The financial sector has a key role to play in moving towards deep decarbonization

The financial sector, understood as a provider of financial services to actors in the real economy, has a key role to play in bringing about systemic change and mobilizing capital for the full decarbonization of the economy. The Finance Initiative of the United Nations Environment Programme - UNEP FI estimates that the world needs investments of between 5 and 7 trillion dollars a year to achieve full decarbonization. At the same time, tens of trillions of dollars are spent every year on the exploration, extraction, refining and transportation of fossil fuels, as well as on the construction, sale, installation and use of technologies that burn fossil fuels to generate electricity or transport people and goods.

There are sufficient financial resources to invest. Policymakers, investors, asset managers and financial service providers must act quickly to redirect financial flows towards a massive expansion of renewables, electrification of other end-use sectors and improved energy efficiency. While this shift has begun, it must go further and faster. It also requires closer and more effective coordination between finance and environment ministries, and financial regulatory and supervisory agencies.

While it is increasingly clear which real-world economic policies foster a country's attractiveness for investments compatible with climate change mitigation, much less attention has so far been paid to the financial sector and the reforms needed to stimulate these investments. At the same time, the rules and information governing financial decision-making have broad implications for countries' overall decarbonization.

What is the role of the financial sector in achieving the goals of the Paris Agreement?

The role of the financial sector is to allocate capital efficiently. Policymakers have a responsibility to ensure financial stability and safeguard citizens' savings. Climate change poses a direct threat to these objectives, as has been emphasized in the past. Mark Carney and other important stakeholders. Moreover, taking the threat of climate change seriously would not only lead to fewer stranded assets and reduced greenhouse gas emissions in the real economy, but would also increase resilience and improve economic profitability. However, in a large number of countries, several barriers still prevent this from happening, such as lack of disclosure of climate risks and underdeveloped regulatory frameworks.

What are the consequences of the current inaction?

Current inaction continues to lead to inefficient allocation of capital, undermining efforts toward decarbonization and financial stability

Ambitious real economy sector policies cannot address the issue of financial sector externalities, but they are critical for financial regulators and market participants to understand the path to transformation. At the same time, financial incentives targeted at specific sectors (such as carbon taxes and feed-in tariffs) provide important signals to financial market participants. However, special interests and inertia make these incentives insufficient to fully decarbonize the economy, making broader financial sector reform necessary.

What obstacles must be overcome?

One of the main barriers to scaling up investments compatible with decarbonization is the prohibitive cost of capital in many developing countries, which often means that investments are not made at the scale required. The cost of capital is largely determined by the perceived risks in investments, but current financial actors have not yet understood and internalized physical climate risk considerations, nor do they fully understand long-term transition risks, and how these can lead to financial instability.

In order to understand and price the risks efficiently, it is necessary to have a thorough understanding of what climate change means for the financial sector and the real economy in general, and to have a clear understanding of how best to take advantage of the opportunities that the transition of the economy may bring.

What reforms are a priority?

There are several reforms in four main areas of financial policy that can help the financial sector adapt to its new role in the climate transition. These are as follows:

• StandardsClimate compatible finance labels and other information tools can help identify which investments unequivocally contribute to decarbonization. They are also useful to avoid greenwashing and increase transparency.
• Prudential regulation: Clarification of fiduciary duties, as well as capital and liquidity requirements, can help lower regulatory barriers and increase incentives for integrating climate considerations into investment and lending decisions. At the same time, prudential regulation can help address the supply and demand for climate-compatible finance. Climate resilience assessments can help financial institutions better prepare for climate shocks.
• Institutional regulation: Regulations targeting specific financial regulators (including stock exchanges) can help encourage financial market participants to manage and report on climate change.
• DisclosureMandatory and transparent reporting of issues at all levels of financial institutions and investee companies provides information for short- and long-term decision making.

Are there advances that can be learned from?

There are some positive developments. More and more countries have begun to understand the importance and urgency of climate finance. This includes:

• The recent efforts of the European Commission action plan on financing sustainable growth and the work proposed in the United States by the Secretary of the Treasury, Janet L. Yellen.
• The G20 has recently re-launched its Sustainable Finance Study Group and upgraded it to a Working Group.
• The Network for Greening the Financial System (NGFS), which aims to disseminate best practices and mobilize general funding to support the transition to a sustainable economy.
• The 26 members of the Sustainable Banking Network sponsored by the International Finance Corporation (IFC), which brings together financial sector regulators and banking associations from emerging markets, have presented policies to promote sustainable financing practices in their countries.
• The Central Bank of Brazil presented a proposal in April of this year to promote sustainable financing practices in the country. The proposed changes include, among others, a requirement that financial institutions incorporate a climate dimension into their socio-environmental responsibility policy and public disclosure of how climate change is incorporated into their risk and management processes.

Versión en español: https://newclimate.org/2021/07/26/the-financial-sector-has-a-critical-role-to-play-in-enabling-global-deep-decarbonisation/