Ethical Finance Round Table | Accounting for Sustainability

At the latest Ethical Finance Round Table, we were joined by Professor Michael Mainelli, Alderman and Sheriff of the City of London, founder of think-tank Z/Yen and qualified accountant, and Jon Williams; Partner, Sustainability and Climate Change, PwC. The discussion centred around the need for companies making commitments to net zero to truly understand what this means for their business models year on year, as well as emissions trading schemes and the need to price embed the true cost of externalities within the economic system. Click the links to watch video of the full session, or the individual presentations from both Michael and Jon.

Key headlines

  • Green finance was born with the creation of sulphur dioxide permit trading
  • The EU Emission Trading Scheme, is often dismissed but appropriate carbon pricing was not achieved due to governments issuing too many permits
  • Carbon pricing works. Miles driven in America dropped 4% in 2011 due to a 32% increase in oil prices, not due to an outbreak of environmental awareness
  • Policy performance bonds could be a useful tool for governments and companies to deliver on their commitments and hedge against climate and policy risk.
  • Over 1,500 companies and 50 countries have made net zero commitments, but very few understand the true scale of the challenge to achieve this.
  • To meet the Paris commitment to limit global warming to 1.5C means an annual reduction in carbon of over 11%. No economy in history has achieved this on a sustained level; the global reduction in 2019 was 2.4%.
  • Financial institutions are unsure of their “carbon liabilities”, and have assumed around 2/3 of the reductions they need for net zero will come from government policy outwith their control. If they are required to offset these emissions, it could cost as much a 500% of the profits from these assets.
  • if the finance sector is to support this transition, every finance professional needs to start understanding these issues and supporting their clients to deal with them.

Professor Mainelli

Michael began by explaining that green finance as we commonly know it came into being with the trading of sulphur dioxide permits in the USA in 1992. Traders thought they might be able to bring down these emissions by around 20%, but actually managed to halve them in just 4 years, creating considerable optimism around carbon permits going into the Kyoto climate conference.

A small group in the City of London, including Professor Mainelli, then picked this up and ran a market around this in London, later developed by the EU in 2002 to become their emissions trading scheme (ETS). This is often thought of as a failure, though Prof. Mainelli argues that the carbon price it produced did fairly reflect the supply of and demand for permits, but the issue was that far too many permits were issued by governments – roughly double what was needed. While governments had committed to keeping the price above 25 euro/tn, it plummeted to pennies shortly after launch.

Top-down pressure on capital allocation is good, explained Prof. Mainelli, but plans and awareness alone are insufficient. There needs to be an internalisation of environmental factors into the billions of everyday economic decisions. Incorporating environmental factors into prices works: in 2011, Americans drove 4% fewer miles not because of “awareness” of issues, but due to a 32% increase in oil prices. In fact, China has now implemented an internal emissions market, so even communists think that carbon markets work.

In Prof. Mainelli's view, carbon pricing is achievable and effective, and if companies internalise carbon in their decisions , there will be no need for banks to decarbonise their loan books, as many are calling for, as the carbon will be internalised in traditional measures of risk and reward. Some of the voluntary schemes, however, leave something to be desired; the issuer of a 25-year carbon credit could simply burn the forest after 26 years!

One area Prof Mainelli felt had a lot of potential was that of policy performance bonds. They were proposed a number of years ago, but never truly caught on in the Anglophone finance community. They have been successful in France, with major companies including Danone and Enel issuing them. One major opportunity around them could be in governments buying bonds – if you miss your emissions target, you pay interest, but if not, you essentially get free government money. The UK government is looking to do this ahead of COP26, which would effectively allow financiers to hedge against government policy. Sadly, progress in this area has not been as fast as it needs to be; one of Prof Mainelli’s final slides was taken from 2007, and the issues remain largely the same in 2021.

Jon Williams

Jon Williams sits on the TCFD, and explained that the endgame for TCFD is forward-looking metrics, but this requires a level of information that businesses and the finance industry just do not have right now.

He posed the question of what is meant by “net zero”? Over 1,500 companies and 50 governments have made announcements or commitments around net zero, but what do they really mean when they make these announcements? Have they got concrete plans and timetables, or are these more “aspirational” commitments? PwC’s Net Zero Economy Index 2020 shows some of the data around net zero and decarbonisation. By combining carbon data and a macroeconomic model, PwC estimate that global carbon intensity fell by 2.4% in 2019.

This is still below what is needed – the decarbonisation rate needed to limit global temperature increases to 2C would be 7.7% per year, and to limit to 1.5C would be 11.7% per year, which no economy in history has every achieved on a sustained basis. The companies that are committing to net zero need to understand that this level of decarbonisation is implied, and start to plan how they will actually achieve that. This is a huge challenge, much bigger than the one faced by COVID.

What is the role of finance? Providing the capital to help the economy transition from where it is today to where it needs to be in 10 or 20 years. Financial institutions need to move from looking merely at their own emissions, to those embedded in their loan books, or portfolios, and to do this it needs more data on emissions downstream.

Financial institutions are largely unsure what their balance sheet and loan books are actually exposed to – most companies  borrow for liquidity, not to tie themselves to financing specific projects. Many have made huge assumptions about how large residual emissions will be – in other words, how much of the emissions reductions will be achieved by government policy without any active interventions on their part. If these assumptions turn out to be inaccurate, the cost of offsetting residual emissions will vastly outweigh the profits from the assets behind them.

Jon concluded by saying that net zero is not a myth. It is a reality, but a very difficult reality. Companies need to take net zero seriously. The pathway to net zero includes climate risk and impact baselining, strategy development, organisational transformation and transparency and reporting. Ultimately, if the finance sector is to support this transition, every finance professional needs to start understanding these issues and supporting their clients to deal with them.

Q&A

The Q&A at the end of the session discussed a number of issues. Michael Mainelli highlighted that the tools for carbon reduction can also be used for maintaining biodiversity, but this is much harder to measure, and that trade is a key issue – it has been a major driver of growth over the last half-century, but there may need to be adjustments for embodied emissions. Jon argued that the furore over pricing nature is often misplaced – it is not that there is a price at which you can destroy nature, but instead that there is a need to put a price on the ‘free ride’ that people get out of emissions, nature and biodiversity.


COP26 – Role of Finance in Tackling the Climate Crisis

COP26 – Role of Finance in Tackling the Climate Crisis

This year’s UN Climate Change Conference in Madrid has wrapped up, and all eyes will now focus on Scotland as next year’s host of what is arguably the world’s most important international conference. Also known (somewhat confusingly) as COP 26, Glasgow will be centre stage between 9 and 20 November 2020 as it welcomes an estimated 30,000 delegates from around the world.

Next year’s climate change conference will be particularly important since it will mark five years since the historic Paris Climate Agreement, which committed countries to strengthening actions to combat climate change and limit the global temperature rise this century to below 2 degrees Celsius. We know however that the world is not on-track to cut carbon emissions which must be halved on today’s levels to restrain temperature increases to just 1.5 degrees Celsius, the upper limit advised by climate scientists. Progress will need to be ratcheted up by next year.

Over 500,000 people marched through the centre of Madrid this month, joined by young climate activist Greta Thunberg, to demand quicker action to tackle climate change, yet many have been left frustrated by the lack of urgency that has characterised this year’s climate conference. Madrid has been dominated by disagreements over carbon emissions trading (where more polluting countries can purchase the right to pollute from countries that have not yet reached their emission limits – seen by many as deeply unfair and a false solution to the climate crisis) and an international push to have rich countries pay poorer countries for “loss and damage” associated with irreversible climate change impacts.

Next year, the spotlight is expected to shine on the thorny issue of how to pay for climate damage, and how to mobilise the trillions needed for international climate financing programmes.

Financing needs to tackle the climate crisis are estimated in the trillions worldwide, and are especially high in the poorest countries and those particularly vulnerable to climate change, such as small island states. The UN estimates a US$ 3 trillion annual shortfall in investments needed to meet internationally-agreed climate and sustainable development goals.

A decade ago, industrialised countries pledged to jointly mobilise US$ 100 billion annually in climate finance by 2020 to address their needs. Yet only US$ 71 billion was raised in 2017, mostly from public sector aid budgets (and with most provided as loans). There is a consensus that more resources need to be mobilised from private markets for climate-friendly investments and to support a “just transition” to net-zero.

This is where our work to promote Scotland as a leading international centre for ethical and responsible finance comes in. The climate emergency has underscored the importance – indeed urgency – of building a financial system that has better outcomes for people and planet at its heart. Our work at the Global Ethical Finance Initiative (GEFI) headquartered in Edinburgh, builds on Scotland’s proud heritage in ethical finance and financial services, to convene the world’s foremost political, business and civic leaders to define and shape the transition to a sustainable financial system.

Within the financial services sector, interest has increased significantly over recent years in the ways it can – and should – look beyond short-term profit and shareholder value towards how it can drive positive social, economic and environmental impact. Increasingly, investors and consumers want to be more thoughtful about the impact their money can make on the world. This has led to a plethora of new initiatives and financial products, such as ethical investment funds, sustainability bonds (where the proceeds are exclusively applied to finance green or social projects), and the development of UN-led Principles for Responsible Investment. Globally, the impact investment market is increasingly popular and is now estimated at over US$502 billion (impact investments are those that seek a positive social and environmental impact in addition to a financial return).

At this year’s climate conference, the European Union unveiled its “Green New Deal” intended to transform Europe’s economy and eliminate its contributions to climate change by 2050. Scotland is even more ambitious: this year it adopted landmark legislation to become a net zero society by 2045, and to reduce emissions by 75% by 2030. Delivering a green transformation that will support employment creation, build skills, boost wages and trigger technological advances will require building a new generation of infrastructure and industries. In addition to well-planned public expenditure that can crowd-in private investment, banks will need to ensure they are able to provide the kinds of financing needed to support this transformation. Aligning their business strategies with society’s goals will in turn will help them leverage new business opportunities and remain competitive with the emergence of the sustainable development economy.

Our view is that finance can be a positive force for change. As we enter a “decade of action” on climate and sustainable development, COP26 in Glasgow in 2020 provides an opportunity for Scotland to showcase the important work it is doing to accelerate the transformation towards a more socially responsible and inclusive financial system – one that serves both people and planet.

 

By Gail Hurley: Senior Consultant, Global Ethical Finance Initiative (GEFI)

Gail was formerly a Senior Advisor to the UN

Follow on Twitter: @gailmlhurley

Follow GEFI on Twitter: @Finance4Change