All large industrial revolutions were powered by finance and all large industrial revolutions powered finance. London Fleet Street financed the economic and political imperialism of the British Empire. The New York Stock Exchange has its roots in the railroad revolution cutting a path across America. At the heart of many keiretsu and chaebol leading Japan’s and Korea’s rise to prosperity is a bank.
Finance powered industrial revolutions of yesterday. We now look to finance to power the industrial revolutions of today and tomorrow, premier among which is the transition to a low-carbon economy. Policy makers have agreed on a global objective of limiting global warming to 2°C above pre-industrial levels. Many scientists think we’re now halfway there and well on our way to a 4°C economy. A move to a 2°C trajectory will require a dramatic shift in the economy, one for which we need a financial sector aligned with climate goals. We will need the help of finance to replace our entire high-carbon capital stock within a few generations and then build it again once over as the developing and emerging economies industrialize – nearly all without the use of fossil fuels, the economic lifeblood of generations past.
It is this logic then that connects the high-level policy promises of a2°C goal with finance. Climate goals require an economic transition to a zero-carbon economy in this century. This transition will require high levels of investment, the ‘clean trillion’ evoked by the International Energy Agency and others. A significant part of this investment will need to be financed through the balance sheets of banks and investors.
The path connecting climate goals to financial markets and investor portfolios is actually a two-way street. On the one hand, financing decisions will impact the viability of low-carbon investments and by extension our ability to deploy the 2°C-aligned capital stock. At the same time, there is also a not so subtle flow in the opposite direction: Climate goals, and indeed climate change more generally, is associated with both significant value creation and value destruction. Value creation and value destruction creates financial opportunity and risk
A growing scrutiny
The traffic on this road is subject to growing scrutiny in financial markets. The attention is visible by all actors, think tanks and NGOs, policy makers and regulators, and financial institutions themselves.
The London-based Carbon Tracker Initiative mainstreamed the concept of a potential ‘carbon bubble’ in financial markets related to high-carbon assets and companies. In the other direction, organizations like the Climate Bonds Initiative and the 2° Investing Initiative are exploring how to measure the alignment of the financial sector, assets, and financial portfolios with climate goals, and developing new financial products. Civil society is also starting to challenge the financial sector publicly with the Asset Owner Disclosure Project (AODP) publishing annual rankings of investors’ climate risk performance.
Regulators are responding. The Bank of England has started researching the threat of climate risk in financial markets. France this year passed the first mandatory risk and climate impact disclosure for investors as part of its Energy Transition Law. And the United Nations Environmental Programm (UNEP) Inquiry on Designing Sustainable Financial Markets is helping governments in emerging economies revolutionize how we think about the role of financial regulation in shifting private capital to climate-friendly investment.
Financial institutions are also responding, slowly, but surely. Over 50 investors around their world have committed to disclosing their carbon footprint by COP21. A group of more ambitious investors have agreed to ‘decarbonize’ their portfolios as part of what is called the Portfolio Decarbonization Coalition. In Europe, Unicredit and ASN Bank are the first banks disclosing their carbon footprint.
To measure, to manage, to regulate
The momentum is promising. Its sustainability however in terms of driving change and impact will likely depend on our response to three challenges.
The first challenge is measurement. Assessment tools and benchmarks in markets are not sufficiently developed to allow for an assessment of the alignment of financial portfolios with climate goals. This is a challenge both of data, but also the assessment frameworks themselves. Without these frameworks, actions by both financial institutions and regulators will remain stunted. The impact of the mandatory investor disclosure passed by France depends on material reporting and accounting frameworks. More generally, we find ourselves in a situation where we understand both economic technology and investment needs, but are clueless on how we should measure 2°C aligned financing needs. Much remains to be done here although promising initiatives are under way.
Once we can measure, the next step is to manage. Having the metrics, whether risk or climate performance related, in place does not automatically imply action. Many financial market practices today act as barriers to action. To mind comes the time horizon of investment mandates and stress-testing models that prevent the assessment of what may be long-term, climate-related risk. Another barrier is the dominance of market-capitalization weighted equity indices as benchmarks for portfolios. These indices constrain investors and their size bias leads them to under-weight green technologies.
To measure, to manage, to regulate. Voluntary standards by investors and better models and products may drive the market. Or they may not. Regulation can have a role in this process, improving transparency, governance, risk management frameworks, and taking advantage of its capital mobilization power. The justification for action comes in the form of consistency. Public policy goals, like the one of reaching the 2°C climate objective, should be consistent across all regulatory actions. Our understanding of this space is still limited however. Regulatory initiatives like the French Law on disclosure, the work of the Bank of England and the G20 on financial risk, and the reference to Green Bonds in the Capital Markets Union Green Paper by the European Commission are promising however.
The space is growing and so are the challenges, but solutions are under way. The success of these solutions depends however not just on their ability to convince finance to power the transition to a low-carbon economy. They depend perhaps in equal measure on how they can, after a global crisis, to power finance in the 21st century.
at the 2° Investing Initiative.
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