Commentary

Aligning Finance with Climate Action

Julie Segal, Visiting Fellow at the London School of Economics’ Grantham Research Institute on Climate Change & the Environment, outlines the challenges and opportunities of the Paris Agreement’s Article 2.1(c).

Aligning investments with climate change mitigation and adaptation goals, as required under Article 2.1(c) of the Paris Agreement, seems sensible – why would we collectively pursue investments that harm people and the planet? But the reality of Article 2.1(c) is more complex.

The Paris Agreement stimulated a reckoning to align public and private finance with net zero and climate resilience. The roots for this lie in the third goal of the Agreement, which is to “make financial flows consistent with low greenhouse gas emissions and climate-resilient development” (Article 2.i(c)), but action to fully implement this objective has been mostly deferred since 2015 when it was penned. Within the United Nations negotiations, Article 2.1(c) has been viewed over time as either an opportunity or a distraction. But now we have had the first ever global UN dialogue about this overlooked clause, in Bangkok in July, and the call made last year at COP27 for a “transformation of the financial system and its structures and processes”, the time is right to get serious about aligning finance with climate action.

Most investments are out of sync with the goals of the Paris Agreement. More money flows to fossil fuel-related investments than to mitigation and adaptation in over 50 global economies, which the Intergovernmental Panel on Climate Change labels a “persistent misallocation”. Countries agreed to limit global warming and adapt to climate-related damages, all in a way that eradicates poverty and advances sustainable development. Finance is required for this to happen – but what are the challenges and opportunities in fulfilling Article 2.1(c)?

Challenges

Developing countries want assurance that wealthy countries will not turn their attention to other areas of finance as a means to replace country-to-country commitments. Wealthy countries are committed to delivering climate finance for developing countries under Article 9 of the Paris Agreement. Consider this a debt owed. Industrialised countries have contributed the most greenhouse gas emissions, while developing countries are experiencing the earliest and most severe damage from climate change impacts. Developing countries need nearly US$6 trillion until 2030 to fulfil their Nationally Determined Contributions (NDCs), yet not even the US$100 billion in annual climate finance promised in 2009 has been delivered.

Article 2.1(c) brings a broader view to align the entire public and private financial system with climate action, including multilateral development banks, international debt, domestic subsidies and tax flows, and private sector investment. Wealthy countries generally agree these other types of finance should complement existing obligations, not supplant them.

But a second challenge is thornier. Developing countries worry about ‘capital flight’, where capital would become unavailable for development projects that produce emissions, like a new port. Avoiding polluting investments is essential to limiting temperature rise, but barring development projects is untenable so long as wealthy countries continue expanding fossil fuel projects. Developing countries deserve autonomy in delivering jobs and good living standards.

In reality, developing countries already face capital flight due to climate change – not because of standards to reduce emissions, but because of investors’ responses to climate vulnerability. Investors price climate-related physical risks into their investment decisions. This has caused a surcharge of more than 1.17% on borrowing costs for climate vulnerable countries. The status quo of finance impedes developing countries’ climate plans.

Opportunities

Article 2.i(c) can be a trigger for countries to reorient their financial systems to drive climate action. Governments can set new priorities of people-centred climate justice and domestic just transitions for both public and private capital. New rules to align finance with climate action and prioritise environmental justice can ensure climate resilience projects get financed.

The need for policy and regulatory action is clear. A welter of net zero initiatives from independent financial institutions and multilateral development banks have not delivered the funds that developing countries need. Least developed countries receive a fraction of global climate finance flows – less than 5% – and over half of this is through debt, which often constrains local economic autonomy. Governments expect private capital to play a helpful role in filling the global climate finance gap, but the idea that this will happen naturally is past its prime. Strategic policy and regulatory reform is required.

Reforms must prioritise both mitigation and adaptation: the bulk of initiatives to date focus only on cutting emissions. A focus on climate resilience is key to ensuring developing countries access the means needed.

Nationally, governments in each country should reform financial flows through domestic policy and regulation. Countries should shift public subsidies from polluting investments to climate solutions, and regulate credible climate transition plans across the economy. New regulation should create accountability for financial institutions and companies to align with climate justice.

Internationally, countries should reform multilateral development banks like the World Bank, including new governance structures with leadership from developing countries; ease and eliminate debt burdens for developing and climate-vulnerable countries; and provide grant-based financing from wealthy countries to vulnerable ones.

The concerns raised by developing countries must be addressed, particularly in meeting public finance commitments and transforming development banks. And while action to reform private sector finance can happen domestically, it needs a demonstrable global boost.

A time for wealthy countries to lead with action

Wealthy countries can align their financial systems with climate action now.

At COP28 in Dubai this December, countries should launch a multilateral ‘Dubai Statement’ to align their private financial sectors with climate action. This should be a commitment to regulate financial sectors to deliver credible climate plans that cut emissions, support adaptation and build just climate resilience. This would bring the climate impacts of private finance into the domain of public policy, and remind finance that it should serve the needs of communities. A multilateral agreement of this type has precedence: two years ago, 34 countries signed the Glasgow Statement to commit to phase out international fossil fuel subsidies.

The global impact from domestic policy changes is significant: over 80% of global GDP is covered by financial activity in just 29 jurisdictions. To fill the climate finance gap, wealthy countries should reform their financial systems in ways that particularly benefit developing countries and spur accessible, affordable and productive investment. Willing countries should lead with domestic policy reform and collectively commit to regulate credible and just climate transition plans from their private sectors.

This article was originally published here by the London School of Economics’ Grantham Research Institute on Climate Change and the Environment

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