Two factors are driving a revolution in the financial industry. Firstly, large consumers such as pension funds and other institutional investors, are increasingly demanding low-risk assets and opportunities which are compatible with the goals set out Paris Agreement. Some large financial organisations are already reducing their risk exposure to high-carbon assets. Axa, one of the largest global insurers committed to invest €12 billion in green projects by 2020; an additional €3 billion divestment from carbon-intensive energy such as coal and oil sands; and phase out new coal and oil sands businesses. Swiss Re, the second largest global reinsurer committed to moving its $130 billion portfolio towards Environmental, Social and Governance (ESG) indices. Meanwhile, $161 billion green bonds were issued globally in 2017 with market experts forecasting $250 billion to be issued by the end of 2018.

Secondly, regulators have continued to sound alarm over the scale of risk to the entire financial sector. Mark Carney, Governor of the Bank of England, warned that climate change would have a ‘catastrophic impact’ on financial markets unless firms do more to disclose their liabilities and risks. In doing so he opened the door for all boards registered in the UK with a fiduciary duty to assess the scale of climate risk in their companies. The European Systemic Risk Board concluded in 2016 that there was insufficient time for a gradual adjustment to a low-carbon economy and that an ‘adverse scenario’ was currently in operation in which abrupt constraints on carbon-intensive assets was the costly norm.

The European Commission’s ensuing High-level Expert Group and Action Plan on Financing Sustainable Growth led to a watershed moment in the history of climate change action. On 24 May 2018, the Commission proposed three regulations addressing harmonised definitions of sustainable investments; disclosure of sustainability risks in investment decision-making processes for financial market participants; and benchmarks to identify assets and products whose carbon footprint is aligned to the Paris Agreement. The impact of these new rules will be immense in attracting the considerable financial flows needed to address the Paris Agreement.

Harmonising definitions of what comprises a ‘sustainable investment,’ or the Taxonomy Regulation as it is more commonly referred to, is essential to ensure confidence and avoid situations that prevent scalability or could severely damage the future of the market for sustainable investments. Bitter experience of the Kyoto Protocol’s controversial Clean Development Mechanism (CDM) highlights the latter. The CDM was inundated by business-as-usual projects that would have taken place anyway or had social and other environmental concerns. A similar problem lurks for some green bonds from China which are used to finance new coal plants albeit at a higher thermal efficiency than standard coal plants. Such scandals could undermine confidence in the market and exacerbate the systemic risk the sector faces.

The Taxonomy Regulation should remove ‘greenwashing’ instances through clear criteria by ensuring finance is directed towards projects that improve the climate; environment; water and marine resources; protect healthy ecosystems and ‘do no harm’. A Platform on Sustainable Finance will oversee the classification of the criteria to ensure adequate screening and oversight is given to any subsequent labels and product standards. It is also expected to hasten the extent to which high-carbon activities become stranded as their business model dramatically changes. The challenge for this taxonomy is how it deals with grey areas when a climate polluting entity seeks to invest in ‘sustainable’ projects whilst continuing current activities.

Although the Commission’s proposal did not propose mandating disclosure of ESG information to investors, it does go a long way to address the lack of transparency on how institutional investors, assets managers and financial advisors assess sustainability risk in their decisions or advice. The proposal ensures advice and purchases made on behalf of clients have a publicly viewable and constantly maintained sustainability assessment unmasking expose to climate risk. This disclosure will be made pre-contract so that buyers are able to take full ownership of their investment decisions. Even if the legislative process doesn’t mandate climate risk disclosure this time, pressure will grow.

In proposing two benchmarks – ‘low-carbon and ‘carbon positive impact’ – market participants will be able to identify much more lucrative and low-risk assets, products and companies that are compatible with the Paris Agreement. Removing ambiguity rewards those that reduce their overall carbon footprints and removes ambiguity for their investors.

So, whether it is a regulator or large companies that can pull the entire market, the space for carbon polluting assets and products will come under increasing pressure from financial markets which is likely to make AGMs and activist investors the key battleground for climate action. The risk of significant financial penalisation due to negative climate exposure will increase dramatically once the ink dries on these proposals.

Note – This article was first published in E!Sharp.