POTSDAM, PARIS, ZURICH – Unless the world reduces greenhouse-gas emissions rapidly, humanity is likely to enter an era of unprecedented climate risks. Devastating extreme-weather events are already increasing in frequency, but much of the worst climate-related damage, such as a sustained rise in sea levels, will be recognized only once it is too late to act.
Clearly, the climate system’s time horizon does not align well with the world’s much shorter political and economic cycles. Listed companies report on a quarterly basis, and recent regulatory changes, such as those mandating increased use of mark-to-market accounting, limit long-term thinking.
Governments usually have legislative cycles of no more than four years, and they must also respond to immediate developments. Yet stabilizing the climate requires sustained and consistent action over an extended period.
AXA and UBS, together with the Potsdam Institute for Climate Impact Research, CDP (formerly the Carbon Disclosure Project), and the EU’s Climate-KIC (Knowledge and Information Community) recently organized a conference in Berlin. There, they discussed with leading experts in green investments and fossil-fuel divestment how financial intermediaries can help to address climate risks.
The financial industry’s active involvement is urgently needed. In the Paris climate agreement reached last December, countries worldwide agreed to limit global warming to well below 2° Celsius, thereby defining the track on which the world must progress rapidly. Over the next 15 years, an estimated $93 trillion will be needed for investments in low-carbon infrastructure.
Government funding alone cannot meet this demand, so the financial sector must help fill the gap. By redirecting capital flows toward proactive efforts to mitigate and adapt to climate change, financial institutions can protect client assets from global climate risks, and from the economic risks that will attend a warming planet. They are also demonstrating their social responsibility for the wellbeing of future generations.
But financing change requires changing finance. And this process is already underway. Development institutions such as the World Bank are reconsidering their investment policies. And, in the private sector, there is growing enthusiasm for “green” bonds, loans, indices, and infrastructure investments.
Still, as the European Commission notes, less than 1% of institutional assets worldwide are invested in environmentally friendly infrastructure assets. Given historically low interest rates and the general lack of attractive investment options, this is an ideal moment to tap into investors’ growing appetite for green financial products.
Many large financial institutions have recently joined a global initiative promoting fossil-fuel divestment. Research findings indicate that global CO2 emissions must be restricted to less than one trillion metric tons between 2010 and the end of the century to comply with the Paris agreement and limit global warming to below 2°C. This means that most available coal, oil, and gas reserves must stay in the ground.
As a result, investments in fossil-fuel energy sources will continue to lose value over time, eventually becoming stranded. Thus, the financial sector’s revaluation of such holdings not only helps to stabilize the climate, but also better protects its clients’ investments, and, by preventing the creation of a “carbon bubble,” helps to stabilize economies. But selling off these holdings will not suffice; the freed-up assets must also be redirected to more sustainable businesses.
For financial institutions and investors to do their part, they urgently need a better understanding of the relevant climate-related investment risks, which the Financial Stability Board (FSB) has divided into three categories: physical, transitional, and liability. Informed investment decisions will require sound, scientifically grounded data and uniform standards to assess these risks, and to quantify opportunities against them.
Effective disclosure will hence be a key part of any new framework. An FSB taskforce – comprising representatives from banks, insurers, institutional investors, rating agencies, consultants, and auditors – is currently shaping voluntary standards, so that companies provide consistent and comparable climate-related financial disclosures to their stakeholders, whether investors or lenders. This will also allow companies to gain valuable insights into their own potential for change, reflecting a time-honored principle: what gets measured, gets managed.
This is no easy task. For example, carbon footprints on their own will not steer investments in the right direction. Instead of identifying the champions of environmentally friendly solutions, these figures merely reveal which companies currently emit the most greenhouse gases. Meaningful disclosure standards must take account of sector-specific information and the impact on business strategies of the transition toward a low-carbon economy.
All the governments that signed the Paris agreement can now be expected to adopt a range of measures to enable them to implement their de-carbonization strategies. In this context, carbon pricing will be an essential part of the policy toolbox. Some governments have already taken steps to promote the development of green products, via tax or market incentives. Overall, such changes to legal frameworks must support, not impede, the private financial sector’s efforts to tackle climate change.
Financing the infrastructure projects that are too expensive for some national governments to finance on their own, but that are essential to the transformation of our energy system – such as wind farms and long-distance power lines – will require a new class of global infrastructure bonds. In the past, governments have encouraged investment in government bonds. Now, in order to increase private investment in building up clean infrastructure, investor-protection measures and dispute-resolution mechanisms must be considered.
The financial sector is ready to spearhead the shift to sustainability. When Germany takes over the G20 presidency next year, it will have the opportunity to convince its partners to create an adequate framework to encourage change in the financial sector that ensures a smooth adjustment to a low-carbon economy. For both public and private actors, the time to act is now.