Why finance is the solution to climate change not the problem

Financial firms are reflecting the real economy and public policy – governments need to set the new trajectory, writes Lynsey Jones

By Lynsey Jones

October 31, 2021

Fossil fuel companies and their financiers have been under attack in recent months from Extinction Rebellion protestors. As well as these more radical actions, campaigns from NGOs regularly criticise financial institutions for being anti-climate. The media attention these actions attract can often be seen as a ‘win’ for climate activists, because polluters and asset managers are put under the microscope and supposedly held to account. But while critics are right to point out that there is more to be done on sustainability, they are wrong to portray the finance sector as a moral villain.

Extinction Rebellion’s tactics are not the right way to go about climate action, particularly not in relation to financial institutions. Their disruptive approach doesn’t lead to meaningful action and can actually be counterproductive, demonising a sector that we need to bring with us on the Net Zero journey. Banks’ lending to fossil fuel companies, for example, reflects the fact that the global economy is still reliant on fossil fuels. They are the symptom, rather than the cause, of the problem.

That’s not to say that banks and financial institutions don’t have agency in how they lend and invest – there are many ways that they can decarbonise their portfolios and invest more sustainably. The sector has already shown that it is willing to move towards greening, through individual action but also collectively through government direction.

A great example of this is the requirement to report in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). This initiative was being implemented by some organisations voluntarily – for example the Universities Superannuation Scheme[1] announced plans to develop a Net Zero strategy well before the Government introduced mandatory disclosures, partly driven by advice from the Ethics Committee for the scheme. But TCFD reporting was made mandatory in the UK – a world-leading measure – to provide clarity to the sector and a level playing field.

However there is more still to be done, both in terms of industry action and government policy. Disclosing is a great first step, but we need to engage with banks and lenders, as well as fossil fuel companies, to get them to set out long-term decarbonisation plans. The UK Government recently announced that it expects so-called ‘transition plans’ to become the norm across the economy – with certain firms required to publish one, or provide an explanation for not doing so[2]. Going forward, we need to see more emphasis on shareholder stewardship, where environmental considerations are seen as core to corporate success, and an expansion of green financial products, so that the industry sees decarbonisation as a growth opportunity rather than a burden and consumers can realise the benefits of sustainable finance.

From a political perspective, there is a strong case for governments to have sky-high ambition on sustainable finance. Not only is there huge potential for green investment to bring in jobs to financial centres, but the investment itself will be key to making the transition to a Net Zero economy affordable for families – by relieving pressure on the Exchequer. In fact, the majority of finance needed to reach Net Zero will likely be from the private sector rather than public finance.[3] Impressively in the UK, £5.8 billion of foreign investment has been secured in just one year for financing green projects. And it’s hoped that three times the amount of government investment can be unlocked from the private sector to support the delivery of transport, energy and nature projects.[4]

Growing the green finance retail market will also be important for increasing financing options as well as engaging consumers in sustainable investment. Green credit cards and car loans that offer favourable interest rates for more sustainable choices can support eco-friendly lifestyles and purchases. Financial products like these would also improve choice for consumers and encourage emotional investment in the transition to net zero, making it tangible for more people. It helps, too, when commercial banks support this kind of action – HSBC has made a global commitment to provide between $750 billion and $1 trillion by 2030 to help clients cut carbon[5].

Sustainable finance can have a much wider influence on Net Zero than the provision of capital to enable it. It has a valuable role to play in building public support and demonstrating the material benefits of Net Zero to individuals. The UK Government has recently launched a green savings bond, in which members of the public can invest anything from £100 to £100,000. The investment will be used by the Government to help finance green projects and then publish details for investors on the environmental benefits. This is a great way for people to keep their savings safe, invest in something positive and get a return from green.

This can’t all be about government action, however. Individual shareholders have a role to play by using their influence and votes for more sustainable ends. In policy circles this is called stewardship. There is evidence that companies with shareholders that are engaged in stewardship have better financial returns on the stock market[6]. Where disclosures aren’t mandatory, shareholder activism is effective in eliciting greater disclosure of firms’ exposure to climate change risks. The stock market also reacts positively following environmental disclosures initiated by shareholders, suggesting that investors value transparency with respect to firms’ exposure to climate-related risks.

Risk disclosure should naturally lead to transition plans. Campaigns such as ‘Say On Climate’[7] are good examples of ways to encourage active stewardship from shareholders – by giving them a vote on transition plans, it encourages publication of the plans, scrutiny, and more effective change. Scrutiny is particularly important in the sustainable finance debate, with claims of greenwashing rife in the sector. Exaggerated or unsubstantiated claims of sustainable practices can be minimised with standards that are used to measure and compare the efficacy of transition plans. The Green Technical Advisory Group[8] has been set up by the UK Government to clamp down on such practices, in part by developing a ‘green taxonomy’, which would provide clarity as to what counts as sustainable.

The broader difficulty with disclosures and transition plans is whether mitigating climate-related risk actually results in better climate outcomes. Some climate change investment funds are engaging in such greenwashing by choosing vaguely defined projects that aren’t independently verifiable as sustainable. And, although not necessarily greenwashing, divesting by moving capital into green projects without doing the difficult work of decarbonising high-carbon assets may not materially improve climate outcomes.

By divesting from fossil fuels or other high-carbon projects, financial institutions are not removing investment from the project entirely, they are removing their investment and potentially decreasing the value of the shares. That leaves an opportunity for another less environmentally-conscious fund to scoop it up. Though as the world moves to decarbonise, these investments will risk becoming stranded and the first-movers to go green will reap the benefits.

We know that there can be good returns on investment from products like green bonds, which is probably why demand for the recent UK green gilt issuance was oversubscribed[9] by a factor of 12. Despite research giving varying answers to this question, it seems that ESG funds do outperform similar stocks that don’t take account of sustainability, but this may not have reached the US markets just yet[10].

It would also be a mistake for banks and financial institutions to ignore sustainability when exercising their fiduciary duty. Incorporating consideration of ESG into all investment decisions increases financial stability and has material impact on returns[11]. For pension funds in particular, long-term performance of assets is key, meaning that investing in renewable energy, which is increasing its share of the energy demand, rather than fossil fuels, which is decreasing[12], could be the more prudent course of action. Factoring in sustainability can align profit with purpose.

It’s clear that the finance sector is making positive moves to decarbonise, but government action is needed to help provide clarity, stability and direction for markets. The Government can provide direction for private finance with targeted regulation and support for emission reductions in the real economy. And giving shareholders a say on climate-related decisions would improve transition strategies, which could lead to greater transparency around green investments, less greenwashing, and more investment in beneficial green projects.

Decisions that we all make today will have long-term consequences – both financial and environmental. So banks and financial institutions should see decarbonisation as an opportunity to seize. As something that should be embedded in every financial decision rather than a niche problem only addressed by specialist ESG funds. For the financial sector in particular, investment decisions made today will have repercussions for years and often decades to come. With just one investment cycle left until our 2050 Net Zero target, it is understandable that protesters are impatient. But only through industry leadership and targeted regulation will we unleash finance in the fight against climate change.

Notes

[1] https://www.ft.com/content/3ecd1c6c-6643-4920-b4f8-0ab04fe0a687

[2] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1026224/CCS0821102722-006_Green_Finance_Paper_2021_v5_Bookmarked_48PP.pdf

[3] https://www.theccc.org.uk/publication/the-road-to-net-zero-finance-sixth-carbon-budget-advisory-group/

[4]https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/936567/10_POINT_PLAN_BOOKLET.pdf

[5] https://www.hsbc.com/who-we-are/our-climate-strategy/providing-sustainable-finance

[6] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3468896

[7] https://www.sayonclimate.org/

[8] https://www.gov.uk/government/publications/independent-expert-group-appointed-to-advise-government-on-standards-for-green-investment

[9] https://www.gov.uk/government/news/second-uk-green-gilt-raises-further-6-billion-for-green-projects

[10] https://www.funds-europe.com/news/esg-can-drive-europe-stock-returns-to-12-outperformance

[11] https://www.unpri.org/download?ac=9792

[12] https://www.theccc.org.uk/wp-content/uploads/2020/12/Sector-summary-Electricity-generation.pdf