In this six-part series, we break down the UN Environment Programme’s (UNEP) recommendations on how to reach the Paris Agreement goals, sector by sector.
- UNEP found that the current pledges will lead to a temperature rise of 2.4-2.6°C by the end of this century.
- The financial system needs to realign to enable change across various sectors to tackle climate change.
- Researchers focused on the energy sector, recommending a spike in investments in low-carbon assets worldwide and a drop in funding towards greenhouse gas-intensive assets.
The Paris Agreement called for a realignment of the financial system and set a new objective for all countries to make finance flows consistent with low-carbon and climate-resilient development pathways. The climate consistency of finance flows needs support and action to transform the global financial system.
Focus on energy transition
UNEP’s recommendations in its Emissions Gap Report 2022 focus on the energy sector, where there is emerging literature on finance and transformation.
Because of the energy focus, investments in low-carbon assets need to rapidly increase, especially in developing countries. These areas, however, are struggling to access capital and face higher financing costs, even though they account for 83% of the global population and half of global GDP in purchasing power parity terms.
This is due to perceived cross-border investment risks and international capital market inefficiencies – frictions that can potentially worsen with increasing climate vulnerability and unsustainable debt burdens. Some countries have turned to new market instruments, such as green bonds, but it has not been enough to address the difficulties.
On the other hand, the transition requires a rapid decline in fossil fuel assets investments, as they lock in greenhouse emissions for decades, leading to stranded assets. The financial sector is highly exposed to emission-intensive sectors, which present significant risks. UNEP warned that the bursting of a carbon bubble cannot be ruled out.
As economic opportunities, risks and returns change quickly, decisions to change the allocation of investments can have a huge influence on economic transitions, even if it is a modest change. The energy transition is estimated to need $4-6 trillion a year, which is only around 2% of total financial assets under management worldwide, but 20-28% of additional annual allocations.
Different actors are affected by climate change
According to UNEP, governments need to set out policies and regulations, influence investments through fiscal policy levers, public finance and information instruments. They own and operate financial institutions such as development finance institutions, ‘green’ banks and climate funds, which can in turn provide financial and technical support to developing countries’ public and private sectors. Export credit agencies, which are also state-owned, can provide government-backed support for the international operations of corporations from their home country.
Meanwhile, the primary mandate of central banks and financial regulators is to ensure price stability and financial stability in the economy. Climate change is already part of the mandate of 114 central banks. The insurance industry has also faced the consequences of climate change, as payouts for catastrophes have increased significantly over the last decade, a trend expected to continue.
In the private sector, commercial banks are financing both low-carbon projects and fossil fuels. Although other private bodies, such as institutional investors, equity markets and credit agencies have an explicit mandate or aim to enable action on climate change, they do not hold it as their primary objective. Moreover, including climate risk in decision-making requires a decades-long time horizon, but most usually consider events spanning between one and five years – making an alignment to the Paris Agreement even more challenging.
Six approaches to public policy
UNEP identified six approaches to transform the financial system: increasing the efficiency of financial markets, introducing carbon pricing, nudging financial behaviour, creating markets, mobilising central banks, setting up climate clubs and cross-border finance initiatives.
Increasing the efficiency of financial markets can be done by establishing financial transparency rules to protect consumers, imposing climate-related financial risk disclosure, and better defining low-carbon consistent or transition activities via taxonomies and classification systems.
Carbon pricing is used to push investors to switch to cleaner assets and lower energy use for consumers. Financial behaviour can also be nudged by addressing system inertia and providing benefits from switching to low-carbon alternatives, for instance with tax breaks.
Public policy, such as regulations, taxes, subsidies and engagement of public financing, can accelerate new product markets for low-carbon technology to replace emission-intensive sectors. Industrialised countries can support the creation of markets in developing countries with green banks.
Conversely, central banks must choose how to react to climate change: either by focusing purely on climate risk assessment, which falls within their primary mandate of financial stability, or by addressing climate change and transition risks through the inclusion of climate risk criteria. Maintaining the status quo will hinder the transformation of the financial system, because risk disclosure alone does not ensure the expected shift in financial decision-making.
Finally, the transformation of the financial system will require setting up climate clubs and international cross-border financial initiatives. This can be done with a range of instruments, such as voluntary standards and agreements on fossil fuel subsidy reductions, agreement on export credit agencies norms, multilateral and bilateral climate funds and multi-sovereign and other guarantee support to de-risk and leverage private investment.