Decarbonising the Economy: The Pivotal Role of the Financial Sector
The physicist Niels Bohr defined an expert as 'a person who has found out, by his own painful experience, all the mistakes that one can make in a very narrow field.' If Bohr's description is accurate, we are all about to become experts on climate change.
2012 was the hottest year on record in the US, and China's most recent winter was its coldest in 30 years. According to research by MunichRe, meteorological and hydrological catastrophes have been rising steadily along with the emissions of greenhouse gases (GHGs): both figures increasing roughly threefold since 1960. In other words, extreme weather is becoming normal weather.
Much of human life and commerce is, however, built on infrastructure that was constructed for a gentler climate. Severe weather, not to mention sea-level rise and other consequences of climate change, will have major impacts on our societies. This has always been the case, but those effects are likely to be magnified to catastrophic proportions as the planet continues to warm.
The need to reduce global GHG emissions is not news, and these recent figures simply highlight the increasing urgency of what we have known for decades: we must transition to a low-carbon, green and resource-efficient global economy to mitigate the risk of dangerous climate change. It is apparent, however, that a key player in this transition has been largely overlooked: the global system of financial intermediation, more commonly referred to as the financial sector.
Large amounts of capital are needed for investment in the rapid development of low-carbon energy infrastructure, particularly in developing and emerging economies. Most political debate and analytical work on the financial sector's role in climate mitigation focuses on how to dramatically increase institutional investment in low-carbon energy infrastructure, which is a vital issue.
The potential role that institutional investors can play in addressing climate change, however, goes far beyond the issue of infrastructure finance. Institutional investors are more than infrastructure financiers: they are owners and creditors of large segments of the global economy.
According to a 2013 report by the Organisation for Economic Co-operation and Development (OECD), institutional investors - including pension funds, insurance companies and investment funds - in the OECD member countries alone had over Euros 70tn of assets under management in 2011.
A 2010 report by the Conference Board estimated that in 2009, institutional investors owned 50.6% of the US equity market by value and 70.3% of the top 1,000 US corporations as measured by market capitalisation. The percentage of the UK equity market owned by institutional investors was comparable: about 70% by value.
Furthermore, the largest proportion of institutional investment by far goes not to the infrastructure asset class but rather to other more conventional asset classes such as listed equity and corporate bonds. The OECD's 2013 report estimated that direct infrastructure investment represented just 1% of pension fund assets on average across the OECD in 2011.
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If we focus exclusively on increasing the amount of institutional investment that goes to low-carbon infrastructure, we ignore the enormous potential that investors have to help decarbonise the economy through the asset classes and investment channels that actually constitute the bulk of their investment.
Quite simply, if institutional investors do not systematically reallocate capital from high-carbon to low-carbon investments, particularly in corporate equity and debt, a transition to a low-carbon economy will be virtually impossible.
Current trends, however, suggest that the opposite is happening. A 2013 report by Carbon Tracker and the LSE's Grantham Research Institute found that over the past two years, the carbon intensities of the main London and New York stock exchanges increased by 7% and 37% respectively. The same report estimated that spending on exploration and development of new reserves by the 200 largest listed fossil fuel companies totalled $674bn in 2012.
With all of these facts and figures in mind, we need to ask how institutional investors, as the owners and creditors of important segments of the global economy, can begin to play a driving role in decarbonising it across all industry sectors, regions and asset classes.
One of the answers to this question, as laid out in a new Investor Briefing by the United Nations Environment Finance Initiative (UNEP FI), is to systematically measure, disclose and, over time, reduce the GHG emissions embedded in global institutional investment portfolios.
Increasingly, regulators, policy-makers, investee companies, pension beneficiaries and the public at large are expecting investors to fulfil play a catalytic role in the decarbonisation of the economy. For instance, there is a growing trend towards mandatory disclosure on climate change and other environmental, social and governance (ESG) factors by companies, including at the international level
At present, most mandatory disclosure schemes target corporations in the real economy and their direct GHG emissions. In a few jurisdictions, however, including the EU, regulators are planning to require financial intermediaries to also disclose their ESG impacts, including the indirect GHG emissions associated with their investment and lending activities.
It is difficult to assess the degree to which institutional investors are already taking action to reduce the carbon footprint of their investments due to the lack of transparency about emissions within the financial sector. While over 4,000 companies disclose their GHG emissions under the Carbon Disclosure Project, which acts on behalf of more than 722 institutional investors, only 17 of the world's 1,000 largest institutional investors disclose their own emissions under the analogous Asset Owners Disclosure Project.
One thing that is clear, however, is that carbon accounting and reporting is a key first step in the decarbonisation process. Investors cannot manage what they do not measure, and they cannot effectively re-allocate investment unless they know where their carbon-related risks and opportunities lie.
While this tool is already available to investors, a variety of obstacles are impeding its widespread uptake. One key obstacle is the lack of a harmonised, high-quality and pragmatic standard for carbon accounting and reporting that is tailored to the particular circumstances of the investment community.
The transition to a green, resource-efficient and low-carbon economy is more urgent than ever, and investors have an opportunity to take a concrete step towards this transition by engaging in the development of such a standard.
Over the next two years, UNEP FI, in partnership with the Greenhouse Gas Protocol, will facilitate an international process aimed at shaping a standard to guide investors to undertake GHG accounting and reporting in a relevant, complete, consistent, transparent, accurate, yet practicable and resource-efficient manner. We invite relevant organisations to join us in this important effort.