We Need a New Financial System to Stop Climate Change
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Bibliographic details
- Authors: MARK CARNEY
- Published: December 1, 2019
Overview
- Author and role: MARK CARNEY, UN special envoy for climate action and finance.
- Central thesis: A new, sustainable financial system is required to stop runaway climate change by aligning capital allocation, risk management, and disclosure with the transition to a net-zero world.
- Framing problem: Climate impacts extend beyond traditional decision horizons (“The Tragedy of the Horizon”), creating misaligned incentives for current financial actors.
Scale of losses and insurance gap
- Insured losses in 2018 were $80 billion, double the inflation-adjusted average for the past 30 years.
- In 2017, insured losses totaled $140 billion and uninsured losses totaled $200 billion.
- In Bangladesh, Egypt, India, Indonesia, Nigeria, the Philippines, and Vietnam, insurance penetration is less than 1 percent.
- Lloyd’s of London estimate: a 1 percent rise in insurance penetration can translate into a 13 percent reduction in uninsured losses and a 20 percent lower disaster recovery burden on taxpayers.
- Macroeconomic benefits from closing insurance gaps include increased investment, higher output (potentially up to 2 percent of GDP), and greater climate resilience.
Urgency and required investment
- IPCC 2018 finding cited: only 12 years left to stop runaway climate change.
- Recent trend: global energy emissions increased 1.7 percent last year.
- To limit warming to 1.5˚C requires a 45 percent decrease by 2030 and net-zero emissions by 2050.
- International Energy Agency estimate: a low-carbon transition could require $3.5 trillion in energy sector investment every year for decades—twice the current rate.
- Under the agency’s scenario requirements by 2050:
- nearly 95 percent of the electricity supply must be low carbon;
- 70 percent of new cars must be electric;
- the carbon dioxide intensity of the building sector must fall 80 percent.
Reporting (disclosure)
- Task Force on Climate-related Financial Disclosures (TCFD): established by private sector, catalyzed by the Group of Twenty; described as a comprehensive, practical, and flexible framework for corporate disclosure of climate-related risks and opportunities.
- Supporters controlling balance sheets totaling $120 trillion now back TCFD-aligned disclosure.
- Climate-related shareholder resolutions spiked to 90.
- Investment managers controlling more than 45 percent of global assets under management now back shareholder actions on carbon disclosure.
- Companies representing over 90 percent of all shareholder advisory services now support the TCFD.
- Four-fifths of the top 1,100 Group of Twenty companies now disclose climate-related financial risks as some TCFD recommendations advise.
- Three-quarters of those who use this information have seen an improvement in the quality of climate disclosure.
- Policy direction: next step is to make disclosure mandatory; the United Kingdom and European Union have already signaled moves in that direction.
- Short-term priority: over the next two years the disclosure process must ensure TCFD standards are as comparable, as efficient, and as decision-relevant as possible.
Risk management (supervisory and firm actions)
- Capital providers (banks, insurers, asset managers) and supervisors must better understand and manage climate-related financial risks.
- Drivers of reassessment: changes in climate policies, new technologies, and growing physical risks.
- Bank of England survey: almost three-quarters of banks are starting to treat risks from climate change like other financial risks.
- Banks are assessing:
- exposure of mortgage books to flood risk;
- impact of extreme weather events on sovereign risk;
- exposure to transition risks (carbon-intensive sectors, consumer loans for diesel vehicles, mortgages for rental properties given new energy efficiency requirements).
- Bank of England supervisory expectations to be embedded into practice:
- Governance: embed climate risk consideration into governance frameworks and assign oversight to specific senior managers.
- Risk management: consider climate change in accordance with board-approved risk appetite.
- Regular use of scenario analysis: necessary to test strategic resilience.
- Appropriate disclosure of climate risks: develop and maintain methods to evaluate and disclose these risks.
- Bank of England initiative: first regulator to stress-test its financial system under various climate pathways, including a catastrophic business-as-usual scenario and the transition to net zero by 2050 consistent with the UK-legislated objective.
- Approach: integrate climate scenarios with macroeconomic and financial models; develop in consultation with industry and stakeholders, including experts from the Network of Central Banks and Supervisors for Greening the Financial System (a 42-member group representing jurisdictions that account for half of global emissions).
New horizon for investment and markets
- Sustainable investment recognized as opening enormous opportunities (transforming energy, reinventing protein).
- Estimated $90 trillion in infrastructure investment expected between 2015 and 2030.
- Green bonds:
- Offer investors stable, rated, and liquid investments with long duration.
- Provide issuers access to a $100 trillion pool of long-term private capital managed by global institutional fixed-income investors.
- Accounted for only 3 percent of global bond issuance in 2018.
- Role of capital markets: shifting from banks to capital markets can free bank balance sheet capacity for early-stage project financing and infrastructure lending.
- Sustainable investing beyond exclusion: must catalyze companies shifting from brown to green.
- Investment strategies:
- “Tilt” strategies (overweight high ESG stocks) and “momentum” strategies (focus on companies that have improved ESG ratings) have outperformed global benchmarks for close to a decade.
- Measurement challenge: inconsistent measurement of ESG is a major hurdle.
- Taxonomy needs:
- EU green taxonomy and green bond standard are a good start but are binary (dark green or brown only).
- Aim for a richer taxonomy capturing “50 shades of green.”
- Eventually asset owners should report the climate pathway of their portfolios.
Avoiding a “Minsky moment” and policy recommendations
- Risk: financial disruption if the market does not adjust efficiently to the transition (a climate “Minsky moment”).
- Role of finance: develop frameworks for markets to adjust efficiently and enable feedback between markets and policymaking.
- Finance complements and amplifies climate policy but does not substitute for it.
- Policy frameworks with greatest impact are those that are:
- Time-consistent (not arbitrarily changed);
- Transparent (with clear targets, pricing, and costing);
- Committed (through treaties, nationally determined contributions, domestic legislation, and consensus).
- Execution path:
- Countries should turn Paris commitments into legislated objectives and concrete actions to increase market confidence;
- More prolific reporting, more robust risk assessment, and more widespread return optimization will hasten the transition and help break the Tragedy of the Horizon.
Key statistics and figures (extract)
- $80 billion: insured losses in 2018.
- $140 billion: insured losses in 2017.
- $200 billion: uninsured losses in 2017.
- Less than 1 percent: insurance penetration in certain highly exposed countries (Bangladesh, Egypt, India, Indonesia, Nigeria, the Philippines, Vietnam).
- 1 percent rise in insurance penetration → 13 percent reduction in uninsured losses and 20 percent lower disaster recovery burden (Lloyd’s of London estimate).
- Potential output gain: potentially up to 2 percent of GDP from closing insurance gaps.
- 12 years: time left per 2018 IPCC report to stop runaway climate change.
- 1.7 percent: increase in global energy emissions last year.
- 45 percent decrease by 2030 and net-zero emissions by 2050: requirements to limit warming to 1.5˚C.
- $3.5 trillion per year: estimated energy sector investment required for a low-carbon transition every year for decades.
- nearly 95 percent: share of electricity supply that must be low carbon by 2050 under IEA scenario.
- 70 percent: share of new cars that must be electric by 2050 under IEA scenario.
- 80 percent: required fall in carbon dioxide intensity of the building sector by 2050 under IEA scenario.
- $90 trillion: estimated infrastructure investment expected between 2015 and 2030.
- $100 trillion: pool of long-term private capital managed by global institutional fixed-income investors.
- 3 percent: green bonds’ share of global bond issuance in 2018.
- $120 trillion: balance sheets controlled by current supporters of TCFD disclosure.
- 90: number of climate-related shareholder resolutions (spiked figure).
- more than 45 percent: share of global assets under management controlled by investment managers backing shareholder actions on carbon disclosure.
- over 90 percent: share of companies representing shareholder advisory services supporting the TCFD.
- Four-fifths: proportion of top 1,100 Group of Twenty companies disclosing climate-related financial risks per some TCFD recommendations.
- Three-quarters: proportion of TCFD information users who have seen improved quality of climate disclosure.
- almost three-quarters: proportion of banks starting to treat climate risks like other financial risks.
- 42-member group: Network of Central Banks and Supervisors for Greening the Financial System membership, representing jurisdictions that account for half of global emissions.
We Need a New Financial System to Stop Climate Change – IMF F&D | DECEMBER 2019
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