Coalitions of private investors are assembling to address the climate crisis, and are starting to make investment decisions to support the net zero transition. But more work is needed to ensure the integrity of their climate finance pledges, and to improve information systems and climate-related financial modelling.
As mentioned, private financial flows are critical to financing the net zero transition. Around 70 per cent of finance for clean energy in EMDEs will need to come from the private sector by 2030, according to the IEA. The Climate Policy Initiative estimates that private sources accounted for 50 per cent of climate finance in 2020, with 20 per cent coming from corporations, 19 per cent from commercial financial institutions, and 10 per cent from households, individuals and others.
There is also broad agreement that public funds are insufficient to cover climate finance needs. But just as importantly, closing this finance gap will not achieve a net zero transition if private capital is still being directed to fossil fuels and other high-emitting assets. The whole financial industry needs to withdraw investment from high-carbon assets at the same time as investing more in climate action. Article 2.1c of the 2015 Paris Agreement on climate change states that the agreement ‘aims to strengthen the global response to the threat of climate change’ by making finance flows ‘consistent with a pathway towards low greenhouse gas emissions and climate-resilient development’.
Efforts are under way to assemble groups of private investors willing to address this issue. The leading such initiative in the run-up to the COP26 climate summit in late 2021 was the Glasgow Financial Alliance for Net Zero (GFANZ), a coalition of financial institutions that have committed to participating in the UN ‘Race to Zero’ initiative. GFANZ unites seven net zero financial sub-sector alliances: the Net-Zero Banking Alliance, the Net-Zero Asset Managers Initiative, the Net-Zero Asset Owner Alliance, the Paris Aligned Asset Owners, the Net-Zero Insurance Alliance, the Net Zero Financial Service Providers Alliance and the Net Zero Investment Consultants Initiative.
GFANZ has 451 members, accounting for a combined $130 trillion in assets under management. By some estimates, the value of these holdings is already theoretically sufficient, assuming they were translated into actual investments, to cover the entire requirement of the net zero transition. In reality, the full $130 trillion will not necessarily be used for that purpose, and implementation of GFANZ pledges – i.e. the disbursement of actual funds – is far from assured. Some of the capital will doubtless remain invested in existing assets (including, presumably, those linked to fossil fuels), and GFANZ also advises that decarbonization finance may be diluted by ‘potential overlap across initiatives, institutions and assets across GFANZ and its sub-sector alliances’. Nonetheless, GFANZ offers a potentially useful mechanism for galvanizing climate investment, as each participating financial institution has committed
to its own separate net zero target.
Other relevant financial sector commitments include those of the Climate Action 100+, a coalition launched in 2017 whose membership currently consists of 700 investors with around $68 trillion in assets under management. Climate Action 100+ was created to ‘ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change’.
Coordinating different initiatives and measuring their progress and impact remains a challenge, in part because of the potential for duplication and overlap cited by GFANZ. Assets under the management of investors in different initiatives cannot be summed. This underlines the need for clearly defined transition pathways, so that individual investors can plan changes to their strategies and portfolios over the coming decades and so that clarity exists on what a viable trajectory to net zero looks like for each sector in each country.
Each transition pathway will need interim milestones, which investors will need to achieve to remain on course for meeting long-term commitments (e.g. full net zero alignment by 2050, according to the Intergovernmental Panel on Climate Change). But information gaps continue to create challenges in this area: investors need to know what a ‘Paris-aligned’ pathway looks like, for example, so that they can determine the percentage of their portfolios that must contain certain asset types (and the precise climate characteristics of those assets) in order to meet Paris targets. This means there is a need for accurate information on whether an asset is net zero-consistent at a given point in time, so that portfolios and investment criteria can be adjusted accordingly if necessary. Financial institutions cannot buy suitable assets if they don’t know whether a particular instrument meets climate criteria or not – indeed, asset owners often use the claim that they can’t find suitable bankable projects in developing countries to justify climate inaction to their shareholders.
Policy will shape investment, so governments themselves must also be more explicit on how they plan to get to net zero, and on what private investors must do to conform to these changes.
A sophisticated system of financial regulation is needed to address this issue, as there are many conceivable pathways to net zero. Policy will shape investment, so governments themselves must also be more explicit on how they plan to get to net zero, and on what private investors must do to conform to these changes. Again, the need for a comprehensive global framework on climate investment, including detailed and consistent taxonomies setting out the characteristics of net zero-aligned assets, is evident.
Integrity, interim targets and credible transition plans
The integrity of private financial institutions’ net zero pledges remains a subject of considerable debate and scrutiny. There was an initial period of excitement around COP26, when hopes were raised by investor commitments. But this has given way to pessimism as fears of empty promises and failure to meet long-term climate targets have increased.
An example of the challenges can be seen in the recent rollback of GFANZ criteria for climate compliance. Initially, membership of the sub-sectoral alliances comprising GFANZ was conditional on following the minimum criteria of the UN Race to Zero initiative, namely: (i) using science-based guidelines to develop plans to reach net zero emissions, covering all three categories (‘scopes’) of emissions under the Greenhouse Gas Protocol; (ii) setting interim targets for 2030; and (iii) committing to transparent reporting and accounting. Notably, pledges had to include emissions indirectly embedded in firms’ portfolios. This was critical because emissions not directly generated by financial firms but associated with their holdings account for 97 per cent of such institutions’ total emissions, whereas emissions from their own operations are almost negligible.
However, in October 2022, after disagreements on the stringency of coal investment phase-out timelines, GFANZ dropped the UN Race to Zero requirements. The GFANZ 2022 progress report now states only that ‘the Alliances will take note of the advice and guidance [author’s italics] of the UN Climate Change High Level Champions and the Race to Zero as well as relevant international bodies’. This contrasts with the 2021 progress report, which stated: ‘Member commitments are … anchored [author’s italics] in the United Nations Framework Convention on Climate Change’s (UNFCCC) Race to Zero net zero criteria, including the requirements to set near-term decarbonisation targets, release plans to support their longer-term pledges and report progress annually.’
The controversy around GFANZ membership criteria and the resistance of some participants to meeting the UN Race to Zero requirements have increased fears that private sector initiatives will amount to little more than greenwashing, and that genuine commitment to net zero in the financial system is weak. Finding the right balance between stringent conditions and attractive incentives is a dilemma for climate-related initiatives: on the one hand, if such coalitions penalize or remove members who fail to present net zero targets by the required deadline, this could discourage new financial institutions from joining. On the other hand, fears of greenwashing increase the pressure on climate alliances to remain stringent in holding private financial institutions to account.
GFANZ is aware of the risks to net zero should it fail to enforce the use of robust transition plans. In June 2022, it sought to address this by publishing guidance on financial institutions’ net zero transition plans. The guidance recommends that financial institutions, at a minimum, set net zero objectives that align with the commitments of their respective sub-sector alliances on climate action in the real economy. In addition, it calls on member institutions to set interim targets and establish accountability mechanisms. GFANZ also published introductory notes and guidance on the use of sectoral pathways to promote engagement between financial institutions and companies in the real economy in setting net zero targets and creating transition plans.
Separately, in March 2022 the Climate Policy Initiative published guidance on factors financial institutions should consider when developing transition plans. The paper outlined six crucial elements to make transition plans credible, advocating that such documents: (i) include progress benchmarks on mitigation with clearly defined timeframes, consistent with a 1.5°C trajectory; (ii) set out a clear implementation process outlining how policies, products, tools, services and relationships could deliver the transition; (iii) cover the whole organization in question, including details on how the transition will be supported by in-house capacity-building and integrated into budgeting and investment plans; (iv) include sustainability targets to avoid negative side-effects; (v) set out transparency, verification and accountability frameworks; and (vi) include regular reviews and revisions, with the level of ambition updated according to progress.
Closing the information gap
The IPCC notes that data on private climate finance flows are still not organized, systematized and used in ways that facilitate decision-making. The consensus seems to be that the problem reflects a deficit of ‘usable information’, rather than merely a data production gap, around the emissions embedded in financial institutions’ portfolios (particularly in relation to private international climate-related financial flows). In other words, although a lot of data is being produced, it is not systematized and analysed in useful ways to orient investment decision-making. This is particularly relevant to the debate around developing new policies and guidance on attracting private finance to climate-friendly investment.
The European Central Bank (ECB) and GFANZ have recently observed that the financial sector is still failing to address climate risks adequately or produce transition pathways that are fit for purpose. The ECB and GFANZ say that most banks lack robust climate risk stress-testing frameworks and relevant data, that such data as are generated are not in usable formats, that the underlying assumptions in climate stress-testing are not transparent, and that transition pathways lack sectoral, temporal and geographical granularity.
There is also widespread agreement that the development of multiple different disclosure frameworks risks creating an undue administrative burden, as each will require the collection of data from financial institutions and their counterparties in the real economy. Although the TCFD’s recommendations offer a potential overarching framework for climate-related risk disclosures, other parallel frameworks exist and more are being developed. These include, but are not limited to, frameworks under the Global Reporting Initiative’s Climate Disclosure Standards Board, the CDP disclosure platform and the Sustainability Accounting Standards Board. Some financial system practitioners characterize the situation as one in which financial institutions are being asked to provide an ‘alphabet soup’ of data to different bodies.
This ultimately means that a large amount of climate disclosure data continues to be produced inefficiently and in an uncoordinated way. The logical conclusion is (i) that relevant databases need to be systematized and made openly available to become useful for financial decision-making; and (ii) that an urgent need exists for shared, consistent frameworks to define portfolio alignment with a net zero pathway.
There is widespread agreement that the development of multiple different disclosure frameworks risks creating an undue administrative burden, as each will require the collection of data from financial institutions and their counterparties in the real economy.
The lack of internationally consistent frameworks applies to both climate risk data and climate impact data. The former estimates the impact of climate change on financial institutions’ profitability and balance sheets; the latter measures the effects of financial institutions’ own activities on the climate itself. Fragmented policy development compounds the problem. As mentioned in Chapter 3, a variety of efforts are under way to create ‘green’ taxonomies and classifications, with regulations and guidelines already in place in four Asian countries – China, Japan, Malaysia and Mongolia – and the EU. Multiple other geographies either have draft taxonomies awaiting approval (three countries), under development (14 countries) or under consideration (two countries). This raises concerns over a potential lack of coherence between taxonomies, and over difficulties in coordinating between different systems and asset classifications.
It also potentially adds to the risk of greenwashing, and even regulatory arbitrage by investors who might seek to take advantage of jurisdictions where carbon neutrality is defined less strictly. This could allow some financial institutions to seek out jurisdictions that admit controversial investment types into their product classifications, potentially resulting in ‘carbon leakage’ as polluting investments are transferred from more stringent jurisdictions to less stringent ones. Such concerns are currently evident in the intense debates around the EU’s taxonomy for sustainable activities, as the system would potentially define natural gas assets and nuclear power plants as sustainable investments.
The final critical aspect of the climate finance information gap is the need for standard methods and tools to integrate metrics on climate-related risks (both physical and transition-related) into financial risk assessment and impact modelling. Traditional financial risk management techniques usually rely on backwards-looking statistical tools, yet the radical uncertainty associated with climate change makes such methods less suitable. More work is needed in two areas: (i) generation of granular, openly available data; and (ii) the development of reliable analytical and modelling methods for assessing empirical evidence and exploring future scenarios.
Scenarios for climate change and climate policy are currently produced through integrated assessment models (IAMs). This is a long-established approach with decades of technical development and use. However, IAM-based scenarios are usually incompatible with economic and financial analysis. As the IAM-based climate change mitigation pathways on which investors currently rely do not model the financial system, there is no direct feedback loop between financial system decision-making and impacts on climate pathways. In other words, IAMs fail to factor in how financial sector actions affect net zero transition pathways, or how changes in such pathways affect the financial system.
This can create misleading assessments of risk. Battiston et al. (2021) explain that the specific NGFS net zero transition scenario which considers an orderly transition (as opposed to those which consider delayed or disorderly transitions) can give investors the impression that there is a low risk of fossil fuel assets becoming ‘stranded’. But if investors wrongly perceive high-emitting assets to be only slightly riskier than low-emitting ones, they may fail to reallocate sufficient capital to the latter.
Furthermore, IAM scenarios are typically not granular enough to be useful for investor decision-making. Most such scenarios model outcomes at a global level, aggregate multiple sectors into their estimates, and are calculated for long-term time horizons (such as 2050–2100) in five-year intervals. This means that results are only available for five-year blocks, rather than on a year-by-year basis or with any greater temporal specificity. All this means that such scenarios are of little use in assessing individual assets, and do not fit into financial decision-making cycles. In addition, many IAM-based models do not include uncertainty analysis, and so are less suitable for modelling potential impacts on the financial system.
Adding climate change to financial planning cycles and time horizons
In September 2015, less than three months before the adoption of the Paris Agreement, Mark Carney, then governor of the Bank of England, made a speech in which he introduced the concept of the ‘tragedy of the horizon’. By this, Carney meant that although the threat from climate change is unequivocal, it is seen mainly as an intergenerational issue beyond normal business and political cycles.
It is also beyond the time horizons of technocratic authorities such as central banks. For this reason, many consider the net zero commitments of financial institutions to lack credibility. Sceptics question the integrity of long-term pledges from institutions whose planning is designed for cycles of hardly more than three years.
Yet since 2015, when Carney made his speech, events have made it ever clearer that the physical and transition risks associated with the climate crisis are not only intergenerational but have tangible effects in the near term. This has discredited the idea of a tragedy of the horizon. Significant short-term financial risks are associated with the existing impacts of climate change, visible in many regions. Recent examples have included deadly floods in Germany, extensive wildfires in Australia, and prolonged droughts in Brazil that have reduced hydropower generation. In the latter case, this has impaired clean electricity generation and energy security, leading to higher electricity prices and wider inflationary pressures. Other relevant examples include recent heatwaves in India and Pakistan (where temperatures hit 50°C in May 2022, with impacts on food security), record high temperatures of over 40°C in the UK in July 2022, and floods in Pakistan in August 2022 that left millions of people homeless. Physical climate risks are thus material for financial institutions even on their relatively short investment horizons.
In addition to physical climate risks, transition risks are material in the short term. Policies and strategies implemented by governments, central banks and financial regulators in line with the Paris Agreement have potentially immediate implications for asset valuations and earnings across several high-emitting sectors. These sectors include, but are not limited to: coal, oil and gas; hard-to-abate industrial segments such as steel, cement and some chemicals; road transportation; and aviation. Moreover, the lack of preparedness of financial investors in terms of accurately assessing emissions throughout their portfolios and complying with new environmental regulations has the potential to worsen threats to financial stability.
