A broken system
We are living through one of the hottest decades ever recorded, with climate-related natural disasters increasing in frequency and intensity. And yet we continue to invest in high-carbon industries, with greenhouse gas emissions at record highs in 2018 and coal finance on the rise. We are also losing biodiversity at unprecedented rates, with over a million species on the verge of extinction. Recent images of the forest fires in the Amazon remind us that tropical deforestation (largely caused by agricultural and infrastructure expansion and livestock ranching) accounts for around 15% of global greenhouse emissions which is a major driver of global heating and environmental degradation.
System change not climate change
We know that limiting global warming, mitigating the effects of climate change and delivering the UN Sustainable Development Goals (SDGs) will require a rapid and far-reaching transformation across the real economy: we need to green the energy system, decarbonise heavy industries including hard to abate sectors like cement and steel, integrate resilience into the design of our buildings, transport systems and cities, and revolutionise the way we produce food and use land. But to achieve net zero emissions by 2050, the financial system also needs to move.
Products, Practices and Partnerships
A massive reallocation of capital away from emissions-intensive investments and into low-carbon solutions across all geographies and all asset classes will require the right products to incentivise clean technology and more sustainable practices. We will also need better institutional practices which build the capabilities and capacity to generate green pipeline. Finally, this won’t happen without innovative partnerships across the development finance, philanthropic and commercial investment communities, including through the use of blended finance vehicles and instruments to mobilise private capital for the SDGs.
By sharing learnings, coordinating action and testing new pilots, the Blended Finance Taskforce aims to showcase actionable solutions and tackle some of the critical barriers which currently prevent the financial system from being an enabler of the low carbon economy. This paper will look at the following key questions:
Products
How can we ensure that sustainable finance products are ambitious enough (e.g. actually aligned with Paris and the SDGs and able to shift portfolios)?
What are barriers and solutions to piloting and then scaling new sustainable and blended finance products?
Practices
What lessons can be shared across development and commercial finance institutions to help build capacity to scale up sustainable investments (e.g. standards, internal tracking mechanisms, pipeline generation etc)
What can the development finance community learn from commercial market and vice-versa to create the right incentives and culture to invest in long-term, low-carbon solutions?
Partnerships
What are the types of partners that could be brought in to successfully scale the sustainable and blended finance “market” (e.g. in financial structuring, pipeline development or project execution)? Who is missing from the conversation?
How can we improve the process of assigning concessional capital to projects and vehicles? (e.g. “matchmaking” platforms or regular tenders to accelerate effectiveness, transparency and lower transaction costs)?
Investing in Paris for a better world
According to the scientific community, limiting global warming and mitigating the effects of climate change will require a rapid and far-reaching transformation across the real economy where we generate net zero emissions by 2050. To do so, we need to green our energy system, decarbonise heavy industries including hard to abate sectors like cement and steel, integrate resilience into the design of our buildings, transport systems and cities and revolutionise the way we produce food and use land.
Achieving these goals will require strong and coordinated political leadership, a recalibration of consumption patterns and pioneering businesses who drive new operating models where value is created through sustainability.
But none of this will happen – or happen fast enough – unless it is combined with a rapid and widespread transition across the financial sector. To have any hope of decarbonising the global economy and delivering ambitious climate targets under the Paris Agreement, we need a massive reallocation of capital away from emissions intensive investments and into low carbon solutions across all geographies and all asset classes.
There is growing momentum and countless new initiatives which are committed to “greening” the financial system. But this is not happening at the necessary scale, speed or with the level of coordination required. The financial system is only responding at the margin.
This means that unprecedented efforts to install renewable power capacity still only translate into 2% of global energy demand and spending on wind and solar has now fallen 8% in 2018 to $332 billion. By comparison, the largest global banks have poured nearly $2 trillion into fossil fuel financing since the Paris Agreement was adopted, with financing on the rise each year.
Coal finance has continued to expand despite more banks and financial institutions taking steps to eliminate their involvement. Carve-outs and loopholes still exist; banks who commit not to finance greenfield coal projects have not necessarily have taken steps to limit their coal-related advisory, insurance and corporate finance work. All of this has corresponded with the highest ever greenhouse gas emissions recorded in the year of 2018.
Investing more and smarter in the new climate economy
To achieve net zero emissions by 2050, a lot more capital will need to shift into the new climate economy which is low carbon, captures and pays for the negative externalities of high-emissions industries like coal or livestock, and which creates value from more circular and sustainable activities.
First, we will need to multiply the annual average investment in low-carbon technologies and energy efficiency by roughly a factor of six compared to 2015 levels. This will mean renewing our energy-related infrastructure to the tune of $200 trillion and decarbonising at least $50 trillion of existing infrastructure over the next 30 years.
Second, we will need to mobilise another $1 trillion each year to make infrastructure more resilient to the inevitable physical impact of climate change. The lion’s share of this needs to go to emerging markets, who are typically on the front-line of climate change and much less equipped to handle the effects.
Finally, we must commit an additional $300-350 billion a year to transform global food and land use systems – which represent at least a third of the most cost-effective climate mitigation solutions, and are also essential to strengthening food security and biodiversity.
Reimagining the way we invest
Investing in the low-carbon economy has traditionally been more capital-intensive than continuing as usual (for example building a wind farm typically has higher up-front costs than building a thermal coal power plant) and this financing requirement has often been a barrier to scaling investment in renewables or energy storage. However, with significant reductions in the cost of clean-tech inputs (especially for solar and wind) and the advent of innovative financial products like green mortgages to incentivise energy efficiency in buildings, it should be easier to repurpose outstanding capital towards low-carbon, resilient assets and increase upfront capitalisation of the system.
It is not only cheaper technology that can accelerate the low carbon transition, but also about new “smarter” delivery models. Solutions which are more distributed, digitised and service-based, and which capture the benefits of new technologies, economic clusters and natural solutions to increase resilience and connectivity (so called “Infra 3.0”) can increase the productivity of assets and reduce costs by offering infra-light alternatives. By taking a lifecycle-approach we can also better understand the costs and benefits of an asset over time, including the impact on maintenance and the cost of negative externalities on human health and the environment.
Increasing infrastructure productivity and cutting investment needs could deliver huge savings, but it will require a wave of financial innovation from sophisticated financial players – shifting investment structures and developing new business models, new partnerships and tech platforms to make it work. Blended finance solutions which use development capital to mitigate investor risks can play a crucial role for this transition.
Development finance institutions can for example help to aggregate projects so that largescale capital can still access smaller scale investments and philanthropic funds can be particularly catalytic to seed entrepreneurs and scale technology innovation, especially in more difficult geographies or high-impact sectors.
The Paris opportunity
The good news is that redirecting our capital flows into low-carbon technologies and regenerative, circular models of production and consumption can both reduce risk and drive higher-quality economic growth and investment returns. Bold climate action is expected to generate $26 trillion in global economic benefits through 2030, creating 65 million new low-carbon jobs while preventing 700,000 premature deaths each year from air pollution. The food and land use sector alone represents a $4.5 trillion annual business opportunity across ten critical transition areas including forests, regenerative agriculture, nutritious diets, healthy oceans, alternative proteins and more efficient supply chains.
Critically, investing “in line with Paris” does not mean jeopardising returns or mandates. On the contrary; it is becoming increasingly evident (and slowly clarified by regulators) that incorporating environmental and social considerations is key to mitigating financial risk and in-line with institutional investors fiduciary duty (e.g. responsibility when acting on behalf of others). Particularly for assets and industries exposed to climate-related physical and transition risks – as well as generating better performance.
This means that shifting the financial system to become more sustainable should be in line with long-term asset owner fiduciary duties as well as the objectives of savers in the broader society. It should really be no surprise that a recent survey suggests that close to 70% of UK pension plan holders want their investments to consider the impact on people and planet alongside financial performance.
Temperature check on sustainable finance
With such a strong business case, is anything happening today? Newspaper headlines suggest that the finance industry is getting on with it – streamlining products, practices and partnerships to transition to the new climate economy and capture the value from this systemic shift. We know that a number of leading investors are grappling to understand their exposure to physical and transition risk. Others are actively pursuing the financial opportunities related to a low-carbon economy – in some geographies this is heavily driven by pro-climate regulatory pressures (e.g. in France, the Netherlands and the UK). In others, it is driven by the need to “future-proof” portfolios for imminent shifts across demography, consumer preferences, technology and climate-related risks.
The media continues to report ambitious climate finance targets from development banks (e.g. committing to Paris-alignment), to profile investment banks as they expand their sustainable finance practices (e.g. JP Morgan and Goldman Sachs), to highlight new climate and resilience initiatives (e.g. newly launched UN Principles of Responsible Banking, ClimateAction100+) and to catalogue acquisitions of climate risk analytics boutiques by mainstream financial advisory and ratings firms (e.g. 427 bought by Moody’s).
Following on from the rise of green bonds, pioneered over a decade ago by the development banks, we have seen new trends emerging for green and sustainable labelled products such as exchange traded funds (ETFs, catering for the passive market), transition bonds (to support brown going green), sustainability-linked loans (tied to environmental performance), parametric insurance offerings (triggered by climate-related disasters) and resilience bonds (as just issued by the EBRD).
Across the industry, there has undoubtedly been a significant uptake in green and sustainable finance activity. The large multilateral banks hit record high $43 billion in 2018, up 22% from the previous year. The macro numbers for global sustainable finance assets under management came in at $31 trillion for 2018, up over 30% from the previous year. These assets reportedly account for a third of total tracked assets; in some regions they account for more than half. This year especially, investors can't seem to get enough of booming sustainability-themed ETFs which exploded in the first half of 2019 having already attracted more than they did in all of 2018.
But is it enough?
Many of the market’s largest players are sitting on the side-lines. Huge variation remains between investors across geographies, and the numbers and sustainability headlines may be somewhat misleading. Only a fraction of these activities could be said to be driving “deep green” climate action. No matter what the numbers, the latest report from global ratings agency S&P, states that banks and other investors are dramatically underestimating climate-related risks.
Very few have a Paris-aligned strategy or “net-zero” ambition. The most common sustainable investment strategy globally continues to be negative or exclusionary screening on the basis of environmental, social and governance (ESG) factors – especially in Europe where this accounts for more than 60% of the total “sustainable finance” universe. Arguably, this kind of negative screening strategy does little to directly support the expansion of low-carbon projects. ESG-integration is becoming more popular, with assets of roughly $17.5 trillion (up 70% past two years). The more active strategies, often coined “impact” or “thematic” investing count for only a tiny fraction of the reported total (current size of the impact investing market roughly at $500 billion).
The product range available to help “green” mainstream capital is still very small and not expanding rapidly enough, despite new products being launched almost weekly and lots of attention given to green bonds in recent years. Specialised labels for sustainable finance funds have been granted to just over 400 financial products in Europe over the last decade, but when compared to over 60,000 funds available on the European market this number gets less impressive. The cumulative total of green bonds issued as of 2019 is still minuscular at $650 billion compared to the total bond market which exceeds $100 trillion.
Perceived trade offs
Relatively few investors have climate change seriously on their core investment agenda. For the large majority, climate issues are still not considered material and do not feature in short-term investment decisions. Some asset owners go beyond the bare minimum, but that’s too few. Why? They are not convinced that pursuing green will deliver and that there is no trade-off between investment performance and sustainable investing. Certainly not in the short-run which drives their own private incentives.
Among hedge fund managers, an overwhelming 60% still do not consider ESG factors when selecting equities for their portfolios. Despite the urgency of the climate situation, the prevailing belief in international finance is that portfolios will have time to gradually evolve. This leaves all mainstream portfolios exposed to the risk of a sudden shift in sentiment – a Minsky moment – by the financial community once climate risk comes to the fore due to some unpredicted event.
As is often the case, finance is characterised by binary risk exposure: a problem can be neglected until it is too late. Even though capital markets are supposed to look to future cash-flows, the combination of discounting methodologies, short-term incentives and the unfamiliar, non-linear nature of climate-related risks makes it almost inevitable that, absent strong regulation, market actors will only respond when it is too late. The ability of cash-rich, carbon-intensive incumbents to reward financial intermediaries with rich fees only compounds the problem.
What needs to change?
Multiple market factors, information failures and policy distortions within the capital markets create a bias towards the status quo – in this case, an economy addicted to fossil fuels and a financial sector which has largely only responded in an ad hoc way to the climate crisis. Given that the low-carbon transition is one that is relatively capital intensive, this becomes a huge problem as money won’t flow at the speed and scale required. As a result, the finance system is itself a brake rather than an accelerator of the required transition.
We could drive real change by tackling the following barriers and accelerating systemic solutions: 1) Creating the right regulatory incentives (amend existing regulations and capital weighting measures to support investing in infra in emerging markets) 2) Clarifying fiduciary duty and changing mindsets (more clarity on what falls within fiduciary duties which can further challenge old mindsets that considering ESG risks limiting returns) 3) Reviewing asset allocations towards infrastructure (increase investors ability to pursue infra in emerging markets and new infra/tech service solutions) 4) Improving taxonomy and quality of green products (differentiate brown from green, challenge asset managers and consultants to not only stay with conventional and proven products) 5) Expanding data tools and transparency (improve ability to assess climate exposure, build out internal climate expertise and expand external information to hold players accountable) 6) Narrowing information gaps and reducing perceived risk (create blended finance structures to overcome barriers for investors to participate in challenging geographies and asset classes)
Encouraging examples of leadership
There are a number of sustainable finance pioneers across the development and commercial finance communities who are trying to tackle these capital-market specific constraints to accelerate Paris-aligned investment. When Greta Thunberg, the 16-year-old climate activist, addressed the 2019 UN General Assembly, she said that global leaders can’t possibly have understood the magnitude of the climate emergency or else they could not keep failing to act.
Of course, we know there are numerous systemic barriers which compound to prevent the capital shifts we need to see in order to accelerate the transition to a low carbon economy. And while it is possible to get disheartened by the size of the task at hand, it is a widespread expectation that pressure for action will only increase – giving courage for political leaders for bold policy, giving mandate for regulators to change rules, pressuring leaders to transform their business models, driving more innovation for technology solutions and incentivising investors to re-allocate capital flows towards a low-carbon pathway.
The areas of change and innovation highlighted in this paper are a good start, but we need to go faster and mainstream this agenda. The good news is that there is already significant momentum happening (e.g. with the arrival of physical risk analytics).
Critical areas to deepen and accelerate change further include to:
Challenge asset owners, asset managers and investment consultants on the heavy focus on quarterly earnings, past track-records and data instead of forward looking and longer-term climate and tech-risk adjusted projections
Work with finance ministers across all geographies to incorporate climate resilience in macro-fiscal and financial frameworks (including working with the insurance industry for new solutions and IMF incorporating climate in its consultations)
Increase public awareness of the power of their personal finances to push for climate (e.g. to unleash the “Greta generation” to demand for sustainable pensions, insurance or bank accounts).
We have to remind ourselves that finance markets can only go so far without the right regulatory and policy context. Furthermore, there is still a deep problem in capital markets related to the short-termism of many of the individual agents and only the asset owners can really change this – and that would take a revolution in the mandates that they, whether as institutions or as individuals, provide to their asset managers and pension providers.
Fortunately, we now have finance ministers, central banks, regulators, credit rating agencies – and importantly, investors and business – all elevating and accelerating efforts on climate. This is exciting and could lead to new norms in capital markets where the herd instinct is very strong.
We also need stronger acts of bold individual leadership combined with support for regulatory action that drives both transparency and capital allocation towards a low-carbon economy. Ultimately, the financial system can and must be an accelerator of this transition; and those who move early will benefit the most. We know what to do, we just have to get going.