Finance at COP 26: Watch out for the unsexy

Expectations ahead of COP 26 in Glasgow regarding the contributions of the finance sector are high. Anuschka Hilke from I4CE explains that our expectations, however, may not currently be high enough. An impactful contribution to achieving climate goals will require the financial community to go beyond reducing their exposure to climate-related risks. To do so, they will need to tackle the unsexy, to change business procedures at the heart. Then, what should you watch out for at COP 26 ?

The finance agenda at COP26 still is highly focused on reporting and risk management

Expectations on the finance sector are especially high for this COP as Mark Carney, former governor of the Bank of England and renowned for having brought climate issues to the attention of central banks, has been nominated as a UN Special Envoy on Climate Action and Finance, and UK Prime Minister Johnson’s Climate Finance Advisor for COP26.

While recognizing the critical role of finance in accelerating and smoothing the transition towards a sustainable future, Mr. Carney’s and other key actors remain focused principally on improved transparency from companies enabling a better management of climate-related risks and opportunities by the financial sector. However, there may be a significant flaw in this theory of change as more far-reaching changes at the financial system level are needed in order to get the transition up to speed.

We need to shift the focus towards strategies for supporting a smooth transition

Let’s take a step back to understand why there is a need to expand the traditional risk approach: Contributing to a smooth low-carbon transition can reduce financial climate-related risks at an individual and system level. But the reverse is not necessarily true: reducing financial risks will not necessarily lead to contributing to a smooth transition.

Indeed, there is little doubt today that a smooth transition to a low carbon economy is the one that reduces at the same time transition and physical risks for financial institutions on a systemic level. So, financial institutions contributing to such a transition should reduce systemic risks and potentially also on an individual level.

Yet, the reverse is much less obvious today as the climate-related risk signal to financial actors is currently too low to trigger the short-term magnitude of change needed for an orderly transition for two reasons. The first is the low visibility of the risk signal. Developing convincing risk assessments is a difficult task (lack of data, multitude of futures to be assessed, partial analysis, methodological challenges, third party verification etc.). This does not mean that we should not integrate the information that we have where possible, but that we need more time and efforts to refine our approach before the risk signal will be fully visible.

The second is the lacking strength of the risk signal in the short term. By design the risk signal will only be at its strongest once the transition path is clear. Risk drivers are political boundaries (through regulation or clear price signals), market demand and market offer. Yet, until at least one of these risk drivers is fully developed, the risk signal is simply not strong enough and harmful activities remain profitable in the short term. Obviously today we are not in the situation where the path is clear, so even if we could measure the risk signal properly, it remains weak until the day where there is a clear policy, demand or offer shock.

So what should you watch out for, when you try to understand announcements at COP 26?

Both aspects result in delayed action if a classic risk approach is followed exclusively, while everyone agrees that swift actions are needed. The next step then is to understand what it needs for financial institutions to effectively contribute to a smooth transition. In this case, contribution is about changing business procedures at the heart, not about getting disclosure right.

What you are likely to hear ahead of and during COP26 from financial institutions are announcements of selected targets and broader objectives, commitments to use existing disclosure frameworks as well as announcements of new “sustainable finance products (benchmarks, funds, bonds and the like). This may sound impressive, but it likely lacks the capacity to deliver on the promise of a contribution to the transition.

Unfortunately, the announcements and steps that can ensure real contribution are likely to be a lot less sexy for communication purposes, but may have more potential to deliver for the transition itself:

• Internal training and capacity building from the board level through to the financial adviser. Yes, it may not sound exciting, but you cannot ask your employees to integrate new procedures if they don’t understand why and how they can be good at it.
• Mainstreaming climate into governance structures. Not just “add-on” climate procedures (once every quarter the board is informed about the climate strategy…) but review of all internal procedures, including internal incentive schemes, if and how they need to integrate the transition AND adaptation issues.
• Coherent long-term “alignment” goals consistent with 1.5°C warming, medium term milestones, short term action plans based on retroplanning,
• Creation of internal pricing signals where the risk signal is not yet strong enough and make them integral parts of decision-making procedures.
• Requiring counterparts to develop transition plans themselves as a condition for investment/financing.
• Clear restrictions on the use of offsetting and the reliance on emission removal

And there may be more aspects yet to define. But figuring this out and how to make it non-optional via financial regulation is what we should put our energy into. There are encouraging signs that go in this direction. COP 26 could be a turning point in this regard.