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Sustainable finance: the next steps

15 April, 2020Mark Jeavons
Mark Jeavons, Senior Economist at Aon, looks at what regulators, government and the banking and finance sector need to do to tackle climate change. Climate Change

The co-ordinated response to Covid-19, despite short-term costs, gives us some hope that governments will be able to collaborate on dealing with climate change once the pandemic is over. Our view is that they will, eventually, work in a co-ordinated way – for example on carbon taxes.

At the moment, the emissions path we are on will lead to well above 2oC of global warming and is more likely to be in excess of 3oC. That means there is plenty more to be done by all companies worldwide and by governments too.

Government intervention

Tackling global warming will require more regulation and government subsidies.

There will also have to be disclosures on carbon emissions and a real acceleration in targets over the next two-to-three years. Some governments are already making noises about increasing carbon taxes.

We will eventually have to go beyond ‘net zero’. In the meantime, the quicker we reduce carbon emissions the better. Quite a few scientists are alarmed by how global warming has increased faster than their models expected and with more non-linearities.

Risk, market data and making models

Insurers are waking up to the fact that they cannot just rely on past historic data. They need to know where we are on the climate change path but making good predictive models is difficult – particularly as we have to try to factor in non-linear tipping points.

It’s quite clear that regulators want us to disclose information on the risks that climate change poses to our portfolio.

We have some information on the pensions side and expect that quality to improve over the next two-to-three years. Last year was about educating trustees and making them aware of climate risks to their pension schemes. Now it’s about what to do.

Most asset managers see climate risk disclosure as important and it will be a licence to operate in the next two-to-three years.

Under the voluntary rules of the Task Force on Climate-Related Financial Disclosures (TCFD) – which are likely to become compulsory – asset managers and companies will not only need to report their greenhouse gas (GHG) emissions.

They will have to explain the climate risks they are exposed to, how they are measured and what actions are being taken to mitigate and adapt to those risks. Quite apart from regulation, there will be pressure from clients. Some could face litigation if they are seen to be acting too slowly.

It’s still hard to say what datasets are most helpful. It is still relatively early days.

MSCI, for example, focuses on material financial risks by sector, which is very useful. But the correlation between the risks identified by different risk-assessment providers can be low. So it’s important to understand the different methodologies and philosophies when choosing data.

Some new start-ups, for example, scrape Twitter feeds to put together scores on environmental, social and corporate governance (ESG). These are more time sensitive and try to capture progress. However, there are risks around this approach as well as potential benefits.

Building the infrastructure

Generating enough renewable energy ten to 15 years from now isn’t the problem. We can have the necessary infrastructure.

The issue is making sure that infrastructure is built. In the UK I think the Government is starting to realise that it is necessary and that ten to 15 years isn’t fast enough.

One of the issues is, it will take significant sunk costs to move away from the current system which will require government financing.

However, it will eventually become clearer that the alternative to significant investment is a much higher loss of natural capital. And then, I think, Government will be willing to undertake the expenditure.

Collaborating on change – globally

There are advantages to being an early mover in green investment. For an economy and society, there are positive green spill-over effects. For example, countries that currently import fossil fuels will enjoy better energy security with homegrown renewables.

In the short-term regulation is likely to disrupt energy intensive industries including agriculture, transport and global supply chains. However failure to act will lead to far higher costs, which will likely run into the hundreds of trillions of dollars by the end of the century.

One of the key areas for tackling climate change is ensuring reliable, renewable energy provision in the third world. It may mean that some areas, such as Africa, start new industries around renewable energy. They will also be looking at better management of water and other environmental services.

Timing and transition

When will asset management have fully green portfolios?

I think different firms will define that in different ways. Having lower carbon emissions is already relatively easy. However, is divesting from oil really green? Oil companies have the infrastructure to roll out the fuel of the future. Shell, for example, has already made a big shift to natural gas and from there to hydrogen is not such a leap.

A lot of renewable energy companies, on the other hand, are still quite small. What is needed is investor engagement to ensure that money flows to renewable energy transformation and that investment in further fossil fuel projects is limited.

What is needed is a clear transition. There also must be the right policies in place for agriculture and industry.

What do regulators need to do to help manage climate change?

I’m a big believer in the economic system. An effective carbon tax and an effective greenhouse gas tax would be a good start. Regulation around transport and energy transformation is also important. A carbon cap would be a good medium-term solution.

Governments also need to think about planetary limitations and developing policies on preserving biodiversity and effective water and other resource management.

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See our Centre for Sustainable Finance