Summary

• Traditionally, climate policies have not directly focused on the financial system as a priority for action.
• Increasing numbers of countries are realising that dedicated policies are needed to overcome market failures and accelerate action within the financial system.
• Experience suggests that financial system reforms involve the 4Rs: national Roadmaps, Reporting and disclosure, managing climate Risks, and Reallocating capital flows.
• International cooperation is also growing, with initiatives on financial disclosure, insurance supervision, financial centre action, and central bank coordination.
• Building on this growing evidence base, clear guidance could now be developed showing how financial sector reform can be included as a core element of long-term climate strategies.

Harnessing the financial system: a missing dimension

Building a net zero economy that is prosperous, inclusive, and resilient will require an unprecedented mobilisation of finance. The full expertise and resources of the global financial system with more than US$300 trillion in assets will need to become fully aligned with the goals of the Paris Agreement and the wider sustainable development goals. This transformation is hardwired in the Paris Agreement, which commits countries to make “financial flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.”

Traditionally, policymakers have taken a twin-track approach to finance and climate action. The first track has been to put in place sector policies for agriculture, buildings, energy, transport, and the urban environment, which in turn are designed to generate demand for sustainable finance. Effective building codes, the pricing of carbon, and incentives for renewable energy all provide important signals to the financial system. The second approach has been to deploy public finance through budget support and policy institutions (such as national and multilateral development banks). This funding is essential to drive the innovation that the private sector will not support, provide key public goods, and, critically, support the transition in developing countries.¹

Until recently, however, climate policy has not explicitly targeted the rules that govern the financial system itself.² Indeed, the financial sector is rarely identified as a focus for action in either the nationally determined contributions or the long-term strategies that have been submitted by governments to implement the Paris Agreement. Clearly, the direct operations of the financial sector have a small direct carbon footprint and face limited physical risks. But the ways banks, investors, insurance firms, and stock exchanges make decisions have profound implications for climate success in key sectors such as agriculture, energy, industry, and transport.

The fact that financial system reform has been the missing dimension of long-term climate action suggests that policymakers have assumed that capital will flow once externalities in the real economy are fixed. But this fails to recognise that market failures exist within the financial system itself; these need to be remedied if capital is to flow for climate action. In addition, the sustainability transition often involves a more capital-intensive model of development—in essence, replacing resource use and pollution with technology and know-how. In practical terms, this means more upfront capital in long-lasting assets, such as efficient lighting, clean energy infrastructure, or circular resource management, in place of the continuous throughput of energy and materials. This makes incentives and regulations that determine the cost of capital, its duration, and its quality of prime importance.

Experience to date suggests that there are five main reasons why a systemic approach to the financial sector is essential.

1. Information asymmetries. Financial decision makers have inadequate information to effectively incorporate climate and sustainable development factors and so misallocate capital. Effective disclosure from corporations, the issuers of stocks and bonds, and financial institutions themselves is needed to close this gap.

2. Misaligned incentives. Incentives within the financial system, including the interpretation of key responsibilities (such as fiduciary duty) have traditionally overlooked the importance of long-term drivers of value such as climate change. Policy reform is needed to clarify financial responsibilities so that market incentives become aligned with climate action.³

3. Insufficient access to finance. Market dynamics on their own often fail to provide sufficient access to finance, particularly for low-income communities, small and medium-sized enterprises, and developing countries. Policy action to promote financial inclusion is often needed through fiscal, regulatory, and institutional reforms, particularly to deliver a “just transition” for workers and communities.

4. Blocked innovation. Considerable financial innovation will be needed to deliver climate goals, but markets may be unable to drive this at the speed or scale required. Governments can shape the pattern of financial innovation through a range of actions to support the growth of green finance, notably to ensure market integrity through trusted standards.

5. Financial instability. Finally, the stability of the financial system as a whole may be at risk from the physical and transition risks of climate change, potentially resulting in both “stranded assets” and disruptions to financial activity. Central banks and other regulators need to take action so that financial actors anticipate these threats in time.

Over the past five years, there has been a growing realisation that policy action is needed to harness the financial system for climate action and sustainable development. The latest research from UN Environment’s Inquiry into the Design of a Sustainable Financial System has found nearly 300 sustainable finance policy and regulatory measures in place as of October 2017, implemented in over 60 countries. The growth in measures has averaged around 20 percent year on year since 2010, with an increase of almost 30 percent since July 2016.⁴ These measures cover all sectors—banking, capital markets, insurance, and investment—and address a range of critical issues such as improving climate disclosure, managing climate risks, and stimulating green investment. In recent years, there has been a rapid rise in system-level roadmaps and policies.

There is now a strategic opportunity for policymakers to deliver a “joined up” approach by explicitly linking long-term climate strategies and financial system reform. This means building an effective bridge between national climate strategies and financial system reforms so that the transition is cheaper, faster, and smoother. The rest of this essay profiles the key elements of effective policy at the national level and points to the need for stronger international cooperation.

Taking systematic action at the national level

Financial systems differ significantly from country to country. Postindustrial economies are generally dominated by capital markets, while most emerging economies are bank-led. Tailored approaches are needed that recognise the specific circumstances of each country, tackling four key areas of financial reform—the 4Rs of Roadmaps, Reporting, Risk, and Reallocation.

1. Roadmaps. A key task is to identify the implications of long-term climate and sustainable development goals for the financial system. A small but growing number of countries, including China,⁵ Italy,⁶ and Morocco,⁷ are developing a strategic response by putting in place sustainable finance roadmaps to do this. China’s “Guidelines for Establishing a Green Financial System” are one of the most comprehensive set of commitments, covering a range of priorities across banking, capital markets, and insurance as well as the need for a new generation of green public-private partnerships as well as local financing initiatives.⁸

In 2016, the European Union set up the High-Level Expert Group on Sustainable Finance (HLEG) to produce its own roadmap.⁹ The HLEG’s final report highlighted the dual need to both mobilise finance for long-term sustainable development and ensure that environmental, social, and governance factors are incorporated into routine financial practices.¹⁰ Emerging lessons on how to deliver national roadmaps are now being consolidated by UN Environment and the World Bank Group.¹¹

2. Reporting. Financial markets need data to operate effectively, and this means the introduction of standardised frameworks for first defining and then reporting long-term climate and sustainability factors. France has taken the lead through its Energy Transition law, which includes a set of reporting requirements for both corporations and financial institutions.¹² Faced with a combination of both insufficient transparency and inconsistent reporting, the Financial Stability Board has focused on establishing a consistent global standard for corporations and financial institutions. Its Task Force on Climate-Related Financial Disclosures (TCFD) has issued an industry-led set of voluntary recommendations covering the ways in which business and financial institutions respond to climate factors in their strategy, risk, governance, and performance metrics.¹³ The next step is to implement the TCFD guidelines at the national level. Here, considerable capacity building will be required, particularly in developing countries, to ensure that the TCFD recommendations are adopted.

3. Risk. Long-term climate factors can have profound financial implications both in terms of physical impacts as well as transition risks in high-carbon sectors. These risks extend from individual assets through financial institutions to the financial system as a whole. Here, financial regulators can play a pivotal role in ensuring that banks, credit rating agencies, insurance firms, as well as investors and pension funds effectively incorporate climate and wider sustainable development factors into their core processes for risk management. Italy’s central bank, Banca d’Italia, has found that climate change can bring “potentially far-reaching consequences for the economy and the financial system,” with over 15 percent of households and 18 percent of local businesses exposed to flooding risk, and that most are uninsured.¹⁴ A critical challenge for both financial institutions and financial regulators when confronting long-term climate threats is how to overcome what Bank of England governor Mark Carney described in 2015 as “the tragedy of horizons,” whereby the catastrophic impacts of climate change will be felt beyond the traditional horizons of most actors.¹⁵ One way to bring future climate shocks into today’s financial decision making is through the application of a range of scenarios to stress-test current allocations and assumptions.

4. Reallocation. Ultimately, all these activities need to result in a fundamental long-term reallocation of capital away from high-carbon to zero-carbon assets, assets that are also resilient to climate shocks and serve sustainable development. Here, the task for policy is one of market creation, ensuring that the growing demand for climate-aligned assets is delivered with both ambition and integrity. The green bond market is an important test case, growing from $7 billion in issuance in 2012 to $155 billion in 2017.¹⁶ In China and India, securities’ regulators have played a critical role in introducing green bond standards that have both enabled substantial market expansion and protected investors from “greenwashing.” Governments can also help seed the market by issuing sovereign green bonds, as has been done so far by Fiji, France, Nigeria, and Poland. The critical next step is to go upstream from debt capital markets into the core loan books of banks, which finance the bulk of climate-aligned activities, particularly in developing countries. The long-term nature of the real estate sector offers considerable potential for “green tagging.” Real estate usually accounts for the largest part of loan books, and there a wide range of energy efficiency and green building standards already exist. The next step is for banks to tag their mortgages and other property loans with environmental performance metrics so that they can prioritise green buildings in terms of cost of capital and risk management.¹⁷ National policymakers can accelerate this process by encouraging the introduction of consistent taxonomies for green and climate finance and evaluating the links between the environmental performance of loans and credit quality.

International cooperation for financing long-term climate strategies

International financial cooperation lies at the heart of the Paris Agreement, not least the commitment of industrialised countries to mobilise $100 billion in financial flows for developing countries each year by 2020. The effective delivery of long-term climate strategies also requires intensified international cooperation on financial system reform to share experience, promote policy coordination, and take common action on shared priorities. Existing examples of international cooperation on financial system reform include the following:

• The Financial Stability Board’s Task Force on Climate-Related Financial Disclosure.
• The G20’s Green Finance Study Group, bringing together G20 finance ministries and central banks to identify policy options to scale up green finance and improve the financial management of environmental risks.¹⁸
• The Sustainable Insurance Forum, which gathers supervisors from nearly 20 jurisdictions to work together on integrating environmental factors into insurance regulation, including through the development of guidance on climate risk.¹⁹
• The Network of Financial Centres for Sustainability, inspired by Italy’s 2017 G7 presidency, which currently includes 17 financial hubs, such as Casablanca, Frankfurt, Hong Kong, London, Paris, Shanghai, and Toronto.²⁰
• The Network of Central Banks and Supervisors for Greening the Financial System, launched at the One Planet Summit in Paris in December 2017 with eight founding members (China, France, Germany, Mexico, the Netherlands, Singapore, Sweden, and the United Kingdom). The Network will help to strengthen the global response required to meet the goals of the Paris Agreement and to enhance the role of the financial system in managing risks and mobilising capital for green and low-carbon investments.²¹

These are all relatively new initiatives. Looking ahead, a more structured approach to gathering and sharing experience on financing long-term climate strategies will be a priority. This will include ensuring that climate change and wider sustainable development factors are incorporated into the standard operating procedures of the global financial system. As the EU’s high-level expert group noted, these include the IMF’s Article 4 reviews by the International Monetary Fund (IMF) and the Financial Sector Assessment Programmes administered by the IMF and the World Bank.²²

Conclusions

If we are to make financial flows consistent with the goals of the Paris Agreement, governments will need to introduce dedicated policies focused on the financial sector itself. Over the past five years, there has been growing experimentation in this area, building up a body of practice. This now needs to become more broadly incorporated into climate policy. One way of doing this would be to develop clear guidance on how financial sector reform could be included in long-term climate strategies.

¹ See Mariana Mazzucato, The Entrepreneurial State: Debunking Public vs. Private Sector Myths (London: Anthem, 2013), for a fuller exposition of the role of public finance in driving clean technology development and deployment. For a synopsis and the introduction, see https://marianamazzucato.com/entrepreneurial-state.

² For a review of why and how financial system action is taking place, see UN Environment Inquiry, The Financial System We Need: Aligning the Financial System with Sustainable Development (Geneva: United Nations Environment Program, 2015), https://unepinquiry.org/publication/inquiry-global-report-the-financial-system-we-need/; and UN Environment Inquiry (2016), The Financial System We Need: From Momentum to Transformation (Geneva: United Nations Environment Program, 2016), https://unepinquiry.org/publication/the-financial-system-we-need-from-momentum-to-transformation/.

³ See the report by Principles for Responsible Investing (PRI) and the United Nations Environment Program Finance Initiative (UNEP FI), Fiduciary Duty in the 21st Century,(London: Principles for Responsible Investment, 2016) for detailed insights into this; https://www.unpri.org/about/pri-teams/sustainable-financial-system/fiduciary-duty-in-the-21st-century.

⁴ Samuel Munzele Maimbo and Simon Zadek, Roadmap for a Sustainable Financial System (Geneva and Washington, DC: UNEP and World Bank Group, 2017), https://unepinquiry.org/publication/roadmap-for-a-sustainable-financial-system/.

⁵ People’s Bank of China, “Guidelines for Establishing the Green Financial System” (2016), https://www.pbc.gov.cn/english/130721/3133045/index.html.

⁶ UN Environment, “Italy Lays Out Roadmap for Increasing Flows of Sustainable Finance,” February 6, 2017, https://www.unep.org/newscentre/italy-lays-out-roadmap-increasing-flows-sustainable-finance.

⁷ Bank Al-Magrib, “Speech of the Governor at the Presentation of the Financial Sector’s Roadmap for Contributing to Sustainable Development and the Fight against Climate Change,” November 14, 2016, https://www.bkam.ma/en/content/view/full/352587.

⁸ For a first review of China’s Green Financial System strategy, see Simon Zadek and Wang Yao,  Establishing China’s Green Financial System: Progress Report (Geneva: UN Environment Inquiry and International Institute of Green Finance, 2017), https://unepinquiry.org/publication/establishing-chinas-green-financial-system-progress-report/.

⁹ European Commission, “Sustainable Finance,” https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance_en, accessed February 9, 2018.

¹⁰ European Commission, “Final Report of the High-Level Expert Group on Sustainable Finance,” January 31, 2018, https://ec.europa.eu/info/publications/180131-sustainable-finance-report_en.

¹¹ Maimbo and Zadek, Roadmap for a Sustainable Financial System.

¹² PRI and Mirova Responsible Investing, “French Energy Transition Law: Global Investor Briefing,” 2017), https://www.unpri.org/download_report/14573.

¹³ Task Force on Climate-Related Financial Disclosures, “Publications,” 2018, https://www.fsb-tcfd.org/publications/.

¹⁴ Banca d’Italia, “Financing the Future: Intervento di Luigi Federico Signorini,” February 6, 2017, https://www.bancaditalia.it/media/notizia/financing-the-future-intervento-di-luigi-federico-signorini/.

¹⁵ Bank of England, “News and Events,” https://www.bankofengland.co.uk/publications/Pages/speeches/2015/844.aspx, accessed February 9, 2018.

¹⁶ Climate Bonds Initiative, home page, https://climatebonds.net/, accessed February 9, 2018.

¹⁷ For the results of a state of the art review of green tagging in Europe, see Nick Robins and Peter Sweatman, Green Tagging: Mobilising Bank Finance for Energy Efficiency in Real Estate (Geneva: UNEP Inquiry and Climate Strategy & Partners, 2017), https://unepinquiry.org/publication/green-tagging-mobilising-bank-finance-for-energy-efficiency-in-real-estate/.

¹⁸ UNEP Inquiry, “G20 Sustainable Finance Study Group Document Repository,” https://unepinquiry.org/g20greenfinancerepositoryeng/, accessed February 9, 2018.

¹⁹ Sustainable Insurance Forum, “News and Events,” https://unepinquiry.org/sif/news-and-events/, accessed February 9, 2018.

²⁰ Nick Robins and Jeremy McDaniels, Accelerating Financial Centre Action for Sustainable Development (Geneva: United Nations Environment Programme, 2017) https://unepinquiry.org/publication/accelerating-financial-centre-action-on-sustainable-development/

²¹ Banque de France, “One Planet Summit—Statement by François Villeroy de Galhau, Governor of the Banque de France,” December 12, 2017, https://www.banque-france.fr/en/intervention/one-planet-summit-statement-francois-villeroy-de-galhau-governor-banque-de-france.

²² This was one of the key recommendations of the European Union’s High-Level Expert Group on Sustainable Finance; see European Commission, “Final Report.”