COP28: 5 reforms to bridge the climate finance gap
Ahead of the UN Climate Change Conference (COP28), Finance Watch sets out 5 key reform proposals to help bridge the climate finance gap.
On 30 November, representatives from countries around the globe will arrive in Dubai to embark on two weeks of politically-charged climate talks. This year’s COP falls at the midpoint between the entry into force of the Paris Agreement – a legally binding international treaty on climate change – and the 2030 deadline for delivering on agreed climate commitments.
With that in mind, a global stocktake will take place at this year’s conference. The world is not on track to limit global warming to 1.5 degrees Celsius, and the goal of this first-ever stocktake is to identify and address gaps in order to chart a meaningful path forward.
One such gap is climate finance. Making our societies more sustainable, while also adapting to the impact of climate change on communities, requires a huge level of public and private investment.
Over the past years, progress in mobilising private finance has been frustratingly slow. Private finance currently accounts for just 40% of climate mitigation investment, a far cry from the 80% share it is required to contribute by 2030.
Initiatives such as the Glasgow Financial Alliance for Net Zero (GFANZ), while well meaning, have failed to translate pledges into action. The stark reality is that the world’s 60 largest banks have approximately $1.35 trillion USD invested in fossil fuel assets.
With the 2030 deadline fast approaching, it has become clear that if the world wants private finance to step up to the plate, the carrot is not going to cut it. Governments will need to use the stick.
As officials gather in Dubai and commence the global stocktake, Finance Watch has compiled 5 key recommendations they must take on board if they want private finance to live up to its climate commitments:
GET REAL ABOUT CLIMATE SCENARIOS
Private finance will only acknowledge the scale of the climate crisis when economic models are adapted to reflect the scientific reality and policymakers take deliberate legislative action based on this information.
Climate scientists warn of tipping points triggering around 2°C global warming and catastrophic consequences beyond 3°C. If temperatures reach these levels, it will have a devastating impact on the more than 3 billion people who live in contexts highly vulnerable to climate change. With such numbers, it would appear economic disruption is inevitable.
However, current figures estimating the impact of climate change on the economy and on the financial world paint a strangely benign picture. The issue is that economists are modelling climate risk in the same way as traditional financial risk. This means that economic models fail to account for the fact that losses from climate change will be disruptively large, unpredictable and permanent. Tipping points and feedback mechanisms, such as melting permafrost and burning forests, could accelerate losses to levels far above those from recent financial crises. But right now, the economic models and climate scenarios used by all finance ministries and international supervisors can’t see them.
GET SERIOUS ABOUT CLIMATE RISK
Private finance will only be able to play its part if the financial system is stable, and the financial system will only be stable if banks and insurers are obliged to account for climate risk.
Climate-related shocks have a physical impact. For example, a severe storm can dramatically affect people’s capacity to repay their loans, which in return impacts the solvency of financial institutions. These risks are currently not accounted for. The same is true for risks pertaining to the transition to a low-carbon economy. As mentioned already, the world’s 60 largest banks have approximately $1.35 trillion USD invested in fossil fuel assets. In the transition to net-zero, many of these assets will become stranded in the shift to a sustainable economy and lose their value. This will mean losses to the banks that finance such assets, and the same is true for insurers. Together with the damage due to catastrophic events induced by climate change, these losses might destabilise the whole financial system causing another financial crisis.
The most practical way of accounting for climate risk would be for lawmakers to mandate higher capital requirements for banks and insurers. In other words, financial institutions that are exposed and contribute to climate risk should have enough of their own funds held liable to cover potential losses to avoid taxpayer-funded bailouts.
MAKE “NET ZERO ALIGNMENT” MEANINGFUL
Private finance can only push the real economy towards carbon neutrality when policymakers take action to ensure meaningful net-zero targets are set and met. Net-zero aligned transition plans must be made mandatory for all economic and financial actors, and these plans must be closely supervised.
Policymakers and financial sector business alliances, including GFANZ, must ensure that what is captured by the “net” in net-zero can decarbonise the real world. The goal of net-zero should not be decarbonising financial portfolios or justifying business as usual; it must be about decarbonising the real world to avoid a climate disaster.
Finance Watch calls on policymakers to upgrade the current regulatory framework to create a comprehensive system of supervision, incentives and sanctions to ensure that net-zero transition plans are credible, become a top priority, and are adhered to and implemented across the economy.
Under this system, financial institutions would be entitled to ‘sustainable’ ‘climate-oriented’ or ‘net-zero status’ only if they sell investment products aligned with science-based sustainable taxonomies or transition-linked financial products with climate-related covenants or are investors or funds engaging with companies on their net-zero transition plans.
Financiers would need to prove to supervisors that they are leveraging their rights as shareholders, providers of credit or insurers to play a stewardship role to ensure their clients adhere to robust net-zero transition plans. Transition plans would not be allowed to include “avoided emissions” and carbon offsets outside of the value chain, and would only allow the use of a realistic amount of capture and storage. Finally, scope 3 reporting would be mandatory.
INCENTIVISE CORPORATE CHANGE
Private finance will only play its part in the sustainable transition when there is a fundamental shift in corporate behaviour and accountability.
Transparency and setting sustainability targets are important, but as the failure of multiple voluntary initiatives have shown, it is not a substitute for changing corporate behaviour and improving corporate accountability.
Countries must adopt a set of incentives and obligations for companies to follow their transition plans and reach their targets. One incentive would be to align a proportion of the variable remuneration given to directors with achieving corporate sustainability targets instead of the current practice of mainly linking directors’ remuneration with financial performance, which leads to short-termism. Directors should also be liable to a due diligence duty when it comes to environmental impacts in their value chain.
Private finance will only drive the sustainable transition when policymakers put a stop to greenwashing. Greenwashing distorts the playing field, favours the least virtuous and wastes precious resources, time and political energy.
Policymakers must take steps to clarify what sustainable investing is, and what it is not. Financial markets need science-based, clear, understandable and robust definitions for sustainable activities (taxonomies), products and labels.
They also require all companies to report in a comparable way on their sustainability performance. Companies must report on how they take sustainability risks and opportunities into account, but also on how their activities and business model materially impact the environment and the company’s stakeholders.
Market participants require reliable ratings for companies and financial products to take sustainability criteria into account when allocating capital. This means disaggregating the environmental, social and governance dimension of the ESG ratings, and stating explicitly whether the rating is about impact materiality or financial materiality.
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