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In 2016, the Paris Agreement defined the global objective of making financial flows consistent with the commitment to limit global warming to well below 2°C (Art. 2.1c). However, pilot studies suggest that the behaviour of institutional investors around the globe will lead to global warming of well beyond 4°C, resulting in major environmental upheavals.
The Paris Agreement Capital Transition Assessment (PACTA) project helps address this gap, providing policymakers and financial supervisors with the tools they need to align financial flows with the Paris Agreement’s goals.
Since the launch of our online PACTA tool in September 2018, there has been significant uptake, with more than 800 users testing more than 4,500 portfolios as of mid-2019. However, most interest thus far has been concentrated in the US, UK, and other major developed markets, with relatively less knowledge of the tool in emerging markets. To address this issue, with support from the International Climate Initiative (IKI) of the German Environment Ministry, 2°ii launched the PACTA for Emerging Markets project in July 2018. The goal is to help promote the PACTA tool in emerging economies, providing policymakers, regulators, institutional investors, and banks with an assessment framework to measure the alignment of financial portfolios and markets with climate goals, as well as transition risks.
Partnership with the California Department of Insurance
Insurance companies based in California face two increasingly critical types of climate-related risk. The first stems from their exposure to fossil-fuel investments, which are liable to precipitously lose their value as the world shifts to a low-carbon economy. The second stems from the state’s growing vulnerability to the effects of climate change, with natural disasters such as forest fires on the rise.
To help the state raise awareness of and cope with these risks, 2°ii has collaborated with the California Department of Insurance since 2016 to conduct analysis and provide information on climate change-related risks to insurers’ bond and equity portfolios.
Helping non-state actors set and implement climate change action strategies
Currently, non-state actors (NSAs), particularly companies and financial institutions, have limited ability to assess how their energy- and climate-related commitments will contribute to the goals of the Paris Agreement, and how to set targets that are aligned with these goals. For instance, companies frequently lack visibility on climate strategies and regulations at the sectoral level, which reduces their willingness to invest in low-carbon technologies. Meanwhile, institutional investors lack standard metrics to select companies whose technological mix/emission pathways are best aligned with a 2°C target.
According to the OECD, meeting the 2°C scenario will require $6.9 trillion annual investments in infrastructure until 2030, versus $6.3 trillion annual investments in a business-as-usual scenario. These investments require precise alignment among governments, corporates, and investors.
However, several important factors hinder efforts to channel investments towards low carbon pathways. For instance, governments frequently lack the referential frameworks and tools to develop national climate strategies (national determined contributions, or NDCs) that are consistent with the 2°C scenario. Likewise, corporates often lack visibility on public climate strategy at national sectoral level, which weighs on their conﬁdence in investing in low carbon technologies.
To address this market gap, the 2° Investing Initiative and Beyond Ratings, a provider of data and analytics services for the investment industry, have joined forces to develop an innovative methodology and suite of services known as National Climate & Technology Investment Pathways (NCTIP).
KR Foundation – WWF Asset Owner Project
Empowering retail investors to divest from fossil fuels
Currently, certain aspects of the European Sustainable Finance Action Plan are not being implemented, particularly when it comes to efforts to respond to retail investors’ non-financial investment objectives.
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With its Action Plan on Financing Sustainable Growth, the European Commission set the ambitious goal of “reorienting capital flows toward sustainable investment”. This objective seems ideally aligned with the strong momentum of impact-related concerns as to financial products among retail investors and numerous financial institutions. Concurrently, the evolution of several financial regulations at the EU level appears to support this movement. In this context, however, the recent EU Ecolabel Technical Report issued by the EC’s JRC has raised serious concerns as to its consistency with such trends. This papers shows that the approach developed in the Ecolabels Report is technically inaccurate, as it is based on flawed assumptions regarding impact in the context of finance, and does not comply with the EU’s own regulations as regards to Ecolabels. As such, the proposed approach appears to be a dead end, generating potential financial and legal risks, especially from a consumer protection perspective, and undermining the overall environmental objectives of the EU. This paper suggests an alternate approach, consistent with the state of scientific research and compliant with existing rules on the Ecolabel and consumer protection, which centers on implementing an Environmental Management System to design and execute the investment strategy.
In the context of the EU Action Plan on Sustainable Finance, the European Commission plans to explore the introduction of a Green Supporting Factor (GSF) under capital requirement frameworks, that would incentivize banks to lend to ‘green’ activities. This takes capital requirement frameworks away from their risk-based origins and this move is widely contested, including by many financial supervisors. This paper suggests an alternative pathway that satisfies both the objective of aligning capital requirements as a way to shift capital towards sustainability, while preserving their core role of supporting risk management in the financial system and avoiding the drawbacks of a GSF. The paper introduces the concept of Sustainability Improvement Loans (SILs), which could merit lower capital charges as they are lower risk. We define SILs and how they could incentivize sustainability practices and reduce risk. The potential pathway to policy application and its estimated effects on banks’ capital and profitability is then discussed, as well as the extent to which the policy is aligned with the financial stability prerogative of financial supervisors.
From shifting the trillions to addressing the billions. There is a growing narrative and traction among investors around contributing to financing the transition to a low-carbon economy. While partly motivated by questions around financial risk, this narrative is driving a number of commitments around investing in the low-carbon economy. This narrative has focused equally on divesting from high-carbon assets and on mobilizing the “clean trillion”.
Largely missing from the debate, however, has been the role of investors in financing and scaling new zero carbon innovation technologies. Such investment in innovation requires much lower overall levels of financing – billions rather than trillions.
This report addresses the missing role of investors and policymakers in this debate, and how they can contribute to solving the climate innovation puzzle.
This report provides guidelines for building an adverse climate scenario that can be used by financial supervisors as inputs into either traditional or climate-specific stress-tests of regulated entities. The report has been designed to cover the key metrics and indicators found in traditional stress-tests, integrating both risks associated with the transition to a low-carbon economy as well as physical risks in a +4°C / +6°C world. The report provides both insights into key indicators needed in the context of climate stress-tests or scenario analysis, the values they would take in the context of transition risk and physical risk analysis based on the existing literature, options for modelling these indicators in the future, and example applications developed by the 2° Investing Initiative.
Financial market participants have been increasingly in the spotlight when it comes to climate change. After years of pressure by divestment campaigns, as well as being targeted by regulators and building internal capacity, the investment community has embarked upon stronger efforts to address climate change with their investments.
There is, however, still some confusion when investors talk about “decarbonization”. Some refer to decarbonizing their portfolios and mean de-risking them against the regulatory and physical effects of climate change. Others refer to decarbonizing the real economy and mean the impact that their investments can have on the climate.
This paper is addressing the latter: How investors can have an impact on the climate across different asset classes. This will be discussed for multiple forms of equity investment instruments, such as listed equity, private equity, venture capital and real asset investments. It will also cover debt investment instruments such as bonds and loans.
Bond markets–representing the largest asset class in capital markets –are critical in the context of achieving the Paris Agreement.
The global bond market is roughly $100 trillion globally–roughly three times the size of the EU and United States GDP combined –and it’s been growing by a factor of ten since the early 1990s. Bond markets are a critical source of capital for governments, companies, and financial institutions. Their advantage lies in the relatively long-term tenor of the debt instrument, as well as the market’s liquidity, reducing financing costs. For securitized instruments, they help institutional investors be exposed to household credit (e.g. through mortgage-backed securities) and banks refinance themselves in the context of providing this credit. In its role as a core pillar of capital markets, bond markets can also play a key role in financing the transition to a low-carbon economy.
Despite their importance, the discussion of bond markets has largely focused on the green bond space, which currently represents a marginal share(<0.5%)of outstanding bonds. This paper focuses on creating a broader understanding of the interface between climate goals and bonds.