To meet the goals of the Paris Agreement, finance must embrace a holistic approach to managing its impact on the environment. Eric Usher, head of UNEP FI, talks to AIQ about this shift in focus and the importance of public and private sector collaboration.

The United Nations’ Environment Programme Finance Initiative (UNEP FI) is a global partnership bringing together the UN and a global group of banks, insurers and asset managers to develop sustainable finance and responsible investment.1

Usher is uniquely placed to comment on how the global financial system should be transformed to deliver on the Paris Agreement

As head of UNEP FI since 2015, Eric Usher has focused on accelerating the deep integration of sustainability risks into financial practice, and building out frameworks for positive impact finance, such as the Sustainable Stock Exchanges Initiative2 and the Net Zero Asset Owner Alliance3 (both of which he is a board member for).

Working with key stakeholders at the corporate, national and supranational levels, Usher is uniquely placed to comment on how the global financial system should be transformed to deliver on the Paris Agreement goal to limit temperature rises to well below two degrees above pre-industrial levels. While he acknowledges there are sticking points, Usher sees a real possibility of implementing effective solutions, provided public- and private-sector actors join forces, as he explained in a wide-ranging interview with AIQ.

How can we transform the financial system to align it with net zero while avoiding its collapse?

The notion of sustainability engagement can be broken down into three aspects. One is managing the ESG risks on a financial institution’s business and financial interests. The second is the scaling up of green financing. And the third, where we have only really begun to see traction over the last couple of years, is the notion of alignment.

Investors, banks, insurers and others are getting better at managing the ‘outside-in’ risk

The risk agenda has deepened significantly. Investors, banks, insurers and others are getting better at managing the ‘outside-in’ risk, which is the impact of environmental or social degradation on their own financial activities and assets. There has also been a big scaling up in the financing of renewables and innovative technologies.

However, it's only really in the last few years that we have realised taking a piecemeal approach is not enough. If we manage all the risks and still only finance green stuff at the margins, we are not going to be addressing climate or other sustainability risks. We have to become much more holistic. It's not about adding on a green finance activity; it's about the entire portfolio, all the products and services that a financial institution – and any actor in the real economy – offers. And it’s understanding that full alignment reality.

This requires a focus on the inside-out; the notion that economic actors need to understand the impact they have on the environment and society. This is not easy, so institutions need to put in place systems to monitor, measure, manage and disclose impacts.

The next stage is to prioritise and focus where it matters most. As a bank, it's no longer about managing your paper or energy consumption. Those are relevant topics, but obviously the most important area for any financial institution is the impact its clients have. This all fits within the goal of moving from green transactions to green institutions.

If you can track the science, it allows you to see through a confusing policy landscape

The final aspect is that this is a strategic orientation. Sustainability can no longer be managed by an environmental, social and governance (ESG) team. The senior leadership in organisations needs to be fully on top of it, including sufficient understanding and expertise to manage these issues at the board level. It has to address them through, for instance, compensation, and you need to get alignment from the top of the organisation down.

If you can track the science, it allows you to see through a confusing policy landscape. Carbon is not priced in everywhere, but if you follow the science, you realise climate change is getting worse. Assuming policy will follow science eventually, using science may well be the most responsible fiduciary approach to take.

This is now borne out with the International Financial Reporting Standards Foundation, as it will be recommending that corporations start to disclose on sustainability impact. That will be an important and closely watched development.4

How can we support financial institutions to invest, lend and underwrite for the transition, and eventually divest from carbon intensive businesses that today might offer higher returns?

Once you have a system to measure and prioritise impacts, the next step is to start setting business targets to make material improvements in specific areas. The place with the most focus today is on addressing the climate challenge. An example is the increasing net-zero commitments being taken by governments and the private sector. An investor who sets a net-zero target is essentially setting a target to manage their climate impact over a specific time period.

Over 100 governments around the world have set a net-zero target

We have been very involved with this, including through the launch of the Net Zero Asset Owner Alliance in 2019. We now also have a Net Zero Insurance Alliance and a Net Zero Banking Alliance, and over 100 governments around the world have set a net-zero target.

UN Secretary General Antonio Guterres considers the Net Zero Asset Owner Alliance to be the gold standard for net-zero initiatives because its members are issuing 2025 targets that follow a science-based pathway to net zero. This group of investors [including Aviva] have been at the forefront of setting targets and designing methodologies to assess how they have been implemented. The investors have worked together to break it down across sectors like energy, transport, cement and steel, and agriculture and, for each of these sectors, to figure out a science-based pathway to net zero.

This then allows investors to work with companies to help and nudge them to be on the right side of the transition. Leaders within an industry will get more support through investors’ proxy voting, the selection of directors and the like; and those who are falling behind will be pressured to change, which could potentially lead to divestment. This is the role of the investment industry.

Insurers also play a critical role in many industries as they go through this transition. Some US coal companies could go bankrupt and no longer have much value from a capital markets perspective but will continue to operate, even in bankruptcy. Insurers who insure such facilities will have much more leverage over them than investors. Banks also have relationships with companies and can apply pressure.

As more industries realise they need to decarbonise, they also realise this is the largest investment requirement in the post-war period

As more industries realise they need to decarbonise, they also realise this is the largest investment requirement in the post-war period, not just to develop new green activities but to green the core of existing activity. And change requires investment, lending, and all aspects of the financial system. It is a risk and a cost, but it's also an opportunity. Even the quest for short-term returns is not stopping this. There are a lot of high-carbon businesses that everybody thought couldn't be changed because of the high returns they provide, yet in recent years those companies have stopped operating, or their business models have totally changed.

Although scientists often see things changing in a linear fashion, capital markets are quirky and can quickly change. If a business is not managing and engaging on issues appropriately, its value can rapidly dissipate.

Obviously, there is a question of how much financial actors can do without the proper pricing on carbon in place. PRI research called The Inevitable Policy Response explains that markets where the policy response remains insufficient are not an excuse to sit back but a reason to pay more attention because the later the policy response comes, the more brutal it has to be to catch up.5 But the financial sector cannot do it on its own, and we need policy signals. They will never come as quickly as we would hope, but in the last 12 months there has been a significant step up.

When Mark Carney issued his famous speech at Lloyds on the tragedy of horizon 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 2025.6 In a way, we have solved the tragedy of the horizon. Internal combustion vehicles are being phased out in many markets by the 2030s, so automakers that have not switched to electric vehicles are already suffering in terms of their valuations. The response has come into the business cycle: if we aren't acting today, we are exposing ourselves, our clients and our shareholders.

What will the financial sector need to look like by 2050?

To sum up what I’ve already touched on, financial actors can no longer just focus on the financial risk attributes of the activities they finance. They need to understand the impact of their financing and, increasingly, regulators will require these impacts to be managed, whether it's the form of climate or other ESG disclosures.

Financial actors can no longer just focus on the financial risk attributes of the activities they finance

All these actors need to see these issues in a holistic manner, having the risk management team implement integrated notions of environmental and social risks. It has to cover all systems within the organisation, including compensation.

That then means setting alignment targets. The challenge of climate risk disclosure is not predicting the future based on what failed in the past; it's predicting the future when we don't exactly know what it will look like. This requires an understanding of the science, and then risk models capable of estimating future losses. Although we always hear the data and methodologies are lacking, increasingly, we can’t wait for the data to be perfect, but must start taking action based on the data we have and improving our models as we go.

The relationship between market actors and regulators will also be key. Historically, the common view was that private institutions should not engage on topics like climate change until they were regulated to do so. That no longer holds true because, as these issues become increasingly complicated, it's hard for regulators to mandate out of the blue. It's much more effective if market actors lean in voluntarily.

For example, with climate-risk disclosures, when leaders started to issue voluntary climate-risk disclosures based on the TCFD recommendations, they showed how it could be done by developing scenario-based models, and regulators learned from that. In markets where regulators decide to mandate those disclosures, they can do so based on what has been done voluntarily. That will be similar in the net-zero transition where, once again, the private sector can lead by example. The relationship between public and private works effectively where it's not one waiting for the other, but it is more of a dance of ratcheting up together.

Some parts of the financial system have fallen behind. Eventually it could be the role of regulators to restrict certain activities

Some parts of the financial system have fallen behind, including in private markets. Progress will need to be made there; we would hope voluntarily, but eventually it could be the role of regulators to restrict certain activities. If some institutions stop financing coal but others don’t, regulators or policymakers need to figure out how to ensure the coal stays in the ground.

Of course, there are a lot of specifics. Investment banking would be a key example. The banking sector has made the most progress on corporate finance, and particularly what is on their balance sheet. But in areas like investment banking, which is an advisory service, or where the exposures are very short term, progress has been much slower. We expect that to change, but we have to figure out what it means to align investment banking activity to Paris or other sustainable objectives. The relationship with banks’ investors will also be key.

We need to make sure everyone is playing their role in mobilising capital towards the transition and, increasingly, limit capital to other damaging activities.

What are the core challenges facing the transition of the financial system?

No one country or company can solve climate change, so leadership comes at a cost if others don't follow. However, in Copenhagen in 2009, the climate negotiations failed when we tried a top-down agreement. It didn't work, geopolitically. The Paris Agreement structure is bottom-up, based on individual countries committing to what they can do. There were sceptics, including myself, in the beginning, but because of all of the soft pressures countries and companies come under, that approach can be more effective.

No one country or company can solve climate change, so leadership comes at a cost if others don't follow

In terms of challenges, the question is how to ensure they follow through. Companies and financial institutions ratcheting up their ambitions have a big impact through the signals this sends to governments to ratchet up their own ambitions.

The Net Zero Banking Alliance was launched in April at the US climate summit. In the closing press conference, John Kerry, President Biden’s climate envoy, was asked why the US committed to targeting a 50 per cent reduction by 2030. He said they didn't have a choice but to follow the financial sector. This gives an idea of why signalling is so important.

It goes back to this dance between public and private, which is the main challenge. We have seen a lot of progress, but we also know we are definitely not on track yet to stay within 1.5 or even two degrees. If we can get it right and move in concert, we can address these issues.

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