The task goes beyond securing financial institutions’ commitment to net zero investment strategies. Indeed, the value of assets under management held by financial institutions (including asset managers, asset owners and insurers) which have already announced net zero targets was recently estimated at around $130 trillion – potentially enough, on paper, to cover much or all of the investment requirement for the transition to net zero, depending on the methodology used. The challenge is to ensure that commitments in principle translate into actual capital flows.
In most cases, a realignment of portfolios will require financial institutions to increase their exposure to emerging or relatively untested investment categories. For this to occur, investors will require regulatory certainty and the establishment of deep, liquid markets in climate-friendly financial assets. As this paper elaborates, central banks and financial regulators can facilitate the process through reform of regulatory frameworks, asset classifications, and climate disclosure rules and criteria. Central banks can also send important market signals by increasing the proportion of ‘green’ investments in their own portfolios. At the same time, such work is invariably vulnerable to economic and financial shocks: it will be incumbent on central banks and financial regulators to ensure that efforts to develop new processes for the net zero transition do not conflict with their responsibilities for market stability (see Box 1).
The case for reform is highlighted by the fact that, despite the pledges mentioned above, the actual amounts invested in net zero alignment to date have been modest. Estimates vary, but broadly speaking the largest total climate-related financial flows in a single year have been $632 billion in 2020, according to the Climate Policy Initiative; or $817 billion in 2020, according to the UNFCCC’s Standing Committee on Finance. Both figures are much lower than the $6.5 trillion per year in new and ongoing spending on low-emissions assets implied by the McKinsey estimates above.
Actual spending aside, some progress on aligning the global financial system with climate goals has occurred in the past five years or so. In 2017 the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) was created as a group to develop common approaches on climate-related financial risk management, and as a forum for promoting cultural change by mainstreaming the net zero transition across the financial industry. The NGFS started with eight institutions, but its membership has increased rapidly and stood at 116 as of July 2022.
An ability to work closely with financial markets arguably makes central banks and financial regulators better placed than government departments to direct international financial flows towards climate action.
Also in 2017, the Task Force on Climate-related Financial Disclosures (TCFD) launched recommendations on climate-related governance, strategy, risk management, and metrics and targets around climate risk disclosures. The recommendations are designed to support all organizations requiring decision-useful, forward-looking information on the financial impacts of climate change, including in financial filings. They offer a starting point for the private sector and financial regulators in understanding how to assess and address climate-related risks.
As such developments illustrate, central banks and financial regulators worldwide increasingly recognize the threat climate change poses to financial stability. They are starting to explore the potential of levers such as climate-related macroprudential regulation and innovative monetary policy to support the net zero transition. Moreover, an ability to work closely with financial markets arguably makes central banks and financial regulators better placed than government departments to direct international financial flows towards climate action. The TCFD’s recommendations have already been adopted in several countries, and some central banks and financial regulators have started implementing climate stress-testing and green bond purchase programmes.
While these advances are significant at the level of certain individual countries, much more must be done globally. A key challenge is to stimulate private cross-border financial flows into net zero-consistent investments. Most financial resources reside in advanced economies, yet most renewable energy investment opportunities are in emerging markets and developing economies (EMDEs). For this reason, much of the focus of this paper is on the challenge of increasing climate-related cross-border private capital flows to EMDEs specifically. Such markets often have little fiscal space for public spending, limiting the ability of their governments to fund the net zero transition and thus increasing the need for private capital. Yet private investors typically see EMDEs as riskier than advanced economies.
An illustration of the complexity and sophistication of reforms needed is that the free flow of climate finance across borders will require the establishment of a more comprehensive system of disclosures around climate risk. Yet this could have the unintended consequence of precipitating capital flight from EMDEs vulnerable to climate change if new disclosure requirements cause investors to assign higher risks to such markets (see Chapter 2 for more detail). EMDEs already have more difficulty than advanced economies in accessing capital markets, yet they often have the greatest need of external finance for climate change mitigation and adaptation. In other words, although an effective system of disclosures and regulations is a necessary condition for the growth of global net zero finance, it is insufficient on its own to ensure wide geographical coverage and market stability. New compliance requirements will need to be complemented by policies that can correct for market distortions and reduce risk aversion so that climate investment – in EMDEs in particular – can grow.
About this paper
In the context of the above factors, the rest of this research paper outlines steps to accelerate investment in climate action and overcome obstacles to wider geographical coverage of such investment. It assesses how private cross-border financial flows may be galvanized and shaped by climate-focused changes in financial regulation. In particular, the analysis explores the options available to central banks and financial regulators in directing institutional capital to net zero-consistent investments (and away from high-emissions assets). It also assesses the efforts of recent private sector initiatives – such as the Glasgow Financial Alliance for Net Zero (GFANZ) – to support banks, asset managers, pension funds, investment consultants and other financial firms in ‘greening’ the financial system.
The findings presented here are based on an extensive desk review of almost 200 academic and policy publications, as well as on bilateral discussions and a roundtable of climate finance experts explicitly convened to feed into this research.
The chapters are organized as follows:
- Chapter 2 reviews the current state of net zero financial flows, and outlines the principle obstacles to their expansion into EMDEs in particular. It makes the case for increased portfolio investment, which is underutilized (relative to foreign direct investment) as a source of cross-border climate finance into EMDEs.
- Chapter 3 examines the opportunity for central banks and financial regulators to incentivize and stimulate net zero-aligned private international financial flows. Among other proposals, it asks whether central banks might expand their operating mandates beyond traditional goals such as price stability, and underlines the need for common standards and consistent taxonomies of climate-sustainable financial products. It also explores how central banks could lead market changes directly by adjusting their asset portfolios or prioritizing climate-friendly instruments in areas such as monetary policy operations.
- Chapter 4 reviews recent initiatives among private investors, including large financial institutions, to move towards net zero. It considers the integrity of financial institutions’ climate pledges, discusses the need for private institutions to publish credible net zero transition plans, and looks at the limits of climate modelling and the consequent implications for financial planning cycles.
- Chapter 5 offers some concluding thoughts and recommendations to strengthen climate action. It identifies three particular points of leverage that could be exploited to unlock growth in international climate finance: mandatory net zero transition plans; central bank asset purchases and reserve management; and international cooperation outside the climate-specific international policy architecture.
