Can Sustainable Finance Save Us from the Climate Crisis?
Written by Nina Pusic & Julio C. Othon
2020 — the world is starting to see the impact of 1°C of warming above estimated pre-industrial levels. The past few years have had the largest wildfire season recorded in California’s history; severe floods due to rising rainfall averages during monsoons in India, Nepal, Bangladesh, and Myanmar; and devastation caused by stronger tropical cyclones, such as Cyclone Idai in Mozambique.
Conversations around the underlying factor exacerbating these disasters, climate change, have gained special traction over the past 5 years notably as a result of the 2015 Paris Agreement — ratified by 189 countries — and the tireless work of activists such as Greta Thunberg. However, climate change first became an issue of unified international concern almost 30 years ago at the signing of the United Nations Framework Convention on Climate Change in 1992.
A parallel can be drawn to socially-responsible investing, the idea that an investor can connect financial returns with positive impact. It has existed since the start of investing itself, but only gained traction over the last decade. This came as a result of the 2008 global financial crisis, when the debate about the financial sector’s accountability came to fruition. However, since 2018 ESG (Environmental, Social, and Governance) investing has gained momentum with the attention devoted to achieving the United Nations Sustainable Development Goals and combating climate change.
Credit Suisse expects that, across all asset classes, ESG products are to reach US$40 trillion by the end of this year with Europe way ahead of the curve, but with the US growing at a higher rate. Within equities, Morningstar reported this August that ESG funds had crossed the US$1 trillion mark for the first time ever — out of the US$41 trillion held by all investment funds worldwide.
Greenwashing: Separating fact from fiction
With an increasing number of multigenerational investors asking for their portfolios to be more aligned with their values, sustainable products are being made available to cater to this growing demand — either through the repurposing of existing funds or the launch of new ones.
While this is initially a cause for optimism, it also brings challenges such as “Greenwashing”. As explained by Mihir Kapadia, chief executive of Sun Global Investments, the term refers to “the process of companies engaging in marketing or public relations strategies to appear aligned with ESG objectives”.
Greenwashing can occur at either the company or fund level. For instance, a business can pretend to look greener by selectively reporting on its socio-environmental impact. Alternatively, major banks can have their buy-side talking about divestment in “dirty” organisations, whereas their sell-side is still offering services for these very same firms. In another example, a fund can present sustainable credentials, even declare itself “fossil fuel free”, without fulfilling its promise.
Adopting a genuine ESG strategy requires funds to develop the capability to execute a sustainability philosophy, clearly demonstrating it in its reporting. When working with ESG ratings providers, for example, it is imperative for funds to complement their work through a thorough internal assessment, particularly as providers’ ratings and methodology still offer great discrepancies. This is a particular challenge for passive funds, which do not make discretionary investment decisions, but rather benchmark on the major index providers, which are supported by ESG data providers. After all, a lot goes behind an ESG rating.
Different applications of ESG
ESG is an umbrella term for different investment focuses. Impact investor Bridges Ventures has developed a spectrum of capital demonstrating the different forms of allocating capital and its relationship with impact as well as risk (figure 2).
The ESG strategies being the most widely adopted are on the left side of the spectrum. These utilise socio-environmental metrics as either a risk management tool — e.g.: negatively screening sectors such as oil & gas in order to avoid transitional risks — or utilising ESG criteria as a tool for screening socially and environmentally net-positive companies — for example, investing in an organisation because its business model addresses a societal issue, such as climate change.
Thematic high-impact solutions, potentially aiming to unleash new market opportunities, tend to be associated with higher levels of risk and/or longer investment horizons. These are often not acceptable by traditional investors, however they currently offer some of the more exciting opportunities from an impact perspective.
The need for more ESG investors
ESG investments that generate competitive returns are still limited, however, to a very narrow array of opportunities. This is observed in a carbon cost curve produced by the Energy Research Centre of the Netherlands, explored in detail by a Harvard Business Review article. It highlights the country’s estimated costs of cutting carbon emissions — and meeting its Paris Agreement reduction target — with the most cost-effective technologies (figure 3).
Each bar represents a different approach for reducing greenhouse gas emissions. Activities above the zero-cost line are currently unprofitable for investors but they provide the highest, and needed, returns for society. As highlighted in the HBR article, for the Netherlands to achieve its 2050 climate target of a 95% reduction in emissions from 1990, all investments in blue would need to be funded.
In order to make these investments competitive, there is an urgent need to adopt climate-friendly policies such as subsidies as well as pricing negative externalities like pollution through carbon credits. For instance, the European Union’s Emissions Trading System has its carbon tonne priced at around 25 euros. While it has helped drive the coal-phase out taking place in the European continent, a carbon tonne’s price needs to go beyond 100 euros for many other climate technologies to be financially competitive.
Additionally, the commitment of investors in tackling the climate crisis should not be understated. Groups such as The Institutional Investors Group on Climate Change (IIGCC), a European membership body for investor collaboration on climate change, are making headway in guiding investors to take action on a low-carbon future. This form of committed and ambitious action is crucial to quickly mobilise capital for the low carbon transition.
But waiting for the financial industry itself to pursue these commitments and mainstream ESG investing one-by-one is not enough to save the planet. To reach a well-below 2°C of warming as mandated by the Paris Agreement, we need systemic, widespread action to reevaluate how all financial decisions are made, and make certain they are compatible with a carbon-neutral future.
Using Law to Accelerate Climate-Responsible Finance
One way we can even the playing field and help mainstream important aspects of ESG investing is to mandate that financial actors disclose the climate-risks of their investments. Law has always been a critical tool to regulate all financial actors across the insurance, derivatives, commercial banking, capital markets, and investment management sectors. To operate under a given jurisdiction, financial actors must comply with domestic regulation, regardless of what their balance sheets say. Therefore, using the law to regulate financial markets in the face of climate change, and mainstream ESG investing, is instrumental in making sure climate action in finance happens at the rate required to meet the Paris Agreement targets and ensure a habitable planet for the coming decades.
Changing financial laws and regulations appropriately can ensure that the widespread change in the industry can happen at the fast pace we need and has binding implications, not something that financial actors can turn their backs on. Moreover, appropriate climate regulation within the financial industry can and will make ESG investing thrive: investing that understands the environmental and climate impacts of its investments can, and must, become the norm.
Developing a more climate-responsible finance sector
Guidelines of best practice in financial actors on climate change have already been outlined by the Task Force on Climate Disclosure (TFCD): an organisation established in 2015 that develops voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders. The TFCD recommends that financial actors disclose the actual climate-related risks and opportunities, while also disclosing how the organisation identifies, assesses, and manages climate-related risk. The transparency in this disclosure is critical, as it first forces investors to understand how their investments are impacting the climate, and second, empowers their beneficiaries and clients to know where their money is going.
Implementing TFCD recommendations as a legal obligation would largely benefit ESG investment funds, as these funds are already conducting the necessary environmental and climate-related analysis of their investments prior to investing. This would give ESG a head start, as non-ESG investments must adapt to disclosing and inevitably addressing climate-related risk.
Nonetheless, the TFCD recommendations, as of now, are only voluntary. The job of law and policymakers is to make these recommendations obligatory as soon as possible — 2020 is the make or break decade and we have no time to waste.
Trailblazing in Climate-Related Disclosure
Luckily, this vision of using the law to regulate financial actors and hold them accountable for their financial impacts is not a distant imagination. Legislation is being enacted right now, in a jurisdiction where lawmakers are bold enough to lead and spearhead the way forward.
New Zealand’s government announced just this month that there will be mandatory disclosures for climate-related financial risks through an amendment to its Financial Markets Conduct Act of 2013. The policy will require banks, asset managers, and insurance companies with more than NZ$1 billion in assets to disclose their climate risks, in line with the emerging global standard from the TFCD. Although it won’t come into effect until 2023 at earliest, the amendment is still trailblazing a path forward for regulating the financial sector on its climate impacts. And it is time for the rest of the world to follow.
Whether it be mainstreaming ESG investing, or legislating for mandatory climate disclosure, it is clear that we have no time to waste when it comes to climate action in the financial sector. Financial actors need to spearhead the path to climate-resilience, and carbon-neutrality through sustainable investments, and those who fail to do so need to be held accountable.
Nina Pusic, LLM in Environment & Climate Change Law ‘20, MA Sustainable Development and Politics ‘19.
Currently an intern at the United Nations Framework Convention on Climate Change with their Adaptation Department.
Julio C. Othon, MSc Climate Change, Management & Finance ’21, MA International Relations ’20.
Former impact investing intern at MOV Investimentos, a Brazilian sustainable venture capital fund.
Originally published at https://recirkl.com on September 25, 2020.