Liebreich: Climate and Finance – Lessons from a Time Machine

Michael Liebreich
Senior Contributor

The global economy’s pivot to low carbon is gathering momentum. By the time of COP26 in Glasgow in November this year, countries responsible for 78% of global GDP will have pledged net-zero emissions by 2050 or, in the case of China and Brazil, 2060.

But is the financial system on track to deliver this scale of change? While there is plenty of innovation – from investors, regulators and markets alike – there remain a number of very big question marks.

Money is flowing – over $500 billion went to net-zero compatible sectors last year, according to a new metric by BloombergNEF. However, no amount of investment in clean energy and transportation will get the world to net zero if the capital markets continue to invest at the same time in fossil fuel-based infrastructure. Investors must also stop funding fossil assets, and they may even have to walk away from assets before the end of their productive lives. How can the capital markets contribute to, rather than impede, such decisions?

A veritable smorgasbord of organizations has sprung up in recent years, promoting sustainable finance from various angles. All of them, however, depend on methodologies that are at best not transparent, and at worst downright misleading.

Before we look at how they might be fixed, we are going to jump in our time machine and take a look at how we got to where we are today.

Cut back to Dubai, 2012

December 2012 found me attending the annual meeting of the World Economic Forum’s Global Agenda Councils in Dubai, along with over 1,000 thought-leaders in 70 topic areas, to network and swap thoughts on the key issues of the day.

While my fellow members of the Agenda Council on the New Energy Architecture were wrestling with renewable energy’s prospects in the dawning-not-dawning ‘Golden Age of Gas’, I snuck off to learn about the future of the financial system in the wake of the Great Financial Crisis. I visited the Agenda Councils on Financing and Capital, Fiscal Sustainability, the Global Financial System, Global Trade and Foreign Direct Investment, the International Monetary System, Long-Term Investing, New Economic Thinking, and the Role of Business; to my shock I found that (as you can still see from the Midterm Reports on the Network of Global Agenda Councils 2012-2014) – not one of them had climate change on their agenda.

When I challenged them, they all gave the same response: it is not up to the financial system to protect the environment: that’s the job of regulators in energy, transport, industry and so on. And, they assured me, as soon as clean solutions made economic sense, the money would flow – but not before, because of their risks. It is worth noting that since then the NYSE Arca Oil Index has lost 19% of its value and the Stowe Global Coal Index plummeted 66% (and was discontinued in December 2020), while the NEX clean energy index is up 337%.

The white paper on financial bias

Prompted by my experience in Dubai, together with Angus McCrone, chief editor of BloombergNEF, I wrote a white paper in January 2013 entitled Financial Regulation – Biased Against Clean Energy and Green Infrastructure?

In it, we accused the global financial system of being “institutionally fossilist”: unintentionally biasing decisions toward incumbent, fossil-based technologies and starving clean energy of the investment its rapidly improving economics should have justified.

We highlighted new Basel rules limiting the ability of banks to provide long-term, non-recourse finance to clean energy projects. Solvency rules that prevented investors from funding infrastructure and public transport. Liquidity rules that made it impossible for pension funds and life insurers to back newer technologies. Definitions of fiduciary duties that stopped pension fund trustees from taking into account ESG considerations. Accounting regulations that failed to require disclosure of climate risks. Public investment funds forced by regulators to use ratings agencies that ignored climate change. And so on.

To their credit, the World Economic Forum published a version of the white paper at Davos in January 2013, kicking off a heated debate among delegates and at subsequent events.

In January 2014, The United Nations Environment Programme picked up the baton, launching an Inquiry into the Design of a Sustainable Financial System, which resulted in October 2015 in a major report entitled The Financial System We Need. Then, December 2015 saw the formation of the Task Force on Climate-related Financial Disclosures (TCFD), chaired by Mike Bloomberg (founder and majority owner of Bloomberg LP) at the request of the Financial Stability Board and its (then) chair Mark Carney (governor of the Bank of England at the time). TCFD has done much to raise awareness of climate change and the need for more climate-related disclosures in financial circles.

Jump back to today

Today, there is a wall of money targeting opportunities in financing the net-zero transition. According to the new BloombergNEF metric, in 2020 a record $501 billion was invested in energy transition sectors – principally renewable energy and the electrification of transport and heat. Over the past five years, $2 trillion of sustainable debt has been issued, over $730 billion in 2020 alone.

Net-zero solutions must surely be in danger of suffering from “irrational exuberance” – to use Alan Greenspan’s famous phrase in 1996, ahead of the dot-com bubble – judging by the fact that Tesla Motors is today worth more than the next ten most valuable car companies combined, or by the pre-revenue companies being rushed onto the public markets via special purpose acquisition corporations (SPACs).

It is now hard to argue that the financial system is institutionally fossilist. Indeed, there is a lively debate going on about whether central banks should be promoting climate action – being ‘institutionally anti-fossilist’ – or not. European Central Bank President Christine Lagarde is pro-activism, Bundesbank chief Jens Weidmann against. For what it’s worth, I tend toward Weidmann’s camp: I think central banks should stick to managing risks within the financial system posed by societal choices, not trying to manipulate the choices made by society.

A smorgasbord of global sustainable finance groups

Today, over 50 global groups are working at cleaning up the financial system – and that’s without counting hundreds of national organizations and regulators, or thousands of think-tanks, universities and financial institutions.

At one end of this sustainable finance sausage machine is civic society – in the form of pressure groups like Go Fossil Free, DivestInvest, Banktrack and Reclaim Finance, as well as multilaterals like the OECD, UNEP and the Coalition for Climate-Resilient Investment. At the other end are central banks – 83 of which make up the Network for Greening the Financial System – and financial centers, 33 of which have banded together as Financial Centres for Sustainability (FC4S).

Between these bookends are groups for every type of financial player. Corporations can join initiatives by the likes of We Mean Business, B Team, Climate Group or Ceres. They can make pledges – to adopt 100% clean energy or vehicles under the auspices of RE100 or EV100, or to target zero emissions under the Science Based Targets Initiative (SBTi). They can try to gain admission to a growing number of climate and sustainability-related indices, competing for the ballooning assets allocated to sustainable exchange-traded funds (ETFs) and other pooled instruments.

For investors, the big one is the Principles for Responsible Investment (PRI), boasting over 3,000 signatories and $103 trillion under management. That accounts for just over a quarter of the $400 trillion of financial assets that the Financial Stability Board says are under management globally. While the PRI operates across all aspects of sustainability, new-ish kid on the block Climate Action 100+ focuses on climate change. Its 545 members so far manage ‘only’ $52 trillion, but were recently boosted by BlackRock under new climate risk disclosure evangelist, Larry Fink.

Institutional investors can join the International Investor Group on Climate Change, the Global Infrastructure Investor Association or the Coalition for Disaster Resistant Infrastructure. Sovereign wealth funds have the One Planet Network, asset managers have the Net Zero Asset Managers Initiative, asset owners have the Net Zero Asset Owner Alliance and bankers can sign up to the Principles for Responsible Banking. Insurers can choose between the Sustainable Insurance Forum, the Munich Climate Insurance Initiative, the InsuResilience Global Partnership for Climate and Disaster Risk Finance and Insurance, and the Principles for Sustainable Insurance.

There are even groups of groups: the Global Sustainable Investment Alliance is an association of regional sustainable investment associations, not to be confused with the Global Investor Coalition on Climate Change.

Time for a little disclosure

There is one thing all the organizations in the business of pushing, pulling, pledging or promoting climate finance need, and that is data. Which brings us to a whole other set of groups working on carbon accounting methodologies and disclosure.

The aforementioned Task Force on Climate-related Disclosure now has over 1,800 supporters, with over $165 trillion of assets under management. Then there is the Climate Disclosure Standards Board and CDP,  (formerly the Carbon Disclosure Project) the pioneer in this space since 2002. This year 9,600 corporations, as well as 810 cities and 130 states and regions, will use CDP’s methodology to report their emissions to investors with over $110 trillion under management. A more recent arrival, the Transition Pathways Initiative, offers a way of assessing whether corporate strategies are in line with the Paris Agreement, while the Climate Bonds Initiative provides methodologies to ring-fence debt raised for decarbonization activities.

When it comes to ESG reporting, the Sustainable Accounting Standards Board has been promoting standardization of ESG data and guidelines for a decade, alongside others such as the Global Reporting Initiative and the Integrated Reporting Initiative.

Then there are groups figuring out how to aggregate the resulting company-level data into portfolios. The 2° Investing Initiative, boasting 1,500 institutional users, offers to help asset managers and asset owners check whether their portfolios are in line with the Paris Agreement. The Partnership for Carbon Accounting Financials, with 102 members managing $20 trillion (including most recently Bank of America) offers a 134-page Global GHG Reporting Standard for the Financial Industry.

It’s a slippery scope

This is where things get interesting (I promise). Every one of the organizations listed above bases its calculations on the methodologies of the Greenhouse Gas Protocol. Originally developed 20 years ago by the World Resources Institute (WRI) and the World Business Council for Sustainable Development (WBCSD), this is the rule-book defining Scope 1, Scope 2 and Scope 3 emissions.

A quick reminder: Scope 1 are emissions from your own burning of fossil fuels or emissions of other greenhouse gases; Scope 2 are emissions embodied in purchased energy services – electricity, steam, heating and cooling; and Scope 3 are emissions elsewhere in your value chain, either upstream or downstream.

Accounting for Scope 1 and Scope 2 is relatively straightforward. A utility’s Scope 1 is a power user’s Scope 2, so if you own shares in both, there is a double-count, but it is fairly easily removed. Scope 3, however, is a whole different ball game.

Take the example of a sustainability consultant taking a flight as part of a client engagement. The resulting emissions would count as Scope 1 for the airline, and Scope 3 for both the provider of jet fuel and the consultant’s employer. They should also, however, be counted as Scope 3 by her client. And by the company which extracted the crude oil from which the jet fuel was produced. And by the owner of the refinery where it was refined. And the ‘fixed base operator’ who delivered the fuel to the plane. The same emissions should also be counted as Scope 3 by the owners of the departure and arrival airports, the leasing company that owns the plane, and the insurers of the oil production platform, the refinery, the airport and the aircraft – as well as the provider of the consultant’s travel insurance. Then there are the companies providing the air traffic control system, components and subassemblies of the aircraft, aircraft maintenance, airport security and catering services.

A big asset owner or asset manager might conceivably hold shares in every one of these companies. Not only that, but in addition to equity, they might own some of each company’s debt too, perhaps several issues of different maturities. And what about derivatives? If you buy a call option on a company’s stock, are you responsible for some of its emissions? A credit default swap? If you borrow stock and sell it short? If you warehouse debt as collateral for a collateralized debt obligation?

How is any investor meant to keep up with this, not on an annual or quarterly basis, but as it changes by the millisecond?

If the goal is to get executives and investors to think about the carbon intensity of the value chain to which their organizations or portfolio companies belong, and to push them to work with other value chain players to reduce emissions, this approach is great. It is clearly working, and its promoters are to be lauded.

If, however, you want to find out how many tons of carbon dioxide companies in your investment portfolio are actually emitting, or if you want to differentiate between two possible funds on the basis of their impacts on the climate, or if you want to regulate your capital markets to ensure compatibility with the Paris Agreements – then Scope 3 is simply a mess.

EU Taxidermy

The European Union, meanwhile, is plumping for a completely different approach: the EU Taxonomy for Sustainable Activities, an attempt to define a master list that should – as described in the definitive BloombergNEF overview (client link here) – make it easy to see which companies are sustainable and, by extension, which investors are backing sustainable economic activity. As so often in sustainable finance, practice and theory diverge fast.

First, the selection of activities approved by the Taxonomy involved hundreds of politically-laden judgments. It turns out to be hard to draw a clear line between good and bad behavior. Natural gas is allowed, but only if it can achieve emissions limits that current carbon capture technology would struggle to deliver. Investments in existing real estate are considered sustainable only if buildings hold A-rated Energy Performance Certificates (which almost none do), while renovations can meet a lower target of reducing primary energy demand by 30%. There’s a free pass if your activity is unsustainable, but required in support of sustainable activities.

Nuclear power has been completely excluded, even though it still produces around 40% of the EU’s zero-carbon electricity and has substantial co-benefits in the medical, food and metrology sectors. Although it might get a reprieve – the Taxonomy is meant to be dynamic – experience of similar exercises from the world of trade suggests that updating it will be a slow and fraught process.

The second problem is around data. From January 2022, all EU-based public companies with over 500 employees will be required to report their percentage of turnover, capex and operating expenditure accounted for by activities listed in the Taxonomy. So far, just four companies have published draft reports: renewable energy and infrastructure developer Acciona, engineering services provider Spie, real estate developer K2A, and water company Suez. All are relatively simple examples, produced by companies keen to promote their green credentials.

For the average EU business, the Taxonomy will entail a level of disclosure far beyond anything found in financial statements. Taken literally, it would reveal profitability by line item, investment plans for individual plants and future project launches. The more likely outcome is that an army of accountants and consultants will ensure that data are estimated and aggregated in such a way as to meet legal requirements while revealing little of value to competitors – or investors.

Take the example of a diversified manufacturer of electrical components. It might sell a range of products via multiple distributors into a global client base that includes fossil as well as renewable equipment providers, using factories inside and outside Europe, some owned and some operating under contract. In other words, it is a typical player in today’s global supply chains. Any disclosure by that company will be little more than educated guesswork – and expensive guesswork, particularly for smaller players.

At the project level, and for the major industries responsible for around a quarter of EU emissions, the Taxonomy might be useful. It should, for instance, help to eliminate the abuse of green bonds to fund activities of dubious environmental benefit, or enable the filtering of recipient projects for EU Green Deal funds. At the corporate level, however, it feels like an incredibly intrusive way to drive additional disclosure of marginal utility.

Then, also from January 2022, the EU expects asset managers to use the Taxonomy to disclose the sustainability of their investments and funds. Given the data integrity questions already described, and given the scale of investment by EU asset managers in private equity and outside the EU – in companies which are under no disclosure obligation – this looks like a considerable over-reach.

Back to the future

Do these flaws in Scope 3-based carbon accounting and the EU Taxonomy mean that the attempt to enlist the capital market in support of net zero is pointless, and should be abandoned? Of course not. They just demonstrate that sustainable finance is still undergoing its Cambrian Explosion, with major parts of the information and regulatory infrastructure still in the process of emerging.

Let’s take a look at four promising trends or areas for action.

1) Overhaul the Greenhouse Gas Protocol

In financial accounting, it has been axiomatic since the time of the Code of Hammurabi (1750 BC) that liabilities are not double counted. Even where parties agree to be “jointly and severally” liable under a contract, total liability only ever adds up to 100%. The entire edifice of tort law has evolved to figure out who is responsible in the event of harm to any person, group or organization.

Seen through this lens, Scope 3 emissions look more like collective punishment than an accounting system. What is needed is a way of allocating responsibility to specific players in an economic activity, which will generally be the first player in the supply chain who could have avoided causing them, but did not do so.

That is my one-line summary of the conclusions reached by the Expert Group on Climate Obligations for Corporations, a collection of 68 eminent jurists and human rights experts who have produced the Principles on Climate Obligations for Corporations. In its 372 pages they attempt to establish – in the absence of explicit law or precedent – where companies’ and investors’ legal obligations with respect to climate change are likely to lie. To do this, they differentiate between emissions that are avoidable and those that are excessive, and take into account which player actually has control over the decisions that drive emissions. The detailed commentary covers groups like investors, insurers, reinsurers – even advertising agencies – and should be required reading.

The Expert Group reaches conclusions that will, for many, make uncomfortable reading: “We [do not] believe that it is justified to allocate emissions generated by the combustion or the use of fossil fuels to the enterprise which put them on the market. The latter stance would make it too easy for others to argue: climate change is not our problem, it is ‘theirs’.”

In other words, holding everyone responsible for emissions means holding no one responsible, and blaming fossil fuel producers – however egregious their past misconduct – effectively means placing the onus for climate action on those with most to lose from accelerating it. Instead of demonizing the supply of fossil fuels, we need to focus primarily on choking off demand. By demanding action on climate while maintaining demand for the products that cause it, society is sending mixed signals.

In addition to reforming the Greenhouse Gas Protocol, we can and must do a far better job of tracking emissions through the value chain. Instead of employing armies of analysts to find gaps and make estimates, each ton of carbon extracted anywhere in the world should automatically be tracked through the point where it is burned to the product or service for which it is used.

Distributed ledger technology could have been designed with a job like this in mind, as the OECD acknowledges in this white paper, particularly in the era of satellite technology, sensor networks, big data and machine learning. Knowing exactly what is emitted and who is responsible will be a game-changer.

2) Accountants will save the world

The core premise behind the push for sustainable finance is that climate risk is currently being mispriced by the market.

The insurance industry has made great strides in the past decade in improving its understanding of physical impacts of climate change and adjusting its premiums accordingly. But as Mark Carney explained in his 2015 speech to Lloyds of London, there are two further categories of climate risk – transition risk and liability risk. And that is where financial accountants come in.

Nothing would focus the minds of investors quite like the announcement of climate-related impairment charges. And our understanding of climate risk has reached the point where it must be reflected in annual reports. One company may have to say that its assets are physically vulnerable without new investment. Another’s flagship asset may have a shortened life due to a host country’s net-zero commitment. A third may find decommissioning charges being brought forward from the distant to the near future. And so on.

In 2019, the International Financial Reporting Standards Foundation (which publishes the IFRS rules used in most of the world outside the United States) issued a seminal discussion paper, explaining how existing IFRS guidelines should be applied in the case of climate risk. Not only did it note the potential for asset impairments, it also pointed out that climate exposure must be disclosed even if it does not appear financially material – it might still affect a decision such as divesting from sectors incompatible with net zero. IFRS is now consulting on a new Sustainability Standards Board, which it may announce during COP26 in November.

The U.K.’s Financial Reporting Council, the independent regulator of auditors, accountants and actuaries, has issued a joint statement with the Financial Conduct Authority (FCA), the Prudential Regulation Authority (PRA) and the Pensions Regulator (TPR). This states that “companies should reflect the current or future impacts of climate change on their financial position, for example in the valuation of their assets, assumptions used in impairment testing, depreciation rates, decommissioning, restoration and other similar liabilities and financial risk disclosures.”

The U.S. Securities and Exchange Commission (SEC) has so far indicated that it does not intend to make climate disclosures mandatory because “capital allocation decisions based on … climate-related factors are substantially forward-looking and likely involve estimates and assumptions.” However, the International Organization of Securities Commissions (Iosco) has recently emphasized that ESG matters should not be relegated to the non-financial realm, so this might change. The U.S.’s Generally Accepted Accounting Principles (GAAP) also lag the IFRS, but have been converging in other areas; they can be expected eventually to follow suit on climate risk.

This long-term shift of climate risk from fuzzy and voluntary ESG reports to quantified and regulated financial statements will mark a huge inflection point in the history of climate action. As Peter Bakker, president of the WBCSD, noted in 2012, “accountants will save the world”.

3) Lessons from H.G. Wells’ Time Machine

Focusing responsibility for Scope 3 emissions on those who make the decisions that cause them, and ensuring that risks are quantified and included in financial reports, will do a huge amount to drive capital into decarbonizing the global economy. Alone, however, they will not deliver a net-zero-compatible financial system.

Let’s divide the world into two types of value chain: one dependent on carbon emissions, the other not. We can call them the Morlock economy (real world, polluting) and the Eloi economy (idealized, clean), after the future described by H.G. Wells in the Time Machine. At present, there are lots of Morlock value chains and not many Eloi ones – but over time we will see that change, as more and more of the economy decarbonizes.

Membership of the Eloi economy may remove responsibility for emissions, but it does not remove physical climate risk, which will have to be disclosed and may still have the effect of driving capital away. An hotel owner facing the prospect of damage to its properties from increasing flood risk will have to report its need to invest in resilience – but that will not provide any incentive for those doing the emitting to stop.

For the Morlock economy, attracting capital is also getting harder, at least in the developed world. The combined impacts of increased disclosure requirements and provisions against climate risk are increasing the cost of capital, in some cases significantly. A 2019 survey by the Oxford Institute for Energy Studies found that institutional investors would use a 40% hurdle rate for any new coal investments.

There are, however, Morlock investors who are not subject to disclosure rules and who perceive climate risk as minimal – think of family offices or private equity investors, perhaps operating in parts of the world where transition risk is barely on the radar screen. The fact is there is nothing much to deter them from investing in fossil assets. To achieve global net zero, however, the entire Morlock economy has to be shut down.

If there were a way for specific climate-related costs – say in the form of increased insurance premiums, actual damages or accounting provisions – to be sent by Eloi organizations to Morlock organizations, the see-saw would rapidly tip. That is, however, fanciful – perhaps a plot device for a 21st century rewrite of the Time Machine – but there is a next-best solution: carbon pricing.

According to a 2020 Guidehouse report on behalf of the World Bank, nearly a quarter of global emissions are already covered by some form of carbon pricing. The EU-ETS has been joined by the Regional Greenhouse Gas Initiative in in a number of U.S. East Coast states, the beginning of carbon trading in China, Canada’s carbon fee and dividend, and a range of national and sub-national systems. We don’t need the single global carbon price so beloved of economists, but we do need further progress in this direction.

We also need a workable Carbon Border Adjustment system, to ensure that the Morlock economy is not given a free ride. With the election of President Joe Biden, the having chances of such a system are much improved.

4) The times they are a-changed

The fourth and final trend of significance is the fact that net zero and carbon removal are now the only games in town.

Cut back once more to the 2012 Global Agenda Council meeting in Dubai. The global carbon budget – the level of cumulative emissions compatible with a habitable climate – was still thought to stretch beyond the lifetime of most energy and transport assets. The name of the game was cap and trade: no need to eliminate emissions entirely, just limit them and ration them toward sectors where reductions are most expensive.

Jump cut back to today, and we are in a world of elimination, not rationing. Since the Paris Agreement and the International Panel on Climate Change’s October 2018 Special Report on 1.5ºC, we know that to maintain a recognizable climate, the goal must be net zero within around a single asset lifetime. The appropriate emissions for any new project, any company, any portfolio is now zero. Yes, some level of offsets and negative emissions is going to be needed, but as a business or investor, relying on them is going to entail risk and drive up your cost of capital.

Unfortunately, none of the currently available carbon accounting methodologies focuses corporations unequivocally on the two goals: reducing controllable emissions and developing high-quality offsets capturing carbon and sequestering it permanently. Science-Based Targets sound great, until you realize that while its targets may be science-based, its associated rules and road maps are not: they set arbitrary targets for Scope 3 emissions, which as we have seen companies generally do not control, and they rule out any use of offsets. That is why we are seeing a fruit salad of inconsistent net-zero pledges by, among others, European oil and gas companies, leaving the work of reconciliation to investors.

While offsets that genuinely capture carbon from the atmosphere must be regarded as legitimate, wheezes like ‘avoided emissions’ must not, as Carney and the Nature Conservancy recently discovered (read more here and here). The world will never get to net zero if avoided emissions count: we’ll just end up with a net-zero Eloi economy, alongside an emitting Morlock economy – one smaller than it might have been but still big enough to breach planetary boundaries.

Where developing world countries require incentives to avoid deforestation or leave fossil fuels in the ground, these must be provided by governments, not private players – the focus of some difficult Article 6 negotiations at COP26 in Glasgow.

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If we can accelerate these four trends – transparently allocating emissions to the organizations causing them; integrating climate risk into financial reporting; extending carbon pricing; and focusing on net zero – we can build a sustainable financial system. A future in which the health of the capital markets is not in opposition to the health of the planet, that is surely a future worth working for.


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