Net zero transition will require massive climate finance investment in low-carbon assets and a reallocation of capital from high-carbon assets.
By 2050 $195 trillion may needed to flow into low-carbon physical assets, accompanied by a reallocation of capital away from high-carbon assets such as those involving fossil fuels, according to Lilia Caiado Couto, research fellow, global economy and finance programme at Chatham House.
For such capital flows to occur, investors will need regulatory certainty and the establishment of deep, liquid markets in climate-friendly financial assets. In most cases, this will mean increasing exposure in emerging or previously niche investment categories. Banks, insurers, asset managers, pension funds and other private institutional investors will need clarity on how net zero portfolio alignment is defined and measured, and on the climate risk characteristics of specific financial assets. Any information regime must be complemented by robust incentives and enforcement – so that in-principle commitments around the ‘greening’ of portfolios are matched by actual investment.
A key task is to stimulate the flow of private climate capital into emerging markets and developing economies (EMDEs), where opportunities for renewable energy investment are typically the greatest. Yet around 90 per cent of private climate finance currently stays within national borders, for reasons that include preferential national policy support, differences in regulatory standards, and market information failures. The cross-border capital flows that do occur are concentrated in the West and China. The problem is compounded by broader risk aversion towards many EMDEs, and by global economic headwinds such as inflationary pressures and EMDE debt sustainability concerns.
Understanding of climate risk in the financial system has advanced in recent years. Significant developments have included the creation in 2017 of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) to develop common approaches on climate-related risk management; the release, also in 2017, of wide-ranging disclosure and governance recommendations by the Task Force on Climate-related Financial Disclosures (TCFD); and the 2022 publication of guidance on net zero transition plans by the Glasgow Financial Alliance for Net Zero (GFANZ). Many central banks, from China to South Africa to Mexico, are developing their own climate investment guidance, along with taxonomies defining the characteristics of net zero-consistent assets.
But a more uniform global framework of climate investment standards and reporting is needed if the recent proliferation of guidance is not to impair coordination between financial systems and asset classifications. Central banks and financial regulators can lead this process by cooperating on the development of high-level principles. One option would be to build a climate information architecture aligned with the Financial Stability Board’s surveillance system.
Central banks and financial regulators also have roles to play in translating a more ‘climate-aware’ financial architecture into actual capital reallocation. One effective lever could be to increase capital requirements for loans associated with high-emissions projects or investments (although easing requirements for loans on low-carbon projects or investments is potentially more problematic). Collateral frameworks could similarly be adjusted so that the value of assets used as collateral would be determined in part by their emissions and climate risk profiles – or, more radically, so that certain polluting assets would become fundamentally ineligible for use as collateral.
Beyond such incentives, central banks have the opportunity to advance climate finance action through their own market operations and investments, potentially creating a multiplier effect in stimulating capital flows to the low-carbon economy. In monetary policy, asset purchase programmes could give preference to net zero-compliant assets. Central banks could move markets through their divestment choices – selling off high-carbon assets would send a strong signal on climate to institutional investors. Central banks could also reweight their foreign exchange reserves in favour of low-carbon holdings, and even incorporate a formal net zero target in their reserve management objectives.
Central banks and financial regulators should explore making net zero transition plans mandatory for multinational financial institutions. Firms’ progress would be measured against milestones set out in such plans, and there would be an associated requirement for transparency in the composition of portfolios and the climate risk assumptions underlying investment strategies. The idea would be for disclosure not only to produce data but to feed into financial decision-making.