The COP26 climate talks in Glasgow wrapped up recently. There, the world witnessed first-hand the passion of youth demanding governments to act with greater urgency while their country representatives worked extra hours to find a common ground.
The COP26 did not unveil a treaty like the 2015 Paris Agreement but guided the implementation and exhorted countries to take steps to keep the global temperature below two and preferably 1.5 degree Celsius. Leaders of developing nations demanded $1 trillion annually from developed countries at least over the next decade to adapt to and mitigate climate change.
COP26 put in place measures for countries to enhance their climate targets next year and phase down coal power and it resolved key issues over the Paris Agreement. Though it fell short in other areas, such as insufficient provisions on carbon markets, social protection and aligning public investments, COP26 also made encouraging commitments to cut methane emissions, halt and reverse deforestation and align private investments to the goal of net-zero emissions.
Delivering on climate finance is the stickiest point of contention between developed and developing countries since most Nationally Determined Contributions are conditional to the availability of finance. Mobilising $1 trillion every year seems to be a daunting task. But the COP26 had witnessed extraordinary support from the world’s finance industry. The largest investors called for a robust and fair deal and promised that they will make the money flow. And banks promised to find ways to promote and channel tens of billions into low-carbon investments.
But private finance will not flow in a vacuum. There is a close relationship between incentives made and the increased climate investments. The public sector needs to focus on the efficiency of the finance industry to help channel people’s savings into investments that will not just give them a short-term return but will also ensure that they are economically sustainable in the long run. The development of a purposeful finance industry is essential for the realisation of $1 trillion clean investment.
The good news is that the financial industry is not short of savings. At the global level, some $300 trillion is represented in capital markets, a little more than half from commercial banks and the rest from insurance and institutional investors. Against this, the clean $1 trillion looks quite modest. But financial markets still have not got enough money flowing in support of a net-zero economy.
One of the reasons is that the motivation for low carbon infrastructure is not strong. If a carbon intensive investment gives a greater return than that of a clean and green one, then the investors cannot ignore the business case of making profits. That is why over 300 financial institutions have urged world leaders to reach an agreement on climate financing. They are ready to pay a price for carbon if it makes their investment relatively more attractive. These institutions have not suddenly become climate activists but have gradually understood that unless the climate is stable, the economy in which they invest will be at risk.
Moreover, most private investments on climate change mitigation in developing countries in Asia are not made by financial institutions but by big corporations. Huge economic rewards could be gained if their profits are directed towards low-carbon investments by pricing carbon.
Though a lot of activities are taking place in the finance systems, there is a long way to go before mobilising $1 trillion. A major cause is that the financial institutions themselves are not well structured to accelerate money flows. They inadvertently give preference to carbon-intensive investments over low carbon ones. For example, credit rating agencies, which determine whether a bond is investible, do not consider the risk beyond three years. So, a bond backed by a fossil fuel-driven power plant can receive the same rating as one backed by a renewable source.
The same is true for accounting standards as well. Even though they claim to be prudent, they do not question the value of stranded assets. The risk measures used to manage banks are backward looking and are ill-adapted to foresee climate jeopardy that lies ahead. Investment institutions, which owe a fiduciary duty of caring for their stakeholders, often ignore the effects of climate change. Shareholders, citizens and policymakers alike need to ensure that the financial system is fit for the purpose of achieving net-zero targets.
The following is not a comprehensive list but includes many initiatives that were successful in several countries: ensuring that credit agencies offer ratings that look into the long-term climate risk, getting companies to report openly on their carbon intensity and agreeing to declare their improvement plans, creating standards of reporting for all companies that can raise money through stock exchanges, getting banks and financial institutions to manage and minimise value at risk through proper screening, making these institutions safer by steering them away from carbon intensive activities, encouraging trustees of investment funds to accept fiduciary responsibility, promoting equity investors to integrate climate considerations, assisting insurance companies in identifying and creating climate resilience, and developing safe standards and taxonomy for green bonds and similar financial products.
In addition to the above, donor, public and multilateral banks must significantly increase their climate portfolios and intensify their efforts to help countries achieve net-zero emissions. Each of these is but one of many small steps. But taken together, they would put the world on a very different course in mobilising the clean $1 trillion.
Director, Research Strategy, Economic Research Institute for ASEAN and East Asia