When we close our eyes and think of a net-zero world, most of us probably see rows of wind turbines spinning above the oceans; landscapes blanketed with solar panels; electric cars humming along the roads. We might imagine ecosystems being restored and protected, and new methods of producing food taking root. We may even believe that people will learn to waste less and share more.
But for all of that to be possible, the global financial system will need to change how it operates. Investors will need to channel capital away from polluting industries and into the technologies and business models that can deliver a greener future.
The first steps on the journey to net zero, therefore, must involve making clear commitments to reducing emissions, over both the long term and short term, and keeping track of progress towards decarbonisation. The build-up to COP26 in Glasgow last year saw a trickle of financial actors that had committed to net zero turn into a flood. At the last count, some 273 firms, collectively managing $61 trillion in AUM, have now committed to net zero by 2050 and joined the Net Zero Asset Managers initiative.
But, as we explore throughout the following pages, actually turning lofty objectives into measurable progress is easier said than done. A particularly thorny issue is the longstanding question over whether investors should divest from the most polluting industries, or whether it is wiser to engage with companies to steer them towards reducing emissions.
Meanwhile, the financial system is increasingly turning to green bonds and sustainability-linked loans as a means of incentivising progress – although these instruments remain vulnerable to accusations of greenwashing.
1. Make commitments and set targets
Financial actors have been queuing up to promise climate action in recent years. Over 90 percent of global GDP is covered by net-zero targets, while more than 550 firms have joined the Glasgow Financial Alliance for Net Zero and pledged to reach net zero by 2050.
In fact, among the largest banks, asset managers and asset owners headquartered in Europe and North America, it is hard to find institutions that have not made climate commitments of some kind.
But whether the pledges made by investors and corporates are truly credible is another matter. After all, a CEO that promises their firm will achieve net-zero portfolio emissions by 2050 can rest safe in the knowledge that they will have long since retired by the time anyone holds them to account.
Attempts to compel members of GFANZ and its sub-groups to commit to detailed roadmaps towards net zero – and to forego fossil fuel investments – have run into difficulties in recent months. Some financial institutions have reportedly considered leaving GFANZ as a result. Former US vice-president Al Gore warned in September that it has “become apparent that some who made impressive pledges did not immediately begin to put in place a practical plan to fulfil those pledges”.
While long-term pledges are important, outlining a clear path to substantially reduce emissions by 2030 is arguably the key metric for climate credibility. Reducing emissions within the next few years will make more impact in limiting warming than action in the 2030s or 2040s. Board members and management teams, meanwhile, know that they can be held personally accountable for progress towards 2030 targets, in a way that is infeasible with 2050 goals.
2. Collect data and measure emissions
Collecting data on current emissions and then monitoring reductions over time are essential steps for investors seeking a credible path to a net-zero portfolio.
But there is much uncertainty about exactly what should be measured and reported by companies. It is already commonplace in many jurisdictions for companies to report Scope 1 and 2 emissions, which covers emissions in their own operations and emissions generated in producing energy that the company uses. But whether companies can and should also be required to report Scope 3 emissions – the upstream and downstream emissions in their value chains that they are only indirectly responsible for – is much more debatable.
Amid the myriad complexities involved in emissions measurement and management, progress in encouraging listed companies to report their emissions has been limited. MSCI reported in March that fewer than 40 percent of companies in its Investable Market Index reported Scope 1 and 2 emissions, while fewer than 25 percent reported Scope 3 emissions.
Nate Aden, finance sector lead at the Science Based Targets initiative, acknowledges that the wide range of initiatives, metrics and measurement systems can be disorienting for investors that lack experience in climate science. “There’s a lot of confusion and a lack of consistency and clear understanding of how things fit together or what may be more or less credible over time,” he says.
But Aden notes that the desire to perfect data collection and measurement mechanisms cannot be an excuse to delay action. “One of the conversations we have with financial institutions is that the data are imperfect,” he says. “Well, if we waited for the data to be perfect, we’d surpass 3C very quickly. We have to act now.”
3. Adopt double materiality reporting
For decades, listed companies have been required to report information considered ‘material’ to investors’ decision-making via accepted accounting standards. But, until recently, companies have been under no obligation to disclose information on how their activities affect society and the environment.
Advocates of ‘double materiality’ have sought to address this perceived anomaly. Organisations such as CDP and the Global Reporting Initiative have spent decades encouraging corporates to disclose data on emissions and other ESG factors. Meanwhile, the EU has begun moving towards mandatory double materiality reporting, most recently through its European Sustainability Reporting Standards.
Commenting on the release of the draft EU standards in May, CDP’s then-CEO Paul Simpson said the new disclosure rules “will bring more accountability, a better understanding of risks and opportunities and of the progress against EU and global goals, and will raise the bar on what is expected from companies”.
Whether the EU’s approach will become the global norm remains to be seen. The International Sustainability Standards Board, formed to develop a global baseline sustainability disclosure regime, has sent mixed signals on double materiality. Its focus is on an enterprise value approach, in which the focus is on how sustainability performance affects a company’s financial valuation. On the other hand, it has sought to co-operate with the GRI – which does take a double materiality approach – in harmonising disclosure requirements.
The GRI said in February that it believed it had made rapid progress in developing a comprehensive set of global standards, adding that “the concept of stakeholder capitalism not based on the concept of double materiality just makes no sense at all”.
4. Engage or divest?
It may seem intuitive that investors seeking to achieve net zero should divest from companies that produce fossil fuels or operate in other highly polluting industries. In practice, however, the dilemma is more complex than it first appears.
Many investment professionals warn that simply divesting from carbon intensive activities is unhelpful, or even counterproductive. “As an asset manager, there’s an easy way to go to net zero and there’s a hard way to go to net zero,” says Megan Starr, global head of impact at The Carlyle Group. She says that if Carlyle divested from around a dozen of the approximately 300 companies in its portfolio, the firm could reduce its Scope 1 and 2 emissions by as much as 95 percent. But, says Starr: “That does not change a molecule of carbon dioxide in the atmosphere.”
Complicating matters further is the growing number of state governments in the US that are seeking to punish asset managers that they perceive as hostile to oil and gas. Texas announced in August that it would require state pension managers to divest from funds that – according to the state government – boycott fossil fuels. Florida has followed Texas’s lead, but other states such as Maine are moving in a completely opposite direction – requiring their pension funds to divest from fossil fuels within the next few years.
While these fevered debates are unlikely to go away, there is no doubt that sustained engagement from investors can also produce beneficial results. “What really matters is the individual trajectory of a given company or asset – where the company starts when you invest in them and where they are when you exit,” says Starr. “The highest decarbonisation potential is actually frequently in the most carbon intensive companies.”
5. Scale up green financing
Given the pressing need to direct financial flows towards projects that accelerate the journey to net zero, it is not surprising that ‘green bonds’ and similar instruments have become increasingly popular.
A green bond works much like a regular bond. The key difference is that the funds raised are used to finance projects that the issuer claims will have a positive impact on the environment. The Climate Bonds Initiative (CBI) reported in October that a cumulative total of $2 trillion in green bonds have been issued since 2007. The market has grown at an annual rate of more than 50 percent in the last five years, peaking in 2021.
After announcing the $2 trillion milestone, Sean Kidney, CEO of the CBI, said the green and sustainable bond issuance must reach $5 trillion by 2025. “To stand a chance of meeting the Paris Agreement’s 2050 targets, we must slash emissions in half [in] this decade. This means scaling capital flows to climate causes at speed.”
The traditional ‘use of proceeds’ green bond, in which proceeds are ringfenced to specific purposes, has been joined by various other instruments as the market has evolved. These include sustainability-linked bonds and loans (SLB; SLL), where the interest rate is partly determined by a company’s performance against pre-agreed ESG targets. The company may, however, use the proceeds of SLBs and SLLs for general corporate activities, rather than for specific projects or purposes.
But many investors are unconvinced that any such instruments always contribute to greener outcomes. It is not hard to find examples of green bonds being used to finance activities that stretch the definition of ‘green’ past the point of credibility. A green bond issued by Airport Authority Hong Kong in January was criticised by Lucie Pinson, director of environmental think tank Reclaim Finance, who claimed that “labelling this project as green is pure high-flying greenwashing”. AAHK, however, noted that it had obtained a second-party opinion from Sustainalytics, which found that the bond was “credible and impactful” and aligned with various guidelines and principles.
Thankfully, there has been steady progress in developing frameworks to help protect investors from greenwashing. The CBI and the International Capital Market Association have both developed voluntary certification schemes for green financial instruments, while the EU is preparing the European Green Bond Standard.
Nevertheless, the green and sustainable finance market faces headwinds in the near-term. Green bond issuance in the first half of 2022 was down by 4 percent year-on-year. This partly reflects the reality that green financial instruments are subject to the same market forces that have resulted in subdued debt issuance more generally this year.
Amid a difficult market environment, rising concerns about greenwashing certainly does not help the cause of green bonds and instruments like SLBs and SLLs. Combatting the perception that greenwashing is rife in the labelled finance market is vital if green financial instruments are to fulfil their potential.