Dr Dorothy Maxwell FICRS Head of Sustainability and ESG Advisory
Jonathan McKeown CIFD, MBA Director of ESG
01st February, 2023
Published in Finance Dublin January 2023 edition.
The 27th UN Climate Change Conference of the Parties (COP 27), while falling short on commitments to further reduce global emissions, delivered breakthroughs on the finance front write Davy Horizon’s Dr Dorothy Maxwell and Jonathan McKeown. Proposals included new funding arrangements, transformation of the financial system to realise the annual need for $4-6 trillion to transition to a low carbon economy, World Bank debt finance changes and a ‘loss and damage’ fund for vulnerable countries. Looking ahead, they say, while short-term economics are turbulent, policy will continue to support scaling finance for a net-zero emissions future.
Global central bank measures to reign in rampant inflation, Russia’s unprovoked military aggression on Ukraine, the resulting energy price hikes and a global supply chain crisis were not what most were expecting in 2022. Meanwhile consumers still struggling their way out of the COVID19 crisis, were faced with having to re-assess discretionary spending as increasing mortgage costs, food price inflation, and home energy bills bite into their incomes.
Against this challenging economic and geopolitical backdrop, the 27th UN Climate Change Conference of the Parties (COP27), the first ‘African COP’, was hosted in Sharm el-Sheikh, Egypt, 7-20 November 2022. In addition to the myriad of regulations that form the EU Sustainable Finance Action Plan, COP27 agreements have implications for corporates and climate finance globally.
The agenda focused primarily on the implementation of the Paris Agreement across 197 signatory countries to halt global warming to a maximum 1.5 degrees Celsius, and the financing, technology and other supports required to get there. Major themes included: climate change mitigation, adaption, water & food security impacts and how to finance a just and fair transition to net-zero emissions and the “loss and damage” cost already occurring. The COP delivered breakthroughs on finance but fell short on achieving commitment to further reduce global emissions and providing clarity on the phase out trajectory of fossil fuels. The G20 Bali summit overlapped with consistent themes. A positive step forward politically was the agreement from China and the USA, the world’s largest emitters, to work together on tackling climate change. As the impacts of climate change are increasingly felt across the globe, the message that greenhouse gas (GHG) emissions must fall is unambiguous. According to the latest climate science “Unless there are immediate, rapid, and large-scale reductions in GHG emissions, limiting warming to 1.5 degrees Celsius will be beyond reach”. Even if all of the current pledges from all 197 countries were implemented, emissions would still increase by 10.6% by 2030 and would result in a 2.5 degrees Celsius warmer world by the end of the century.
For corporations, action means committing to GHG emissions reduction targets to align with the 1.5 degrees Celsius commitment and verified to Science Based Targets initiative (SBTi - see GLOSSARY) standards. SBTi, widely regarded as the gold standard, provides clearly defined pathways for companies to reduce GHG emissions. Targets are considered ‘science based’ if they are in-line with what the latest science deems necessary to meet the goals of the Paris Agreement.
According to UN Climate Change Executive Secretary, Simon Stiell, in the COP27 close, “We have determined a way forward on a decades-long conversation on funding for loss and damage” to address the impacts of climate change on communities already affected. This was a major achievement given the slow pace of delivery on a 2020 commitment by the developed countries to provide $100 billion per year to impacted countries. The EU shifted the stakes by committing to this late in the day at COP27 and the Agreement was passed.
A wider overhaul of the financial system to realise the circa USD$4-6 trillion climate finance needed annually has also been proposed, supported by a newly agreed “transition committee” and a range of packages, plus revamps to debt finance from the World Bank and IFC. To deliver this, the focus for 2023 in preparation for COP28 is expected to keep the spotlight firmly on climate finance to include transformation of the financial system, structures and processes – and engaging with governments, central banks, commercial banks, institutional investors and other financial actors.
The voluntary asset managers net zero initiatives had several updates at COP27 including:
Norway’s sovereign wealth fund, the world’s largest at $1.3tn AUM, recently stated it intends to become a more vocal shareholder and plans to vote against companies that fail to set emissions targets. Conversely, Vanguard recently announced that it was resigning from the Net Zero Asset Managers initiative stating “We have decided to withdraw from NZAM so that we can provide the clarity our investors desire about the role of index funds and about how we think about material risks, including climate-related risks — and to make clear that Vanguard speaks independently on matters of importance to our investors”.
Regardless of the views of individual asset managers, it seems clear that increased focus on decarbonisation targets for asset managers’ portfolios will impact the universe of assets eligible for inclusion in portfolios. Listed corporates wishing to access a broad investor base must be transparent about their emissions across Scope 1-3 and should comprehensively and credibly communicate a defined sustainability strategy that includes clear and measurable goals. By aligning to SBTi, corporates can widen their investor base to those investors with decarbonisation targets such as members of NZAM.
Article 8 investment funds (EU funds which promote environmental characteristics) and Article 9 investment funds (EU funds which have sustainable investment as an objective) use many inputs to make investment decisions and it seems likely that in future these will include ratings information from at least two ESG Ratings Agencies.
Regulators next year are expected to release their findings from studies on ESG Ratings Agencies and are expected to set out their expectations regarding transparency of ratings methodology at the very least. Corporate ESG Ratings vary widely depending on each agency’s assessment of ESG risks inherent in the corporate being assessed. Ratings transparency should enable better comparisons. However, data will remain key and corporates that are unable or unwilling to disclose information such as their Scope 1-3 emissions will likely be penalised.
The importance of supply chain decarbonisation (Scope 3) at COP27 was underlined by the US government walking the talk with new procurement requirements for suppliers to publicly disclose GHG emissions & climate-related financial risks and set science-based emissions reduction targets.
The importance of supply chain decarbonisation cannot be underestimated. This is often where most of a corporation’s carbon footprint lies and there are growing demands to report on this. In the EU, this is captured via the Corporate Sustainability Reporting Directive (CSRD) which requires large corporates currently subject to the Non-Financial Reporting Directive to formally report on Scope 1-3 emissions from 2024. This, and government green procurement requirements, are driving growing demand for decarbonisation down the supply chain.
Countries were put under pressure at COP27 to raise their Nationally Determined Contributions, but progress was limited. Governments were requested to strengthen their 2030 targets by the end of 2023 and accelerate efforts to “phase down unabated coal power and phase out inefficient fossil fuel subsidies”.
In the EU, ambition on mitigation has been accelerated by the direct effects of sanctions on Russia and its REPowerEU renewables policy. REPowerEU aims to rapidly reduce EU dependence on Russian fossil fuels by accelerating the clean transition, joining forces to achieve a more resilient energy system and a true Energy Union. Building on the EU Fit for 55 climate change policy and actions on energy security of supply and storage, REPowerEU puts forward an additional set of actions to save energy, diversify supplies, speed up substitution of fossil fuels and smartly combine investments and reforms.
According to analysis by the Commission, REPowerEU will require an additional investment of €210bn between now and 2027, on top of what is needed to realise the objectives of Fit for 55. This massive investment requirement will be partly funded through the Recovery and Resilience Facility. As well as accessing the facility, the expectation is that energy companies will engage in green bond issuance and in sustainable and green loans to ensure funding is in place to make the capital expenditures necessary to their decarbonisation strategies and targets.
Volumes in green & sustainable bonds and sustainability-linked loans are expected to continue to rise as sovereigns and corporates seek to access capital with coupons and loan margins tied to green projects or material corporate sustainability KPIs. With the increase in volumes due to increased supply and demand, it will be key that use of proceeds, targets and KPIs are independently assessed and verified to a high standard to maintain the integrity of the green finance market.
It is clear that the corporate capital stack is becoming increasingly tied to environmental and social indicators. On the equity piece, investors will be looking for well-communicated sustainability targets and decarbonisation. On the debt piece, banks are beginning to offer sustainability KPIs in loans and the way forward is likely an increasing focus on ESG risks to the business as well as opportunities.
Looking ahead to 2023, while the short-term economics are turbulent, policy continues to support acceleration of corporate ambition on climate change and scaling finance for a net-zero emissions future.
If you would like further information, please contact Davy Horizons at sustainability@davy.ie.
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