Today’s economies around the world share two features: the first is that most economies are currently too carbon-intensive to be compatible with a “2 degrees” world. The second is that the importance of financial markets for a well-functioning economy has significantly increased.
The United Nations Environment Program Finance Initiative — a partnership between UNEP and the global financial sector — was created in the context of the 1992 Earth Summit with a mission to promote sustainable finance.
Over 200 financial institutions, including banks, insurers and fund managers, work with UNEP to understand today’s environmental challenges, why they matter to finance, and how to actively participate in addressing them. Now, over 20 years later, we are in the middle of COP21. And one of UNEP FI’s key challenges is the role of private finance in combating climate change.
The central question now is: How can we induce the required changes in the financial clockwork that determines both the allocation of capital and the behavior of corporations?
The challenge is that in a business-as-usual environment, high-carbon investment strategies still offer attractive risk-return profiles and scale — too often more so than those offered by low-carbon alternatives.
On top of this, government subsidies continue to proactively support carbon-heavy lifestyles. What is actually needed from public agents is serious efforts to address externalities by internalizing them, starting with the historically unprecedented externality of carbon emissions.
So, let me be crystal clear: Steering broad economic development in line with societal interests is the job of legislation and government.
Public policy must penalize, not favor, high-carbon lifestyles and options while rewarding climate-compatible alternatives. What is needed are incentive and sanction schemes, at a meaningful level, that truly address the carbon externality, and in doing so, alter the risk-return equation of investments in favor of climate-compatible options.
Now, as regulation is not unfolding or too timidly put in place, what change can then be induced via the world’s financial markets?
There are at least three notions that help us answer these questions.
1. Political economy: Policymaking does not occur in a vacuum; it results from the ongoing dialogue with the private sector, including financial institutions.
2. Material risk: Risks such as stranded high-carbon investments can be reasonably expected to materialize for the medium-term future.
3. Reputation: What is important to any organization — beyond risk and return — is reputation.
The political economy
The political economy of climate change is to date influenced predominantly by business interests in the real economy — particularly in carbon-intensive sectors such as mining, energy, transport, chemicals, and land-use. The financial sector is largely absent or silent unless mobilized by environmental organizations such as Ceres, the Institutional Investors Group on Climate, or UNEP FI to sign onto annual policy statements. That’s unfortunately not enough to make a difference.
This means that, in coming years, UNEP FI members, need to expand, deepen, and intensify the nascent investor advocacy — basically, green lobbying — on climate change that we have seen in recent years, and we need to build on the work delivered by the UNEP Inquiry on financial regulation. We also need to further demystify the private financial landscape so that policymakers can better put it at the service of climate-change objectives.
Likely emergence of material risks
While greenhouse gas emission regulation is not considered a material factor today by financial institutions, the coming years and decades are likely to see a major increase in the ambition and reach of GHG regulation. As climate change progresses and disruptive events occur more frequently, the pace of policy could surpass expectations.
This would have deep implications for carbon-intensive investment as well as for the financiers and investors ‘locked’ into corresponding assets and companies. This likely scenario should firmly be on the radar-screen of investors and financial strategists.
This means that via UNEP FI financial institutions need to further the understanding in financial markets of the risks presented by climate change; and of the capacities of corporations to prevent value destruction from those risks. The risks that we need to better understand include those policy and technological risks related to the low-carbon economic transition as well as the physical — meaning the hydrological and meteorological — risks resulting from climate change.
The last decade has seen significant progress in carbon disclosure. To date over 4,000 companies have responded to investor demands for information by increasing reporting. Their expectation is that sound disclosure and environmental overperformance are rewarded by investors while incomplete disclosure and underperformance are penalized.
This link hinges, however, on financial institutions making use of disclosed information and integrating it into decision-making. The problem is that the degree to which the investment community is integrating carbon and climate factors into decision-making is unknown.
So while information on the environmental performance and carbon risk exposure of a broad range of real economy companies is readily and publicly available, information on how investors and other FIs themselves are faring, remains anecdotal.
Consequently, civil society and regulators are expanding their focus from the environmental record of corporations to that of financial intermediaries, who are under increasing pressure to disclose climate-related performance and risk information of investments and portfolios.
It is in response to the above-mentioned risks and reputational considerations that mainstream financial institutions are committing to disclose the climate performance of their own portfolios. Some financial actors are going even further: They are committing to also setting corresponding portfolio targets and to moving to action quickly, such as through the Portfolio Decarbonization Coalition, established in 2014 by UNEP FI, CDP, Amundi and AP4.
One of the main challenges in this space is that the metrics at portfolio level that financial institutions should use to measure and disclose their degree of ‘climate alignment’ do not exist yet; It is still very unclear how exactly investors could convey their alignment and how it could be assessed by regulators and the general public.
Therefore, together with the World Resources Institute, the Greenhouse Gas Protocol, and the ‘2 Degrees Investing Initiative’, UNEP FI is implementing the Portfolio Carbon Initiative that aims to develop carbon risk metrics and a global climate-performance disclosure standard for investors and other FIs.
There is no doubt that, if we want to successfully tackle climate change, we need determined government action on climate change. We count on a successful outcome from COP21. This does not mean, however, that financial institutions can afford to wait and be complacent. The financial sector is too vulnerable to the potential effects of climate change to remain passive.
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