Harnessing the financial system is essential if we are to make a successful transition to a low-carbon, resilient and sustainable global economy. Climate change brings a three-fold imperative for the more than US$300 trillion in assets that make up the financial system.
First, investment in low-carbon solutions (particularly energy efficiency) has to be scaled up to the tune of over US$1 trillion per year. Second, investment needs to be shifted away from high carbon assets. Citigroup has estimated that the value of unburnable fossil fuel reserves could amount to over US$100 trillion by 2050. And third, financial innovation is urgently required to strengthen the resilience of communities to climate shocks: in the world’s poorest 100 countries, less than 3% of the population is served by effective insurance protection against natural hazards.
Overcoming these challenges requires a systemic response – combining both market and policy innovation. Building on its longstanding partnership with the banking, insurance and investment sectors through the UNEP Finance Initiative, in January 2014, UNEP established an Inquiry to identify policy options that would strengthen the alignment between the financial system and sustainable development.
Clearly, mobilising capital for the transition will require action in the real economy to price carbon and natural capital, remove perverse subsidies and introduce ambitious sectoral policies to attract sustainable investment into energy, buildings, industry and agriculture.
Public finance is also essential, particularly in terms of international flows of funding to support action in developing countries. Reforms within the financial system are also needed to complement these key strategies – and the task of the Inquiry was to identify steps being taken by financial system rule-makers, such as central banks, regulators and standard-setters, to incorporate sustainability factors into the fabric of the financial system.
What the Inquiry found was a ‘quiet revolution’ in policy and practice, captured in its global report, The Financial System We Need.Twenty-seven of the world’s leading stock exchanges are now working together to include sustainability into their listing requirements for companies. Sixteen banking regulators from across the developing world are incorporating social and environmental factors into risk management. And regulators across 14 jurisdictions now require pension funds to disclose information on their approach to environmental, social and governance (ESG) issues.
As Mark Carney, Governor of the Bank of England commented recently, “green finance cannot conceivably remain a niche interest over the medium-term.”
Looking ahead, the tasks for financial system reform in the face of climate change can be summarised as the 4Rs of capital raising, enhanced responsibilities, strengthened risk management and systematic reporting.
Capital Raising: Considerable financial innovation will be required to mobilise the sums required for the transition. A critical arena are the world’s US$100trillion debt capital markets, where issuance of ‘green bonds’ grew three-fold in 2014 to US$36bn. This is set to be exceeded in 2015. New voluntary principles and standards are emerging to ensure market integrity – and with the Climate Bonds Initiative, the Inquiry has highlighted 10 steps that policymakers can take to expand the green bond market.
Enhanced Responsibilities: Greater clarity is also needed on the responsibilities of financial institutions for managing sustainability factors. In the investment world, a landmark report on global practice published this year concluded that “failing to consider long-term investment value drivers, which include ESG issues, in investment practice is a failure of fiduciary duty”. More broadly, sustainability needs to be embedded in the values, incentives and skills that drive financial culture.
Risk Management: Leading banks, insurers and investors are intensifying the ways in which they respond to climate risks. For example, the Portfolio Decarbonisation Coalition has brought together institutional investors seeking to cut carbon emissions inUS$220bn of assets by COP21. Policymakers can help to strengthen this trend by encouraging the use of sustainability stress tests – assessments of the impacts on financial assets and institutions of a range of environmental factors, such as air pollution, carbon emissions, natural hazards and water stress. France is the first country to announce that it will include climate factors into the routine stress tests for its banking sector.
Systematic Reporting: Better flows of information underpins all of these tasks – enabling consumers to pick the right financial products, investors to make informed choices and regulators to assess the threat to the resilience of the financial system from climate disruption. One of the key developments in 2015 has been the decision taken by the Financial Stability Board to propose a new climate disclosure task force. This will carry out a stock-take of existing practice, identify the needs of users of climate information and potentially develop common disclosure principles.
Taken together these steps will not just help to ensure a smooth transition to a climate secure economy, but could also contribute to the efficiency and effectiveness of the financial system as a whole.
