Why climate change demands the reform of our financial system

Nairobi – Paris, May 22, 2015 – Harnessing the global financial system to deliver climate security, reduce the risks of high carbon assets, and scale up capital for the low carbon transition is possible, but will only happen with a comprehensive, system-wide approach to financing – including the $37 trillion of energy infrastructure – in the next two decades.

Drawing from an array of policy innovations, some of which are already taking place at the country level, ‘The Coming Financial Climate’, a new report by the UN Environment Programme (UNEP), identifies measures that can make climate security an integral part of a sustainable financial system.

These measures cover risk, capital mobilization, transparency and a shift in the financial culture. Each country will need to decide how these options relate to its financial system and priorities for action.

The World Bank estimates that over the next 15 years, the global economy will require US $89 trillion in infrastructure investments across cities, energy, and land-use systems, and US $4.1 trillion in incremental investment for the low-carbon transition to keep within the internationally agreed limit of a 2 degree Celsius temperature rise.

Tackling climate change requires economic transformation and a re-channeling of private finance.

According to the report, the task for those charged with governing the financial system is to enable the orderly transition from high-carbon to low-carbon investments, and also from vulnerable to resilient assets.

As with all financial shifts, this is likely to generate a set of transition risks for incumbent assets – risks that are not reflected in conventional models for delivering financial stability, which could create billions of dollars of stranded assets.

Achim Steiner

“To create lasting value in the real economy, we need to continuously evolve the effectiveness of our financial system thereby aligning the financial economy with the needs and markets of the future. Recent trends such as last year’s US$ 270 billion market for renewable energy investments and the emergence of new principles, standards and incentives for the fast-moving ‘green bond’ market are indicative of the scope for transformation”, said UN Under-Secretary-General and Executive Director of UNEP, Achim Steiner.

“Integrating sustainability criteria that include environment and social factors into the rules that govern the financial system can substantially strengthen the resilience of the world’s financial systems, which has been a key goal of governments and regulators since the global financial crises of 2008. If brought to scale, the approximately US $300 trillion global financial system could help close the widening gap in sustainable development investment.” he added.

Yet, financial markets do not tend to effectively price environmental resources, resulting in undervaluation of natural capital stocks such as clean air, productive soils and abundant water in 116 out of 140 countries across the world.

Christian Figueres

Christiana Figueres, Executive Secretary of the UN Framework Convention on Climate Change (UNFCCC), said, “The pathway to combating climate change, restoring the balance of planet Earth and unlocking opportunity for billions of people is clear – a peaking of global emissions in the next ten years, followed by a deep de-carbonization of the global economy.”

“In order to achieve this, and support the aspirations for growth and poverty eradication of developing countries, the globe’s financial systems need to better price pollution and invest in real wealth. It is happening but nowhere near the scale required. Paris 2015 can be a trigger that starts directing the trillions of dollars required away from high carbon, high risk investments and infrastructure towards the low carbon, Green Economy that is everyone’s future,” she said.

The costs of high carbon growth include severe health impacts and disruption to infrastructure, water and food security, which in turn trigger greater market volatility, as well as livelihood and economic impacts, particularly in developing countries. In Kenya existing climate variability is already costing up to 2.4 per cent of GDP per year.

Market and policy failures have resulted in the structural mispricing of climate risks, exacerbated by short-term thinking and misaligned incentives, such as the huge subsidies to fossil fuels. This damage is expected to deepen and make risks increasingly unmanageable if we cannot achieve a zero net emissions level of CO2 in the second half of this century.

The process to evolve a more sustainable financial system will intensify in 2015 as governments converge to agree on a global framework for financing sustainable development. Critical steps include the Financing for Development conference in July, the launch of the new UN Sustainable Development Goals in September and the finalization of a new agreement at the UN Climate Change Conference in Paris.

The transition is clearly underway with global investments in renewable energy – accounting for nearly half of net power capacity added worldwide in 2014.

But the financial needs of low-carbon and resilient economies go far beyond renewable energy and require a system-wide response. A comprehensive approach to financing this transition is required. Stronger action is needed to drive the demand for green finance – for example, through carbon pricing and incentives for clean energy.

Public finance will remain a critical component but can only provide a portion of the capital required nationally and internationally.

In China, annual investment in green industry and infrastructure could reach US$320 billion in the next five years, with public finance estimated to provide no more than 10 to 15 percent of the total. To address this challenge, a task force, co-convened by the People’s Bank of China and the UNEP Inquiry, has recently published a comprehensive set of recommendations for establishing China’s ‘green financial system’.

In a marked departure from the past, emerging economies with rapidly developing financial and capital markets are playing a leading role in this all-important reshaping. After all, it is many of these countries that experience the worst effects of environmental degradation and climate change; impacting health, livelihoods and costing life.

In Brazil, for example, integrating environmental and social factors into risk management is increasingly viewed as a way of strengthening the resilience of the financial system.

In South Africa and Singapore, better disclosure of environmental and social performance in stock market, security offerings, among transactions is now seen as necessary to deliver market efficiency.

In OECD countries, which have shown less appetite to advance sustainability as a design principle of their financial systems, the UK’s Bank of England stands as a notable exception having initiated for the first time ever a prudential review to explore whether climate change poses a systemic risk to parts of the UK’s financial sector.

The current shift toward green finance in developing countries can have a significant international impact. At the same time, international action – from knowledge sharing to the development of suitable standards and oversight – is vital to advance green finance.

Other suggested financial sector reforms highlighted by the report include:

1. Expand the scope of risk management

Banking: Place long-term sustainability and climate factors in risk management systems and prudential approaches for lending and capital market operations (‘green credit’)

Investment: Ensure that institutional investors (including pension funds) manage long-term climate factors as part of core risk, fiduciary and other investment obligations

Insurance: Integrate long-term climate factors into wider insurance frameworks for inclusion, solvency, underwriting and investment

Stress Testing: Across financial sectors and markets, develop scenario based tools to enable a better understanding of the impacts of future climate shocks on assets, institutions and systems

2. Enable the orderly reallocation of capital markets.

Capital Markets: Upgrade debt and equity capital markets through standards, regulatory refinement, indices, enhanced analysis and fiscal incentives

Green Banks: Establish green investment banks to strengthen the structure of the financial system and crowd in private capital

Central Banks: Review monetary operations including collateral, refinancing, asset purchases and others to incorporate green finance and climate assets

3. Make transparency systemic

Corporations: Ensure that corporations and issuers of securities publicly report on critical sustainability and climate factors to investors and other stakeholders

Financial institutions: Enhance disclosure by financial institutions on al- locations to green assets, climate performance and exposure to risk, as well as integration in investment analysis

4. Strengthen financial culture

Capabilities: Build capabilities among financial professionals and regulators on sustainability and climate factors

Incentives: Link remuneration, compensation and broader incentive structures with sustainable value creation over the long-term

The report is available at: www.unep.org/inquiry/Portals/50215/Documents/ES_English.pdf

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