Let the Climate Finance Flow

As negotiators get down to business at COP27 in Sharm El Sheikh, effective channelling of climate finance flows will be high on the agenda.

Two major topics of discussion on the agenda for COP27’s Finance Day were ‘Mobilising Finance for Climate Action’ and ‘From Ambition to Action: Mobilising Finance for Climate Solutions, Adaptation and Resilience’.

On this critical issue, there has been no absence of good intent. At COP26, the Glasgow Financial Alliance for Net Zero (GFANZ) declared a sector-wide commitment of US$130 trillion – a number that has increased over the year to US$150 trillion – of private capital to transition the global economy to net-zero greenhouse gas emissions.

The magnitude of private sector firepower committed to addressing climate change now lies broadly in line with requirements to reach a low-carbon economy. But delivering on that target will be no mean feat since, as even Mark Carney, UN Special Envoy on Climate Action and Finance, conceded in a recent BBC Radio interview: “In the end, finance makes something possible. It doesn’t make it certain.”

Once mobilised, private sector finance will undoubtedly play a significant role in realising a successful transition. Commitment needs to translate into action, and there challenges remain.

“The level of private sector engagement was very noticeable at COP26,” said John Green, Chief Commercial Officer at asset manager Ninety One. “But, since then, private capital has struggled with how to orientate itself in a way that is both doing the right thing practically and seen to be doing the right thing.”

Delivering on ambition

Yet, with greenhouse gas emissions still rising, governments subsidising the consumption of fossil fuels and more coal and oil being extracted from the ground to mitigate the current energy crisis, there is a mismatch between the financial community’s pledges and its ability to effect transition quickly enough. It explains why activists and the public demand that the finance sector does more to address climate change. It also brings into question whether a financial ecosystem exists that can deliver on the ambition.

“Finance is used to feeling it’s in the driving seat,” said Simon Hallett, Head of Climate Strategy at global investment firm Cambridge Associates. “We have to acknowledge that with the transition to net zero, finance is an enabler not really the driver.”

The impetus for net zero following the Paris COP came from the academic community, was endorsed and framed by policymakers, and requires business model change, often radical, to be implemented by corporates. Finance plays the part of a conduit between the ambition of asset owners and the corporates effecting real world change.  It needs to flow into areas where it can make most impact. While finance can enable the transition, it can also get in the way.

Transition cannot take place without finance being channelled towards economies that are ready to commit to net zero and which offer scalable solutions and projects to realise agreed targets. But, by any measure, the capital required for transition is not yet finding its way to the places it is most needed and at the levels necessary.

“There’s a pool of ambition and direction on one side and a pool of complexity and practicality on the other side,” said Hallett. “And between those two positions you’ve got to get to the deliverable outcome.”

There’s natural tension throughout the system. Getting the right balance between being ambitious on targets and action and ensuring the right regulation and reporting tools are in place is complicated.

“Asset owners need to motivate corporates to change, and finance is the intermediary,” said Hallett. “But to actually implement it, we need to have methodologies in place and a change in approach.”

Engagement ring

For investors, engaging with investee corporates in the transition process has replaced the blunt tool of divestment as a means of decarbonising portfolios. A portfolio’s carbon emissions can be targeted and measured but decarbonisation at the portfolio level does not necessarily equate to real world impact. Active engagement may even increase its carbon emissions in the short term.

“Private sector capital has grappled with the challenge that although it can clean its portfolios, if it’s not actually financing the transition in a very practical way, it’s not having any impact in terms of actual emissions delta,” said Green. “Portfolio target setting is evolving towards transition plans rather than linear carbon intensity reductions. That’s the right way to go.”

For capital to have an impact on real world carbon, it needs to tackle the problem of the heavy emitters first. For those with a credible and science-based transition plan in place, the commitment to follow it through is building, aided by the tools to measure the impact, and the finance to support its transformation. In parallel, the conversation between investors and corporates has moved on to constructive engagement.

Engagement in the form of voting, tabling resolutions, and regular dialogue with management creates a feedback loop between asset owners, managers and corporates that has the potential to ensure decarbonising targets are ambitious, impactful and achievable. Measuring the impact of engagement itself, however, is not easily quantified and the act of engagement can be the target ‘engagement washing’ accusations.

“There’s a risk of engagement washing just in the same way that there is of greenwashing,” said Venetia Bell, Group Chief Sustainability Officer at Gulf International Bank and Head of Strategy at GIB Asset Management, a sustainable investment firm. “For an investor, it’s not just a question of the number of companies that an asset manager has engaged with, it’s about the impact from that engagement.”

Demanding data

There needs to be accountability to ensure meaningful transition with real world impact is being achieved.

“With private sector capital, there are multiple different stakeholders, and those stakeholders want to know that their capital is working in the right way. That requires data and evidence,” said Green.

GFANZ is supporting the creation of a new free-to-use database that will hold and share all the financed emissions of financial institutions, their targets and the progress against those targets. This, Carney says, “will give a level of accountability and transparency that people deserve”.

The International Sustainability Standards Board (ISSB), an investor-focused initiative of the International Financial Reporting Standards (IFRS) Foundation, is also trying to bring some degree of consistency to the question of data and reporting. It supersedes existing voluntary frameworks for sustainability reporting, the lack of standardisation between which has hampered comparisons by investors. In March 2022, ISSB released drafts of its sustainability reporting standards aimed at helping companies streamline sustainability disclosures and facilitate a baseline comparison.

Standards are a useful foundation in setting the direction of travel, but they should not be so strict as to constrain investment.

“The ISSB standards are excellent; it’s great to have them,” said Bell. “But people will need to adopt them at a pace that’s suitable for their business model, where they are in their sustainability journey and how material all of the factors are for them.”

The ISSB approaches climate from an equity or debt owner’s perspective and its materiality to the valuation of the business, but many have insisted that its standards need to broaden out soon to cover impacts as well as risks to enterprise value.

“It’s not so much a question of whether the impact of an investment is positive or negative on my business but what’s the impact of my business on the world?” said Hallett. “We’re essentially asking companies to reengineer their businesses for their own benefit and partly for a shared benefit.”

Patient capital

Philanthropy is a practice not normally ascribed to the financial sector. Nor should the change in business model and mindset be seen as altruistic, as there are opportunities for first movers.

“In the case of climate change, we need to think of profit and investment as being aligned rather than in conflict,” said Cécile Cabanis, Deputy Chief Executive Officer, Tikehau Capital. “The energy transition should not be seen purely as a cost, it’s an investment. Once companies have gone through the transition cycle, they become well placed to earn profit and investors get a return. You need to align investment time with the time needed to transition. The transition needs patient capital.”

The difficulty, particularly in the context of many economic headwinds, is that finance tends towards addressing short-term crises at the expense of long-term climate ambition. But finance can bring long-term solutions, according to Cabanis, who uses the example of closed-end funds with duration aligned “to the time you need for the transition”.

The duration conflict is just one of the tensions playing out in financing the transition. There’s tension between ambition and delivery, regulation and over-regulation, technology innovation and solution implementation. There is also the risk of pushback and uncertainty from financial institutions, particularly when they are faced with differing messages from policymakers and politicians, as has recently been the case for US banks.

What is without question, however, is that investors should not wait to see a complete set of policies from regulators before acting.

“There are choices,” said Cabanis. “You can either do things on a small scale and wait for the day when everything becomes clear – but by then it is too late. Or you accept that you don’t know everything and that things can change on the way, so you set ambitious targets to work towards. If you’re clear on what you’re trying to achieve and transparent about what you do, then we can already start acting.”

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