AIQ: Cleaning up capitalism

Cleaning up

Transforming finance for a net zero world

To align with net-zero emissions targets, the financial system needs a radical transformation.

“If we continue with business as usual, the likely erosion of value could be in the tens of trillions of dollars. Transforming finance now can help avoid those losses. In that sense, it's a colossal insurance plan,” says Steve Waygood, chief responsible investment officer at Aviva Investors.

Transformations are needed across all industries that will require funding from the financial system, which must manage the myriad risks that arise.

The 2021 Finance Climate action pathway report, published by the Marrakech Partnership under the aegis of the United Nations, states: “It is essential that finance and the power of markets are harnessed in the service of delivering a just and smooth transition to a resilient, net-zero-emission global economy that accounts for the climate impacts of its activities.”1,2

From outside-in to inside-out

For the transition to be effective, finance must radically change its approach from outside-in – measuring and mitigating the risks posed by climate change to finance – to inside-out – measuring and mitigating the impacts finance has on the planet.

“Financial actors can no longer just focus on financial risks,” says Eric Usher, head of the UN Environment Programme Finance Initiative (UNEP FI)3. “They also need to understand the impact of their financing and, increasingly, we are going to see regulators mandating the disclosure of these impacts. The change has to be holistic and cover all systems within the organisation, including compensation.”

Within the core of the international financial architecture are banking, insurance and investing.

“At the heart of those pillars is the real economy, underwritten and capitalised by those sectors, then come national finance ministries, who oversee the central banks, who oversee the regulators, who oversee the pillars,” says Waygood. “We need to look through that whole picture. We need to work inside out and change incentives in the real economy so that externalities are internalised. But we also need to work outside in and make sure the whole system aligns with the Paris goals.”

Data, disclosures and macro stewardship

The UN’s Finance climate action pathway report states that to reach net zero by 2050, “every financial decision must take climate change into account and financial flows must be consistent with low greenhouse gas emissions and climate-resilient development”.

The Finance Climate action pathway report recommends mandatory disclosure of climate-related risks by companies, local authorities such as cities, and at the asset level, so financial institutions can integrate those risks into their decisions. It also calls for regulatory oversight and macroprudential intervention over financial institutions’ use of data to form transition plans and science-based short- and long-term targets for decarbonising financed emissions.

This should be supported by updated accounting standards, auditing practices and listing rules on stock exchanges, so the true cost of climate risk is reflected on balance sheets.4

Financial institutions can tell regulators where the market failures lie

Waygood believes regulators and financial institutions working in partnership – which he calls macro stewardship – is the best way to address the market and regulatory failures.

“Financial institutions can tell regulators where the market failures lie, both together can explore how they might be corrected, and regulators can deploy the levers of change, such as fiscal measures or market mechanisms like trading schemes. The more investors join forces, the more change we can achieve,” he says.

Regulation

Regulators are setting out their expectations.5 Though guidelines vary across jurisdictions, they cover governance and strategy, including reshaping business models and aligning remuneration policies, risk management and disclosure.

In April 2021, the Basel Committee on Banking Supervision published a paper on climate-related risk drivers and their transmission channels, developing a framework for the modelling and management of climate risk for banks.6

If we aren't acting today, we are exposing ourselves, our clients and our shareholders

In the same month, the European Insurance and Occupational Pensions Authority (EIOPA) published an opinion piece aiming “to foster a forward-looking management of [climate] risks to ensure the long-term solvency and viability of the industry”.7

The authors of the Finance Climate action pathway report hope that by 2050, financial markets, institutions and systems will be in place to support and fund a resilient zero-carbon economy and society.

“In 2015, everyone still thought of climate change as an end of century notion, but over the last six years we have shifted the focus to 2050, and now even 2030 or 2025,” notes Usher. “The response has come into the business cycle: if we aren't acting today, we are exposing ourselves, our clients and our shareholders.”

References

  1. Set up in 2016, in the wake of COP21, the Marrakech Partnership supports implementation of the Paris Agreement by enabling collaboration between governments and the cities, regions, businesses and investors that must act on climate change. 'Marrakech Partnership for Global Climate Action', United Nations Climate Change, 2021
  2. ‘Finance - climate action pathway’, United Nations Climate Change, 2021
  3. UNEP FI is a global partnership bringing together the UN with a global group of banks, insurers and asset managers working to develop the sustainable finance and responsible investment agendas. UNEP FI has established some of the most important sustainability-oriented frameworks within the finance industry, including the Principles for Responsible Investment (2006), the Principles for Sustainable Insurance (2012) and the Principles for Responsible Banking (2019)
  4. ‘Will accountants save the world? An interview with Richard Murphy’, Aviva Investors, August 6, 2021
  5. ‘Climate change and sustainability: Global regulators step up the pace’, EY, 2021
  6. ‘Climate-related risk drivers and their transmission channels’, BCBS, April 14, 2021
  7. ‘EIOPA issues Opinion on the supervision of the use of climate change risk scenarios in ORSA’, EIOPA, April 19, 2021

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