The ingredients for climate-related capital requirements
This article was authored by Martina Menegat.
Climate-differentiated capital requirements for financial institutions have been proposed as a method for ‘crowding in’ green investment by making it either cheaper to finance climate-friendly activity, or more expensive to finance harmful activity. The debate has been polarised between these two options: a ‘green-supporting’ factor or a ‘brown-penalising’ factor. Yet, things are not always simply green or brown, and the range of policy options is far more varied than this binary choice.
Capital requirements are cushions of capital that banks are required to hold in order to absorb losses, expressed as a percentage of deposits – with a reserve ratio of 20%, banks would need to keep 20% of all their deposits on hand to guard against losses. Adjusting the right amount of capital requirements is a delicate exercise. With a capital ratio fixed at 100%, banks would simply be piggy-banks, able to take in deposits but barred from lending money and investing in the economy. With undercapitalized banks, the risk is insolvency, which triggers expensive recovery interventions. Currently, under the Basel framework, banks hold a minimum capital ratio of 8% based on their risk-weighted exposures.
The main argument for introducing climate-differentiation capital requirements is that climate change poses relevant, uncosted, risks for the financial system.
Central banks are increasingly committed to identifying, measuring, and assessing climate-related financial risks (CRFRs). The Governor of the Bank of England, Andrew Bailey, believes that stress tests and scenario analysis are the best tools to evaluate CRFRs. Yet, so far they have been incapable to help banks in adjusting their exposures to climate risks.
The main obstacle to accurate pricing of CRFRs is their ‘radical uncertainty’: even if we are pretty sure that a combination of CRFRs will materialise in the next future, there are no advanced methods for calculation. CRFRs are also endogenous to the financial system: the misalignment between the global financial system and Paris climate targets exacerbates the same risks that central banks are trying to measure.
According to Greenpeace UK and WWF UK, UK financial institutions have exposure to high-emitting companies for 1.8 times the country’s domestically produced emissions. Advocates of short-term action argue that patchy data are better than nothing. Hard rules on banks are thought to correct the ‘feedback loop’ between finance and climate, in turn reducing systemic climate risks.
Regulators are showing increasing interest in this topic. While the European Banking Authority is expected to publish its advice to the European Commission on the integration of sustainability in capital requirements by 2023, in the Canadian parliament there is already a proposed law to adjust capital requirements to climate risks generated by exposures to high-emitters.
However, proposals to change banks’ capital requirements have been harshly opposed by the financial industry and so regulators prefer to be cautious. The Bank of England has already examined the possibility to introduce a brown penalising factor, but identified a series of obstacles. Most notably, heightening capital requirements for profitable companies that are conducting brown businesses could destabilise the financial system. Conversely, easing requirements for green companies (the so-called green supporting factor) without accurately calculating their risk profile could create a green bubble.
Climate-related capital requirements need not be reduced to green-supporting or brown-penalising factors. The energy put into the debate is much wider. Academics and civil society organisations have formulated three proposals that are of particular interest.
First, economists have suggested combining a green-supporting and a brown-penalising factors. The simultaneous adoption of such factors will have positive effects on reducing global warming, and thus diminish physical risks for financial institutions. Yet, the same research found that, for example, combining a brown-penalising factor with green fiscal policies will be more apt in addressing financial stability concerns.
Second, other experts argue in favour of a climate systemic risk buffer. A buffer is an additional cushion of a bank’s capital that can be introduced to address exposure to systemic risks. Supervisors can apply a climate buffer on all banks that are particularly vulnerable to CRFR or on all assets that face high risk to be stranded.
Third, a coalition of NGO and CSO organisations has proposed to introduce a one-to-one capital or a 1250% risk weight rule on banks. In this case, banks would be required to hold an amount of capital at least equal to their exposures every time they finance new fossil fuel projects – which are at higher risks of becoming stranded assets in the light of national transition plans.
No single policy is a silver bullet. If introduced, climate-differentiated capital requirements will produce a small contribution to reducing the pace of global warming. It is also unlikely that a slight increase in capital requirements for high-emitter companies will disturb massively the financial system.
Opponents of climate-differentiation capital requirements are right in a sense: they are not the perfect instrument to deal with climate change. However, the perfect instrument simply does not exist. Instead, we have a toolkit of regulatory instruments at our disposal. We need creativity and debate to face the climate crisis.
On the Path to COP28: how we got here, and what to expect for finance
Our Path to COP28 campaign is building momentum for climate action from finance at COP28, and we will launch the campaign on 24 October in Dubai.
While COP27 in Sharm El-Sheikh is just a month away, COP28, taking place in Dubai in 2023, will see many financial institutions make major progress reports on and updates to their COP26 commitments. Our campaign builds upon the success of the prior Path to COP26 campaign to coordinate the finance sector ahead of this crucial summit.
In this blog, we take a look at what COP is, the role of finance, some of the key milestones along the path to Glasgow, and what to expect in Sharm El-Sheikh and Dubai.
What is COP?
COP stands for Conference of the Parties to the United Nations Committee on Climate Change. COPs are where the world comes together to agree on climate action, on how to mitigate climate change and adapt to it. As Manuel Pulgar Vidal, the COP20 President from Peru told us at our 2021 summit, this is no mean feat, as COP is “a multilateral process, with almost 200 countries: so everybody counts”.
Finance at COP
But what does all this mean for the financial industry? The early COPs like Kyoto were focused mainly on getting governments to agree on the basics of climate science, and what the targets for carbon emissions reduction should be in order to prevent or minimise.
Since then, attention has shifted increasingly towards action, looking at how we actually achieve the targets that the political process produces. One core component of this is finance. Most agree that addressing climate change requires significant transformation of our economies, particularly around the energy sector. Creating new industries and reshaping existing ones requires investment; while governments can provide some of the funding, the sheer scale of the challenge means that private finance must play a significant role. Since COP21, finance has been playing an increasingly important role at the summit.
The history of COP
COP1
The first summit, COP1, took place in Berlin in 1995. The foundation for the summit, and for the UN’s climate work, came from the Earth Summit in Rio in 1992. Presiding over the summit was Angela Merkel, Germany’s Environment Minister at the time.
COP3
A landmark early achievement of the COP process was the signing of the Kyoto Protocol at COP3 in 1997. The agreement set the groundwork for climate diplomacy, and was refined at subsequent COPs. However, key emitters such as the US withdrew from the treaty, and it took until 2005 to come into force.
COP6
COP6 at the Hague in the Netherlands saw a crucial issue come to the fore: paying for climate mitigation and adaptation in developing countries. Lack of agreement over this central question led to the collapse of the talks.
COP15
In 2009, COP15 in Copenhagen saw massive protests and was generally regarded as a failure. Many criticised the summit for not producing an ambitious, legally binding agreement in line with scientific recommendations. Others felt this was never a likely outcome given political considerations.
COP16
A solution to the “who pays for climate action?” question was agreed at COP16 in Mexico: the $100bn Green Climate Fund for developing countries. More than 10 years on, this has still yet to be delivered: the failure to do so has harmed trust in the process. There has been disagreement over how much public and private finance should contribute, and the recipients of funding.
COP21
In 2015 in Paris, COP21 saw the signing of the Paris Agreement, and the first real participation of private finance. The agreement represented a consensus that addressing climate change requires significant economic transition, particularly in the energy sector.
As finance is key to economic transition, the agreement included international mechanisms to promote climate-friendly finance, carbon trading, technology transfer and adaptation to climate change impacts. It also set the stage for the Taskforce on Climate-related Financial Disclosures, or TCFD, which has made its way into law in several countries in the years since, and significantly boosted climate bonds.
A notable contribution from private finance was a major petition to governments to commit to climate action: prior to that it was “assumed that capital markets opposed such regulation”, according to David Pitt-Watson, Chair of UNEP FI during the summit.
COP26
COP26 in Glasgow, saw the most significant progress since Paris, with the signing of the Glasgow Climate Pact. It still received a mixed reception from climate advocates, many of whom felt the agreement did not go far enough on securing binding targets, such as the last-minute amendment to “phase down”, rather than “phase out” coal. Arguably the most significant commitment was that made by all nations to come back before COP27 with enhanced emission-cutting pledges.
Nonetheless, the summit did see greater recognition than ever, from all across society, of the perils of climate change. One aspect of this was more involvement from financial institutions. The Glasgow Finance Alliance for Net Zero, or GFANZ, was launched, aiming to unite many existing initiatives, while individual financial institutions from around the world made net zero commitments of their own.
The future of COP
COP27
At COP27, in Sharm El-Sheikh, success is likely to be judged on four core areas: Mitigation, Adaption, Climate Finance and Loss and Damage. A key focus across the summit is likely to be issues for developing countries – as the COP process is driven by the host country’s diplomatic service, key themes often reflect that country’s priorities. On the finance side, we expect to see updates on potentially strengthening GFANZ, progress reports from financial institutions and a focus on nature and the need for nature-based solutions to climate change.
COP28
COP28 in Dubai will see the results of the first major stocktaking on the Paris Agreement. The process began at COP26, and will conclude in Dubai. This process is likely to be mirrored in the private finance side, as financial institutions provide results on their COP26 commitments, and update them.
Our Path to COP28 campaign will drive action from finance at COP28, and launches on 24 October in Dubai.
1.5 degrees is alive, but its pulse is weak: the finance sector must step up to save it
Unsurprisingly, COP26 president Rt. Hon Alok Sharma MP did not have much time for television in 2021. Yet, amidst the lull of the Christmas festivities, he too was able to join the billions of viewers who tuned into Netflix’s record-breaking film Don’t Look Up. Adam McKay’s climate change allegory sees a pair of scientists (Jennifer Lawrence and Leonardo DiCaprio) catapulted into an impromptu media tour, as they try to warn the people of Earth that a comet is on course to obliterate the planet in less than six months.
In his speech at Chatham House reflecting on COP26, Alok Sharma recalled the closing scenes of the film. As walls shake and flames engulf the landscape, DiCaprio’s character Dr. Randall Mindy tells his family who are gathered around him, braced for impact: “The thing of it is we really did have everything, didn’t we, in the end?”, echoing the fact that – as the COP26 President said – limiting global warming to 1.5 degrees is still a possibility, albeit a remote one now.
The harrowing images of planetary destruction at the end of Don’t Look Up Now remain largely confined to cinematic representations and worst-case climate modelling scenarios, but the sense of urgency felt so acutely by McKay’s central protagonists was clearly visible in Alok Sharma’s speech. At the heart of it was a clear message shared by all of us at GEFI: now is the time to transform the commitments gained at COP26 Glasgow into tangible action and to deliver on the promises set out on the banks of the Clyde just over 12 weeks ago. Doing so, as Rt. Hon Alok Sharma reminded us, is our “last best chance” to mitigate irreversible climate change and avoid what Barbados Prime Minister Mia Motley movingly labelled the “death sentence of 2 degrees” if we fail to keep the 1.5-degree target set by the Paris Agreement alive.
Although the pleas for action underpinning Don’t Look Up are ultimately thwarted by political inertia, Sharma was key to emphasise both the wins achieved at COP26 and the broader reasons for hope. Central to the success of the Glasgow climate pact, he argued, was a sense of collective self-interest. Alongside this shared sense of global urgency to prevent the worst of irreversible damage to people and planet, Sharma was keen to stress that the commitments of the Climate Pact were also born out of the “economic case for climate adaptation and mitigation” shared by all leaders over the course of negotiations. Investing in warning systems and defences, for instance, could yield over 4 times the amount paid in damages, whilst failure to do so will restrain global economy’s ability to grow (the equivalent cost of wiping out 20% of GDP every year).
At GEFI, we echo Rt. Hon Sharma’s sentiment that finance (and mobilisation of the finance sector) is key to ensuring that the economic gains of a sustainable transition are not lost or left as merely promising words on paper. Alongside what Rt. Hon Sharma cited as a “need to turn our focus to loss and adaptation finance to develop the dialogue started in Glasgow”, his speech also highlighted a further three steps that the finance sector must deliver on, as global attention turns to COP27 and COP28:
- Show we’re on track to deliver £100 bn goal
- Encourage firms to deliver with integrity to unleash public and private finance
- Work hand in hand with COP27 Egypt and COP28 UAE to learn from success of Glasgow whilst also engaging with civil societies and young people
Over the course of our Path to COP26 campaign, we have echoed Rt. Hon Sharma’s call to bring together stakeholders across finance and beyond to raise ambition and drive climate action. Through our Strategic Campaigns, Research & Advisory, Capacity Building, and Practical Solutions we will continue to inspire change and mobilise the finance sector throughout 2022 to deliver the promises of COP26 Glasgow.
A failure to do so brings us dangerously close to the dramatic scenes of Don’t Look Up. We will have, to quote Alok Sharma, “mitigated no risks. Seized no opportunities. We will have fractured the trust built between nations, and the 1.5-degree target set out in the terms of the Paris Agreement will slip from our grasp.”
As Sharma ultimately reminded us, “1.5 is still alive but its pulse weak.” If we do not want to look back on a life of abundance that we allowed to willfully slip through our fingers, then the finance sector must be the ones to step up and deliver on the solutions needed to save it.
Ellen Davis-Walker
Digital Content Executive
The Path from COP26: Implementing the Glasgow Climate Pact | Ethical Finance Round Table
We heard from a varied panel during this Ethical Finance Round Table who delivered their thoughts on COP26, COP27, finance for nature and more, with a series of interesting presentations followed by a lively panel discussion. Click here to watch a recording of the full session now, or click on the names of each of the presenters - Hakima El-Haité, Ashley Hamilton Claxton, Sefton Laing & Jamie Ervin - to see their opening remarks.
Hakima El-Haité, President of Liberal International kicked off by asking how COP26 has succeeded in meeting the hopes of the global south. She emphasised the need to ask ourselves what we achieved and what is next. This COP26 was meant to show progress in CO2 emissions reductions and ambitions for next 5 years and show trust. The developed world was expected to fulfil its promises, and we missed an opportunity to be on the correct side of history, said Hakima.
Ashley Hamilton Claxton, Head of Responsible Investment at Royal London Asset Management followed, and explained that getting commitments from financial sector is easy; action is the hard part. COP26 has inspired more conversations with clients about climate in the past 3 months than RLAM have had in the prior 8 years. Ashley suggested that we need a bottom-up approach (carbon metrics, bonds etc.) but need to develop a high level plan as to how we are going to achieve NZ and the terms of the Glasgow Climate Pact. She cautioned that there is a risk that finance can become a distraction for policy makers - a panacaea for all of our problems around the environment. Finally, she explained that perfect data is a distraction; data will never going to paint a full picture or be complete and can tell a skewed side of a story but is vital for building tools and systems needed post COP and beyond.
Sefton Laing, Senior Climate and Environment Specialist at Baillie Gifford pointed out that COP26 was the first COP at which Big Finance truly arrived. The commitment to trillion dollar funds is a massive step forward, however there is a gap between allocated finance and practical action on the ground - money is not always regulated or properly allocated if you listen to NGOs. He echoed Ashley’s point about the need for strong governance and shifts towards policy to support the individual commitments we have seen particularly from financial services.
Finally, Jamison Ervin of UNDP highlighted 7 trends from the past year on financing nature and 7 predictions for the coming year, looking at how nature has contuined to shoot up the agenda on both climate and finance, and predicting that it will continue to do so.
Path to COP26 videos available on EFx
After a successful COP26, all of the videos from our events in and around Glasgow are now available at http://efx.global/COP26.
Across the 2 weeks, we organised a series of events covering climate finance, looking at nature, economics, faith and pensions in detail.
Net Zero Pensions at COP26
The risk posed to society by climate change is undeniable. If we fail to limit global warming to below 1.5°C, as agreed at the Paris climate summit in 2015, catastrophic effects will be felt across the globe especially to those who are most vulnerable. US climate envoy John Kerry stated earlier this year that COP26 would be the "the last best chance" to avert the worst environmental consequences for the world.
The pledges made during COP26 could limit global warming to 1.8°C1 and the commitment of international financial companies through the Glasgow Financial Alliance for Net Zero (GFANZ) to $130 trillion of private sector capital to achieve net zero by 2050 are encouraging but the implementation of these pledges and commitments will be the key if we are to meet the Paris Agreement.
The whole economy depends on achieving net zero by 2050 or sooner but pension funds could play a fundamental role in shifting the economy to protecting the planet, even if governments fail to act.
During COP26 at an event hosted at Glasgow University by the Global Ethical Finance Initiative (GEFI), senior representatives from pension funds and asset management came together to discuss net zero pensions. The event was opened with a keynote address from Ivan McKee, Scottish Government’s Minister for Business, Trade, Tourism and Enterprise who noted Scotland’s long history in the pensions industry, with the first mutual life office opened in 1815. He also noted that Edinburgh is now the biggest employer in the UK for jobs in the pensions sector. He highlighted Scotland’s commitment to combatting climate change, being one of the first countries in world to declare a climate emergency, and the need for private sector investment. He stated the ambition for “Scotland to be a superpower when it comes to ESG investment.”
Pension funds are stewards of assets
There was a challenge for pension funds to consider stewardship at the heart of their approach and to invest in a planet that is worth living on. The importance of pension funds playing a role in combatting the climate emergency was highlighted by Faith Ward, Chair of the global body leading change in the sector, the International Investors Group on Climate Change (IIGCC) and also Chief Responsible Investment Officer at one of the biggest UK public sector pensions schemes, Brunel Pension Partnership. She addressed the fears of some pension trustees who see their fiduciary duty as maximising returns by stating that there will be “no fiduciary duty if there is no functioning society or economy”. Pension funds must be active owners of companies to make sure that they decarbonise their operations rather than jettisoning carbon intensive companies from their portfolios allowing big emitters to carry on driving global warming.
Collaboration is key
There needs to be collaboration between government, regulators and industry to deliver on net zero commitments - it will be challenging for pension funds to achieve net zero without collaboration.
During the event, there was a call to government to use regulation and legislation to incentivise investment in companies that are part of the solutions to climate change rather than part of the problem.
It was highlighted that it is important for asset owners like pension funds to work together through groups such as IIGCC, a membership body with over 360 investor members with €49 trillion in assets and ClimateAction100+, an initiative for asset owners to engage with the world’s largest corporate greenhouse gas emitters to take necessary action on climate change. Tim Orton, Managing Director of Investment Solutions at Aegon UK stated that “getting to net zero is not a competitive sport it is an imperative.”
Pension funds working with their asset managers to deliver net zero is also fundamental to amplify the change. Faith Ward highlighted that Brunel Pension Partnership has a formal policy on climate change that clearly sets out the expectations for their asset managers.
Net zero is a transition to a destination rather than a quick fix
Reaching net zero by 2050 will be challenging – many pension funds who embark on the journey to deliver a net zero commitment do not necessarily know exactly how they are going to get there. Making a commitment is a signal to the market of the direction of travel. Barry O’Dwyer, CEO of Royal London, observed that the transition to net zero is unlikely to be quick and it needs to happen in a just and equitable way, this was reiterated by Faith Ward who stated that social impacts alongside climate impacts must be considered.
Action must start now
Although there are still challenges to be overcome, sufficient tools exist for pension funds to start taking action now to deliver net zero by 2050 or earlier. The IIGCC’s net zero framework provides a comprehensive strategy for asset owners to deliver on their net zero commitments. Barry O’Dwyer stated that there was “no time to be passive”.
There are challenges still to be overcome
Challenges still exist around knowing how carbon intensive a portfolio is, expertise on climate change in pension funds, and trustees putting net zero at the centre of the governance of funds. David Russell, Head of Responsible Investment at USS, noted the progress that had been made in respect of data but this has predominantly been focused on public equities, access to data for sovereign debt and private markets remains a challenge. It is important to measure the baseline but also note where climate progress is expected and set milestones for companies. Eva Cairns, Head of Climate Change Strategy at abrdn, noted that temperature metrics alone do not tell the full story, other metrics are necessary to identify transition leaders. She also noted that abrdn were currently working on valuing and calculating avoided emissions.
Tim Orton noted that to achieve net zero we need different capabilities than we have had in the past and highlighted the importance of sustainability professionals and governance structures including steering groups on net zero.
Divestment versus engagement
Engagement was seen as a positive tool to drive decarbonisation in the real economy; divesting from a high emitting company that someone else buys does not reduce their atmospheric emissions and that collective engagement through initiatives like ClimateAction100+ will drive change. It was stressed that engagement with high emitting companies must include measuring where they are now, where they need to go as well as recording the progress made. The Transition Pathway Initiative was identified as a useful tool to assess companies' preparedness for the transition to a low carbon economy.
GEFI has a dedicated net zero pensions workstream and has published two key reports on the topic, the policy positioning paper setting out the key challenges faced by pension funds in their net zero journey and the transition roadmap paper providing practical steps pension funds can take to overcome the key challenges as well as set and deliver on net zero commitments.
View all of the videos from our Path to COP26 programme at https://www.efx.global/cop26/.
Finance for Nature in Nature at COP26
FINANCE FOR NATURE AND COP26
As the exhibition tents, plenary rooms and coffee stalls are being dismantled, and Glasgow returns to a form of normality, one of the overwhelming takeaways from the COP26 Climate Conference was just how important finance and financing nature will be for the journey to net zero.
Research by the World Economic Forum (WEF) has estimated that $44 trillion of economic value generation – more than half of the world’s total GDP – is moderately or highly dependent on nature and its services and is therefore exposed to nature loss1. Whether you are talking about algae carbon sequestration, women’s empowerment, indigenous land rights or how to create a green jet fuel, much of the conversation was focused on the topic of finance.
The key question is how can we change the financial system to better include nature?
While new public funding pledges were made, in the context of the undelivered $100bn climate finance for poorer countries and the covid pandemic, it is easy to remain sceptical. John Kerry (US Special Presidential Envoy for Climate) highlighted the role of private finance on the first day of the conference. Speaking at the American pavilion he stated that “no government in the world has enough money to fuel this transition as rapidly as we need it but the private sector does.”
While there is disagreement on whether The Glasgow Climate Pact was a success or not, COP26 has left exhibitors, delegates, attendees, protesters, the press and the world at large with the impression that it will matter more than ever now, where we put our money. Money will be our vote as private citizens, as businesses and as countries. It is the driver. It is the tool we can use to put pressure on moving things into a higher gear. Or indeed the thing that will hold us back.
The debate is now one of innovation and transition – namely to the way we include (or continue to exclude) nature from our accounts as Prof Dasgupta discusses, and whether our traditional investment models can accommodate new parameters such as nature, biodiversity loss (upstream or downstream) and social impact.
During the GEFI Finance for Nature in Nature COP26 programme we heard from business and financial leaders, regulators, multilaterals, NGOs and others who discussed frameworks and impact measurements around nature. Despite the recognisable complexity of practical implementation and the interdependency of climate and nature, momentum is building around the critical need for markets to better align to a net zero world.
The development of the TNFD (Taskforce on Nature-related Financial Disclosures) was acknowledged as a very useful tool that will help to facilitate reporting on the risks in relation to nature. Andrew Mitchell, (founder of Global Canopy) reflected that “we cannot ignore nature and only focus on climate or carbon. Covid-19 is the perfect example of this. The pandemic is an environmental problem”. Tony Goldner, (Executive Director of TNFD) noted in the same high-level TNFD panel that it is not if but when nature related risk disclosure is coming, however, we still need to create a language around this. Edward Lockhart Mummery (Convenor at the Broadway Initiative) called for the need to “create a new financial architecture for nature investment”. There was also an acknowledgement that there was currently insufficient pricing of externalities in respect of nature and that natural assets needs to be viewed as assets rather than liabilities.
Although GEFI has been looking at financing nature since 2018, regular COP participants expressed their delight that nature has finally being catapulted up the formal agenda. This was noted as being a step change in comparison to previous COPs. Hosting the GEFI nature programme within a beautiful national park provided an inspiring backdrop for participants to move from talk to action. It was also evident that the nature conversation has moved beyond a collection of environmentalists, scientists and policy professionals with financial institutions and corporates willing not to only listen and learn but consider the practical steps they must take to address climate change and protect nature and biodiversity.
Another common theme, despite the criticism that this COP had been too exclusive and elitist, was that young and indigenous communities are key to solving this crisis and their voices must be heard. Indeed, some argue that, as those most impacted by climate change today and in the future, they should be leading the conversations. They should not just be in possession of just a seat at the table, but rather the entire table.
Usha Rao-Monari (Under-Secretary-General and Associate Administrator of the United Nations Development Programme) made this point at GEFI’s opening session for Finance for Nature in Nature where she questioned whether young and indigenous communities are being provided with an appropriate platform and, on the occasions when they, are she expressed concern that their voices have been drowned out by the noise. This was echoed throughout the conference noticeably by Elizabeth Mrema (Acting Executive Secretary of the UN Convention on Biological Diversity Secretariat) and Patricia Espinosa (Executive Secretary of the United Nations Framework Convention on Climate Change (UNFCCC)) to mention a few.
The GEFI COP26 programme presented several examples of how financing nature and nature-based solutions (NbS) (including community-led project), is not only possible but profitable. So, if financing NbS is key to solving the climate crisis, including financing indigenous peoples, where are we now? Mrs Mrema noted that only 3% of global finance is being spent on NbS - this figure is too low if we are to keep 1.5C alive. The wholly unequal distribution of these resources is a further hindrance.
The question that echoed around the GEFI HQ during COP26 was: is it all too late?
Having explored the halls of the Blue Zone and Green Zone, as well as hosted an array of events throughout the two weeks, there is a dichotomy between those who contend that solving the nature crisis is complex and others convinced that it is pretty simple! Seeing practical examples of how it can be done provide hope but challenges remain around transferability and scale. The confidence boosted by speaking to sustainable finance leader is quickly tempered when the next conversation it with a finance leader who just doesn’t get it.
However, on reflection, the prevailing sentiment is that this is doable. In the words of Professor Stern (leading climate economist) “we have to invest to get there, but we will get tremendous returns. Just look at renewable power”. Despite some media spin the majority of people involved in COP26, and across the GEFI programme, are far from ready to give up. We need to learn from what works, what has not worked and collaborate to ensure that finance flows to the right places, at the right levels and at the right time. This required existing investment models and measurement and reporting frameworks to be redesigned.
Willie Watt (Chair of the Scottish National Investment Bank) stated that GDP is not a sustainable measure of growth, and the sustainability of growth itself has to be reassessed, suggesting big changes are needed. Nonetheless, Abyd Karmali (Managing Director, ESG & Sustainable Finance at Bank of America) noted that ESG has helped move the financial world towards nature-based finance, signalling that change is happening and can happen quickly.
At GEFI we remain committed to raising awareness and inspiring financial institutions across the globe to recognise their role in financing nature. In 2022 we look forward to building on the progress we have made this year by supporting the Biodiversity COP15 in April and the Climate COP27 in November.
We will work to keep the conversation open, relevant and critical to support the industry’s movement towards change, so get involved where you can.
View all of the videos from our Path to COP26 programme at https://www.efx.global/cop26/.
Islamic Finance & Faith in the SDGs at COP26
For many, a warming climatic system is expected to impact the availability of necessities like freshwater, food security, and energy, while efforts to address climate change, both through adaptation and mitigation, will similarly inform and shape the global development agenda. The links between climate change and sustainable development are strong. Poor and developing countries, particularly least developed countries, will be among those most adversely affected and least able to cope with the anticipated shocks to their social, economic and natural systems.
As national ministers and heads of state convened in Glasgow, Scotland, to accelerate action towards the goals of the Paris Agreement and the UN Framework Convention on Climate Change (UNFCCC), for the 26th UN Climate Change Conference of the Parties (COP26) the Global Ethical Finance Initiative (GEFI) curated a unique programme to focalise this sustainable development challenge through the prism of Islamic finance, a proxy to the global south.
To raise awareness and drive climate action at COP26 GEFI, a non-profit dedicated to enabling finance to deliver positive change and help achieve the UN's Sustainable Development Goals (SDGs), ran a Path to COP26 campaign. The “Faith in the SDGs” workstream, led by the Islamic Finance Council UK (UKIFC), curated a unique one-day hybrid Islamic finance programme to coincide with the COP26’s finance day (Wednesday 3rd November 2021). Islamic finance experts from across the globe gathered both in-person, at the stunning Ross Priory on the banks of Loch Lomond, and remotely to demonstrate the important role Islamic finance can play in supporting climate action in the global south and beyond.
In the SDGs, UN Member States express their commitment to protect the planet from degradation and take urgent action on climate change. One of the most salient factors that challenge the achievement of the SDGs by 2030 is the shortage of financial resources. Several reports and studies have stated that around US$5-7 trillion dollars are required every year to achieve the SDGs, and with governments and donor agencies unable to meet demand, private sector funding is required.
The natural alignment between the SDGs and Islamic principles together with the size of the industry (currently US $2.5 trillion and expected to reach US $3.8 trillion in 2022[1]) mean that Islamic finance is well placed to create instruments that drive significant capital towards the SDGs and climate action.0 The ambitions of the SDGs are consistent with the objectives of Shariah (maqasid al-Shariah) which aim to bring benefits to mankind and prevent harm as well as ensure sustainability of life on earth. SDG alignment presents a unique opportunity for Islamic financial institutions to showcase the inherent social good and ethical basis of Islamic finance.
One of the key challenges in implementing the Paris Agreement and addressing climate change is the funding required to implement projects that contribute positively to Nationally Determined Contributions (NDCs). Whilst three quarters of countries have adaptation plans in place, financing remains an issue. According to UNEP FI “annual adaptation costs in developing countries are estimated at USD 70 billion” with his figure “expected to reach USD 140-300 billion in 2030 and USD 280-500 billion in 2050”.[2]
Islamic finance is not limited to Muslim countries and has the potential to support the delivery of NDCs. This could be particularly attractive to the 57 Organisation of Islamic Cooperation (OIC) member states which collectively represent over 1.82 billion people (24% of the total world population) and include several low-income countries that are politically or culturally marginalised.
The GEFI / UKIFC Islamic Finance programme at COP26 provided a high profile platform to explore the role Islamic finance can play in attracting the capital needed to achieve the Paris Agreement and deliver the SDGs.
The first session, delivered in partnership with the United Nations (UN) and UN Economic and Social Commission for Western Asia (UNESCWA), discussed how Islamic social financing instruments can collectively promote the principles of social justice, solidarity, brotherhood and mutuality which can serve to help communities respond to and become more resilient to climate change whether related to food and water shortages, displacement as a result of natural disasters, or environmental education amongst other impacts.
Dr. Rola Dashti, Executive Secretary of UNESCWA noted the heavy debt burden in the Arab region, with eight times more debt received than grants for financing climate projects between 2013 and 2019. She highlighted zakat and wakaf assets (which exceed USD$3trillion throughout Muslim countries) as an importance source of grant funding to support innovation in sustainable development. She also provided details of the ESCWA Climate-SDGs Debt Swap / Donor Nexus Initiative which supports the conversion of national debt servicing payments of foreign debt into domestic investment for implementing climate-resilient projects that advance national SDGs. She asked that we all act collectively to utilise Islamic social funds to support the acceleration of the SDGs.
Dr. Al Meraikhi, Humanitarian Envoy to the UN Secretary-General highlighted the launch of International Dialogue on the Role of Islamic Social Financing in Achieving the Sustainable Development Goals between the UN and the Islamic Development Bank (IsDB) and noted that faith-based organisations have a crucial role in addressing the finance gap to achieve the SDGs.
The next session saw the UKIFC, Her Majesty’s Treasury, Ministry of Finance in the Republic of Indonesia Ministry, Islamic Development Bank, London Stock Exchange Group and GEFI jointly announce the launch of a High-Level Working Group on Green Sukuk (HLWG).
The 3-year initiative will direct investment to reduce greenhouse gas emissions in the world’s regions in most need. The announcement followed work of the Global Islamic Finance and UN SDGs Taskforce and a recent report “Innovation in Islamic Finance: Green Sukuk for SDGs” commissioned by UNDP Indonesia in which the UKIFC estimated that an additional US$30+ billion of capital towards the SDGs can be raised by 2025 through green and sustainability sukuk. To unlock this finance the HLWG has been launched to coordinate international efforts. The report showed how green and sustainability sukuk can be a viable financial instrument attracting billions of dollars of capital for green projects that support the delivery of the Paris Agreement.
The HLWG, led by the founding partners, will bring together expert global stakeholders with the UKIFC and GEFI acting as Secretariat. It will focus on the following objectives:
- Ensuring green and sustainability sukuk is highlighted at annual COP summits up to and including 2023 to increase awareness of the instrument and proactively encourage the issuance of such sukuk by all market stakeholders (corporates, multilaterals and sovereigns) as a key Islamic financing key tool.
- Assist and enhance existing established global standard setting bodies and regulatory initiatives run by the UN, IsDB and others (e.g. PRI, NGFS, Transform, PRB) to encourage better alignment of the Islamic finance industry with the global green and sustainability financial movement.
- Identify and address specific existing challenges for green and sustainability sukuk on the supply and demand side.
As part of the introduction to the session UKIFC Managing Director Omar Shaikh outlined the natural alignment between the principles of Islamic finance and the role that green sukuk can play in channelling finance towards the climate emergency and the SDGs.
John Glen, Economic Secretary to the Treasury and City Minister then highlighted the UK’s strong credentials in green and Islamic finance and positioned green sukuk as an important route to secure investment for sustainable projects. He noted the vital role that Islamic finance must play in the green agenda. Julia Hoggett, Chief Executive, London Stock Exchange plc later welcomed the HLWG as a significant milestone for the development of Islamic finance and sustainable finance globally and stated that Islamic finance is a key component of sustainable finance. She also stressed the need to scale green sukuk to ensure that access to finance in a manner consistent with faith values.
As a pioneer in the issuance of international green sukuk, Sri Mulyani Indrawati, Minister of Finance, explained the Republic of Indonesia’s commitment to using the HLWG to share experiences and provide valuable precedents at the same time learning and applying best practices approaches. With the world recovering from global pandemic, Sri Mulyani Indrawati said that the HLWG provides the urgent momentum for nations, multilateral institutions and corporates across the world to work together to grow sustainably for future generations.
The Islamic Finance programme concluded with a Global Islamic Finance and SDGs Taskforce meeting. The Taskforce is a unique collaboration between the public and private sectors spearheaded by the UKIFC, HM Treasury, IsDB and assisted by GEFI. It brings together global Islamic finance practitioners to explore the opportunities for OIC member states to develop a collective approach to sustainable finance and funding the SDGs and climate-linked NDCs.
The meeting included:
- An update from Sima Kamil, Deputy Governor of the State Bank of Pakistan who presented on the pioneering work in sustainable banking being undertaken as part of the Pakistan working group.
- A presentation by Gatehouse Bank, Chief Executive Officer Charles Haresnape on a Guidance Note prepared in partnership with UKIFC and GEFI to provide a consistent approach to reporting and disclosure for Islamic banks signed up to the UNEP FI Principles for Responsible Banking.
- An update from UKIFC Advisory Board member Sultan Choudhury on the progress of the largest ever global Islamic finance survey on sustainability.
After two weeks of negotiating, the Glasgow Climate Pact was successful in maintaining the focus on 1.5 degrees Celsius as well as creating a 2-year timetable for agreeing to more ambitious and faster NDCs to provide a lever for more progressive countries to ensure slower countries make the step up. Although the agreement to “phase down” coal power angered some it is notable that this is the first COP agreement that has made a direct reference to phasing down fossil fuels.
The Pact urges developed countries to “fully deliver” the $100bn per year goal through to 2025 as agreed in 2009. It also agrees to double the proportion of climate finance going towards adaptation and, despite a lack of progress, it confirms that a “technical assistance facility” will be introduced to support loss and damage in relation to climate change in developing countries.
Whilst private finance is not a substitute for increased public finance, it will be vital in increasing the scale and reach of climate action and enabling the transition. The programme was a high-profile platform for Islamic finance at COP26 and through the practically focused discussions has demonstrated how Islamic finance can be used effectively by developing countries to support NDC’s by attracting investment, at scale, to projects that, in line with the Paris Agreement, reduce national greenhouse gas emissions.
View all of the videos from our Path to COP26 programme at https://www.efx.global/cop26/.
[1] ICD - Refinitiv, ‘Islamic Finance Development Report 2019: Shifting Dynamics’ https://www.zawya.com/mena/en/ifg-publications/231019121250Z/
[2] United Nations Environment Programme (2021). Adaptation Gap Report 2020, Nairobi.
The Wealth of Nations in the 21st Century Launched
During the 18th Century, the Scottish Enlightenment put the Glasgow at the heart of world thinking. Today, as the world comes to Glasgow for the COP26, we ask what we can learn from one of the great pioneers of the Scottish Enlightenment: the renowned economist and former lecturer at the University of Glasgow, Adam Smith.
As part of the Adam Smith at the COP workstream of our Path to COP26 campaign, we have prepared a unique essay series entitled The Wealth of Nations in the 21st Century, looking at the climate crisis through the eyes of Smith. Click here to read the series, see below for a summary or read coverage of the series in Bloomberg.
This work updates Smith’s famous Wealth of Nations for the climate era. Expert authors from the fields of finance, economics, politics, development and central banking have taken the 5 ‘books’ of the original and written 5 essays drawing on Smith’s themes and reflecting on the climate crisis. They consider both how Smith’s thinking can guide our approach to climate action, and what he himself might have thought about the climate crisis.
We are extremely grateful to Lord Meghnad Desai, David Pitt-Watson, Usha Rao-Monari, Prof. Sir Anton Muscatelli, Tan Sri Dr Zeti Aziz, George Gray Molina, Dr Michele Battisti & Dr Craig Smith for sharing their fascinating insights. They have provided a truly remarkably review of the on-going relevance of Smith’s work, applying the Wealth of Nations, as well as drawing on the Theory of Moral Sentiments, to contemporary climate issues.
The essay series, supported by Royal London, will be launched at the University of Glasgow, where Smith once taught, during our Adam Smith at the COP evening lecture series on the 8th, 9th & 10th of December. Sign up now to join us online. Our wish is that the essay series encourages and inspires creative thinking and practical action to leave a small and enduring legacy after this crucial summit.
Foreword
In the foreword, Nicola Sturgeon, First Minister of Scotland, reflects on the importance of Smith to Scotland, and what he might think of the modern economy. “We cannot know exactly how Smith would have responded to the climate emergency, but given his support for reasonable protections against, for example, abuse of monopolies it seems likely that he would have supported regulation to guard against the destruction of the planet,” she wrote, adding that “It is the perfect time to reach back into our past as we look ahead to a future that is cleaner, greener and more just.”
Book I: ‘Of the Causes of Improvement in the productive Powers of Labour’
Lord Desai begins the reimagining of The Wealth of Nations and inspired, or perhaps dismayed, by the contents of Book I, challenges whether Smith has mis-defined the concept of value. Proposing that the conception of value outlined by Smith is a gross simplification of reality which has led future economic thinkers to adopt a theory of value so reductionist in outlook that all free inputs or negative impacts are ignored, as they had no monetary value.
Lord Desai reminds the reader of the flaws of such a reductionist approach, “between sowing and harvesting, there is a time gap where Nature performs the difficult task of ripening seed into crop. The time that creates value is unpaid for.” This critique of reductionism and misinterpretation of value translates equally well to time spent working in the home or caring for family.
Thus, asserts Lord Desi, the definition of ‘value’ remains the key to rethinking 21st century economic calculus, where an approach that applies the principles of cost accounting to including the ‘free’ goods Nature provides us offers a conservative and yet radical pathway to valuing all that is valuable.
Book II: ‘Of the Nature, Accumulation, and Employment of Stock’
David Pitt-Watson guides the reader through Book II which concerns the nature, accumulation, and employment of stock. He begins by broadening the conception of capital to include the services provided by nature, reminding us that Smith never considered that the services of nature as we know them might come to an end. And would surely have noted that if that money is applied in a way which destroys natural capital, it will reduce the prosperity of the world, potentially catastrophically.
He reminds us that for Smith, political economy was a practical question of how to “provide a plentiful revenue or subsistence for the people, or more properly to allow them to provide such a revenue for themselves”. In presiding over the decline of the benign stable conditions which underpin the growth of our civilisations we become responsible for navigating the pathway to net zero. And for those who say achieving net zero is too difficult and too expensive, he hypothesizes of what Adam Smith, the father of modern economics might say. Ultimately wealth depends on the accumulation of capital to make workers productive – if nature withdraws its capital, no prosperous future can await our children – and the economic gains of the last 250 years will all be lost.
Book III: ‘Of the different Progress of Opulence in different Nations’
In revisiting Book III, Usha Rao-Monari explains how the Industrial Revolution catalyzed a dramatic shift in the “opulence of nations”. In a similar way, the rise of the need for net zero economies is changing which development pathways are open to countries. The emission-intensive economies of today will become the “least sustainable countries” of the 2050s, she argues.
Alongside these deeper processes, we are likely to see a ratcheting up of regulatory policies regarding carbon pricing and disclosure standards. This leads us back where we started: research and development, technology, innovation and productivity as drivers of future growth –as they were in the 1770s boundaries.
Rao-Monari argues that Amartya Sen shifted the conversation on progress and development in the 1990s with the concept of human development, or “development as freedom”. This was the idea that progress was not defined not by the accumulation of assets, income or wealth, nor the achievement of a steady state goal, but the capability of each human being to choose both the ends and means of their daily lives.
While Smith is often revered as the Father of Economics, his other distinguished role is being part of the Scottish Enlightenment. The 21st century is once again faced with a period in history where scepticism to authority of all types and the power of reason is in question. Once again, argues Rao-Monari, we are tasked with a simple but powerful challenge: to use evidence, truth and reason to address the problems of our times.
Book IV: ‘Of Systems of political Economy’
In revisiting Book IV, Sir Muscatelli proposes that proposes that Smith’s core insight holds true: “that the system of political economy which is established is dependent on how trade impacts on domestic interests. As trade creates winners and losers, the political economic effects of trade openness and its acceptance among most people will be crucially affected by the success of other policies, including industrial policies and the ability to find employment for those who may be negatively affected, as well as on the role of the welfare state and redistributive policies at large.”
Muscatelli reminds us that Smith saw a close and enduring link between politics and economics, which benefited from analysis that is based on a case-by-case analysis of the impact on incentives and the unintended consequences of the policy. This point, famously illustrated by the metaphor of the invisible hand, is that policies have unintended consequences, and these consequences can be negative as well as positive.
Muscatelli asserts that even an effective and open trade policy is not sustainable in an environment in which some or all of the redistributive policies of welfare states do not generate improving living standards for the poorer sections of the population. Noting that the rise in global trade has contributed to a rise in inequality within individual nations; the potential for social dislocation caused by the rapid decline of specific industries and the added complexity when including environmental factors.
In closing Muscatelli draws on the arguments of Smith to offer three recommendations as we seek to address the climate challenge at COP26. That we consider trade policy in the context of societal and environmental challenges; we recognizing the impact on different groups in society and we revitalise international multilateral institutions to ensure they can handle the challenges ahead.
Book V: ‘Of the Revenue of the Sovereign or Commonwealth’
In reviewing Book V Dr Zeti Aziz, revisits the question of whether there is an optimal arrangement in which the private sector can participate collaboratively with the government in the provision of the public goods. The duties of a sovereign; to protect society from danger, from oppression and injustice and to provide the supporting infrastructure and public works that were considered as vital for the well-being of the society, remain uncontested.
However, the unheeded warning that proliferation of public companies and the separation of ownership and management would lead to negligence has indeed come to fruition and delivered the anticipated destructive consequences. In response, he proposes that the decades of negligence and plundering of the nature, confer an additional responsibility and accountability on the owners of capital - to ensure the sustainability of our planet.
In closing Dr Zeti Aziz proposes a vision of a 21st century Adam Smith as a strong voice and advocate for the protection of the environment, including to the risks that may have intergenerational implications leading to higher overall costs to our planet and humanity. In this case, the call would be for urgent action from both the state and the market to deliver an outcome that would allow our progress and prosperity to be enjoyed by future generations.
The Theory of Moral Sentiments
CLosing out the series, Royal London Climate Change Lead, Kaisie Rayner, introduces Smith's earlier and less famous (but no less important) work, The Theory of Moral Sentiments. She argues that this provides a guide for reading The Wealth of Nations, and more clearly brings out the socially-minded Smith.
The Wealth of Nations in the 21st Century launching next week
During the 18th Century, the Scottish Enlightenment put the Glasgow at the heart of world thinking. Today, as the world comes to Glasgow for the COP26, we ask what we can learn from one of the great pioneers of the Scottish Enlightenment: the renowned economist and former lecturer at the University of Glasgow, Adam Smith.
As part of the Adam Smith at the COP workstream of our Path to COP26 campaign, we have prepared this unique essay series entitled The Wealth of Nations in the 21st Century, looking at the climate crisis through the eyes of Smith.
This work updates Smith’s Wealth of Nations for the climate era. Expert authors from the fields of finance, economics, politics, development and central banking have taken the 5 ‘books’ of the original and written 5 essays drawing on Smith’s themes and reflecting on the climate crisis. They consider both how Smith’s thinking can guide our approach to climate action, and what he himself might have thought about the climate crisis.
We are extremely grateful to Lord Meghnad Desai, David Pitt-Watson, Usha Rao-Monari, Prof. Sir Anton Muscatelli, Tan Sri Dr Zeti Aziz, George Gray Molina, Dr Michele Battisti & Dr Craig Smith for sharing their fascinating insights. They have provided a truly remarkably review of the on-going relevance of Smith’s work, applying the Wealth of Nations, as well as drawing on the Theory of Moral Sentiments, to contemporary climate issues.
The essay series, supported by Royal London, will be launched at the University of Glasgow, where Smith once taught, during our Adam Smith at the COP evening lecture series on the 8th, 9th & 10th of December. Sign up now to join us in person or online. Our wish is that the essay series encourages and inspires creative thinking and practical action to leave a small and enduring legacy after this crucial summit.