How taxonomy, trajectory and Ecolabel could save our children
When a frog sits in water that is slowly boiled it stays put until it loses the ability to jump and eventually dies. Mankind inhabits a planet that is gradually being heated towards lethal temperatures. Will we wait to address the problem until we are too weakened from floods, heatwaves and mass migration to save ourselves or our children?
Perhaps the most chilling scientific insight is that to save future generations, even if average temperatures rise by 4°C, we will have to discipline our economy into a net climate neutral state this century. This means that all global gross greenhouse gas (GHG) emissions will have to be captured and stored.
We are currently dozens of gigatons of GHG emissions away from being net climate neutral each year, and there is no realistic way to achieve this in less than several decades. Like the frog at a higher temperature, we have already lost the ability to jump, but we may be able to crawl out.
This will take discipline at levels similar to those exhibited by people who have lost 60kg in a multi-year diet. Much like a diet, we need to determine our accurate weight, avoid as much unhealthy food as possible and incentivise healthy food.
Sadly, these prerequisites have not been met.
First, academics estimate that only 21 firms worldwide report their complete scope-one GHG emissions, while thousands of firms underreport or avoid reporting altogether1. In other words, regulators and asset owners do not know the weight of their constituents.
Second, capital markets struggle to be effective as sell-side actors and advertise or legitimise investments that are more conducive to maximising their fees than minimising sustainability risks.
Third, we need stronger incentives for climate neutral solutions, largely within diversified multinational corporations.
So, while European regulators and asset owners are committed to incentivising the necessary action, they face a complex challenge without having the necessary prerequisites in place.
Defining a complex endeavour such as the EU action plan for financing sustainable growth and its Technical Expert Group (TEG) by the many things it encapsulates can be confusing. Therefore let us describe it in terms of the things it does not encapsulate.
First, the TEG does not include a single accountancy firm that has audited the thousands of corporations that underreport their emissions. Second, it does not include credit raters or non-green bond investment bankers. So no-one is structurally conflicted by short-term fee maximisation without relevant risk exposure. The TEG’s membership are buy-side organisations and aims to work towards a conflict-free version of capitalism. For this the EU deserves praise from the academic community, even though it only found space for a single academic.
But avoiding the impediments to the diet does not mean the necessary awareness, incentives or discipline are in place. How can this come about?
To create awareness, there are corporate disclosure reports, investor disclosure requirements and the Ecolabel. Firms are recommended, but not obliged, to collect data on as much of their scope-one GHG emissions output as they can and to estimate the remainder based on the precautionary principle (that is, if in doubt, err on the side of the planet), while requesting their scope-two and scope-three suppliers also comply. Incoming investor disclosure requirements and the Ecolabel will raise awareness among individuals in the corporate finance supply chain and those with sufficient capital.
To create incentives to finance green activities, one only needs two things – asset owners and green activities. So theoretically this is easy. Unfortunately, decades of organic capital market development have led to few solutions to directly finance beyond venture funding and green bonds. Corporations represent various activities in their financial issuance without transparent purpose of proceeds.
Sector-classified investments are even worse as they usually involve classifying a range of activity into a single sector, confusing the naïve. What seems easy in theory is challenging in practice and will require activity classifications. But activity classifications without green thresholds are insufficient; hence the EU would need to assess at which efficiency levels an activity could be considered green.
Beyond this, it will require financial analysts to map and weight corporations into such an activity matrix, a process that will only be accurate if corporations are not permitted to pay for their desired classification. Considering these difficulties, it is an amazing achievement that the EU is on track to have a taxonomy completed on schedule.
To create the discipline, corporate constituents need constant reminders to keep to their GHG emission diet. The best parties to issue these reminders are the owners and those who refinance their activities – shareholders and bond investors. Asset owners and their delegates have a crucial role as guardians of decarbonisation. Without them we will behave like the frog.
Organised through groups such as Climate Action 100+ or the Transparency Pathway Initiative (TPI), asset owners are unsung heroes. So for them to remind their corporate constituents, they need an appropriate investment style that reminds them – climate transition investing (CTI).
This is based on the simple idea that heavily-emitting index constituents must either reduce the (intensity of) their GHG emissions by more than 7% per year or the index provider may reduce their constituent weight by at least 7% in the equivalent year.
The CTI concept is based on the Paris Agreement and the International Panel on Climate Change’s 1.5°C trajectory with no or limited overshoot2. If enough of us adhered to the CTI style, it would enable investors to decarbonise their portfolios towards net climate neutral by 2050, giving mankind a chance to crawl out.
1. https://climatedisclosure100.info/. Any corporation which confirms in writing to have reported 100.0% of its Scope 1 GHG emissions is welcome to contact this initiative
2. The author has personally discussed this with scientists such as Joeri Rogelj, lead author of the IPCC’s 1.5° report. All scientists consulted are convinced that the discipline of the trajectory is the key to achieving the decarbonisation required.
Andreas Hoepner is full professor of operational risk, banking and finance, University College Dublin, and is a member, in a personal capacity, of the EU technical expert group on sustainable finance. This article is based on the author’s working paper ‘Designing legislative interventions to finance sustainable economic growth: towards a conflict-free capitalism’, which is available on request