The finance sector came together in Glasgow, but different rules and perspectives may yet prove divisive.
COP26 opened with a two-day World Leaders Summit, followed by a series of themed days, starting with finance. This means that the titans of the money world were acutely aware of the task ahead by the time they took the stage.
The politicians’ speeches had confirmed the findings of a report published in late October by the UN Framework Convention on Climate Change (UNFCCC). Current plans were putting the world on a path to 2.7 degrees Celsius of climate change and private money was going to be critical to efforts to push the trajectory down toward 1.5.
On ‘Finance Day, UN Special Envoy for Climate Action and Finance Mark Carney assured COP26 that the finance sector was ready to play its part. Assembled under the Glasgow Financial Alliance for Net Zero (GFANZ) banner, the former governor of the Bank of England revealed that more than 450 global financial services firms – representing US$130 trillion or 40% of the world’s financial assets – had committed to align their business strategies with the goals of the Paris Agreement.
“The core message today is that the money is there for the transition, and it’s not blah blah blah”, Carney told delegates, referring to the dismissive verdict on COP26 given by climate activist Greta Thunberg.
Transforming business models
GFANZ is the coordinating body for a handful of sector-specific net zero initiatives representing banks, insurers, asset managers, asset owners, investment consultants and other financial service providers. It is a member of the UN’s Race to Zero campaign, which monitors and regulates the actions of non-state actors to achieve net zero emissions by 2050.
“The financial sector’s net zero commitments (including those through the Race to Zero campaign) drive them to rethink their lending practices, portfolio investments and underwriting of climate-sensitive sectors, transforming their business models towards financing greener business segments,” says Maria Malyukova, Analyst at Moody’s Investors Service.
Members of GFANZ must set regularly renewed science-based targets to map their path to net zero emissions by 2050 at the latest, deliver their “fair share” of the UN-endorsed effort to cut global emissions by 50% by 2030, and report on progress annually.
By COP26, more than 90 founding institutions had set short-term targets, including commitments initiated prior to GFANZ’s foundation in April. The total includes 29 members of the UN-convened Net Zero Asset Owners Alliance (NZAOA), which have committed to reducing portfolio emissions by 25-30% by 2025 under a protocol announced in January, and 43 members of the Net Zero Asset Managers initiative (NZAM), which have published targets for cutting emissions by 2030 or sooner.
Targets have also been published by members of the Net Zero Banking Alliance (NZBA) members, which includes banks representing US$66 trillion, over 43% of banking assets worldwide.
“Mandatory disclosure requirements such as the pledge by GFANZ/NZBA members to disclose financed emissions, targets and progress on decarbonisation will give evidence of follow-through on the commitments,” Malyukova adds.
The overall impression is that the finance sector is making a firm commitment to financing a timely transition to a global net-zero economy. The Race to Zero framework is rigorous, regularly updated in line the climate science and committed to ejecting those that drag their feet.
But the task is complex, not least because the finance sector has existing commitments, relationships and revenue streams covering every industry and market across the planet, many to the heavy-emitting sectors. GFANZ has set itself a monumental challenge and everyone will notice if it falters.
To bolster its chances, GFANZ is building up its governance, priorities, processes and membership rules. As well as GFANZ baseline criteria set by the Race to Zero, informed by a Finance Sector Expert Group, its sub-sector groups set more detailed criteria for members. GFANZ will also be guided by an advisory panel of independent experts and NGOs to inform its priorities and activities.
It has set up seven work streams, covering sectoral pathways, transition plans for the real economy and financial institutions, measurement of portfolio alignment, mobilisation of private capital, policy advocacy and commitment building.
But as with all grand coalitions, there is a risk of moving only at the pace of the slowest, and of some voices being under-represented. Already there are reports of schisms. Prior to COP26, the Financial Times reported leading banks’ reluctance to align with the ‘Net Zero by 2050’ roadmap laid out by the International Energy Agency (IEA), which effectively rules out financing new fossil fuel exploration after this year.
Instead, they favour following a similar but less narrow path based on the scenarios outlined by the International Panel on Climate Change (IPCC). GFANZ’s advisory panel includes a number of organisations which have endorsed the IEA’s scenario.
“It’s quite a technical point,” admits Rory Sullivan, CEO of Chronos Sustainability and Chief Technical Advisor to the Transition Pathway Initiative. “But how you define benchmarks and who you work with on benchmarks defines your level of ambition to a large extent.”
At a time when pressure is rising on the finance sector to raise its ambition, the choice of a less-demanding routes to net zero could send the wrong signal.
“The challenge for GFANZ is whether it can maintain its aspirations to work with industry while ensuring it is aligned with the IEA’s net zero pathway,” says Sullivan. “That’s an open question at the moment. If it doesn’t align with the IEA, it could undermine the credibility of the enterprise.”
There could also be further internal dissent if the NZAOA – historically the ‘greenest’ of the sub-sector initiatives now marshalled under GFANZ – pushes for the broader coalition to pick up the pace. At a time when it has yet to prove added value beyond its sub-sector groupings, GFANZ’s governance and accountability will be crucial, says Sullivan.
“Do asset owners have sufficient influence and oversight to ensure that GFANZ doesn’t undermine their efforts? GFANZ needs to demonstrate that it is being appropriately ambitious. Part of that is about demonstrating it is aligned with IEA, but it also needs to ensure its decisions and conclusions are subject to sufficient scrutiny by asset owners,” he adds.
The weighting game
Undoubtedly, banks have been slow out of the blocks in adjusting their business models to the realities of climate change. A number have been subject to shareholder resolutions, largely because of their continued exposure to fossil fuel exploration. Earlier this year, research from responsible investment charity ShareAction found that none of the top 25 banks in Europe had published a comprehensive net zero plan, despite 20 out of 25 having committed to net zero by 2050.
ShareAction’s EU Policy Officer, Caroline Metz, argues that regulators need to encourage both banks and insurers to take fuller account of climate risks to their balance sheets. Capital regulations could be weighted to reflect the risks from financing firms on the fossil fuel industries.
This would allow banks to build up much-needed capital buffers, she says, which would cushion individual firms and safeguard overall financial stability.
“Adequate capital buffers are fundamental because, unlike net-zero pledges and governance provisions, they allow financial institutions to be materially prepared for climate risks and related losses,” says Metz. “They are also an effective way to steer investment and other business activities towards sectors and activities that would contribute to a transition to a low-carbon economy.”
There are signs from the European Central Bank and the Basel Committee on Banking Supervision that prudential regulation is already moving in this direction. In November, the latter announced a consultation on developing a set of principles for the effective management and supervision of climate-related financial risks at international banks, covering disclosure, supervisory and regulatory measures.
In Europe and other developed regions, climate risk is already being deeply embedded in the supervisory process, following several years of rapid regulatory evolution, says Moody’s Malyukova. This includes the introduction of climate-related disclosure requirements, internal capital assessments as well as stress tests.
Malyukova points out that 38 central banks from countries comprising 67% of the world’s emissions intend to carry out climate-related stress tests to review the climate resilience of regulated firms, with 33 planning to issue guidance on managing climate-related financial risks. “This will enhance the financial sector’s climate-risk management and help reduce carbon transition risk. Expectation of further tightening regulation is pushing financial institutions to pre-emptively focus on addressing climate risks as well,” she says.
Nevertheless, Sullivan believes there is further scope for prudential regulators to influence financial institutions’ approach to managing climate risk through other channels, for example by making adjustments to expectations of directors in the execution of their fiduciary duties.
The UK Companies Act was recently tweaked to require directors to take full account of their responsibilities to all stakeholders. Sullivan suggests a logical evolution of current practice might be to recognise an explicit duty to consider both the risks to the business from climate as well as the risks that company poses to the climate. This shift could be effected via a statutory instrument, rather than primary legislation.
“An enterprising prudential regulator might look to tie double materiality to notions of directors duties. That would require directors to have the knowledge to be aware of the risks and impacts and to personally act if they’re aware of major risks to business or a major impact of the business on the climate,” he says, adding that such responsibilities could extend beyond the financial services sector both to listed firms and to privately-held businesses.
Driving real-world decarbonisation
As partners and service providers to their GFANZ colleagues in the NZAOA, asset managers have a longer-standing commitment to net zero than banks, but progress in the sector is still varied.
This was reflected in an update published ahead of COP26, which detailed the interim targets of 43 NZAM members, including early signatories Legal and General Investment Management, Wellington, AXA Investment Managers and DWS. It revealed that 35% of their collective AUM, totalling US$4.2 trillion, is already being managed in line with achieving net zero by 2050.
“While the headline percent figure looks low, a closer read of the individual reports shows that asset managers have already pledged a significant portion of their ‘in scope’ AUM – namely listed equities, corporate debt and real estate investments – where there are well established decarbonisation methodologies,” noted a report by Credit Suisse. Several of the methodologies being used by managers are currently being extended to include a wider range of asset classes, including private equity.
Nevertheless, a quarter of firms committed to managing 100% of their assets in line with net zero, meaning others are currently well below the group’s 35% average. Critics have also pointed out that NZAM members are not yet required to adopt a fossil fuel policy, with ShareAction recommending that managers publish fossil fuel phase-out plans for all assets being managed in line with net zero.
A recent Morningstar report, ‘Asset Managers and Net Zero Investing: The Road Ahead’, said asset managers are hamstrung in setting and meeting targets by a lack of reliable data. “Asset managers feel less equipped to commit to portfolio targets because corporate disclosure and company-level emissions data remains weak or inconsistent, an because portfolio-level commitments are conditional on clients’ ambitions,” it said, also noting survey evidence that showed managers actively developing net zero investment strategies.
Hortense Bioy, Global Director of Sustainability Research at Morningstar, says the NZAM update reflects the different stages of asset managers on their net zero journeys and varying degrees of client pressure.
“Some managers have been divesting over the past two years from the largest emitters, often having engaged with them, but concluding that they’re not moving fast enough and thus do not justify the financial risk of remaining invested at this point in time,” she says, adding that certain managers are also motivated by clients, especially serving institutional investors in the Netherlands and the Nordics.
Bioy says NZAM members’ commitments to decarbonise their portfolios may lead to greater engagement activity in next year’s AGM season. “Most managers don’t expect to decarbonise their portfolios by divesting from the biggest emitters,” she says, pointing out that the NZAM encourages members to focus their efforts on driving real-world decarbonisation.
“We expect most asset managers to intensify their active ownership programmes. That means more engagement, having a robust escalation strategy, filing and co-filing shareholder resolutions related to climate, and being willing to consider divesting if the engagement fails.”
A more proactive approach to stewardship applies not just to carbon-intensive firms, but also their financial backers. With asset owners already warning of their intention to vote against banks in the 2022 AGM season if they do not align with the IEA’s net zero scenario, GFANZ members could find themselves pulled in different directions.