Economic net-zero is set to start in the UK. In its Greening Finance roadmap published yesterday ahead of COP26 in Glasgow, the UK Government confirmed that it will introduce 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.
Climate risk management (CRM) is often erroneously conflated with seeking or achieving alignment with climate outcomes (ACO). But, while there is some overlap, they have different objectives and often different results. Meanwhile, we are not moving in the right direction for investors, companies, or the climate.
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. The threat 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.
The G20 Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) has created a framework on climate-related risk exposures. And there has been a plethora of new initiatives, products, and services intended to help financial institutions measure and manage climate-related risks.
But if we are going to achieve net-zero 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 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 urgently to 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.
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, as well as create demand for new ways of measuring performance using the latest earth observation, AI, and data science methods.
Mandatory net-zero 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
The fact is, CRM can make little or no contribution to ACO. For example, a company’s exposure to projected increases in carbon prices in Country A could lead to emitting production being moved to Country B - which has lower environmental standards. Overall, this could, therefore, increase net carbon pollution. Or a company could hedge its exposure to projected increases in carbon prices through derivatives contracts such as swaps. But this would not change the underlying economic activities – and have little or no impact on emissions. Or a retail investor could disinvest from FTSE 100 fossil fuel companies, and reduce their exposure to climate-related transition risk. But this would make very little or no difference to whether the fossil fuel company becomes more likely to achieve ACO.
Depending on who buys the shares, it could in fact, make ACO less likely.
This is not to say that CRM cannot result in better climate outcomes. Company A’s exposure to projected increases in carbon prices could be reduced by reducing carbon emissions - thereby helping ACO. A universal owner, such as a large pension or sovereign wealth fund, could potentially contribute to lowering climate related risks by advocating for timely and effective climate action by governments.
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.
In December 2021, it will be six years since the G20’s 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 climate risk 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 ACO. We now need to focus on designing and implementing the net-zero carbon transition across the economy. Mandatory net-zero transition planning will create needed demand for both real economy solutions and capital to finance those solutions.
By Dr Ben Caldecott, founding Director of the Oxford Sustainable Finance Group and the Lombard Odier Associate Professor of Sustainable Finance at Oxford. Since November 2019, he has been seconded to the UK Cabinet Office as the COP26 Strategy Adviser for Finance.