9 of the Paris Agreement.
But from a central banking perspective, Article 2.1(c) encompasses a much broader understanding still of the climate-consistency of private as well as public financial flows. This ‘all-encompassing’ scope considers all aspects and types of investments and financing activities, whether they are public or private, stocks or flows, domestic or international. It is about the alignment of every actor in the real economy, from households and small companies to multinational banks, governments and, crucially, central banks. As set out in the NGFS’s submission, aligning Article 2.1(c) is about “starting from public climate and development finance and the private resources it mobilises to public finance in general and, eventually, to the financial system and all the financial flows it supports”.
What can central banks do to make finance flows climate-consistent?
By supervising systemically important banks and other finance actors such as insurance groups, central bank policy and actions play a large part in channelling finance flows towards climate objectives. Current approaches are primarily focussed on ensuring that finance actors account for climate-related physical and transition risks in their decisions. A growing number of central banks have adjusted their policy frameworks to incorporate these risks, for instance by using stress tests to model the effect of climate risks on macro-financial stability, mandating the disclosure of climate-related risks by regulated banks, or measuring the carbon emissions of their own non-monetary-policy portfolios.
At COP27 in Glasgow, NGFS members made further commitments to expanding their efforts beyond risk-based approaches, which raise awareness of the need to reallocate capital but may not truly result in capital reallocation favourable to the transition towards net zero and climate-resilient economies. As highlighted by the G20 Sustainable Finance Working Group and by the OECD, there are growing concerns over the actual progress on implementing billions of dollars’ worth of net zero financial commitments made by public and especially private financial institutions every year.
Where mandates allow, central banks can play a more proactive role in closing this implementation gap. First, prudential supervisors have a key role to play in ensuring that financial institutions design and deliver credible net-zero transition plans: Norway’s submission to the UNFCCC’s call for views recommended that financial institutions should be mandated to publish transition plans. These provide a detailed, multi-year account of targets and actions that set out how their business model and strategy are compatible with the objectives of the Paris Agreement. The NGFS also recently published an initial stocktake on what supervisors are doing to oversee transition plans.
Second, supervisors can adjust their monetary policy frameworks to support Paris-aligned finance flows more broadly, such as by introducing green differentiated capital requirements that favour Paris-aligned lending practices and penalise misaligned ones.
Third, central banks can look beyond capital reallocation and towards capital mobilisation. The NGFS recently published its concept note for an upcoming handbook on scaling up blended finance, arguing that central banks play a crucial role in building an attractive investment environment for such instruments to function by harmonising regulatory approaches, including minimum reporting requirements in transition plans.
Central banks in the sprint to COP28
There are practical and policy limits to what central banks can do to support the ‘making finance flows consistent’ agenda under Article 2.1(c). For example, they may not have the sustainability mandate to take a more proactive stance. But mandates can be changed, and the United Kingdom’s submission on 2.1(c) calls for a central bank mandate reform that includes mention of the Paris temperature and adaptation goals.
For central banks in emerging markets and developing economies, there is a deeper issue at stake: it is not possible to realign finance flows where they hardly exist in the first place. As set out in the NGFS submission, central banks cannot compensate or “substitute for firms or households in their investment and consumption decisions nor compensate for gaps in climate policies”. They are also unable to regulate the behaviour of informal enterprises or private equity. This means that there needs to be a strong linkage between their climate finance commitments, and that their mandate can support financial inclusion. A recent paper from the INSPIRE research alliance set out the latest thinking on what inclusive green finance (IGF) could involve. For example, IGF policy approaches can steer capital directly to climate-vulnerable segments of the economy in alignment with adaptation objectives, by offering credit guarantee schemes to micro, small and medium-sized business borrowers in relevant sectors, for instance. Progress on Article 2.1(c) will be assessed as part of the first global stocktake (GST) at COP28 in Dubai, an audit of the world’s collective progress against the goals of the Paris Agreement. Central bank activities and policies demonstrate that they can align their agendas on ‘greening the financial system’ and ‘making finance flows consistent’ to support the implementation of Article 2.1(c). The second meeting on implementing the article, to be held under the Sharm el-Sheikh dialogue in October, offers another chance to recognise this role and harness central banks’ ability to unlock progress on the long-term finance goal ahead of the COP in Dubai from 30 November.