What’s new in the development of sustainable finance? (Policy Brief)

DISCLAIMER: The author of this article is expressing his personal opinion and does not represent the institution that employs him.

Never before have the challenges of greening the financial system been so much at the forefront of public debate, whether on issues such as « greenwashing » or the inclusion of natural gas and nuclear energy in the European taxonomy. The role of regulation and supervision in scaling up sustainable finance has only grown in importance. However, although COP26, held in Glasgow in November 2021, resulted in several advances, the climate commitments made continue to put the world on track for a temperature increase of around 2.7°C by the end of the century (as the UN pointed out in a recent report). In this context, what can be said about the key challenges currently facing the financial system in order to align it with a low-carbon trajectory, as required by the Paris Agreement?

Recent interest in European taxonomy

The taxonomy is defined as a roadmap for transition that the European Commission has been developing since 2018. The need for a « common language » of sustainability, to inform financial decision-making or avoid  » greenwashing  » practices, ultimately relies on shared criteria at the level of each sector, but also on their  » reporting  » at the level of each company. However, this need for a roadmap is a macroeconomic requirement—alongside other tools.

A recent paper by the French Treasury highlights the key role of industry in greenhouse gas emissions and the powerful leverage of improving the carbon efficiency of production. However, progress on this front requires massive funding. Historian Adam Toozeregularly emphasizes, for example, the  » scenario planning  » required for the transition: he is supported in this view by the work of many economists and climate physicists. The implementation of the Paris Agreement’s objectives (which are aligned with science and could theoretically be achieved technically and economically) through national commitments highlights significant inconsistencies. These include a lack of visibility on the changes in processes and business models that need to be implemented to achieve carbon neutrality targets, and an understanding of the difficulties of decarbonization (e.g., economicdisruption , innovation, changes in demand, non-linearity of emissions reductions, etc.).In this context, much of the discussion focuses on determining roadmaps for governments, businesses, and the financial system, based on given energy-climate scenarios (such as the  » net-zero  » scenario published by the International Energy Agency in May 2021).

The Taxonomy also helps to satisfy a need for a « vision » that is still in its infancy in this area (at this stage, at least, pending the results of the European  » Fit-for-55  » package).

The Taxonomy has also recently attracted particular attention: any technology « outside » its first version is not considered to contribute substantially to the transition. This sends a strong signal, particularly in terms of financing.

A range of tools to support the transition through the market

Transparency is obviously a key element in any effort to get the financial sector to play its part. Information helps maximize the internalization of environmental costs by companies and manage the risks arising from climate change and the low-carbon transition, which requires information that is as comparable and robust as possible. However, this should not be used as an excuse to avoid other types of progress, as reporting has its limitations.

Above all, there must be a closer link between a security and its underlying asset: the issue of carbon pricing is key. Research has shown, for example, that despite investor appetite for green bonds (and the resulting opportunities to diversify their bond base), the premium does not reveal a substantial valuation gap between green and brown bonds (with equal risk). The cost of financing « brown » assets (e.g., fossil fuels) must therefore be increased.

Investors have a real ability to influence companies to reform by strengthening their environmental requirements. For example, by adjusting downward the weighting of companies with the highest greenhouse gas emissions, or by restricting their investment universe.

Many tools exist (e.g., shareholderengagement , transition bond issues, etc.), but the exponential growth of instruments based on the achievement of specific sustainability targets is particularly interesting[v]. This raises key assessment and audit issues to ensure that the transition is effectively implemented by the companies being financed.

What has COP26 achieved in terms of the development of sustainable finance?

Beyond certain relative advances made possible by the Glasgow Pact adoptedfollowing COP26 (reducing the use of coal, preserving ecosystems to mitigate global warming, necessary reduction in methane emissions), three issues should be highlighted:

1. First, the formation of (voluntary) alliances of financial actors, who will have to develop robust methodologies for decarbonizing their portfolios and balance sheets. The issues of credibility and effectiveness that will arise in the coming months for this type of initiative will need to be monitored.
2. Second, the phase-out of fossil fuels. Still in its infancy in the Glasgow Pact, it has materialized more strongly through alliances of states (e.g., on ending public financing) or targeted initiatives (e.g., the EU/US partnership on the transition of the coal industry in South Africa). The role of the financial sector in this context is becoming urgent.
3. Finally, there is a need to go further on taxonomies at the international level (a crucial issue for the G20) and to agree on global standards for non-financial transparency (similar to what already exists for financial matters).