UNLEASHING CLIMATE CAPITAL NVIRONMENTAL FFAIRS

Dr Dambisa Moyo A three-pronged approach for unleashing climate capital

ENVIRONMENTAL AFFAIRS

UNLEASHING CLIMATE CAPITAL

AUTUMN 2021

Tariq FancyWhy ESG initiatives are a dangerous distraction

Guy Opperman MPThe role of pensions in mobilising climate capital

Rt Hon Dame Andrea Leadsom MP and Rt Hon Amber Rudd The case for a carbon offset kitemark

Mark CliffeHow central banks underplay climate risks


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W W W . P O L I C Y E X C H A N G E . O R G . U K

COURSE CORRECTION

When we began Environmental Affairs, our aim was to acknowledge the fact that environmental issues now touch on almost all areas of policy and therefore we must hear from experts in those other areas, as well as environmental specialists. It should be no surprise, then, to hear the occasional disquiet of our writers when faced with the application of ‘green’ concepts in their respective fields of expertise. That disquiet is on vivid display in the pages of our new edition.

Asked to consider policies surrounding ‘climate capital’, and the need to reform the financial system to help address climate change, several of our contributors took the chance to cry ‘foul’ at the current state of the Environmental, Social and Governance (ESG) investment agenda. As a result, this edition is no paean to ESG. Rather, it is clear from many of our essayists - each of whom sees climate change as a very real threat - that ESG is a mess.

In the thirteen years since the financial crash, there has been much soul-searching over the proper role and responsibilities of capitalism in society. Over the same period, the climate crisis has gained political and popular traction, providing an ideal issue on which companies can display their credentials as thought leaders, technologists and change makers. The resulting mix of strategies has created mass confusion about what matters, what works, and what does not. A lucrative industry has grown up around ESG, from the financial firms selling green-labelled products to the data firms measuring them, to the consultants advising a confused market.

A confused market is filled with dangers for the buyer and the seller, as George Akerlof pointed out in his 1970 paper, The Market for Lemons. Buyers don’t trust what’s on sale, so they demand lower prices to limit their risks. Sellers are under-incentivised to invest in and deliver high-quality goods (Akerlof ’s ‘peaches’), and so buyers face a degrading market (increasingly full of what Akerlof called ‘lemons’).

In the context of sustainable finance, a clearer price signal combined with reliable accounting, such as a system-wide carbon price, would cause the market to self-correct, at least in part. But that price signal is absent from the aggregate global marketplace and so it continues in confusion.

There is no shortage of buyers for things like carbon offsets, as former Energy Secretaries Amber Rudd and Andrea Leadsom point out in their essay, but the paucity of information about how effective offsets are means that Akerlof ’s ‘lemons’ are turning

up in large numbers. Many carbon offsets are unworthy of the name. Rudd and Leadsom call for a kitemark to assure buyers when they are getting peaches.

Credulous buyers are being sold misleading ESG products more widely than carbon offsets, as BlackRock’s former CIO for Sustainable Investing Tariq Fancy argues. His experience and research suggest that the current approach to ESG investing may be doing more harm than good by convincing voters that corporations have the climate crisis in hand. Fancy calls ESG initiatives a ‘dangerous distraction’ that undermines democratic pressure for governments to intervene.

Judson Berkey notes that sustainable finance has come a long way, but still finds its way down rabbit holes such as green taxonomies, and is in need of better alignment methods.

Solutions lie in a range of places, from Mark Cliffe’s arguments in favour of far more accurate and practical central bank stress tests, to Ben Caldecott’s call for mandatory company transition plans, and Mauro Cozzi’s prioritisation of data on supply chain emissions.

As Lynsey Jones makes clear, financial services are reflecting the real world - their actions are a symptom of policies in the real economy and campaigns against them can be counterproductive. Ed Birkett and Benedict McAleenan similarly stress the limits of divestment campaigns, which hide away polluting assets that still operate viably, rather than confronting the fundamental economics. Guy Opperman agrees, and argues that pension funds are among the best-placed to help to manage down such assets within a responsible transition.

Almost all of our contributors make one point clear: that governments must take the lead on coordinating the green finance agenda. It is not enough to leave it to financial institutions to feel their way to a climate standard. Economist Dambisa Moyo, our opening essayist, sets the agenda clearly, with a stable framework that gives market signals about the direction of travel, whilst allowing companies space to innovate. They can invent technologies and build business models that will end climate change, but companies are not proving able to self-regulate their way to Net Zero. If governments are to unleash private capital for the climate, they must start leading the way.

Editor

Much-needed new approaches to sustainable finance are emerging, but public policy must play a key role.

mailto:[email protected]


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Course Correction 3Much-needed new approaches to sustainable finance are emerging, but public policy must play a key role

A Three-Pronged Attack 8Dambisa Moyo makes the case for a new policy and market environment designed to unleash climate capital

The Case for a Carbon Offsetting Kitemark 16The UK needs to lead the way in creating a gold standard for carbon offsets, say former energy secretaries Andrea Leadsom and Amber Rudd

A Dangerous Distraction 19Companies are creating a misleading narrative that they can change the world through ESG initiatives - governments must make systemic change, writes Tariq Fancy

The Long Game 24Pensions are the key to sustainable finance and getting us to Net Zero, argues Guy Opperman

Building Bridges to the Future 28Sustainable finance policy and regulation need better alignment mechanisms, argues Judson Berkey

Net Zero Transition Planning should be Mandatory Across the Economy 30Risk management does little to achieve climate outcomes, argues Ben Caldecott

Grasping the Nettle on ‘Scope 3’ 33It’s time to get real on the world’s hardest-to-reach emissions

CONTENTSUnleashing Climate Capital | Autumn 2021


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Why Finance is the Solution to Climate Change not the Problem 36Financial firms are reflecting the real economy and public policy - governments need to set the new trajectory, writes Lynsey Jones

Stressful Tests 39Banks need to recognise that climate risks are bigger and more pressing than the central banks’ stress test scenarios suggest , says Mark Cliffe

The Limits of Divestment 46Unlike divestment, transition plans can actually deliver substantial emissions reductions, argue Ed Birkett and Benedict McAleenan


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Judson BerkeyJudson Berkey is Group Head of Sustainability Regulatory Strategy at UBS. He was previously a policy analyst at the Institute of International Finance. Judson is a graduate of Harvard Law School.

Ed BirkettEd Birkett is a Senior Research Fellow, Energy and Environment at Policy Exchange. Ed joined Policy Exchange in 2020 after spending a year at Harvard as a Kennedy Scholar. He was previously a developer of large-scale solar and energy storage projects.

Lynsey JonesLynsey Jones is Climate Programmes Manager at the Conservative Environment Network (CEN), leading their work on transport and finance policy. Prior to joining CEN she worked in Parliament for several years as a researcher for two Secretaries of State for Transport.

Ben CaldecottDr Ben Caldecott is founding Director of the Oxford Sustainable Finance Group and the Lombard Odier Associate Professor of Sustainable Finance at the University of Oxford. Since November 2019 he has been seconded into the UK Cabinet Office as the COP26 Strategy Advisor for Finance.

Mark CliffeMark Cliffe is a board advisor and thought leader on the impact of disruptive change. He is an Advisory Board member at Project Syndicate, Helmsley Partners and Nimbus Ninety and a CEPR Associate Fellow. He was previously Chief Economist and Global Head of Research for ING Group, having earlier led similar teams at HSBC and Nomura Research Institute.

Mauro CozziMauro Cozzi is the CEO and co-founder of Emitwise, a machine learning technology that enables companies to automatically measure, report and reduce their carbon footprint across their operations and supply chain, future-proofing businesses for a zero-carbon world.

Tariq FancyTariq Fancy is the founder of The Rumie Initiative, a free and open microlearning platform that helps underserved communities around the world to access education. He previously served as Chief Investment Officer for Sustainable Investing at BlackRock.

CONTRIBUTORS

Andrea LeadsomThe Rt Hon Dame Andrea Leadsom DBE MP is the Member of Parliament for South Northamptonshire. She has served as Secretary of State for Business, Energy and Industrial Strategy, Leader of the House of Commons, Secretary of State for Environment, Food and Rural Affairs, Energy Minister and City Minister.

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Dambisa MoyoDr Dambisa Moyo is co-principal at Versaca Investments. She serves on several corporate boards including 3M Corporation, Chevron, Conde Nast, and Oxford University Endowment’s investment committee. She has authored four New York Times bestselling books. Her latest is “How Boards Work - And How They Can Work Better in a Chaotic World”.

Benedict McAleenanBenedict McAleenan is Senior Adviser, Energy and Environment, at Policy Exchange and Editor of its Environmental Affairs journal. He is also Managing Partner of the political risk firm Helmsley Partners.

Guy OppermanGuy Opperman MP is Parliamentary Under-Secretary of State for Pensions and Financial Inclusion at the Department for Work and Pensions. Guy is the Member of Parliament for Hexham, a seat he has held since 2010. Prior to serving in Parliament, Guy worked as a barrister.

Amber RuddThe Rt Hon Amber Rudd served as Member of Parliament for Hastings and Rye between 2010 and 2019. During that time, she served as Secretary of State for Energy and Climate Change, Secretary of State for Work and Pensions, and Home Secretary. Since leaving elected office, Amber has taken on roles advising several firms in the energy and technology sectors.

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E N V I R O N M E N T A L A F F A I R S

There is not a single room of policy makers, corporate board members, or investors that I have been in where people are not subscribed to the importance of a low carbon future, and the urgency of the transition to a global economy that is rooted in sustainable energy.

However, the global climate challenge facing the world, and policymakers in particular, is hugely daunting.

To put the climate threat into context, consider that today:• We are consuming the equivalent of 100 million barrels a

day of oil; with fossil fuels representing 80 percent of the existing energy stack supply.

• Global emissions are over 50 billion tonnes a year – and worldwide emissions increased, despite global quarantines due to the COVID pandemic between 2020 and 2021; and worryingly that, “Global net human-caused emissions of carbon dioxide (CO2) need to would need to fall by about 45 percent from 2010 levels by 2030, reaching ‘net zero’ around 2050,” according to the IPCC.

• The International Energy Agency (IEA) estimates that the energy transition alone could require US$5 trillion of investment every year if we are to achieve net zero by 2050. This is more than double the annual investment of US$1.9 trillion made today.

• There are over one billion people – or 15 percent of the world’s population – that today lack access to energy and power supply in an affordable, sustainable and reliable way.

• The World population is continuing to expand and expected to reach 9.8 billion by 2050 - increasing the risk of consigning billions to energy poverty, with real consequences for living standards, access to education, and healthcare and worsening inequality.

Against this stark backdrop, it is perhaps unsurprising that the UN Secretary General António Guterres described the current outlook as ‘code red for humanity’ as the UN’s Intergovernmental Panel on Climate Change (IPCC), released its climate change report in August 2021.1

Why Public Policy MattersThe energy transition means, in practice, that the world has to transform how it consumes energy across global industry, transportation, electricity and how we heat and cool buildings.

Public policy, technology, and consumer preferences are the three levers that have the greatest influence on how we address climate action.

Of the three, public policy arguably matters the most because it has a direct impact on the energy transition- say by steering greater public investment in the direction of green initiatives; and as policy mandates can also indirectly alter and catalyse both technology and consumer preferences.

For example, policy can provide incentives - such as tax

By Dambisa Moyo

A THREE-PRONGED ATTACK

Dambisa Moyo makes the case for a new policy and market environment designed to unleash climate capital

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benefits, subsidies, or even outright bans - for consumers to adopt newer technologies. It can also drive shifts in behaviour and curb use of conventional carbon-based fuels.

In particular, governments are implementing policies that favour low carbon energy technologies through financial support, subsidised infrastructure, zero carbon building codes, and bans on combustion engine vehicles.

According to the IEA, 55 percent of the cumulative emissions reductions required to achieve Net Zero by 2050 could come from consumer choice alone.

Moreover, setting the right policy environment is also crucial to urgently drive climate action at scale and with speed, as well as to change the tone of the conversation.

Too often policy steps towards climate action are reactive, and focused on risk mitigation. And too rarely on proactive investment opportunities with an eye towards innovation and breakthrough technologies; such as blue and green hydrogen, extending battery life duration, and small reactor nuclear generation IV innovations.

Of course, an investment thesis for climate action must address water scarcity, extreme weather events, and the risks of

increasing emissions. For example, many companies are already making strides around disclosing Scope 1, 2 and 3 emissions, which includes the complex job of measuring emissions associated with suppliers and customers.

And there are, to be sure, returns to be generated from efforts in risk mitigation – in terms of operational efficiencies, cost savings, improvements in water and energy usage, and societal benefits such as cleaner air.

However, the path to Net Zero by 2050 is steep – and if the world relies too heavily on risk mitigation, which could shrink the global economic pie, and not enough on investment, we will struggle to achieve it. Therefore, investment in climate action, which could expand the economic output, is critical, and the real upside for business and society are investments in innovation.

Good policy must be at the core for the shift from risk mitigation to investment in innovation to happen, and unleash climate capital, and thus is the foundation of the Green Industrial Revolution. The hallmarks of good policy are that it is clear, transparent, time consistent and ultimately supports private investment in research and development; fostering long-term fixes not short-term wins.

The energy transition as defined by IEA analysis, means that to reach net zero in thirty years, fossil fuel use must fall from 80 percent of energy supplies today down to just 20 percent by 2050. This pace of change is fraught with both enormous economic and political risks.

Globally, 80 percent of energy supply today (mostly from fossil fuels) is produced by majority state-owned enterprises such as Saudi Aramco, Petrobras of Brazil, China’s CNOOC, PDVSA in Venezuela and NNPC from Nigeria, whereas private corporations produce roughly 20 percent today. Climate policies in these countries are not just matters of market regulation, but

The hallmarks of good policy are that it is clear, transparent, time consistent and ultimately supports private investment in research and development

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directly affect fiscal stability. In most of these places, climate policy is a fraught political question. Diplomatic and cross-border approaches must recognise that these state interests often dwarf private enterprise.

However, good policy can resolve macroeconomic and political hurdles, which is why it is so essential to navigate the transition and ultimately enable the world to achieve future energy supply and Net Zero scenarios.

On the economic side, good policy can help reduce the green premium; the cost difference between relatively cheaper fossil fuel energy sources and more expensive renewable sources such as solar, offshore wind, hydrogen, geothermal, biofuels, battery and nuclear.

By encouraging smart investments, good policy can upgrade the regulatory environment and tackle the cost constraints that still today make renewable energy sources unaffordable and cost prohibitive and thereby unable to scale.

Tax incentives, subsidies, transparent regulation, first loss guarantees, global accounting standards on disclosures, regulatory capital requirements can, at a minimum, support financial institutions, private equity firms, asset owners and managers, to better manage how they deal with climate change risks, while encouraging investment in the energy space.

Policy efforts in the financial capital markets have already led to record increases in the ESG debt market. Global ESG bond issuance has skyrocketed from US$270 billion in 2019, to over US$3 trillion ESG debt market in 2021, and with this has come tighter spreads and costs to borrowers.2 No doubt, improvements in financial regulation, such as tax breaks on green bonds akin to those prevalent in the US municipal bond market, could further accelerate and support the expansion of the green bond capital markets.

Good policy can also catalyse private equity investments needed to find and fund research and development in technological innovation, which will be crucial in the energy transition (including decarbonization and carbon capture) of the world’s economic and energy systems.

Additionally, public policy is central in not only supporting efforts towards innovation, but crucially helping to ensure that these technological breakthroughs, and bringing renewable power online, can happen at scale, supported by 21st century public goods including modernizing manufacturing, buildings, logistics infrastructure, and a skilled workforce.

Crucially, good policy can also help manage divestment in conventional energies such as coal to ensure a smooth transition that is consistent across borders. Done in a haphazard way, disinvestment in conventional energy companies and assets lowers investment in the global energy system, leading to supply shocks, creating shortages, and driving up what is becoming referred to as Net Zero or Green Inflation, thereby worsening peoples living standards and consigning more people to energy poverty.

With respect to geopolitics, good policy can not only smooth over the political contours of managing the energy transition within a country, but also between countries.

With multilateral institutions such as IMF and World Bank having seen their influence challenged over the last two decades, it is essential that national leaders continue to come together and lead policy development beyond COP26.

Specifically, policies that take a global view can help contend

with geopolitical schisms between developing and developed economies. The former are largely poor and heavily dependent on cheaper, carbon-based, energy sources to boost their economic chances. The latter, having reached higher economic levels, have greater degrees of freedom to balance the trade-offs between economic needs and environmentalism, and thus more latitude to be more aggressive in the pursuit of climate action.

Savvy policy also sets up an environment where climate investments – done right – will not only speed up the energy transition, but also counter the international knock-on effects from energy poverty – including disorderly migration and geo-political conflict. For example, it can support affordable debt packages and investment in distributed renewable energy systems that enhance energy security rather than exacerbating energy dependence.

All in all, because the world clearly needs need greater public and private investment to scale up renewable power, it is imperative that we foster a policy environment for unleashing climate capital. Good policy is the centrifugal force that will help global companies and investors make better capital allocation decisions. Moreover, public policy can help investors worldwide shepherd roughly US$50 trillion, which, according to JP Morgan, is today earmarked to Environmental, Social and Governance (ESG) priorities - much of it aimed at climate action.

For example, policy can set stronger and more consistent standards for ESG investments. It could also, as discussed later, reward investors for leaning towards investment targeting innovation rather than simply screening out fossil fuels.

In what follows, I offer three specific ways in which public policy can support the energy transition and double down on efforts to avert a climate disaster.

These are: first, to instil policies toward more transparent carbon pricing; second, to put in place a more principles-based, as opposed to rules-based, regulatory environment; and third, to strengthen the corporate governance framework so as to bed down better oversight of company efforts toward a low carbon energy system and future.

The Case for Transparent Carbon pricingGovernments, businesses, and individuals, have never been fully expected to account for their carbon emissions.

This opacity has clearly contributed to market mispricing, and the negative externalities of pollution and carbon emissions contributing to the climate crisis today.

Having a visible carbon price reduces opacity, and better reflects the true costs of energy supplies, as part of the normal course of the market. While financial market transparency has its undisputed benefits, we should not discount the shocks that

Good policy is the centrifugal force that will help global companies and investors make better capital allocation decisions.

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more energy pricing can bring, and thus the important role policy must play in this regard; such as smoothing market disruptions.

For example, according to the IEA, the quest to reach Net Zero will require CO2 prices (such as carbon taxes) in advanced economies rise from currently approximately $10-$60 per tonne to $130 per tonne by 2030 and globally to at least $200 per tonnes by 2050.

Such a trajectory needs policy transparency, public investment and space for innovation, to help companies to quickly adopt new low-carbon technologies. Without such policy supports, the consequences of such an enormous cost jump would constrain supplies, undermine businesses and their business models and has considerable implications for what individuals and businesses will pay for energy.

Attempting to price carbon costs into our economic models is a pursuit of more accurate economics.

However, carbon emissions are so fundamental to our way of life that this must be applied to the whole economy, not just certain business models such as transportation, utilities, and construction. Unless this happens, capital allocation will not be efficient.

Applying a carbon tax or emissions trading scheme to price carbon can be fiercely complex and may need to be iterative. Yet

once applied, it creates more transparent market signals, and thus a clearer picture for business to make capital allocation and human resource decisions.

As a practical matter a 2018 paper by Policy Exchange found that a carbon border adjustment mechanism (CBAM), by which imports would be taxed at the border to ensure they paid the same carbon price as UK producers, would clear out web of subsidies, levies and rules. Explicit carbon pricing and its simplifying effect might never be universal, but it will be a step in the right direction.

Crucially, an international approach to carbon pricing will lower the regulatory risks of operating across borders. Simpler, shared standards, such as common carbon prices, alleviate the trade impact of borders and would help to mobilise, rather than hinder, capital allocation.

A global treaty on carbon pricing seems nowhere on the horizon, but the blunt force of CBAMs may push more governments to adopt their own carbon pricing regimes. As the EU proposes a CBAM, Australia’s awareness that 30% of its exports go to Europe has driven the carbon pricing conversation into its political mainstream.

A proposal from the OECD suggests that the EU should recognise policies such as coal phase-out as equivalent to its own carbon pricing (in order to avoid trade barriers with countries that lack explicit carbon prices), but reliance on implicit pricing in this way will not create the simplicity that businesses need to allocate efficiently.3

Fundamentally, it is the job of governments to set the market framework; and to do so as broadly as possible so as to allow private enterprise, competition and the public welfare that springs from them. If societies care about climate change, then this can be built into the market through carbon pricing.

Governments must not shirk this responsibility and pass

Simpler, shared standards, such as common carbon prices, alleviate the trade impact of borders and would help to mobilise, rather than hinder, capital allocation.

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it to companies, who must grapple with a mosaic of vague and blurry ESG standards in lieu of a clearer price signal. The resulting confusion is predictable and means efforts are suboptimal and even ineffective in combatting climate change.

Politicians must set a fair and accurate economic model by pricing carbon into market design, then letting companies get on with what they’re good at. That is, harnessing the genius of allocating capital and generating real risk-adjusted financial and societal returns.

Towards More Principles-Based RegulationAfter the broad market framework is set in favour of a more accurate economics that includes priced externalities, then we must think about how regulators go about their climate action efforts, particularly in the financial sector but in many others too. Should they issue detailed legal checklists, or provide guidelines on broader expectations about good behaviour?

A regulatory regime based on the intention literally to “rule out” anything undesirable and “rule in” today’s most suitable technologies is unlikely to deliver the innovative flexibility and space needed for an unprecedented, rapid shift toward net zero technologies.

Such a stance risks constraining the investment marketplace to the technologies and logic of yesterday. No doubt a rules-based approach makes a business landscape arguably clearer and more predictable, which might appear attractive qualities under the Rule of Law. But it can also be limiting, conducive to a check-box culture and requires the presence of lawyers at every turn.

The rules-led regulatory model is largely championed in the European Union, emerging naturally from the French legal model. Indeed, it is part of the bloc’s geopolitical strategy: to combine the gravitational draw of 500 million affluent consumers with the regulatory heft of the European Commission.

By doing so, companies around the world will find it simpler to understand the EU business environment. GDPR is a case in point, with the data regime slowly emerging as a global standard far beyond European shores. CBAMs are another more positive influence, with the EU developing the first major such system.

However, there is a danger that the EU’s approach to a ‘green taxonomy’, which builds a high fence around acceptably ‘green’ technologies, will also create such a draw despite its many inconsistencies, ideologies and political risks. It is an example of a strict prescriptive and precautionary model that could undermine global innovation and progress on climate and other fronts.

Rules tend to focus on what you cannot do and this encourages a risk mitigation mentality rather than promoting innovation.

The alternative is principles-based regulation (PBR), which sets its focus on expectations of behaviour and standards, rather than specific rules. This brings advantages for those looking to regulate whilst supporting the freedom of the firm to innovate.

Principles-based regulation has been championed by the UK and is an evolution of its common law approach, which learns and adapts over time. It seems no coincidence that the first industrial revolution began in the framework of such a legal system, and it is well suited to support the next – the Green Industrial Revolution.

The advantages of principles-based regulation are many,4 but for our purposes the two leading benefits are allocative efficiency and cross-border application. Under PBR, it is up to the firm to find the best way to fulfil expectations, finding the most efficient way to do so. This lowers the cost of compliance, but also prevents a box-ticking and risk-averse culture that limits imagination.

Equally, the costs of doing business across borders are lowered when common principles are in place in each jurisdiction, which is far more plausible than exact rules and detailed regulations. In essence, supporting cross-border exchanges of ideas and enhancing global commerce. Just as with carbon pricing, comparable regulatory regimes make it easier to invest in emerging markets without creating conflicts with ESG expectations.

A clear example is the “carry trade” in a globalised world: the ability to borrow at low rates in developed economies and invest that capital in higher-yielding emerging markets. This arbitrage has benefits for climate justice as capital is channelled to poorer economies, but is hampered by rules-led regulations. Post the 2008 financial crisis, for example, stricter capital rules

for banks have made it harder for capital to flow as prescribed by the carry trade. National focus among financial institutions forces corporations to overhaul how they fund their international operations and return capital to shareholders.

If we want to decarbonise the developing world – and indeed the world in its entirety – and compete with Chinese dominance in these markets – then PBR helps emerging countries to operate on more level terms with richer countries and creates ESG visibility in the process.

Principles-based regulations certainly have their drawbacks. They can tend towards sclerosis as supplementary guidance requested by firms solidifies into de facto rules – a phenomenon that may have contributed added to the 2008 crash. To avoid this, they must be reviewed and refreshed often, and such unnecessary layering should be resisted.

A leading example in the latest generation of PBR is the UK Financial Conduct Authority’s Senior Managers Regime (SMR). The SMR expects boards to assign roles for climate action to designated senior managers, among other measures. This is not light-touch – an accusation often levelled at PBR – but the assignment of agency and personal responsibility.

Similarly, the UK’s Prudential Regulation Authority’s Supervisory Statement on climate risks makes it clear that firms are expected to lay out their exposure and plans to manage climate-related risks, or face regulatory intervention. Yes, this is risk-focused, but its approach leaves space for companies to

The UK is far from the only proponent of principles-based regulation. Its common law counterparts, especially in the Anglosphere and the Commonwealth, would likely welcome a diplomatic push in favour of such an approach.

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identify upsides.The UK is far from the only proponent of principles-based

regulation. Its common law counterparts, especially in the Anglosphere and the Commonwealth, would likely welcome a diplomatic push in favour of such an approach.

As part of its ‘Brexit freedoms’, the UK should lead an informal coalition of such nations, including the US, Australia, Canada and much of the Commonwealth. These countries must consciously resist the straitjacket of rules-led ESG regulations, and unlock their capital markets to beat climate change.

With carbon pricing built into the economic design of markets, and with principles-based regulations setting behavioural expectations of firms, this leaves the firm itself to take up the gauntlet. There is a growing role for boards to lead the development of long-term strategies and cultures that reflect societal expectations and thereby protect the firm’s social ‘licence to operate’.

Company Board-level Governance and StewardshipIn economics theory, Coase’s theorem argues that there are costs to society that everyone bears, but the responsibility for the costs is unassigned, so no one does anything about it.

Coase says that to deal with these negative externalities we need to identify and give the problem to someone to solve: it doesn’t say who to give it to; but that we should make them own the consequences. Ideally, the entity to give the risk to is the one who is best equipped to manage it.

A confluence of factors mean that the private sector and businesses, have largely been assigned the cost of climate change, and therefore assumed the responsibility of catalysing climate action and driving climate change, de facto if not de jure.

These include:

• Geopolitical fissures and the absence of agreement by the international community on how best to address climate change. This is particularly worrisome given the lack of consensus among the leading advanced economies underlined as competing interests and differing approaches ahead of COP26.

• Additionally, there is the absence of agreement between the world’s worst CO2 emitters – China and the US, who together represent nearly 40 percent of global emissions – on how to convincingly address the climate challenge.

• The fact that only a few countries have explicitly and publicly announced net zero targets alongside appropriate plans for achieving them, and that the US commitment to the Paris climate accord has been inconsistent under different administrations, means there is a policy vacuum that corporations step into to try and tackle climate concerns.

• Global corporations have also picked up the climate baton as they face relentless expectations from institutional investors, pension funds and endowments, increased scrutiny by regulators, and they remain under pressure from society writ large, to curb their emissions and overhaul their business models to become greener.

• Climate action campaigns press for greater disclosure, and push for action and demonstrations to show that companies are drastically cutting their emissions and making concerted efforts to upend their use of the existing, traditional energy sources.

• Anti-fossil fuel campaigns push for more aggressive stress tests and even threatening defunding and divestment from companies – and in particular banks and traditional energy companies – in a dogged quest to speed up the energy transition at any cost.

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As a consequence, companies themselves have grasped the nettle moving from economist Milton Friedman’s 1970 doctrine, which in short espouses “the business of business is business” stance to one which embraces the utility of a broader stakeholder regime as enshrined in the Business Roundtable statement in 2019.

With these tectonic changes, and new ESG priorities emerging for businesses, has come a flurry of new reporting metrics, resets in evaluating executive compensation to better measure climate targets, the greening of company operations, and business models to embed water and energy intensity targets, as well as more aggressive investments in renewables.

Still there is more that policy can do to help the private sector optimize its allocation of capital and resources towards profitable returns, while finding sustainable and equitable solutions to the enormous climate challenge.

A key part of this is policymakers making sure that a lack of policy clarity does not (inadvertently) lead companies to make investments today that are undermined by new policy direction tomorrow – and fail to generate real financial returns above the cost of capital.

After all, it is a profoundly dangerous idea that corporations alone will solve the complex dynamic optimization problem of climate change.

There are, to be sure, compelling arguments for corporations and private investors being ideal problem solvers. They generally have and manage resources with foresight – and can look over 10-30 years horizons. They do focus future investments and upside, and are generally comfortable with navigating through uncertainty.

But even so, public policy can help define parameters for better governance for 21st century corporations and the broader business landscape.

Specifically, policy can help improve corporate boards and governance so that: companies move from broad, shorter term commitments and proclamations to target deeper climate change with more specific and measurable (say 5-year) strategic plans; companies enhance disclosures and metrics – so that a company’s performance can be compared against peers, as well as companies in other sectors, and the companies progress over time; boards ensure that companies are driving for innovation and upgrade finances, operations and business models to address climate change; and finally, futureproofing organizations by planning for the transition of assets (bad banks).

Climate action initiatives should be strategic and long-term focussed and not drawn to tactics and short-termism. Boards should act boldly to oppose short-termism by continually setting their sights on long-term strategy.

The average Chief Executive’s tenure in the Russell 3000 index is seven years. That shortens to 5.5 years in the FTSE 100.5 Research by the Financial Times finds that, in high-emissions sectors such as oil, aviation and cement, there will be an average of four holders of the CEO position before the Net Zero target date of 2050. As the newspaper quotes one business leader, this makes climate-related targets “next, next, next, next management’s problem.”6 This doesn’t necessarily lead to a lack of targets and commitments, which abound in the corporate world. But it can keep meaningful ESG action low down on the corporate action plan, creating a mismatch between public declarations and actual capital allocation.

Even 2030, the focus of the Paris Agreement’s Nationally Determined Contributions (the voluntary emissions targets that will be the focus of COP26), is further away than most CEOs’ leaving parties.

As individual C-Suite leaders struggle to see past their own tenures, then corporate boards must do so for them. Otherwise, the ball is effectively being thrown back to governments and regulators. So that, working in concert, regulators and corporate boards could require more detailed climate plans – such as 5-year plans - that could be Paris-aligned.

The G7’s commitment to TCFD shows how regulators can help boards encourage identification of underlying systemic risks to financial stability. Companies should be producing strategic plans that clearly factor in the physical, transitional and liability risks posed by climate change and the societal response.

Better still, firms should be laying out the efficiency gains of climate-related measures combined with other trends. Such opportunities should be built into long-view strategic plans and required by boards as standard.

Short-term approaches and thinking can quickly lend themselves to charges of green washing and worse still misallocation of capital as boards and companies they serve are pushed to invest in renewable assets to demonstrate “green credentials” and burnish their reputations, which in turn can lead to inflation of renewable assets prices and ultimately create bubbles.

Boards must tackle the climate problem with a clear-eyed view of their own role as stewards – responsible for leaving a stronger, healthier firm over the long-term, than they found. To assist in this effort their governance role must be steeped in metrics and disclosures.

Board audit function and committees have detailed metrics for financial performance, operations, and even worker audits.

In the context of climate efforts, the Climate Action 100+ Net Zero Benchmark enables boards to assess the climate transition plans of management – and to anticipate the views of shareholder and activist investors. Such independent data sources are increasingly important for boards that must take a wider view of society’s expectations and a longer view of global trends. The energy trajectory will not be a switch from today’s equilibrium to a future equilibrium, but a transition which will not be linear – and will ebb and flow, and thus must be managed sensibly.

Meanwhile, a leading example of corporate governance setting a responsible climate agenda for firms is South Africa’s King Committee. Commissioning an update to the previous four King reports (a ‘King V’), this time incorporating climate

2030, the focus of the Paris Agreement’s Nationally Determined Contributions (the voluntary emissions targets that will be the focus of COP26), is further away than most CEOs’ leaving parties

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considerations, could be endorsed by governments and industry bodies. The reports help to set a standard of behaviour that large and smaller entities can adopt at the board and senior management levels.

Rebalancing incentives to reflect climate expectations can be done in the short and medium terms, such as altering executive compensation to include 10-year deferred payments that vest only if carbon emissions reach a Paris-aligned metric in 2030.

With the support of policy, company boards have an important role of reminding and emphasising to management that the more options that we have to address and accelerate climate action, the better.

A criticism of the overarching climate agenda is that it lacks an openness to innovation. That current climate action efforts are often prone to a priori picking winners versus losers, rather than allowing/enabling innovation to sieve out the best, scalable, sustainable, cost-effective solutions.

Current efforts and framing necessarily leads to a narrative that “everything renewable is great, and everything fossil fuels-related is awful”- a doctrine that engenders a rush to judgement; even though the reality of what works and what does not, is to large extent not yet known. For example, existing fossil fuel infrastructure can support the production of blue hydrogen, carbon capture and storage, and – through natural gas – can provide a transition fuel in emerging markets where growth outpaces renewable deployment. Moreover, electric vehicle and existing battery technology still relies considerably on fossil fuels – thus we should not be in a rush to jettison fossil fuels which are supporting the energy transition.

In essence, efforts that are too hasty and too doctrinaire could delay the energy transition; and make it harder for society to maximize the chance of finding a sustainable, equitable, and greener solution to climate risk.

Additionally, company boards will be expected to better oversee the transition and how best to manage stranded assets – such as coal through the energy transition. Part of this effort will be around possibly ring-fencing so-called “bad” assets, and managing them down accordingly.

ConclusionEach level of the three-tier market has a role to play: in setting the market framework and the clarity of price signals through carbon pricing; in creating the high-level expectations of firms at the regulatory tier; and in setting the governance framework and company culture and other norms that factor climate into the firm’s short and long-term strategies.

Taken together, in a more joined up, holistic way, these actions help to set a business environment that leaves companies ample space to allocate capital efficiently and create the solutions needed, but with clear expectations of a move to a Net Zero economy.

There are myriad other measures needed, from clear sector-specific policies for Net Zero transition, to new technologies that will make all of the above easier and more effective. However, first we must set the right market environment. The prevailing status quo, often characterised by vague and disparate, non-binding ESG frameworks, is not helping anyone – not least the climate.

Notes1. https://news.un.org/en/story/2021/08/10973622. h t t p s : // w w w.b l o o m b e rg . c o m /p rof e s s i o n a l / b l o g /

game-on-esg-debt-issuance-passes-3-trillion-with-record-speed/3. S.Fleming and C.Giles (September 2021), “OECD

seeks global plan for carbon prices to avoid trade wars”, Financial Times. Link.

4. For a good list of its benefits, see B.McAleenan and B.Caldecott (March 2020), “Capital Shift”, Policy Exchange. Link.

5. J.Plender (August 2021), “Corporate bonus culture impedes the push for net zero”, Financial Times. Link.

6. Lex (September 2021), “Net zero pledges: not even next management’s problem”, Financial Times. Link.

https://news.un.org/en/story/2021/08/1097362

https://www.bloomberg.com/professional/blog/game-on-esg-debt-issuance-passes-3-trillion-with-record-speed/

https://www.bloomberg.com/professional/blog/game-on-esg-debt-issuance-passes-3-trillion-with-record-speed/

https://www.ft.com/content/334cf17a-e1f1-4837-807a-c4965fe497f3

https://policyexchange.org.uk/wp-content/uploads/Capital-Shift.pdf

https://www.ft.com/content/e117a80e-0666-440e-881c-e0f4500c2319

https://www.ft.com/content/083c3972-d729-4867-82dc-a6806b83a7bd

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On the path to ending climate change, we are on the cusp of nothing less than a green industrial revolution. Whether it’s harnessing the wind or hydrogen, or creating ‘green steel’, there are extraordinary leaps being made. History shows us however, that every industrial revolution requires a set of compromises and a lot of difficult choices.

One of those compromises is expressed in the term ‘Net Zero’ itself: to achieve a stable level of carbon emissions in the atmosphere, the world will need to offset some unavoidable emissions. Achieving absolute zero emissions globally by 2050 is impossible from where we are today, but the challenge of Net Zero is definitely within our reach through the use of high-quality carbon offsets, from carbon capture technologies to peatland restoration.

How much greenhouse gas will need offsetting depends on the different scenarios for reducing global emissions. The UN’s Intergovernmental Panel on Climate Change (IPCC), the world’s foremost scientific authority on climate change, expects that the world will need 100-1,000 billion tonnes of CO2 to be actively removed from the atmosphere by the end of the century if we are to avoid catastrophe. That’s equivalent to about 1.4 billion

tonnes per year. To put that in context, the USA’s total emissions in 2019 were around 5 billion tonnes.

This will need to happen whilst we also reduce our other carbon emissions to almost zero, which will require a global switch to zero-carbon energy sources such as renewables and nuclear, as well as finding radical new ways to perform industrial processes such as cement, fertiliser and steel production. Calls for absolute zero are simply not realistic.

Cement, steel and fertiliser (among many other commodities) are so fundamental to our way of life that we cannot just flip a switch. New technologies in those sectors are being developed, but deployment and cost reductions take time. In some cases, we will be pleasantly surprised, as we were in the UK with our rapid innovations and cost reductions in offshore wind. In others, we will be disappointed. But in all circumstances, we must expect carbon emissions to still be around in 2050.

A top priority must be to reduce the damage that we are already doing: our atmosphere already contains too much greenhouse gas, meaning that every new tree grown should be for the purpose of reversing the damage already done, not simply providing cover for yet more emissions. This means that offsets must be used only where carbon intensive technologies are unavoidable for the time being.

The question, therefore, is not whether we should offset emissions, but how we are going to do it. Governance must be water-tight; accounting processes must be rigorous; communication must be crystal clear. Anything less than this risks inaccuracy at best and climate-damaging fraud at worst.

Many major firms have already declared Net Zero targets.

By Rt Hon Andrea Leadsom DBE MP and Rt Hon Amber Rudd

THE CASE FOR A CARBON OFFSETTING KITEMARK

The UK needs to lead the way in creating a gold standard for carbon offsets, say former energy secretaries Andrea Leadsom and Amber Rudd.

Governance must be water-tight; accounting processes must be rigorous; communication must be crystal clear.

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Microsoft has said it will be carbon negative by 2030 and then go on to remove its historical emissions by 2050.1 Shell has committed to being Net Zero by 2050.2 Many other firms have adopted similar goals. This clearly demonstrates the commitment of business as well as the creative spirit of enterprise in achieving Net Zero.

The dates and the details of these individual Net Zero commitments vary, but most of these action plans involve a significant element of carbon offsetting. Yet the market for carbon offsets has a long way to go before an acceptable level of maturity, pricing and accountability is in place.

In a world where investors – both retail and institutional – express a desire for companies to deliver against climate targets, it is a matter of fiduciary duty to ensure that these Net Zero strategies pass muster.

At the same time, consumers are also actively trying to shift their own buying patterns towards firms that share their values on the environment. Government regulation must support their ambition. However, too often firms who make claims about carbon offset are unregulated and unaudited. Not only that but the price of carbon offset can be wildly inaccurate. For example, airlines are offering carbon offset options to passengers that price carbon at around €8-18 per tonne of carbon dioxide3 – a 65-75% discount compared to the EU’s recent traded price of around €55 per tonne.

Decarbonisation should be the first choice for every organisation in the world, ahead of carbon offset. The fact that carbon offsets are currently trading at a significant discount to the traded carbon price is a concern as it results in minimal incentive to decarbonise versus offset. Price discovery is critical to accurately incentivising the right behaviour.

Progress underwayThe EU and UK both operate compliance-based carbon markets. That is, we require certain industries (energy-intensive industry,

power generators and domestic/European aviation) to pay for their carbon emissions via tradeable allowances. The removal of permits over time, not to mention other policy measures, means the price should go up, depending on how quickly new low-carbon technologies fall in price.

Outside these industries, voluntary carbon offsets create a form of carbon pricing. However, as mentioned above, this carbon pricing mechanism is far below the level necessary for a meaningful transition, mainly because the benchmark for offsets is currently set too low. Accusations of greenwashing abound. These markets need maturity and standards if they are to realise their significant potential in fighting climate change.

Well-developed Voluntary Carbon Markets (VCMs) will help to improve transparency and accounting, as well as funnelling private capital into climate solutions beyond compliance industries. These non-traded sectors, such as agriculture and forestry, can also bring a host of co-benefits, from economic development to biodiversity investment and human health improvements.

This also creates a smoother glide path for currently non-traded industries to be brought under the remit of compliance markets later on, which will reduce future policy complexity and economic pain.

Mark Carney, the former Governor of the Bank of England, and Bill Winters, CEO of Standard Chartered, have made huge strides towards developing a better marketplace for carbon offsets. Their Taskforce for Scaling Voluntary Carbon Markets (TSVCM) has made important contributions to setting the necessary frameworks, not least a governance body to help oversee them.

Other programmes, such as the Voluntary Carbon Markets Integrity Initiative (VCMII), the Business Alliance to Scale Climate Solutions and the Carbon Pricing Leadership Coalition, are building on this agenda to develop standards and mobilise finance into Voluntary Carbon Markets. The VCMII in particular

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brings an additional focus on integrity and the need for civil society to help to develop the rules of VCMs.

All of this is helpful in moving the agenda forward, but we argue that the UK Government should take a leading global role in setting a ‘gold standard’ for carbon offsets. This standard should take the form of a UK Government ‘kitemark’ for verified, high-quality carbon offsets. Such an intervention by the UK would send a signal that VCMs have a major role to play. It would also send a signal to the market that those who do invest in high-quality offset products will have the confidence of the state.

Setting the StandardA government-backed ‘British Carbon Offset Standard’ (BCOS) kitemark would provide assurances to buyers and sellers that their carbon offsets had achieved the very highest standard. A product or service bearing the BCOS kitemark would tell its buyer that its embedded emissions had (in part or in whole) been cancelled out through a reliable and long-lasting offset. The kitemark will play an important role in improving the standards of existing voluntary carbon markets.

On the demand side, a BCOS kitemark would provide confidence that funds have been spent well and have made a difference. For example, companies could use BCOS-certified offsets to assure investors that the ‘Net’ in their Net Zero transition plans was meaningful. That will not just provide peace of mind, but protection from future ESG regulatory risks, since it reduces exposure to climate-related public policies.

Similarly, consumers can be confident the carbon emissions from their international air miles or their online shopping deliveries really have been offset using a high-quality BCOS-certified offset . The sale of truly zero-carbon products based on such ‘gold standard’ credentials will likely become common.

The kitemark would also provide confidence on the supply side, since it would effectively provide government assurance to any technologies or business models recognised by the scheme. Everything from carbon capture technologies to peatland restoration projects will be able to attract investment.

Permanent CCS in geological reservoirs could become the gold standard of offsetting techniques, but this requires heavy private and public investment. The UK’s own commitment to carbon capture usage and storage would promote investment, jobs and growth in the UK as a result of a trusted carbon offset sector.

The BCOS would also facilitate investment in partner countries who were ambitious to redevelop their own lost forests, waterways and other precious carbon stores.

Pricing of a global offset market should be subject to clear regulation. Unrealistically low carbon offsets are usually based on poor verification. A carbon price of £5 per tonne is unlikely to cover the costs of ground preparation, planting, protection and long-term management of a tonne of carbon even in such a relatively simply offset as planting a new tree. Carbon pricing should reflect the real costs of offsets spread over a long time period.

A team of researchers at Oxford University has set out four high level ‘Principles for Net Zero Aligned Carbon Offsetting’.4

These ‘Oxford Principles’ make it clear that the focus of offsets should be on removal of carbon already in the atmosphere, not on avoided emissions such as investing in renewable energy projects.

To act as a gold standard, the kitemark would therefore need to focus on carbon removal schemes, not on avoided emissions. Similarly, it should prioritise long-term arrangements such as geological storage or mineralised carbon and long-term legal contracts, such as conservation covenants for land sector projects. It is good to see the UK aiming to include negative emissions technologies in its Emissions Trading Scheme, which would support this approach.

To create momentum and demand for the kitemark, the Government should integrate it into public procurement rules. The UK Government spends £290 billion per year on procurement, and in June 2021 announced that any procurement contract over £5 million should require the counterparty to have a Net Zero-aligned emissions reduction plan. Any such plan is likely to rely, at least in part, on carbon offsets.

The governing body of the BCOS kitemark would police its use and misuse in a similar way to other assurance schemes, such as the Forest Stewardship Council (FSC) and Red Tractor.

Time to set another world-leading standardThe UK has been a leader in many climate-related fields. We have set a world-leading framework for science-led policy through the Climate Change Act. We have substantially decarbonised our electricity system and invested heavily in new technologies, from hydrogen to carbon capture and storage and small modular reactors.

We have committed to decarbonising road transport through a 2030 phase-out of new petrol and diesel cars, which will now be delivered in large part through a California-style Zero-Emission Vehicle (ZEV) Mandate, which will require manufacturers to sell more ZEVs each year.

Finally, the UK has created world-leading standards in green finance. All of these efforts are aimed at reducing emissions and are tested against high standards. Offsets represent the crucial ‘Net’ in ‘Net Zero’ and must meet the same level of assurance. The UK can lead the world in this vital missing piece of the jigsaw on our road to global decarbonisation.

Notes1. B.Smith (Jan 2021), “One year later: The path to carbon

negative – a progress report on our climate ‘moonshot’”, Microsoft.

2. .Ambrose (Apr 2020), “Shell unveils plans to become net-zero carbon company by 2050”, The Guardian.

3. J.Guthrie (Sep 2021), “Why airline schemes for easing guilt over flying are dodgy”, Financial Times.

4. Allen et al (Sep 2020), “The Oxford Principles for Net Zero Aligned Carbon Offsetting”, Oxford University.

the market for carbon offsets has a long way to go before an acceptable level of maturity, pricing and accountability is in place.

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W W W . P O L I C Y E X C H A N G E . O R G . U KE N V I R O N M E N T A L A F F A I R S

“Society is demanding that companies, both public and private, serve a social purpose.” My former boss, Larry Fink, the CEO of BlackRock, wrote that line in 2018 in his annual letter to the CEOs of the world’s largest corporations. It wasn’t the first time someone had said it, but it was the first time that someone whose firm managed over $6 trillion in assets had said it.

Financial institutions like BlackRock wield 75% of the world’s shareholder voting power, on behalf of investors large and small, and BlackRock leads the pack. It owns seven percent of the companies on the S&P 500. As the firm’s Chief Investment Officer for Sustainable Investing, I led the effort to incorporate Environment, Social and Governance (ESG) activities across all the firm’s investment activities. This was exactly where I wanted to focus: if we were successful in showing how we could invest trillions of dollars across different strategies and geographies in a way that achieved strong profits while also creating better environmental and social outcomes, the rest of the industry would follow — reforming capitalism in the process.

Given the boundaries of fiduciary duty, however, in most jurisdictions the concept of social purpose can only be applied to business operations if it helps, or at least doesn’t hurt, investment profits — meaning you can’t forego profits with someone else’s money, even if you think it’s for a good cause. As Nell Minow writes in the Harvard Law Forum for Corporate Governance, the foundation of capitalism is strict adherence to fiduciary obligation, because it “gives credibility to capitalism by addressing

the agency cost risk of entrusting money to others.”So in most major economies, companies are legally obligated

to deliver shareholder value as their primary role. As a group, they have met their obligations brilliantly. From top to bottom, from CEO compensation to divisional budgeting and P&L to managerial targets, structures, and incentives, we’ve built private firms from the ground up to do one thing really well: extract profits. Though many companies deliver great things for society, from low-cost food to groundbreaking medicines to a supercomputer in every pocket, the fundamental measure of corporate success is still profit.

In the face of this unfortunate reality, we led the way in popularizing a new and optimistic view: that companies with better performance on environmental and social issues would enjoy larger profits in the long-term, as there was no disconnect

By Tariq Fancy

A DANGEROUS DISTRACTION

Companies are creating a misleading narrative that they can change the world through ESG initiatives - governments must make systemic change, writes Tariq Fancy.

In most jurisdictions the concept of social purpose can only be applied to business operations if it helps, or at least doesn’t hurt, investment profits

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E N V I R O N M E N T A L A F F A I R S W W W . P O L I C Y E X C H A N G E . O R G . U K

between ‘purpose’ and profits. It was kind of like saying that good sportsmanship in basketball is not at odds with scoring points.

But it was more than that: we argued that companies that embrace sustainability early create more profit for shareholders over the longer-term, which is a bit like saying that good sportsmanship on the court is linked with eventually scoring more points as a result. And therein lies today the glowing promise of “ESG integration” in the industry: it offers better ways to pick out those companies considered to be ‘doing good’, which we argued to be the same as ‘doing well’.

I travelled the world to promote this notion, and our green investment products, which helped BlackRock to stay at the cutting edge of a quickly expanding - and highly lucrative - part of the financial sector. I sincerely believed that while sustainable investing was not perfect, it was a step in the right direction in

the critical question of how business and society should intersect in the 21st century.

Unfortunately, I now realize that I was wrong. The narrative that has built around ESG investing is, in fact, a dangerous distraction from the need for governments to make systemic changes. Our current situation is like leaving it to individual sports players to behave with admirable sportsmanship, even if they have been trained and incentivized first and foremost to score points at all costs. Some will, many will not. The real solution is to change the rules of the game and the incentives of those who play it.

Sustainable investingSustainable investing is a confusing area of finance that often means different things to different people. Most of the time it

means building investment portfolios that exclude objectionable categories, such as ‘divesting’ of fossil fuel producers in an apparent attempt to fight climate change. Unfortunately, there’s a difference between excusing yourself from something you do not wish to partake in and actively fighting against something you think needs to stop for everyone’s sake. Divestment, which often seems to get confused with boycotts, has no clear real-world impact since 10% of the market not buying your stock is not the same as 10% of your customers not buying your product. (The first likely makes no difference at all since others will happily own it and will bid it up to fair value in the process, whereas the second always matters, especially for a company with slim profit margins and high fixed costs.)

Since the early 2000s, many investors have moved past divestment to faster growing areas of sustainable investing,

such as a newer focus on impact and ESG products, all with a general goal of leaning toward or even creating positive and often measurable social impact alongside strong financial returns. Green bonds, where companies raise debt for environmentally friendly uses, is one of the largest and fastest-growing categories in sustainable investing, with a market size that has now passed $1 trillion. In practice, it’s not totally clear if they create much positive environmental impact that would not have occurred otherwise, since most companies have a few qualifying green initiatives that they can raise green bonds to specifically fund while not increasing or altering their overall plans. And nothing stops them from pursuing decidedly non-green activities with their other sources of funding. If the economy is growing, it’s quite feasible that you can increase your impact investments while also increasing your stake in fossil fuels.

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Another red-hot area in sustainable investing allows investors to own baskets of more “responsible” stocks, as Larry pointed out in his January 2021 letter: “From January through November 2020, investors in mutual funds and ETFs invested $288 billion globally in sustainable assets, a 96% increase over the whole of 2019.” Since ESG products generally carry higher fees than non-ESG products, this represents a highly profitable and fast-growing business line for BlackRock and other financial institutions.

Since such products own some percentage less of polluters and low-ESG shares than the relevant market benchmark, the underlying ‘theory of change’ behind these tilts is the same as divestment: trillions of ETFs that adhere to this form of ‘soft divestment’ just aggregate into some fraction’s worth of de facto market divestment. But because they collect baskets of shares already traded in public markets, investing in such a fund does not provide additional capital to more sustainable companies or causes.

A series of other sustainable products across the spectrum of financial assets — from debt to equity, public to private — have all grown in recent years, all with similar promises to also satisfy societal needs in the pursuit of profit, often even measuring a second “social bottom line.”

Despite the popularity of these products, it became clear to me that the degree of overlap between purpose and profit in my own firm’s investment activities was less than I had expected, or could possibly justify the widespread hype. As I moved through meetings with senior managers across the firm to explore how ESG data could improve their investment processes, I saw firsthand that for most investment strategies only a few ESG issues concretely mattered. It sometimes depended on the location: having an animal rights controversy is worse if you’re based in California than if you’re based in China.

Some things are only important when public attention is squarely focused on them: think of how the #MeToo and #BlackLivesMatter movements have elicited hurried responses from companies acknowledging shortcomings in their diversity and inclusion efforts. (And a number of promises that have not been met yet.) The idea of fickle public attention to preserve society’s long-term interests is a prospect that should alarm us all. Senior managers know that the shareholders’ AGM will happen every year with the same reporting and profit expectations, but the media spotlight on any given social topic will keep moving.

It isn’t just the fickleness that causes damage; these business-led initiatives actively undermine societal pressure for more meaningful interventions. Working with Ryerson University and the Strategic Council, a polling firm, we conducted a study in 2020 to better understand public attitudes on building a more sustainable society. The poll included three thousand people of all ages in the US and Canada.

We showed respondents a headline related to Larry’s 2018 letter on purpose and seven other similar headlines around new sustainability initiatives — mostly to do with businesses voluntarily taking the lead and other headlines in the sustainable finance space — and asked them to indicate whether they thought each was helpful in driving social change or not. All eight headlines were generally believed to be helpful. This is even though a number of them were decoys that I asked the polling firm to include in the study, knowing full well that they were window dressing with little to no real-world impact. Most people, it

appears from our research, do not know what works in climate change mitigation and what doesn’t, leaving them vulnerable to ‘greenwash’ marketing.

More worryingly, we used a control group to gauge respondents’ views in the absence of such headlines. In our American sample in particular, exposure to headlines about businesses’ ESG initiatives made people 17% more likely to say that business, not government, will lead the way in building a more sustainable economy. In effect, ESG-related headlines are giving people a false sense that the problem is being addressed, even when those headlines refer to ineffective measures. The ESG marketing is not just ineffective greenwash – it is actively reducing democratic demands for more impactful policies. It is a deadly distraction.

It turns out that a large, multinational profit-making machine that’s built to do one thing really well operates exactly as we should expect it to. If we expect companies to ‘do the right thing’ but the expectation is not enshrined in law in a very specific way, then we should not expect different results.

The fiction of the free marketAt the time of the COVID-19 lockdowns in my home country of Canada, the government did not rely on individuals to choose to ‘do the right thing’ to control the virus. While some of the decisions were ham-handed and seemingly arbitrary, one thing was clear: the experts who were advising our government did not think it wise to leave adherence up to the voluntary good graces of our better selves alone. So rather than relying on voluntary compliance to flatten the COVID-19 curve, our government actively ensured that lockdown measures were mandatory through forced closures and penalties. Those who didn’t adhere to the rules endangered us all, so we were generally fine with stiff

penalties that applied to anyone caught flouting the guidelines.The alternative to mandatory lockdowns was relying on

individuals to be responsible, which would have left us at the mercy of the least socially responsible people in our communities. How we fare in the face of such systemic, societal problems is not defined by the best behaved, but the worst.

If voluntary and individual measures are clearly not good enough to bend our society’s COVID-19 infections curve downward, then why do the experts think that such measures will bend our society’s greenhouse gas emissions curve downward? And there’s the rub. On climate change, just as with COVID-19, the experts are not advising us to leave it to individual, voluntary action. They know that it won’t work. The issue is that we’re not listening to them.

Taking climate change as an example, every serious voice in the elite now claims to believe the science; but few are listening

How we fare in the face of such systemic, societal problems is not defined by the best behaved, but the worst.

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to the policy experts on how we must enact the changes the scientists are telling us we need immediately.

This is William Nordhaus, the American Nobel Prize-winning economist, in a lecture at Stockholm University:

“Economics points to one inconvenient truth about climate change policy. And that is that in order to be effective, the policies have to raise the price of carbon, or CO2, and in doing that correct the externality of the marketplace… I think one of the insights of economics… one that I feel very strongly about… is that if you’re going to be effective, you have to raise the price. Because putting a price on our activities is the only way…”

“We have to get billions of people, now and in the future. Millions of firms. Thousands of governments… to take steps to move in the direction we want. And the only way you’re going to do that effectively is to increase the price of carbon.”

What Nordhaus is effectively saying is that we must change the rules of the game. These are the rules by which every player must abide, or face serious criminal consequences. Carbon pricing is a simple and elegant solution that changes the incentives of all companies in a clear and fair way. Elon Musk has said an internationally effective carbon price would solve the problem of climate change “almost over night”. The reality is of course more nuanced, requiring a broader set of sweeping policy measures, but Musk and Nordhaus are not far off.

What Nordhaus is emphatically not saying is that companies will solve the problem on their own, out of good intentions and a sense of social duty. If you want to change the behavior of all of the players in the game, you have to change the rules of the game for everyone. Instead, on sustainability issues we’re currently being told that our hope lies in standing back and relying on some players sometimes deciding to pursue good sportsmanship, purely voluntarily, even if playing dirty helps them fulfill their legal duty to score maximum points.

I knew for sure that Goldman Sachs CEO David Solomon knew all of this after reading an op-ed he published in the Financial Times in December 2019. After long passages that proudly list various new Goldman initiatives to be greener, he included a curious near-caveat toward the end: “To give us the best chance of combating climate change, governments must put a price on the cost of carbon, whether through a cap and trade system, a carbon tax or other means.”

At this point in the discussion, we’re all brainwashed to say the same thing: Gasp, but wouldn’t that mean that the government

is intervening in the free market? Fixing the rules of this system so that it produces better societal outcomes is not “intervening in the free market” — especially as there is no such thing as a ‘free market’ in the first place. A market economy is at its core a collection of rules. No rules, no market. Just as every competitive sport has clear rules, competitive markets need rules: no rules, no game. Nor is there one set of preordained rules: every rule, ranging from the number of years a new idea gets patent protection to the corporate tax rate, is a deliberate decision that has implications for the outcomes of the system. If we change the rules of the game, we’ll get different outcomes, all of which can be described as market outcomes.

The capital allocation processes that Wall Street and the City manage connect our savings with the most productive uses of that capital in our economy. If you were to tell a portfolio manager to lower the carbon footprint of their portfolio, most will nod their heads and agree it’s important, but then return to allocating capital to the most profitable endeavors. If, on the other hand, a negative externality is “internalized” by the government through, say, a pollution tax, thus lowering the profitability of heavy greenhouse gas emitters, capital allocators will automatically react as fast as they can, allocating less capital to these now less profitable opportunities.

Friedman and societal needsThe voice of the late economist Milton Friedman has dominated the question of social value and capitalism for the last half-century. In his seminal 1970 essay entitled “The Social Responsibility of Business is to Increase its Profits,” he argued that “a corporate executive is an employee of the owners” and that their primary responsibility is to maximize shareholders’ profits. The Friedman doctrine has come to dominate and define Western shareholder capitalism.

What’s most galling about the entire debate is how Friedman’s own message has been mangled. Yes, he said that the sole purpose of a business is to generate profits for shareholders. But that didn’t mean that he thought no one should look out for the public interest: in the very same paper he argued that the responsibility for protecting society fell to civil servants, whose authority business executives should not usurp as such roles “must be elected through a political process.” In fact, he called the idea of business executives taking on this role to be “intolerable” on grounds of political principle.

We are currently seeing this ‘intolerable’ situation play out. A large group of leading CEOs in 2019 signed the US Business Roundtable’s (BRT) statement on stakeholder value, declaring that profit was not the sole purpose of a company and shareholders only one of its many important stakeholder groups. “There were times that I felt like Thomas Jefferson,” said Johnson & Johnson CEO Alex Gorsky, who led the drafting of the BRT’s statement. It’s easy to understand why he felt that way, given the weight of such lofty words. But not enough people have asked a simple question: does it make sense that a CEO should feel like a famous US President? Only one of them is elected by the people. In vital questions about the direction of society, democratic representatives are ceding ground to unelected CEOs.

Perhaps unsurprisingly, the BRT’s social aspirations seem rather far off reality. As Aneesh Raghunandan and Shiva Rajgopal

We should grant ourselves the right to be skeptical, even downright cynical, since we have to make this work.

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point out in the paper “Do the Socially Responsible Walk the Talk?”, relative to their peers, publicly-listed BRT signatories report higher rates of environmental and labor-related compliance violations, pay more penalties as a result, and have been lobbying actively in recent years against a price on carbon, the elimination of tax loopholes, and a number of other initiatives designed to fight climate change and rising inequality. And a new report last September confirmed that since the global pandemic began, BRT signatories have proven no better than anyone else in protecting jobs, workplace safety, and labor rights, or doing anything to redress racial inequalities.

Fix the rulesI left BlackRock in part to help with very real family business issues. Unofficially, I had also privately concluded that there was no point continuing in that role: trying to create real-world social impact through sustainable investing felt like pushing on a string.

Unfortunately, I now realize that it’s worse than I originally thought: the evidence around the deadly distraction made it clear that we weren’t just selling the public a wheatgrass placebo as a solution to the onset of cancer. Worse, our lofty and misleading marketing messages were also delaying the patient from undergoing chemotherapy. And all the while, the cancer continues to spread.

Between now and 2030, the stakes are so high that we should grant ourselves the right to be skeptical, even downright cynical, since we have to make this work. In light of that, the lazy prevailing attitude — that ongoing discussions around “stakeholder value” are automatically steps in the right direction — seems unwise.

I decided to speak out about it because somewhere out there, a kid in Bangladesh is going to bear the consequences of our inaction. Increasing cyclones, floods, and extreme weather conditions will cause her and her family to lose their livelihood and turn into economic migrants - even though they have next to no carbon footprint themselves. I thought that in returning to the finance industry with BlackRock I would have been helping to change that.

Instead, I was contributing to a giant societal placebo that was actually lowering the likelihood that we’d ever implement the kinds of concrete reforms that she and billions around the world need right now, and then working to protect wealthier people’s investment portfolios from the carnage that would unfold as a result. And somehow this was being sold to the public under the

The tools, such as ESG data and reporting standards, can be useful since they help us to start measuring the side effects we need to manage better, and the people, who bring sustainability expertise, are also critically needed

guise of responsible business. In sounding the alarm, my hope is to expose this illusion for what it is: a dangerous fantasy.

Every year, companies invest more and more in sustainability initiatives. The tools, such as ESG data and reporting standards, can be useful since they help us to start measuring the side effects we need to manage better, and the people, who bring sustainability expertise, are also critically needed. But the overarching narrative that these alone will matter without rule changes risks rendering all of these efforts meaningless or even counterproductive. Having coaches who teach clean play doesn’t do much if cheating and dirty play still wins games. Should we wait for profits and purpose to magically overlap on their own, or does an outside and rather visible hand need to enforce new rules of the game to make it happen faster?

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The UK needs a win-win to get to Net Zero and to create real growth around a green industrial revolution. I believe we can do this. UK workplace pensions, which sit under my portfolio as Pensions Minister, will play a massive part. In the pensions space, a combination of green gilts, public-private partnerships, a change to pension spending and our new approach can crack the defining problem of the 21st century.

The UK already leads the world in combatting climate change. We are the first G7 country to legislate for Net Zero by 2050, the first to put climate reporting into law, and have delivered the biggest reduction in emissions in the G7. But we need to change the wider dynamic. Change the perception amongst the public as to the challenge of climate change. This is not a burden we have to carry, but an opportunity to be grasped. And this particularly applies as we are first in the market and therefore have a competitive advantage. How we act now will determine both the climate outcome but also our own returns. And it will shape the political mood of this great country.

As the UK Pensions Minister these last four years I have

placed climate change at the heart of reforms. I am certain we can both drive forward the change but also get us the new growth we are all seeking. There is no doubt that sustainable finance and our pensions industry are uniquely placed to help provide the necessary investment required.

Everyone is now in agreement that if we are to reach our ambitious climate targets, we need to invest in clean energy solutions like wind, solar, nuclear, and hydrogen. The question is how to mobilise that investment.

Major energy projects tend only to be paid for using government revenue, levies on bills, borrowing or by the investment of the vast financial muscle of the UK pensions market. Or a combination of all four. The state paid for the first generation of nuclear power. Subsequently, renewables were developed using widespread government subsidies. But in a post-Covid world financing projects is going to be harder. The British State – like most other countries - is struggling with the £400 billion added costs to the Exchequer because of the pandemic. As a Conservative, I would argue that taxes are already high with the richest 1% already paying more than 25% of the UK’s total tax take, and general taxes having recently gone up to accommodate social care and increased NHS costs. So, finding new tax revenue for Net Zero measures will be difficult. It’s not impossible as I outline below when we discuss green gilts, but, as a government, we must accept that we are working in a constrained fiscal space. Extra borrowing by the government is simply not sustainable long term, until balance sheets get repaired. And the private

By Guy Opperman

THE LONG GAME

Pensions are the key to sustainable finance and getting us to Net Zero, argues Guy Opperman MP

sustainable finance and our pensions industry are uniquely placed to help provide the necessary investment required

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sector has taken a hit from the pandemic too. The capacity of individual companies to spend or even borrow more is limited and likely to become more constrained as rates rise in response to inflation. I accept that some companies have the capital to spend, but the market is a very different place to two years ago. However, there is a way ahead. As a champion of sustainable finance for several years, I have been driving new legislation and advocating for a different type of investment strategy. This work is now producing real change.

In 2018, the Department for Work and Pensions (DWP) started the process of legislating to ensure pension schemes started taking their climate and sustainability obligations seriously. This came in the form of Environmental, Social and Governance regulations (ESG), which I brought into law as Minister. These regulations mean that occupational pension schemes, with more than 100 members, must take due account of climate risk in their investment practices. These must now be included as “financially material considerations” in each scheme’s Statement of Investment Principles (SIP). These reforms are transforming investing. At the same time, there has been a psychological and practical change in the minds of pension scheme trustees and their asset managers. They now fully accept the risks of climate change to UK pension funds.

It is in the pension schemes’ members’ interests that we transition quickly: the reasons are multiple but just focus for now on pension scheme member returns. The evidence suggests that financial returns will suffer in higher climate warming scenarios. This can be seen in several ways. We are already experiencing severe weather events at increasing frequency. These damage physical assets and supply chains, increase migration and conflict, and – in turn – result in losses to pension scheme assets.

Clearly, very soon, the international community is coming together to expand upon the promises made at the

Paris Conference, with the UK hosting COP26 in Glasgow. We will all need to play our part going forward, from the biggest business to the individual consumer with our choices and daily decisions. And there is something that tens of millions of us as British citizens have that can play its role in cutting carbon emissions too: a pension.

This Conservative government has made tangible progress in shaping sustainable finance both to tackle climate change and to ensure a good return for pension scheme members. But these pensions still need investment opportunities. So that is why I and others have been pressing for an alternative investment vehicle. And it is happening; let me give two major examples.

Green Gilts I, and others, have been pressing for a UK government green gilt to provide a venue for such sustainable investing. Green Gilts are raising billions for green government projects like zero-emissions buses, offshore wind, and schemes to decarbonise homes and buildings in this financial year. They are issued to institutional investors such as pension funds and provide a fixed rate of return until their expiry. The UK’s inaugural Green Gilt is a 12-year bond, maturing on 31st July 2033. Other countries such as France are already doing this. And in September 2021 it happened here in the UK.

£10 billion was raised from the sale of the Gilt on the launch day: this was the largest inaugural green issuance by any sovereign, with the largest ever order book for a sovereign green transaction. A second issuance in October raised a further £6 billion with an order book that was 12 times oversubscribed, indicating the huge appetite for such investment vehicles.

By launching the Green Gilt in the run-up to COP26 next month, the UK is demonstrating its commitment to tackling environmental challenges and the vital role that green finance

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plays in this fight. This funding will be used to finance vital green government projects across the country, including things like clean transportation, renewable energy, climate change adaptation, and preserving our natural environment. In helping us to build back better and greener, it will also help to create jobs as we transition to net-zero.

As set out in the Government’s Green Financing Framework, published earlier in the summer, the money raised by the Green Gilts will be used to finance expenditure. But it also massively kickstarts private sector investing, mobilising the considerable reserves that built up during the unprecedented monetary policy conditions of the pandemic. The Green Gilt will be followed later in the year by the world’s first standalone retail Green Savings Bonds, issued by NS&I. These two products will allow UK investors and savers to join the collective fight against climate change while creating green jobs across the country. At present, the Green Gilt does not include new nuclear projects, but I hope that this could change as the partnership to create new nuclear will need considerable government support for the private sector, although the private sector will pay the lion’s share.

Long Term Asset FundAt the same time in September 2021, we launched the Long Term Asset Fund (LTAF) as a venue for UK auto-enrolled workplace pension funds to invest in. This is the product of a year’s worth of work by the Productive Finance Working Group. It is a partnership between government, regulators, and industry, upon which I was proud to participate. It was co-chaired by the Governor of the Bank, the Chief Executive of the FCA, and the Economic Secretary to HM Treasury.

Appropriately managed, investment in such assets has the potential to generate better returns for investors, including those saving for retirement in auto-enrolled Defined Contribution (DC) pension schemes, given their typically long-term investment horizons. These types of pension schemes are an increasingly important vehicle for saving for retirement, given their assets have increased from around £200 billion in 2012 to over £500 billion today, and are expected to double to £1 trillion by 2030.

Investment in productive finance assets can also benefit the wider economy by facilitating the transition to Net Zero technologies and infrastructure. Without a doubt, this can provide a boost to long-term growth and support an innovative, greener future for the UK. Don’t take my or the Chancellor’s word for it: this idea has the backing of the industry, from the Investment Association to Hargreaves Lansdown to the managers of large pension schemes like the Tesco Workplace Pension Scheme.

The LTAF is also designed to bring other advantages. There is growing international demand for access to long-term assets such as infrastructure and building projects, so structures such as the LTAF will help the UK to keep its place as a leading global centre for asset management, linking to wider important opportunities such as the development of green finance as part of the wider focus on sustainable long-term growth. Investment in Net Zero is a part of this. In short, opportunities exist to market this and benefit from it in every way. And I am sure future long-term asset funds can be bigger and better.

Putting the consumer in chargeSome might argue that what I have outlined is very ‘techy’, and not accessible to the consumer. In other words, the normal man or woman in the street. But whether they are on the Clapham Omnibus or down the pub they still care about what is happening to get us to Net Zero. To fix that we have introduced climate-based financial reporting. This was started with the Pension Schemes Act 2021, which was passed through Parliament in January. It makes pensions safer, better and greener. It also empowers the consumer. The background is as follows: To facilitate the world in helping to get to net zero, the Task Force on Climate-related Financial Disclosures (TCFD) was set up and its recommendations established a framework for declaring the potential impacts of climate change on the financial system. It is supported by many key figures and organisations, from the World Bank to the G20 Financial Stability Board, and the UK government’s climate change adviser, Mark Carney, the former Governor of the Bank of England. I met with Mark in January 2020 and we agreed to implement climate reporting into UK law. This would be a world first.

The Pension Schemes Act now includes the new provisions that will allow the government to mandate pension schemes to adopt and report against the TCFD recommendations. We are asking trustees to consider the financial risks posed by climate change to their members’ investments. Trustees should then disclose how they have done so to their members and the public. Again, with this transparency comes accountability, change and empowerment.

The Act gives the Government the power to require schemes to take account of the UK’s Net Zero targets, as well as the Paris Agreement goals of limiting the rise of average global temperatures, with a view to ensuring that there is effective governance of the scheme with respect to the effects of climate change.

More people than ever before are thinking about how their pension is invested. Many people are now taking a personal interest in how their savings can play their part in getting Britain to Net Zero. The next stage is pension scheme portfolio alignment with the Paris Agreement.

Measuring Paris Alignment will allow schemes to assess their exposure to transition risks using forward-looking metrics. Taken together with existing disclosure requirements, this metric will inform trustees’ decisions around stewardship, voting and investments. Paris Alignment reporting also has the potential to be a powerful tool for communicating to members a scheme’s progress in transitioning to Net Zero.

Simply selling these assets to others without the same environmental concerns or governance oversight is counterproductive and will do nothing to get Britain to Net Zero

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Stewardship and its consequencesAt the same time, we are tackling stewardship and the role that pension funds have in driving where and how their money is invested sustainably. Stewardship of high-carbon companies, when done effectively, can drive down real-world emissions, and reduce the climate risk to which the scheme is exposed, and more importantly shape that company’s evolution. Trustees need to hold their asset managers to account to ensure scheme members’ best interests are protected.

Currently, schemes must produce and publish a Statement of Investment Principles (SIP) which details the policies controlling how they invest, including their stewardship activities. However, a review my officials undertook earlier this year found that SIPs were generally high level and unilluminating, especially concerning voting and engagement.

It is clear to me that there is currently a misconception among trustees that stewardship is not a key part of their work, or that they are unable to carry out any stewardship activity due to the way they invest. This kind of attitude must change if we are to create sustainable outcomes for members. We have already taken steps to accelerate progress to address this governance oversight. In July, the DWP launched the Occupational Pensions Stewardship Council. The Council is already building trustee stewardship capability and strengthening the asset owner voice in engagement with service providers. The Council has 32 members, including occupational and local government pension schemes, representing over £570 billion in assets under management.

Furthermore, the Taskforce on Pension Scheme Voting Implementation (TPSVI), which I established in December 2020, published a set of recommendations last month intended to help industry improve voting systems and increase the number of asset managers who are prepared to engage with their clients’ voting preferences. The Stewardship Council is working closely with members of the TPSVI and together they will be able to use their collective power and expertise to improve stewardship across industry.

And later this month I will be consulting on guidance that seeks to help trustees fully understand their requirements on stewardship and voting, and how they should report these activities in their annual Implementation Statement.

Divestment and sustainable financeI am a passionate advocate of everyone understanding where their money is invested. Anything that aims to engage savers with their pensions and encourage sustainable investments is a good thing. But widespread divestment would be a disaster and we must constantly push back against those who argue that this is the way ahead. Clearly, some of those advocates are far left like Extinction Rebellion but even the Labour Party has dabbled with ideas of divestment.

Some climate campaigners – with good intentions – have argued that divesting pension funds away from high carbon assets will help us achieve our Net Zero climate goals. I disagree. Simply selling these assets to others without the same environmental concerns or governance oversight is counterproductive and will do nothing to get Britain to Net Zero. And it is going to be

business, backed by sustainable finance, that will create largescale hydrogen, carbon capture, scalable battery technology, new nuclear and so much more. That needs capital.

Partnership with business is the way to achieve the innovative change required. By investing in sustainable assets, trustees can nudge, cajole, and vote firms towards lower-carbon business practices. COP26 will be key to securing the investment in UK pension schemes which are genuinely world-leading in this space.

My glass is very much half full. I believe we can get to Net Zero by 2050 and create the new jobs, new tech and so much more that the UK needs.

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Nothing is more powerful than an idea whose time has come. Not actually found in any of Victor Hugo’s works, this quote is an apt description of sustainable finance. While still short of the incremental $5-7 trillion per year necessary to achieve the UN Sustainable Development Goals (SDGs), according to the Institute of International Finance assets under management in ESG funds were USD 2.5 trillion in mid-2021, up from $400 billion in 2015 and the stock of sustainable debt issuance was $2.9 trillion by mid-2021, up from $200 billion in 2015. This growth is a testament to the shared objectives around the Paris Agreement and the SDGs. Although there is still much to do, finance is starting to flow to support the transition to a more sustainable economy.

The growth of sustainable finance has been matched by growth in sustainable finance policy and regulation. That idea has arrived on different timelines in different jurisdictions creating potential for fragmentation. Europe was first out of the gate with its comprehensive 10 point Sustainable Finance Action Plan in 2018. To date this has developed into an impressive 1049 page rulebook across the Taxonomy, Disclosure, and Benchmark Regulations and ECB and EBA guides on risk management and disclosure alone. This is starting to rival the 1626 page Basel Framework. The difference is that the Basel Committee took 45 years to develop its rules while the EU has taken 4 years since first sustainable finance proposals.

Other countries, while not developing at the same pace as Europe, have also started to put in place their regulatory frameworks. The most recent example is the announcement of the UK Green Finance Roadmap. Thus, it is too much to

expect full alignment of sustainable finance regulation. But there are still areas where this is possible and we should learn lessons from the past. In the aftermath of the global financial crisis, there was a strong desire by regulators to align around a single framework. As a result today we have a well-regulated derivatives market, systemically important banks with credible recovery and resolution plans and substantially stronger capital and liquidity regimes. We need to learn from this and continue to foster alignment around a global framework for sustainability finance with a focus on three key areas: transition, climate scenario analysis, and disclosure.

First, there is still potential to align on the concept of transition. We will only achieve the Paris Agreement if we transition all sectors. While technologies largely exist to de-carbonize, there are lock-in challenges as well as difficulties to scale solutions given the need to have supporting systems e.g. charging stations for electric vehicles or battery storage for renewable energy. This makes it critical to align real economy and financial policies around clear government statements about phase out dates for technologies such as internal combustion engine vehicles or fossil fuel power and heating. The same is true of broader environmental needs where policy signals are key to success.

A mechanism to support this effort can be Taxonomies. These make a clear statement of what the end goal is for a sustainable economy. However, on their own, they do not necessarily give the timing or pace of the pathways for a given industry to transition and, within an industry, for a given company to complete its evolution. They also try to create a new measurement system

By Judson Berkey

BUILDING BRIDGES TO THE FUTURE

Sustainable finance policy and regulation need better alignment mechanisms, argues Judson Berkey.

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focused on greenness whereas companies have been working on better disclosures of carbon emissions for years already.

A focus on transition naturally leads to a focus on companies. It may be easier to build a governance, monitoring and reporting framework around companies than activities given that we already have well established company reporting frameworks today. Transition is a nuanced and multifactor discussion not easily boiled down into a single measure of greenness at a point in time.

There are concepts being developed for how to guide transitions and assess company commitments to transitions. Clear rules for the governance, disclosure, and measurement of transitions are critical and would give the financial sector further confidence when investing in companies in transition. This is why we welcome collaborative efforts such as the recently announced Transition Pathway Initiative Global Climate Transition Center, due to be launched in early 2022. There are also interesting regulatory frameworks to consider such as the Japan FSA work on transition guidelines.

Ultimately we need regulatory alignment that supports transition and innovation by ensuring assumptions are consistent, disclosures are comprehensive, and firms live up to commitments while aligning with region and country specific pathways. This has already started with the recent update of the TCFD guidance to include transition plans and TCFD becoming a regulatory requirement in jurisdictions such as the UK, Switzerland, and Singapore, among others.

Such an approach would give countries another option to the implementation of detailed Taxonomies, given the significant data requirements to make them work. For example, investment managers will need almost 250,000 data points on Taxonomy alignment and Adverse Impact for the average fund and a typical bank will need more than 1 million data points from its corporate counterparties to make their required EU disclosures. Most of those data points do not even exist yet. Thus, it will be a multi-year process to implement the EU Taxonomy in the most sophisticated ESG market in the world. Other countries may not have the luxury of taking such an approach. A focus on transitions and alignment would be a faster road that has the further benefit of leveraging market-based approaches.

Second, we need global alignment in the emerging climate risk scenario analysis exercises. They build on established financial stress tests but adapt them to the timeframes (30 years vs 3-5), data needs (e.g. forward looking scenarios), and objectives relevant for climate change. The exercises run by ACPR and PRA show how collaboration between authorities and private sector can develop actionable insights. Several public officials

from the PRA and FED have also helpfully distinguished these scenario analysis exercises from what we know as financial stress tests today and the ECB has indicated that its 2022 test will not have direct capital implications. Continuing these efforts every few years, perhaps in regulatory sandboxes, would be helpful to the market. Through work at the Institute of International Finance, the financial industry has developed proposals on how to further align such exercises and ensure they continue to be learning exercises that support climate transitions.

A third topic that may be open for at least partial alignment is on disclosure both for investment products and companies. The current market based standards from International Capital Markets Association and Loan Marketing Association for disclosure have worked well for the professional market with few if any instances of greenwashing. Thus, they should be relied upon for that market. The retail market may be different though and the fast relabeling of many funds to meet the European SFDR categories may raise cause for concern. However, actions by the HK SFC, MAS, SEC, and Swiss FINMA show that active review and enforcement based on existing norms can keep the market honest. Detailed product disclosure requirements and templates are certainly one way to ensure comparability. However, it would be helpful to consider market standards to clearly identify product types (e.g. as proposed by IIF, UK IA, and ICI) as well as efforts to improve investment strategy disclosure (e.g. current exposure draft on product disclosure by CFA Institute) before rushing to regulate a de novo regime.

When it comes to corporate disclosure we can and should build on market efforts. The emerging work to develop an IFRS Sustainability Standards Board (SSB) climate standard is a great example of how the power of an idea can bring together what seemed to be diametrically opposed voluntary standards. Global investors / banks need to be able to take a global view and international standards that offer consistent disclosures are the best way to achieve this. We welcome the example of the UK pre-commitment to modify its TCFD disclosure proposal to align with an IFRS standard. The recent prototype published by the EU EFRAG also very helpfully based many of its proposed disclosure items on TCFD and other market efforts while adding aspects of the EU double materiality approach to disclosure. The world manages with two financial accounting standards (IFRS and GAAP). It can do so again if some jurisdictions wish to push through international standards to establish new floors of their own. The only condition should be that standards are not applied extraterritorially and there is an equivalence or mutual recognition regime developed.

There is one quote that definitely can be attributed to Victor Hugo. At the 1849 Paris Peace Conference he suggested that major countries could soon be “stretching out their hands across the sea, exchanging their products, their arts, their works of genius, clearing up the globe, making deserts fruitful, ameliorating creation under the eyes of the Creator, and joining together, to reap the well-being of all” The vision of building bridges to the future is something that should inspire the current G20, FSB, IFRS, and international standard setter efforts. The private financial sector will gladly roll up its sleeves to help make this a reality.

Ultimately we need regulatory alignment that supports transition and innovation by ensuring assumptions are consistent, disclosures are comprehensive, and firms live up to commitments

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Over the last decade the idea that climate-related risks, whether physical or transition, can strand assets in different sectors of the global economy has become much more widely accepted.1 The threat of climate-related risks stranding assets has spurred work by financial supervisors and central banks, who have announced new supervisory expectations and climate stress tests to help improve the solvency of individual financial institutions, as well as the resilience of the financial system as a whole.2 The G20 Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) has created a framework to help companies and financial institutions consistently measure, manage, and report their climate-related risk exposures.3 There have also been a plethora of new initiatives, products, and services intended to help financial institutions measure and manage climate-related risks.

But climate risk management (CRM) is often erroneously conflated with seeking or achieving alignment with climate outcomes (ACO). While there is some overlap between CRM and ACO they have different objectives and often different results.

CRM can make little or no contribution to ACO. For example, reducing a company’s exposure to projected increases in Country A carbon prices could entail moving emitting production to Country B which has lower environmental standards, potentially increasing net carbon pollution overall. Or a company could hedge its exposure to projected increases in carbon prices through derivatives contracts such as swaps, which would not alter the underlying economic activities of the firm and thus have little or no impact on emissions. Or a retail investor could disinvest shares from a fossil fuel company listed on the FTSE 100, thereby reducing their exposure to climate-related transition risk, but this will make very little or no difference to whether the fossil fuel company becomes more likely to achieve ACO. Depending on who buys the disinvested shares, it could in fact, make ACO less likely.4

This is not to say that CRM cannot, intentionally or unintentionally, result in better climate outcomes. A way to reduce Company A’s exposure to projected increases in carbon prices could be reducing the company’s carbon emissions, thereby helping ACO. A universal owner, such as a large pension or sovereign wealth fund, by advocating for timely and effective climate action by governments could potentially contribute to

By Ben Caldecott

NET ZERO TRANSITION PLANNING SHOULD BE MANDATORY ACROSS THE ECONOMYRisk management does little to achieve climate outcomes, argues Ben Caldecott.

Firms and financial institutions signing up to the TCFD, for example, may think that by doing so they are making a difference to the climate, when this is not necessarily the case

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lower climate-related transition risks across their holdings if governments heed their advice. CRM and ACO can work together in specific financial products, for example, a bank providing a sustainability-linked loan. Company A secures a lower cost of capital from the bank if it achieves ambitious, predetermined carbon reduction targets. A lower cost of capital is possible because Company A has calculably lower credit risk due to less energy use resulting in lower energy bills and lower potential future carbon price liabilities. The lender can share some of that

reduction in credit risk with the borrower, creating a win-win where the borrower secures a lower cost of capital and the bank makes more money.

These synergies between ACO and CRM are clearly important, and it makes sense to maximise them at every opportunity. But that is different from saying there is always a positive relationship between them both, or that CRM automatically and inevitably leads to ACO. It does not.

There is a risk associated with the accidental (or sometimes intentional) conflation of CRM with ACO. Firms and financial institutions signing up to the TCFD, for example, may think that by doing so they are making a difference to the climate, when this is not necessarily the case. Policymakers and civil society groups may have unintentionally made this mistake easier to make, by hyping-up one CRM framework, the TCFD, in way that is disproportionate to its potential climate impact.

In December 2021 it will be six years since the TCFD was announced on the side lines of COP21 in Paris. Progress has been made but it also highlights some of the challenges of relying on disclosure as a theory of change. Even if every economic and financial actor signed up to the TCFD and implemented it perfectly, we would still not have global alignment with

climate outcomes. And, of course, the idea that we will secure comprehensive or effective TCFD implementation globally anytime soon is naïve. It will take many more years to achieve anything like global coverage for some of the most basic climate-related information disclosures. In an area where time is of the essence – we must achieve net zero emissions by mid-century to deliver Paris, and physical climate-related risks are already having a material impact – this is deeply unsatisfactory.

Instead of incidentally contributing to ACO through CRM

initiatives like the TCFD, we need specific ways of dealing with and contributing to the challenge of alignment. These need to be articulated, developed, and scaled across the financial system rapidly. Without rebalancing the distribution of effort and spending more time explicitly on ACO, we cannot ever hope to align finance and the financial system with climate change objectives.

What should we do? First, we should lock in and continue to build on the critically important CRM work, including the TCFD. That includes making TCFD mandatory, but must also include a range of potentially much more important things for CRM, including: updating risk-based capital adequacy frameworks so they take account of climate-related risks; spurring the next

One of the most significant things we can do to spur rapid ACO is to make net zero transition planning mandatory across the economy.

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Notes1. Caldecott, B. 2018. Stranded Assets and the Environment:

Risk, Resilience and Opportunity. 1st ed. Oxford: Routledge.2. NGFS. 2019. First Comprehensive Report: A Call for Action

Climate Change as a Source of Financial Risk.3. https://www.fsb.org/2019/06/task-force-on-climate-related-

financial-disclosures-2019-status-report/4. Ansar, A., B. Caldecott, J. Tibury, J. Tilbury, and B. Caldecott.

2013. “Stranded Assets and the Fossil Fuel Divestment Campaign: What Does Divestment Mean for the Valuation of Fossil Fuel Assets?” Smith School of Enterprise and the Environment, University of Oxford, (October).

generation of data and analysis capabilities required to properly measure and manage such risks; and changing supervisory expectations globally so all supervised firms, from asset owners to insurers, need to action climate-related risks at the board and senior management-levels or risk supervisory action.

Second and in parallel, we need to urgently open up new frontiers for ACO, of which there are many. One of the most significant things we can do to spur rapid ACO is to make net zero transition planning mandatory across the economy.

This looks set to start in the UK. In its Greening Finance roadmap published ahead of COP26, the UK Government confirmed that before 2025 it has introduced mandatory sustainability disclosures across the economy that will incorporate the requirement to disclose net zero transition plans on a comply or explain basis. This is a world first. Its implementation now needs to be accelerated and copied internationally.

And in the same way that governments make new five-yearly climate targets under the Paris Agreement, financial institutions (as well as companies and other non-state actors) should be asked to do the same, with subsequent annual reporting of progress. Such target setting should feature as part of mandatory Net Zero transition plans.

The transition underway is the most capital intensive in human history. Net Zero transition plans will create demand for packages of new financial products and services to help companies transition, as well as create demand for new ways of measuring performance using the latest earth observation, AI, and data science methods. Mandatory Net Zero targets and transition plans are also a potential sensitive intervention point, where a modest change can create disproportionate benefits for and non-linear growth in climate action. This is one of the reasons why this is potentially so important and why other countries should adopt this framework.

climate targets under the Paris Agreement, financial institutions (as well as companies and other non-state actors) should be asked to do the same,

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As we approach COP26, many of us hold out hope that a silver bullet – like the COVID-19 vaccine - will break through in time to save us from climate breakdown. In reality, the solution is more prosaic: to realise Net Zero we need a transformation in how we account for carbon.

The UN’s landmark ‘Code Red’ report1 confirmed that we are indeed choking the planet, but the subsequent UN Synthesis report, which revealed that, instead of halving emissions by 2030, we’re heading for a 16% rise2, is a deafening alarm that we’re losing the race. We need a step change in how carbon is measured, managed and reduced to stand a chance of achieving Net Zero.

The mission to reach Net Zero, or completely negate the greenhouse gases produced by human activity, has come a long way fast. The Net Zero Tracker (NZT)3, which provides an overview of the 2,000 largest publicly traded companies in the world by revenue, finds that over 80% of global GDP (measured via purchasing power parity) and 77% of global greenhouse gases are now covered by a national Net Zero targets into countries, regions, cities and businesses.

The dirty secret of carbon accountingA core reason that emissions are rising is that the current system of voluntary disclosure and reporting on emissions leaves too much scope for creative accounting. A large and growing number

of companies accurately measure their direct emissions (Scope 1), plus the indirect emissions from the power they buy (Scope 2). However, the largest proportion of carbon footprints - up to 95% - often comes from supply chains, plus everything that happens after a product or service is sold, including ongoing processing,

further transport, use and disposal (Scope 3 emissions). Reporting against Scope 3 is less certain as indirect emissions are released outside of companies’ control. The inherent uncertainty means most companies are unprepared to measure Scope 3, or even to know what data they need to begin the process. Since no company can reasonably argue they are ‘Paris-aligned’ if they do not calculate Scope 3 emissions, most corporates are therefore not Paris-aligned.

Given Scope 3 reporting is hard and it’s voluntary, most

By Mauro Cozzi

GRASPING THE NETTLE ON ‘SCOPE 3’

It’s time to get real on the world’s hardest-to-reach emissions

over 80% of global GDP (measured via purchasing power parity) and 77% of global greenhouse gases are now covered by a national Net Zero targets into countries, regions, cities and businesses.

https://unfccc.int/news/full-ndc-synthesis-report-some-progress-but-still-a-big-concern

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firms do not face up to the challenge. Most firms take the ‘à la carte’ approach to carbon reporting - selectively choosing to disclose and tackle the lowest hanging fruit, while often ignoring the largest emissions sources. Unless tracking and disclosure of Scope 3 emissions improves, companies cannot realistically plan and realise science-based transitions to Net Zero emissions.

To realise Net Zero, we all need to take the set menu on carbon measurement – including Scope 3 emissions, where the broadest opportunities for carbon reduction lie.

The good news is that managing Scope 3 is achievable. Over 85% of the emissions that we track for our customers are in Scope 3, and according to investor sustainability leader Ceres, over 3,000 companies report Scope 3 emissions under the CDP. So, how can companies embrace the unknown to address Scope 3?

To prevent perfection being an enemy of progress, measurement of Scope 3 emissions demands that a large number of assumptions are made up-front, which can then be refined

over time. Michelangelo believed every block of marble contained a work of art waiting to be released. Similarly, with the right focus, every corporate can chip away at areas of uncertainty surrounding their Scope 3 measurement, until their emissions profile comes into sharp relief.

Data is the secret weapon of Scope 3 The secret lies in data, which are increasingly collected by sensor networks across supply chains and volunteered by customers. Machine learning can absorb the vast complexity of labyrinthine supply chains and use algorithms to analyse data on procurement, logistics, and products - before zeroing-in on key hotspots. When companies are equipped to collect emissions data on an almost real-time basis, AI can set controls and steer decision-making to drive efficiencies, cutting costs and carbon, while staying ahead of investor expectations and regulations, such as the Taskforce for Climate-related Financial Disclosure (TCFD). In this way, carbon accounting can play a strategic role as a point of engagement with suppliers, customers and industry peers.

This data then fuels engagement with suppliers, investors and customers alike - enabling businesses to tackle the carbon hotspots of their product or service. The upside is that engagement on Scope 3 makes supplier relationships less transactional and more of a partnership . With the system change and shift in capital that’s coming with the transition to Net Zero, such strong networks and information exchange are vital. Whether it’s spotting supply shortages or revealing collaboration opportunities, such as sharing logistics resources, such as fleets across networks - accurate, transparent data is the key to resilience.

The largest proportion of carbon footprints - up to 95% - often comes from supply chains, plus everything that happens after a product or service is sold, including ongoing processing, further transport, use and disposal (Scope 3 emissions).

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Big business wants a level playing field The chicken-and-egg situation that currently prevents mainstream business from ‘grasping the nettle’ of Scope 3 is that not all companies will set Net Zero targets until all the data is available, and all the data cannot be obtained until more companies disclose. This is an area where smart policy making can have a massive impact by introducing robust carbon accounting standards.

As we approach COP26 a wave of corporate coalitions have called for greater regulatory stringency on climate. For example, in October, Chancellor Rishi Sunak received a letter from 30 companies with over $4.5 trillion in assets, including Aviva, BT and Tesco, calling for mandatory Net Zero reporting.

It may seem unusual for multinationals to call for tighter governance, but many firms around the world are already on the path to Net Zero. They have addressed their direct emissions and have publicly committed to net zero targets. Now, they want to go all in, by fully embedding these plans into their workforces and supply chains, and to see their competitors take the same measures in pursuit of a fairer market

The climate disclosure imperativeClear, unified regulatory frameworks for mandatory carbon disclosure would actually cut the cost and workload involved in reporting to multiple stakeholders, from investors to partners and customers, on climate. There has reportedly been a 35% year-on-year rise in companies disclosing their carbon exposure under the CDP framework, including most European and US multinationals. For these companies and many others, investor pressure to meet ESG metrics already effectively makes their reporting mandatory, though the metrics vary. Now, by legislating firms to publish credible Net Zero transition plans, policymakers can increase demand both for green solutions and the capital needed to finance them.

One of our own investors, Schroders CEO Peter Harrison, has called the current climate disclosure imperative, “a 1929 moment, a once-a-century shift in the way companies are valued. Before the Wall Street crash, a company could report whatever level of profits it chose. In the aftermath, and amid the Great Depression, robust accounting standards were introduced and remain with us today.”

I would agree. Only through full disclosure can we fully face up to the challenge of reconfiguring our societies around Net Zero – and only through policy change can markets shift away from unsustainable practices - towards climate-positive solutions.

Accounting for carbon as currencyIn his bestselling book, ‘Sapiens: A Brief History of Mankind’,

Yuval Noah Harari states that:

“Cowry shells and dollars have value only in our common imagination. Their worth is not inherent in the chemical structure of the shells and paper, or their colour, or their shape. In other words, money isn’t a material reality — it is a psychological construct.”

Now that we know the survival of the human species is dependent on our ability to balance a rapidly shrinking carbon budget, it’s time we accounted properly for that. It’s time we consciously built the same universal construct around carbon as we do for currency. It’s time we disclosed on carbon with the same accuracy that earnings are disclosed in standard accounting practices.

Notes1. https://news.un.org/en/story/2021/08/1097362.2. Full NDC Synthesis Report: Some Progress, but Still a Big

Concern | UNFCCC3. https://www.zerotracker.net/

smart policy making can have a massive impact by introducing robust carbon accounting standards.

https://news.un.org/en/story/2021/08/1097362



https://www.zerotracker.net/

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Fossil fuel companies and their financiers have been under attack in recent months from Extinction Rebellion protestors. As well as these more radical actions, campaigns from NGOs regularly criticise financial institutions for being anti-climate. The media attention these actions attract can often be seen as a ‘win’ for climate activists, because polluters and asset managers are put under the microscope and supposedly held to account. But while critics are right to point out that there is more to be done on sustainability, they are wrong to portray the finance sector as a moral villain.

Extinction Rebellion’s tactics are not the right way to go about climate action, particularly not in relation to financial institutions. Their disruptive approach doesn’t lead to meaningful action and can actually be counterproductive, demonising a sector that we need to bring with us on the Net Zero journey. Banks’ lending to fossil fuel companies, for example, reflects the fact that the global economy is still reliant on fossil fuels. They are the symptom, rather than the cause, of the problem.

That’s not to say that banks and financial institutions don’t have agency in how they lend and invest - there are many ways that they can decarbonise their portfolios and invest more sustainably. The sector has already shown that it is willing to move towards greening, through individual action but also collectively through government direction.

A great example of this is the requirement to report in line with the recommendations of the Task Force on Climate-related

Financial Disclosures (TCFD). This initiative was being implemented by some organisations voluntarily - for example the Universities Superannuation Scheme1 announced plans to develop a Net Zero strategy well before the Government introduced mandatory disclosures, partly driven by advice from the Ethics Committee for the scheme. But TCFD reporting was made mandatory in the UK - a world-leading measure - to provide clarity to the sector and a level playing field.

However there is more still to be done, both in terms of industry action and government policy. Disclosing is a great first step, but we need to engage with banks and lenders, as well as fossil fuel companies, to get them to set out long-term decarbonisation plans. The UK Government recently announced that it expects so-called ‘transition plans’ to become the norm across the economy - with certain firms required to publish one, or provide an explanation for not doing so2. Going forward, we need to see more emphasis on shareholder stewardship, where environmental considerations are seen as core to corporate

By Lynsey Jones

WHY FINANCE IS THE SOLUTION TO CLIMATE CHANGE NOT THE PROBLEMFinancial firms are reflecting the real economy and public policy - governments need to set the new trajectory, writes Lynsey Jones

Extinction Rebellion’s tactics are not the right way to go about climate action, particularly not in relation to financial institutions

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success, and an expansion of green financial products, so that the industry sees decarbonisation as a growth opportunity rather than a burden and consumers can realise the benefits of sustainable finance.

From a political perspective, there is a strong case for governments to have sky-high ambition on sustainable finance. Not only is there huge potential for green investment to bring in jobs to financial centres, but the investment itself will be key to making the transition to a Net Zero economy affordable for families - by relieving pressure on the Exchequer. In fact, the majority of finance needed to reach Net Zero will likely be from the private sector rather than public finance.3 Impressively in the UK, £5.8 billion of foreign investment has been secured in just one year for financing green projects. And it’s hoped that three times the amount of government investment can be unlocked from the private sector to support the delivery of transport, energy and nature projects.4

Growing the green finance retail market will also be important for increasing financing options as well as engaging consumers in sustainable investment. Green credit cards and car loans that offer favourable interest rates for more sustainable choices can support eco-friendly lifestyles and purchases. Financial products like these would also improve choice for consumers and encourage emotional investment in the transition to net zero, making it tangible for more people. It helps, too, when commercial banks support this kind of action - HSBC has made a global commitment to provide between $750 billion and $1 trillion by 2030 to help clients cut carbon5.

Sustainable finance can have a much wider influence on Net Zero than the provision of capital to enable it. It has a valuable role to play in building public support and demonstrating the material benefits of Net Zero to individuals. The UK Government has recently launched a green savings bond, in which members

of the public can invest anything from £100 to £100,000. The investment will be used by the Government to help finance green projects and then publish details for investors on the environmental benefits. This is a great way for people to keep their savings safe, invest in something positive and get a return from green.

This can’t all be about government action, however. Individual shareholders have a role to play by using their influence and votes for more sustainable ends. In policy circles this is called stewardship. There is evidence that companies with shareholders that are engaged in stewardship have better financial returns on the stock market6. Where disclosures aren’t mandatory, shareholder activism is effective in eliciting greater disclosure of firms’ exposure to climate change risks. The stock market also reacts positively following environmental disclosures initiated by shareholders, suggesting that investors value transparency with respect to firms’ exposure to climate-related risks.

Campaigns such as ‘Say On Climate’7 are good examples of ways to encourage active stewardship from shareholders - by giving them a vote on transition plans, it encourages publication of the plans, scrutiny, and more effective change

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Risk disclosure should naturally lead to transition plans. Campaigns such as ‘Say On Climate’7 are good examples of ways to encourage active stewardship from shareholders - by giving them a vote on transition plans, it encourages publication of the plans, scrutiny, and more effective change. Scrutiny is particularly important in the sustainable finance debate, with claims of greenwashing rife in the sector. Exaggerated or unsubstantiated claims of sustainable practices can be minimised with standards that are used to measure and compare the efficacy of transition plans. The Green Technical Advisory Group8 has been set up by the UK Government to clamp down on such practices, in part by developing a ‘green taxonomy’, which would provide clarity as to what counts as sustainable.

The broader difficulty with disclosures and transition plans is whether mitigating climate-related risk actually results in better climate outcomes. Some climate change investment funds are engaging in such greenwashing by choosing vaguely defined projects that aren’t independently verifiable as sustainable. And, although not necessarily greenwashing, divesting by moving capital into green projects without doing the difficult work of decarbonising high-carbon assets may not materially improve climate outcomes.

By divesting from fossil fuels or other high-carbon projects, financial institutions are not removing investment from the project entirely, they are removing their investment and potentially decreasing the value of the shares. That leaves an opportunity for another less environmentally-conscious fund to scoop it up. Though as the world moves to decarbonise, these investments will risk becoming stranded and the first-movers to go green will reap the benefits.

We know that there can be good returns on investment from products like green bonds, which is probably why demand for the recent UK green gilt issuance was oversubscribed9 by a factor of 12. Despite research giving varying answers to this question, it seems that ESG funds do outperform similar stocks that don’t take account of sustainability, but this may not have reached the US markets just yet10.

It would also be a mistake for banks and financial institutions to ignore sustainability when exercising their fiduciary duty. Incorporating consideration of ESG into all investment decisions increases financial stability and has material impact on returns11. For pension funds in particular, long-term performance of assets is key, meaning that investing in renewable energy, which is increasing its share of the energy demand, rather than fossil fuels, which is decreasing12, could be the more prudent course of action. Factoring in sustainability can align profit with purpose.

It’s clear that the finance sector is making positive moves to

decarbonise, but government action is needed to help provide clarity, stability and direction for markets. The Government can provide direction for private finance with targeted regulation and support for emission reductions in the real economy. And giving shareholders a say on climate-related decisions would improve transition strategies, which could lead to greater transparency around green investments, less greenwashing, and more investment in beneficial green projects.

Decisions that we all make today will have long-term consequences - both financial and environmental. So banks and financial institutions should see decarbonisation as an opportunity to seize. As something that should be embedded in every financial decision rather than a niche problem only addressed by specialist ESG funds. For the financial sector in particular, investment decisions made today will have repercussions for years and often decades to come. With just one investment cycle left until our 2050 Net Zero target, it is understandable that protesters are impatient. But only through industry leadership and targeted regulation will we unleash finance in the fight against climate change.

Notes1. https://www.ft.com/

content/3ecd1c6c-6643-4920-b4f8-0ab04fe0a6872. https://assets.publishing.service.gov.uk/government/up-

loads/system/uploads/attachment_data/file/1026224/CCS0821102722-006_Green_Finance_Paper_2021_v5_Bookmarked_48PP.pdf

3. https://www.theccc.org.uk/publication/the-road-to-net-zero-finance-sixth-carbon-budget-advisory-group/

4. https://assets.publishing.service.gov.uk/government/up-loads/system/uploads/attachment_data/file/936567/10_POINT_PLAN_BOOKLET.pdf

5. https://www.hsbc.com/who-we-are/our-climate-strategy/providing-sustainable-finance

6. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3468896

7. https://www.sayonclimate.org/8. https://www.gov.uk/government/publications/independ-

ent-expert-group-appointed-to-advise-government-on-standards-for-green-investment

9. https://www.gov.uk/government/news/second-uk-green-gilt-raises-further-6-billion-for-green-projects

10. https://www.funds-europe.com/news/esg-can-drive-eu-rope-stock-returns-to-12-outperformance

11. https://www.unpri.org/download?ac=979212. https://www.theccc.org.uk/wp-content/up-

loads/2020/12/Sector-summary-Electricity-generation.pdf

It’s clear that the finance sector is making positive moves to decarbonise, but government action is needed to help provide clarity, stability and direction for markets

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Central banks, supervisors and regulators are turning up the heat on banks and insurers to confront the risks arising from climate change. Many, mostly in Europe and Asia, are conducting ‘stress tests’ over the coming months. These stress tests are meant to show the impact on the financial institutions’ capital adequacy stemming from different pathways for global warming and climate policy responses. While regulators note that the tests are exploratory1, the signs are that they will not be stressful or shocking enough to make much difference the financial institutions’ behaviour.

Early pilot studies largely echo the European Central Bank, which, looking out to 2050, misleadingly suggests that a ‘hot house’ scenario would be barely more damaging to the economy or financial system than scenarios involving policies that that deliver on ‘Net Zero’ pledges to cut green house gas emissions. The ECB’s recently released pilot stress test2 estimated that the ‘hot house’ scenario of 3 C of global warming would result in a fall in GDP output of less than 5% (0.2% p.a.) relative to current trends, compared with just under 2% (0.1% p.a.) if ‘Net Zero’ is implemented in an orderly fashion . Meanwhile, the ‘hot house’ would result in a barely noticeable increase in the probability of default (PD) on corporate loans to 2.3% compared with 2.1% under Net Zero.

The modesty of official projections of the financial risks from climate change look especially odd in the light of recent events. The violent disruption from the Covid 19 pandemic, the volatility in the global economy and markets – not least in energy – have coincided with unprecedentedly damaging weather events

and climate scientists on the UN’s Intergovernmental Panel on Climate Change (IPCC)3 declaring a “code red for humanity”. Consider that last year alone global GDP fell 3.5%, more than 6% below trend, in other words more than the cumulative damage that the ECB suggested would occur over the next three decades in its hot house scenario. Exceptional though the past year has been, it will surely prompt Bank boards to take a sanguine view of the ECB’s estimates.

What makes this doubly curious is that the central banks are making the right noises on the need for swift climate action. “Urgent action is not an option; it is an imperative”, according to Frank Elderson of De Nederlandsche Bank (DNB), who chairs the Network of Central Banks and Supervisors for Greening the Financial System (NGFS)4. Yet while they partly acknowledge some of the limitations of their pilot projects, the urgent tone of

By Mark Cliffe

STRESSFUL TESTS

Banks need to recognise that climate risks are bigger and more pressing than the central banks’ stress test scenarios suggest , says Mark Cliffe

The central banks’ long term scenarios shed little light on how to operationalise these Net Zero commitments. This will require shorter term scenarios that set out the potential paths over the next few years

https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op281~05a7735b1c.en.pdf

https://www.ipcc.ch/report/ar6/wg1/


https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp210429~3f8606edca.en.html

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their rhetoric is not reflected in their scenarios. Their scenarios have so far been based on assumptions and models which ignore or downplay crucial elements of climate risk, notably the rising frequency of extreme weather events, and critical triggers, tipping points and interdependencies between the climate, the economy, politics, finance and technology.

As a result, they underplay the potential downside risks that might plausibly challenge the health not just of vulnerable financial institutions, but the system as whole, and potentially on a horizon far shorter than 30 years ahead. In other words, they fail to provide the stress that would prompt urgent action. This point is reinforced by the fact that they also downplay the opportunities, or the upside risks, that stem from the transition to Net Zero by continuing to underestimate the pace of technological change.

An urgent rethink is required The NGFS is committed to developing and sharing best practice on climate risk management5. The Bank of England, like the ECB, is building on NGFS-developed scenarios for its stress tests of banks and insurers next year6. They have made commendable progress on translating the macro scenarios into financial risk, for example by employing large data sets to model credit risk down to the firm or location level7. But the indications are that fundamental limitations of their approach are not about to be addressed.

The Bank for International Settlements (BIS), aka ‘the bank for central banks’, highlighted the challenges last year in a report entitled ‘The Green Swan’.8 It has called for an ‘epistemological rupture’, essentially a complete rethink, in the approach to climate risks, which involve “interacting, nonlinear and fundamentally unpredictable environmental, social, economic and geopolitical dynamics”. As yet, there is little sign of progress on this.

So how can central banks change their approach to stress test scenarios to inject more urgency into the responses of

financial institutions? It is essential that they highlight that there are a much broader range of outcomes than they have so far suggested, and acknowledge that the risks are heavily skewed to the downside. There are four important ingredients that should drive this urgent rethink.

1. Focus on shorter time horizons. Action is needed now to head off long term existential threats. So far central banks and the financial services industry have tended to view climate risk as predominantly a long term problem. Climate scientists warn that the damaging effects of global warming will continue to build up over the coming decades even if we succeed in reaching ‘Net Zero’. This reflects the fact that the climate responds with a lag not to the rate of green house gas emissions, but the stock of past emissions. Moreover, if we fail to achieve Net Zero, large parts of the planet would become unliveable later in the century. This dire threat underlies policy makers’ desire to encourage financial institutions and other businesses to confront these long term risks.

The central banks’ climate risk scenarios stretching out to 2050 and beyond have certainly driven home the wholesale transformation needed to decarbonise the economy. Using ‘integrated assessment models’ (IAMs), they have modelled how rising prices on carbon emissions (and greenhouse gases in general) could eliminate fossil fuels from the energy mix, but perhaps for a small proportion offset by carbon removal processes. The rush by financial institutions to sign up to commit to 2050 Net Zero targets shows how they have taken this message on board9.

However, the central banks’ long term scenarios shed little light on how to operationalise these Net Zero commitments. This will require shorter term scenarios that set out the potential paths over the next few years10. This will enable financial institutions to embed climate change into their business plans, which rarely stretch beyond five years. The need for this is pressing, because

https://www.bankofengland.co.uk/stress-testing/2021/key-elements-2021-biennial-exploratory-scenario-financial-risks-climate-change


https://www.bis.org/publ/othp31.pdf

https://www.gfanzero.com/


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it is generally recognised that the world needs to mobilise now if Net Zero is to be achieved; indeed, the developed world is aiming to be around half way there by the end of the decade.

Indeed, switching from a 30 year horizon to 2025 or 2030 will necessitate changes to their scenario designs that force them to confront the other three ingredients of the necessary rethink. A crucial, and ironic, aspect of this is that on a sub-10 year horizon the main driver of climate risk scenarios is not the climate itself, since global warming and increased extreme weather events are already largely ‘baked in’. Rather attention is thrown onto the

transition risks surrounding what action we collectively take, which shifts the spotlight on politics and policy, technology and markets, and finance and behaviour. In the process, this shift would confirm that climate risks are both bigger and more pressing than the central banks’ modelling indicates.

2. Stop ignoring or downplaying crucial risks. The central banks make no secret of the limitations of the modelling behind their long term climate scenarios. Extreme weather events, political disruptions, financial markets, behavioural and technological change are all aspects that are difficult to capture. Given the complexity of the problems and the absence of much of the required data it is understandable that they should try to simplify the exercise by steering away from them. But the old aphorism “All models are wrong, but some are useful” begs the question of whether the simplifications that the central bank modellers are making are leading us astray.

It is hard not to conclude that by assuming away, ignoring or downplaying crucial risks they are substantially understating the range of possible outcomes. At the core of the scenarios produced by the NGFS11, and adapted by member central banks, are a range of integrated assessment models (IAMs) which produce pathways for emissions, global temperature and energy mix pathways. On some variables, the IAMs produce very different results, so the first simplification is average these out.

The IAMs examine physical risks through the lens of rising global temperatures, which are assumed to damage productivity. Other chronic, or sustained, physical risks such as rising sea levels and acute risks, comprising extreme weather events such as storms and floods, are not directly modelled. This is a serious drawback since, as the Intergovernmental Panel on Climate Change (IPCC) recently underlined, such events will become

more frequent, intense, persistent and more widespread, even if uncertainty over their precise timing and location will remain. 12 Aside from the direct costs of such events, the rising costs of adaptation investments, and the subsequent potential benefits, are ignored. So too is the collateral damage wrought on other aspects of the natural environment, such as the loss of bio-diversity, natural resources, water or air quality.

The shortcomings are particularly serious for ‘business as usual’ scenarios where policy fails to curb emissions and global warming rises beyond 3 degrees. These scenarios would lead to dramatically higher increases in both chronic and acute physical risks, as well as the associated adaptation costs.

Physical risks aside, other important risk drivers are missing from the NGFS scenarios. It noted in June that “there are other uncertainties that are not captured due to modelling simplifications such as behavioural change, policy heterogeneity and market allocation of capital”. Yet such factors could have a profound impact on the outlook.

The fact that finance is absent from the IAMs is particularly troubling, given the massive shifts in capital flows that are required. This could create frictions that the models ignore.

Central bank climate scenarios make the simplifying assumption that climate policy is reflected solely by prices on carbon emissions. Carbon pricing is used as a proxy for regulations and other non-price-based policies. This makes it easier to model the energy transition, but overlooks the enormous political frictions, domestically and internationally, that would arise from sharp carbon price increases.

Central banks, who are ultimately answerable to their governments, are understandably wary about making explicit assumptions about dramatic political or policy changes. But the awkward truth that the Net Zero challenge is intrinsically political. Since climate change stems from market failure to price carbon emissions adequately, the path towards Net Zero will depend heavily on when, where and how governments

step in to change market behaviour and stimulate the required innovation and investment.

The capping and then winding down of fossil fuel-based activities will create many losers as asset values fall and jobs are lost. Redistributing some of the benefits of the greening of the economy to compensate them will require deft political handling, which has so far been lacking. Meanwhile, the uneven distribution of both physical climate damages and fossil fuel production threatens geo-political conflict which in extremis could trigger wars and mass migrations. None of this features in the scenarios published by the central banks.

3. Recognise the importance of non-linear dynamics in accelerating change, for good or ill. It is problematic enough that the central banks stress test scenarios exclude or downplay some crucial risk factors. What is worse is

Central banks, who are ultimately answerable to their governments, are understandably wary about making explicit assumptions about dramatic political or policy changes. But the awkward truth that the Net Zero challenge is intrinsically political

Tipping points mean that existential threats could be closer than linear modelling suggests

https://www.ngfs.net/sites/default/files/media/2021/08/27/ngfs_climate_scenarios_phase2_june2021.pdf


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that they fail to capture the degree to which climate change, and the action to counter it, will be messy and disruptive.

The models that the central banks employ portray worlds in which change is generally smooth, linear and orderly. True, the NGFS has a ‘disorderly’ scenario, but this incorporates represents merely a one off delay of policy action to 2030, after which their models revert to smoothly transitioning towards ‘Net Zero’. Yet the reality is that climate change, and its human causes and responses do not progress smoothly, but with non-linear changes that are often dramatic and unexpected.

In the midst of unprecedented change, historic data is of limited use, and models will be prone to make errors that grow exponentially worse the further out you look. The concept of ‘VUCA’, the acronym for volatile, uncertain, complex and ambiguous, is particularly apt for climate change, and it makes quantifying scenarios hazardous. It also points to a far wider range of outcomes than the central banks have so far suggested. As a report from the Grantham Research Institute put it “A stress test that does not include the low probability, high impact consequences of climate change is not strictly a stress test”.13

This is all the more reason for central banks to switch their focus to climate-related financial risks that may arise on the shorter, sub 5 year, horizons used in traditional stress tests. Beyond that, scenarios become progressively less useful. Attempts to produce detailed quantification down from a country and sector level to a local and business level on a multi-decade basis are liable to descend into a “number theatre” of colossal databases of useless data. In the spirit of Carveth Read, who said “it is better to be roughly right than precisely wrong”, numbers attached to long term scenarios should be seen as illustrating their narratives rather than the basis for financial planning, still less financial regulations.

Over the next few years, as described earlier, uncertainty around financial risks will stem more from the transitional

risks around human action than from the climate itself. That said, scientists are increasingly concerned that rising physical risks are bringing the climate and environment closer to critical thresholds, or tipping points, which lead to sudden accelerating change and potentially irreversible damage. A notable example of this is the sudden melting of polar ice caps, which threaten higher sea levels, accelerated coastal erosion, flooding and storm surges. Such tipping points mean that existential threats could be closer than linear modelling suggests. 14

The linear models at the heart of the central banks’ scenario methodology also fail to capture crucial non-linearities around changes in prices, politics, technology and behaviour. The responses to the Covid-19 pandemic are a vivid illustration of the failure of forecasters to capture the potential for disruptive volatility and shocks that can crystallise long term risks into immediate damage and catalyse lasting changes in behaviour. Consider how the plunge in oil prices prompted BP and other major oil companies to write off billions from the value of their reserves and announce more ambitious targets for their renewable energy investments. It is not just the physical world that is subject to tipping points.

Central banks are certainly conscious of the volatility of energy and asset markets. Yet the IAMs that they have at the centre of their scenario modelling ignore the fact that in these markets price volatility is a feature, not a bug. The recent surge in natural gas prices, which has seen wholesale prices in Europe and Asia jump five-fold over the past year, may affect market behaviour, public policy and investment for years to come. In other words, peaks and troughs in prices can accelerate changes. Sadly, this is not yet factored into central bank modelling:

“The future pathways of commodity prices are highly uncertain […] mitigation scenarios [do] not capture the full range of outcomes. Pathways do not

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account for the possibility of ’sell-off ’ behaviour from producers, or other volatility between 5-year time steps.” NGFS June 2021.

Politics, and with it policy, has its own distinctive non-linearities. For long periods, governments may resist change fearing a popular backlash from those who stand to lose out from it. Then periodically, sudden shifts emerge as pent-up pressures for change burst through following changes of government or shocks such as recessions, natural disasters or international conflicts.

The swings in climate policy in the US make this point very clearly. President Biden has dramatically reversed US climate policy away from the denialism of President Trump, to an approach even more activist than that of President Obama. For building scenarios, the good news here is that at least there is a predetermined electoral cycle - the 2024 election already

looms large. Moreover, the outcomes are – usually - binary. But the bad news is that while we have some sense of timing around alternative scenarios, the scale of the policy shifts that they could trigger is a much tougher call: would a future Trumpian President withdraw from the Paris Climate Accord again?

4. Adopt a systemic approachThe fourth ingredient of the needed rethink on climate risk is to address the complex interactions between the drivers and impacts of climate change. Earth systems and the economic, financial, political and social systems are interdependent in a way that can lead to complex feedbacks. This provides another reason why linear modelling may fail to capture the pace and scale of change. Complex systems have emergent properties, or unexpected behaviours, which are hard to predict from the individual parts of the system. As Professor Tim Jackson puts it:

“Three features of the [Net Zero] transition—rapid structural change, massive investment shifts and ‘post-normal’ behaviours—mean that conventional equilibrium or partial equilibrium models aren’t much help to us. They assume too much homogeneity in behaviour. They have little or nothing to represent the complex structure of financial balance sheets through which transition risks may be propagated. And they are likely to miss the dynamic feedbacks that occur between the real and the financial economy” 15

Adopting a systemic perspective to climate risk is challenging, particularly as it must factor in positive feedback loops and tipping

points that may compound the errors on long term projections. This is where the scenario approach can help. It starts not with detailed quantification and modelling, but by focusing on the factors that are most uncertain and impactful. It then aims to develop structured, plausible and revealing narratives based on how these factors might relate to one another.

Unfortunately, the central banks have made limited progress in developing a more systemic approach to their climate scenarios. The most obvious problem is that their scenarios focus squarely on the consequences of climate change while ignoring its causes. Climate change is not happening in isolation: different paths for economic growth, policy, technology, and consumer behaviour would result in different paths for emissions and the climate, which would then feedback into different paths for climate risks.

To take an example, varying the baseline of global GDP growth by merely +/-0.2% p.a. would result in a cumulative change of over +/-5% by 2050. This would itself double the range of variation seen in the ECB’s pilot scenarios. Aside from flowing through into energy demand and carbon emissions, this would open up different pathways for policy, investment and market prices. This is before we even begin to build in the likelihood of upswings and recessions into the narratives. Indeed, such cyclical shocks, which are at the heart of traditional solvency stress tests, arguably should be a critical component of climate-related stress tests as well.

Meanwhile, physical and transition risks are still largely treated separately in the central banks’ exercises. Yet it is clear that increased extreme weather events are already increasing the social and political pressure for action. Having experienced the damage from climate change first hand, people are more inclined to support remedial policy action and change their behaviour. Conceding that the central banks are not capturing such tipping points, the NGFS notes that “Studies that have assessed the potential impacts from tipping points on policy responses find that emissions prices should be up to eight times higher”16.

It is easy to see how the uneven damage from climate change could generate conflict. As Gernot Wagner puts it, “For good reason, the green transition is viewed as a matter not just of energy but of geopolitics. We are undergoing a historic shift from petrostates to “electrostates”17. This could heighten risks from policy clashes, leading to protectionism, weaker growth, higher inflation, higher interest rates, and reduced investment and innovation.

Again, the central banks’ scenarios have not accounted for such possibilities. They look solely at the macro-economic and financial damage from physical climate change and the impact of transition.

For long periods, governments may resist change fearing a popular backlash from those who stand to lose out from it. Then periodically, sudden shifts emerge as pent-up pressures for change burst through

Physical and transition risks are still largely treated separately in the central banks’ exercises. Yet it is clear that increased extreme weather events are already increasing the social and political pressure for action

https://cusp.ac.uk/themes/aetw/blog-tj-modelling-transition-risk/

https://www.project-syndicate.org/commentary/climate-action-increasingly-cheaper-than-inaction-by-gernot-wagner-2021-05

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On top of this, it is possible to envisage strong feedback loops between politics, policy incentives, technological progress, financial flows and consumer adoption. On the negative side, a rush for the exit could lead to a sudden stranding of fossil fuel assets as prices crash, creating an economic and political crisis. On the positive side, climate policies including carbon pricing, regulation and public investment could catalyse private investment and innovation, rapidly driving down costs and prices, stimulating consumer demand while improving financial returns.

A more realistic perspective, recognising the emergent properties of complex systems, would point to a far wider range of outcomes. This is because of the path dependency of outcomes, whereby ‘one thing leads to another’, such as how a change of government leads to a new policy direction. So instead of a linear interpolation of a long term forecast, this calls for an iterative ‘decision tree’ progression of short term scenarios, allowing for shocks to create new paths. Since this rapidly multiplies the possibilities, producing longer term scenarios requires models that can handle more complex computations or more simplified qualitative analysis.

Conclusion There is no doubt that the central banks, supervisors and regulators recognise the urgency of climate change. This is why they are conducting stress tests on the financial risks that it poses to the banks and other financial institutions. Sadly, the signs are that the scenarios that they are providing for this purpose will not be stressful or shocking enough to make much difference the financial institutions’ behaviour. Perhaps inadvertently, they risk fostering complacency.

Despite their justified humility about their current modelling, the central banks’ scenarios suggest that climate risk will make little difference to growth or financial losses even on a 30 year horizon. In the ECB’s case, the cumulative total difference in GDP between their business-as-usual ‘hot house’ scenario and an orderly policy ‘Net Zero’ scenario is barely 3%. This is despite escalating physical risks and the dramatic transformation in the economy that decarbonisation will entail. This modest range of variation is against the basic essence of the scenario method, which is to explore a wide enough range of possibilities to provide strategic insights.

If the central banks wish to inject the needed urgency into the financial institutions’ embrace of climate risk the next phases of their stress testing exercises will have to rise to the challenge set by the BIS for an ‘epistemological rupture’. There are four ingredients that could feed into the rethink required.

First, given the urgency, the scenarios should be on shorter time horizons of five years or less, in line with traditional solvency stress tests and the planning horizons of the financial institutions. The financial sector is already well on the way to be fully signed up to being ‘Net Zero’ by 2050, so the challenge is to operationalise this now and to recognise that the financial risks and opportunities are far larger and more immediate than the central bank scenarios suggest. The ECB’s latest announcement that next year’s stress test will incorporate policy and weather shocks in 2022 is therefore a welcome step forward.

Second, the scenarios need to incorporate crucial risks which they have so far assumed away or downplayed. Extreme

weather events, political disruptions, policy shifts, financial markets, behavioural and technological change are all aspects that are difficult to calibrate and model. But failing to account for them severely reduces the realism and useful of the scenarios for stress testing purposes. By limiting the time horizon to no more than five years, it should be possible to capture more of these factors in scenarios which reveal a broader and more meaningful range of outcomes.

Third, the scenarios need to acknowledge that fact the risks are non-linear, making the likelihood of extreme outcomes far more likely. The central banks’ models yield smooth orderly changes and fail to capture the risk that the climate may breach thresholds beyond which damages may accelerate and become irreversible or existential. Although tipping points are perhaps not so likely for the physical climate if we step back from a thirty to a five year horizon, they are still eminently possible for transitional climate risks. Socio-political disruptions, policy shifts and market spikes and crashes could all feature in more illuminating short term scenarios.

Fourth, the scenarios need to acknowledge the complexity of the interactions between the drivers and impacts of climate change. Earth systems and the economic, financial, political and social systems are interdependent in a way that can lead to complex feedbacks. These could either delay or accelerate change in a way that the central banks’ conventional linear models do not capture. This adds layers of uncertainty which argues for embracing the precautionary principle by making assumptions that result in a broader range of outcomes.

But the scenario method provides room to develop plausible narratives around these interactions. The pandemic has provided a timely lesson in how nature can trigger rapid changes in human behaviour, whether it be politics and policy, markets and innovation, or social norms and consumer behaviour. In the case of climate change, official forecasts continue to underplay the fact that the costs of renewables are falling, partly through policy support, in a way that is triggering tipping points in business and consumer demand.

On the flipside, the central banks also understate how policy inertia or missteps could crystallise longer term financial risks from stranded fossil fuel assets and labour well before 2030, let alone 2050. It is time to inject some real stress into their climate stress tests.

On the negative side, a rush for the exit could lead to a sudden stranding of fossil fuel assets as prices crash, creating an economic and political crisis. On the positive side, climate policies including carbon pricing, regulation and public investment could catalyse private investment and innovation

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Notes1. A key feature is that the stress tests are based on forward-

looking scenarios using a suite of forecasting models rather than traditional backward-looking probabilistic risk models.

2. ‘Economy-wide climate stress test Methodology and results’, ECB, September 2021 https://www.ecb.europa.eu/pub/pdf/scpops/ecb.op281~05a7735b1c.en.pdf

3. UN Intergovernmental Panel on Climate Change (IPCC) AR6 Climate Change 2021: The Physical Science Basis https://www.ipcc.ch/report/ar6/wg1/

4. All the way to zero: guiding banks towards a carbon-neutral Europe’ Keynote speech by Frank Elderson, April 2021 https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp210429~3f8606edca.en.html . In his latest speech he followed up with a call for legally-binding transition plans, including verifiable milestones: ‘Overcoming the tragedy of the horizon: requiring banks to translate 2050 targets into milestones’, October 2021 https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211020~03fba70983.en.html

5. For its latest survey of progress see ‘Scenarios in Action A progress report on global supervisory and central bank climate scenario exercises’ NGFS, October 2021. https://www.ngfs.net/en/scenarios-action-progress-report-global-supervisory-and-central-bank-climate-scenario-exercises

6. ‘Key elements of the 2021 Biennial Exploratory Scenario: Financial risks from climate change’ Bank of England, June 2021

7. https://www.bankofengland.co.uk/stress-testing/2021/key-elements-2021-biennial-exploratory-scenario-financial-risks-climate-change

8. The ECB’s notes that its “economy-wide stress test has made significant advancements […] largely thanks to the creation of an unprecedent database that combines climate and financial information for millions of firms worldwide”. ECB Sep 2021 ibid.

9. ‘The Green Swan’, Bank for International Settlements (BIS), January 2020 https://www.bis.org/publ/othp31.pdf

10. See, for example, the recently created Glasgow Financial Alliance for Net Zero: https://www.gfanzero.com/

11. An interesting early exception to the central banks’ preference for long term scenarios is the De Nederlandsche Bank, which produced a set of 5 year scenarios in 2018: ‘An energy transition risk stress test for the financial system of the Netherlands’ https://www.dnb.nl/media/pdnpdalc/201810_nr-_7_-2018-_an_energy_transition_risk_stress_test_for_the_financial_system_of_the_netherlands.pdf

12. ‘Climate Scenarios for central banks and supervisors’, NGFS, June 2021 https://www.ngfs.net/sites/default/files/media/2021/08/27/ngfs_climate_scenarios_phase2_june2021.pdf

13. As US Federal Reserve Governor Lael Brainard hinted

at more severe damage recently when she noted, “These cumulative and chronic changes could have economic effects that differ substantively from the historic experience, for example, if they contribute to shifts in the location of economic activity or the sectoral composition within a region.” https://www.federalreserve.gov/newsevents/speech/brainard20211007a.htm

14. ‘The new climate scenarios for central banks and supervisors’ Grantham Research Institute on climate change and the environment, June 2020

15. https://www.lse.ac.uk/granthaminstitute/news/the-new-climate-scenarios-for-central-banks-and-supervisors/ 4/6

16. The NGFS scenario portal notes that “Tipping points and impacts from extreme weather events are not accounted for”. https://www.ngfs.net/ngfs-scenarios-portal/

17. Modelling Transition Risk’, Professor Tim Jackson February 2021 https://cusp.ac.uk/themes/aetw/blog-tj-modelling-transition-risk/

18. my emphasis] BIS July, ibid19. ‘The Climate Tipping Point We Want’ Gernot Wagner,

Project Syndicate, May 2021 https://www.project-syndicate.org/commentary/climate-action-increasingly-cheaper-than-inaction-by-gernot-wagner-2021-05






https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211020~03fba70983.en.html

https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211020~03fba70983.en.html

https://www.ngfs.net/en/scenarios-action-progress-report-global-supervisory-and-central-bank-climate-scenario-exercises






https://www.bis.org/publ/othp31.pdf


https://www.dnb.nl/media/pdnpdalc/201810_nr-_7_-2018-_an_energy_transition_risk_stress_test_for_the_financial_system_of_the_netherlands.pdf






https://www.federalreserve.gov/newsevents/speech/brainard20211007a.htm

https://www.federalreserve.gov/newsevents/speech/brainard20211007a.htm

https://www.lse.ac.uk/granthaminstitute/news/the-new-climate-scenarios-for-central-banks-and-supervisors/



https://www.ngfs.net/ngfs-scenarios-portal/






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At COP26, alongside national commitments to “keep 1.5 degrees alive”,1 companies will be lining up to announce their own Net Zero commitments.

It is easy to be sceptical about these corporate commitments as their scope and robustness varies wildly, from credible plans based on emissions reductions and permanent carbon sequestration to flimsy plans based on business-as-usual plus carbon offsets of sometimes dubious quality.

The weakness of some plans will justifiably fail to placate activists. In response, activists are likely to step up their campaigns for divestment from fossil fuels. In the financial sector, many plans already include divestment (selling off assets that contribute to climate change, for example polluting energy infrastructure). However, the inconvenient truth is that divestment does little to reduce emissions.

Divestment mainly transfers emissions to companies that are less bothered by pressure from activists, so it is the equivalent of hiding the emissions problem under the carpet. Worse, institutions are often congratulated for divesting of existing assets and even rewarded with higher ESG ratings, despite the fact that the operations and underlying economics of those assets largely remain unchanged. Those who hold onto assets with the intention to manage them down in a Paris-aligned timeframe attract criticism.

So, what will actually deliver? As Policy Exchange has previously argued, mandatory “Net Zero transition plans” can

be an important part of the puzzle.2 By standardising reporting and requiring major companies to explain how they intend to reach Net Zero, these plans will encourage companies to do the hard work of actually reducing their emissions, rather than just outsourcing them. Minimum standards for transition plans will ensure that where offsets are involved, they are audited and proven to be high quality.

Transition plans do have weaknesses, but they demonstrate that the green finance industry is maturing, something that should be welcomed. Part of that maturity is an awareness that divestment is often just a gesture, so more nuanced policies like transition plans are needed.

Surface-level successThe divestment movement has had a number of high-profile successes in recent years, securing commitments from ninety UK universities to partially or fully divest from fossil fuels.3 These victories include a high-profile commitment from the University of Cambridge, which says it “aims to divest from all direct and indirect investments in fossil fuels by 2030”.4

Campaigners are now increasingly focusing on pension funds. For example, the campaign group Divest USS is calling for the Universities Superannuation Scheme (USS) to divest from fossil fuels, tobacco and arms manufacturers.5 USS is one of the largest pension funds in Europe. The campaigns may prove

By Ed Birkett and Benedict McAleenan

THE LIMITS OF DIVESTMENT

Unlike divestment, transition plans can actually deliver substantial emissions reductions, argue Ed Birkett and Benedict McAleenan

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successful in their goals and they contribute to a more hostile market environment for fossil fuel companies, but the real-world impacts on emissions are limited. Losing investors is one thing, losing customers is what matters far more.

Benefits of divestmentThere are two main benefits of divestment. Firstly, divestment from listed companies causes a short-term hit to their share prices, which disincentivises CEOs and other corporate leaders from investing in higher-carbon assets.

Secondly, divestment strangles capital from investing in new fossil fuel infrastructure; research from Oxford Universities’ Smith School suggests that this is already happening. The Smith School finds that, in the last ten years, the cost of financing renewable energy projects has fallen significantly, whereas the cost of financing coal power stations has increased by 56% over the same period.6 Large asset managers are complaining that divestment is partly to blame for a ‘credit crunch’ in oil and gas that is adding to energy supply woes.7

This experience demonstrates that the cost of capital for certain types of projects can be increased, but only if the vast majority of funders demand a higher rate of return. For example, China has now committed not to build any new coal-fired power stations abroad. Along with similar commitments from other traditional funders, this commitment will all-but end global export financing for coal-fired power stations, pushing up cost of capital further.

By contrast, there are still many governments and financial institutions that will fund new investment in oil and gas projects; this is one reason why the cost of capital for oil and gas projects has not changed significantly over the last decade.8

The limits of divestmentDespite the best intentions of many in the divestment movement, unfortunately there are a number of downsides to the strategy. Firstly, once assets are divested, the firm divesting loses control, influence and oversight of these assets.

The divested assets may be bought by a company in a different jurisdiction or by private owners who are less susceptible to pressure from activists. The divesting companies would have had a far bigger impact on carbon emissions by remaining as an investor and working with other shareholders to force the company to reduce its emissions.

Secondly, divestment risks penalising companies that are making good-faith attempts to manage down existing assets as part of an ordered transition plan (although some divestment decisions do now retain investments in companies that have committed to reduce their emissions). Conversely, divestment risks rewarding companies who abrogate responsibility for their historical emissions and their development of high-carbon assets.

Thirdly, divesting from publicly traded firms doesn’t reduce emissions or change the economics of existing operations. Divestment may drive down share prices but, perversely, this can increase dividend yields for the new owners. Hedge fund manager Crispin Odey recently argued that divestment was creating good investment opportunities for his company, because big institutional investors “are all so keen to get rid of oil assets, they’re leaving fantastic returns on the table”.9 In addition, a rush into green assets risks creating a “green asset bubble”, which reduces returns for those investors chasing the limited pool of green assets.

Fourthly, divestment could end up penalising developing countries. Even if we don’t like it, these countries may need new fossil fuel infrastructure to provide basic services to their citizens.

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For example, Egypt has recently completed construction of four huge gas-fired power plants to alleviate ongoing power cuts.10

Whilst these plants burn fossil fuels, they are significantly better than relying on coal and, presuming the contracts were structured correctly, can complement renewables by operating flexibly (turning down when it is sunny and turning up during the evening peak). In addition, these power stations could be retired or retrofitted (with carbon capture or efficiency measures) in the 2030s or 2040s, meaning that they could be part of a Paris-aligned transition to a low-carbon and prosperous Egyptian economy.

Taken together, these drawbacks of divestment suggest that a more nuanced approach is required, which is where transition plans come in.

Transition plansLooking beyond divestment, policymakers are taking a two-stage approach to implementing green finance rules. Policymakers have already agreed to implement disclosure rules such as those recommended by the Task Force on Climate-related Financial Disclosures (TCFD). In June this year, the Finance Ministers of the G7 countries agreed to support a move to TCFD-aligned climate disclosures.11

TCFD disclosures will encourage companies to pursue a combination of mitigation and adaptation. However, these disclosures alone are unlikely to be enough to drive Paris-aligned decarbonisation; TCFD is about companies managing their own exposure to risk rather than managing down their existing assets. For example, companies could choose to divest from their more polluting assets, rather than retiring them over time.

Policymakers are now moving beyond disclosures, by requiring companies to implement mandatory transition plans. In March this year, Policy Exchange argued for mandatory transition plans for the most systemically-important companies, 12 an approach that the UK Treasury department is now proposing as part of its “Roadmap to Sustainable Investing”, published earlier this month.13

However, transition plans aren’t a panacea.One weakness of transition plans is that they don’t fully address the risk of companies offloading assets to others (i.e. divestment). Ideally, transition plans should be “asset based”, with companies taking responsibility to manage down and retire their high-carbon assets over time, or at least create stewardship plans to account for retirement.

Secondly, transition plans may require companies to reduce the supply of high-carbon products more quickly than demand reduces. Even when demand for oil and gas falls, underinvestment in new production could contribute to significant price rises, which would hurt energy consumers.

Thirdly, transition plans encourage companies to diversify their operations; for example, transition plans encourage traditional energy companies to develop new businesses in low-carbon industries such as renewable energy. However, this may not be what investors want.

Investors often prefer companies to focus on their core business; investors can then clearly decide how exposed their own

investment portfolio is to various risks including climate risks. Responding to this demand from investors, some European energy companies have been split into renewable and non-renewables entities. For example, Uniper was formed when E.ON split off its fossil fuel assets into a new company.14 In some ways, Uniper is acting a “bad bank” for E.ON’s climate liabilities.

In addition, when companies have tried to diversify, some investors have tried to break them up. For example, Shell claims that hedge funds are trying to split the company into multiple companies, with the oil, chemicals and refining business split from the company’s renewable energy division.15

It is a fair challenge from investors when they argue that they should be allowed to choose the exposure of their own portfolio to climate and other risks by investing in a range of specialised companies, rather than Governments forcing all companies to operate in both higher-carbon and lower-carbon industries.

Transition plans must be supported by economy-wide decarbonisation policies.Despite the good intentions behind divestment, it is clear that it risks concentrating higher-carbon assets in private markets, where investors are under less pressure from activists. Far from harnessing the financial sector to reduce emissions, this risks driving carbon-intensive activity into shadows. Mandatory transition plans are a step in the right direction; however, there are valid questions that are being asked about whether it is right to force companies to hold both higher-carbon and lower-carbon assets within a single portfolio. There is almost certainly more that governments can do to mitigate this risk, for example by supporting the creation of “bad banks”, which would allow and even incentivise companies to spin off higher-carbon assets into specialist vehicles designed to run down polluting assets in a Paris-aligned timeframe.

In any case, it is clear that these “green finance” policies work best when they are supported by economy-wide actions from governments, whether that is regulation on car manufacturers to sell more zero-emission vehicles, or carbon pricing and carbon border adjustments. With a combination of transition plans and decarbonisation policies in place, the financial sector would inevitably play its part in creating the Net Zero economy.

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Notes1. Cabinet Office (September 2021). Speech by Alok Sharma:

Cutting global emissions is essential to keeping 1.5 degrees alive. Link

2. Policy Exchange (March 2021). Capital Shift. Link

3. People & Planet (undated). Universities committed to pursuing fossil fuel divestment. Link

4. University of Cambridge (October 2021). Cambridge to divest from fossil fuels with ‘net zero’ plan. Link

5. Divestuss.org (undated). Divest USS! Link

6. Oxford University Smith School (April 2021). Significant fall in cost of financing renewable energy projects. Link

7. Matt Levine (October 2021). Nobody is Drilling the Oil. Link.8. Ibid9. Fletcher, L. and Brower, D. Financial Times (October

2021). Hedge funds cash in as green investors dump energy stocks. Link

10. The Glboal Power & Energy Elites (November 2019). The Global Power & Energy Elites 2020: Projects. Link

11. Reuters (June 2021). G7 backs making climate risk disclosure mandatory. Link

12. Policy Exchange (March 2021). Capital Shift. Link

13. HM Treasury (October 2021). Greening Finance: A Roadmap to Sustainable Investing. Link

14. E.ON (January 2016). Separation of E.ON business operations completed on January 1: Uniper launched on schedule. Link

15. Wilson, T. Financial Times (October 2021). Shell warns hedge funds risk derailing energy transition. Link

https://www.gov.uk/government/speeches/cutting-global-emissions-is-essential-to-keeping-15-degrees-alive

https://policyexchange.org.uk/publication/capital-shift/

https://peopleandplanet.org/fossil-free-victories

https://www.cam.ac.uk/news/cambridge-to-divest-from-fossil-fuels-with-net-zero-plan

https://divestuss.org/

https://www.smithschool.ox.ac.uk/news/articles/210419-significant-fall-in-cost-financing-renewable-energy-projects.html

https://www.bloomberg.com/opinion/articles/2021-10-27/billionaire-investors-are-worried-about-oil-drilling

https://www.ft.com/content/ed11c971-be02-47dc-875b-90762b35080e

https://www.global-energy-elites.com/articles-2020/egypt-megaproject-completed-in-record-time

https://www.reuters.com/business/environment/g7-backs-making-climate-risk-disclosure-mandatory-2021-06-05/

https://policyexchange.org.uk/publication/capital-shift/

https://www.gov.uk/government/publications/greening-finance-a-roadmap-to-sustainable-investing

https://www.eon.com/en/about-us/media/press-release/2016/separation-of-eon-business-operations-completed-on-january-1-uniper-launched-on-schedule.html

https://www.ft.com/content/6570670d-715e-433b-95dc-674e3e496a24

UNLEASHING CLIMATE CAPITAL NVIRONMENTAL FFAIRS

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