In a little over a year, the world will converge physically and virtually on Glasgow for COP26 hosted the United Kingdom in partnership with Italy. It will then be six years after the landmark Paris Accord, and the stakes could not be higher. Despite prolonged lockdowns of large swathes of the global economy, the earth’s car- bon budget continues to be rapidly depleted, the physical risks of climate change continue to mount, and the sixth mass extinction continues to progress. Paris was a triumph of commitment and process. Commitment by [193] governments to limit temperature rises to below 2 degrees, with a stretch target of 1.5 degrees. Process in the innovation of Nationally Determined Contributions, whereby countries set their own pledges, and the world transparently added them up to see whether those efforts did the job. That calculation, 2.8 degrees of warm- ing even if all countries fulfilled their pledges, was as sobering as it was disciplined. And it set the tone on the road to Glasgow: climate policy in the public and private spheres would be driven by data and data analytics because slogans won’t solve an existential crisis. In the event, many countries have fallen short of their pledges, and the IPCC estimates that the world is on course for up to 4 degree warming by the end of the century. At current rates of emissions, we have less than a decade left to stay within the carbon budget that keeps temperature rises below 1.5 degrees with 50% probability. Getting back on track will require a redoubling of public efforts and a quantum change in private investment. The IEA estimates that the low-carbon transition could require $3.5trn in energy sector investments every year for decades – twice the rate at present. Under their scenario, in order for carbon to stabilise by 2050, nearly 95% of electricity supply will need to be low carbon, 70% of new cars electric, and the CO2 intensity of the building sector will need to fall by 80%. For private markets to anticipate and smooth the transition to a net zero world, they need the right reporting, risk management, return optimisation. Our objective for Glasgow is to build these frameworks so that there is a new financial system in which every decision takes climate change into account. This requires a fundamental reordering of the financial system so that all aspects of finance— investments, loans, derivatives, insurance products, whole markets—view climate change as much a determinant of value as creditworthiness, interest rates or technology. A world in which the impact of an activity on climate change is a new vector, a new determinant, of value. Doing so requires new data sets and new analytic techniques. The challenges are enormous and the timescales tight, but the prize are protecting the planet while seizing the greatest commercial opportunity of our time. In order to bring climate risks and resilience into the heart of financial decision making, climate disclosure (reporting) must become comprehensive; climate risk management must be transformed, and sustainable investing (returns) must go mainstream.

Reporting Catalysed by the G20 and created by the private sector, the Task Force on Cli- mate-related Financial Disclosures (TCFD) is a comprehensive, practical and flexible framework for corporate disclosure of climate-related risks and opportunities. Since the TCFD set out its recommendations for climate-related disclosures, there has been a step change in both demand and supply of climate reporting. The demand for TCFD disclosure is now enormous. Current supporters control balance sheets totaling $140 trillion and include the world’s top banks, asset managers, pension funds, insurers, credit rating agencies, accounting firms and shareholder advisory services. The supply of disclosure is responding, with four fifths of the top 1100 G20 companies now disclosing climate-related financial risks in line with some of the TCFD recommendations. Suitable for use by all companies that raise capital, the TCFD recommendations include a mixture of objective, subjective and forward-looking metrics: - Include disclosure of governance, strategy and risk management; - Establish consistent and comparable metrics applicable across all sectors, as well as specific metrics for the most carbon-intense sectors; and - Encourage use of scenario analysis so as to consider dynamically the potential impact of the risks and opportunities of the transition to a low carbon economy on strategy and financial planning. The TCFD will call on new skills from measuring Scope 3 emissions to assessing strategy, risk and performance under different climate pathways. The next step is to make these disclosures mandatory through initiatives by national authorities, regulators and international standard setters. Understanding and using such forward-looking impact disclosure will become a core skill across the private financial sector.

Risk management The providers of capital—banks, insurers, asset managers—and those who supervise them all need to improve their understanding and management of climate-related financial risks. Changes in climate policies, new technologies and growing physical risks will prompt a reassessment of the value of virtually every financial asset. Firms that align their business models to the transition to a net zero world will be rewarded handsomely. Those that fail to adapt will cease to exist. The longer meaningful adjustment is delayed, the greater the disruption will be. Climate risks differ from conventional risks in several critical respects, including: Their unprecedented nature. Past experience and historical data are not good predictors of the probabilities in the future. Indeed, as the insurance industry has learned, yesterday’s tail event is becoming today’s central scenario. Their breadth and magnitude. They will affect every customer, in every sec- tor in every country. Their impact will likely be correlated, non-linear, irreversible, and subject to tipping points. They will therefore occur on a much greater scale than the other risks financial institutions are used to managing. That they are both foreseeable, in the sense that we know some combination of physical and transition risk will occur, and uncertain, in that the timing and scale is path dependent. Although the time horizons for physical risks are long - not the usual 3-5-year business planning horizon, but over decades—addressing major climate risks tomorrow requires action today. Indeed, actions over the next decade—prob- ably in the next three to five years—will be critical to determining the size and balance of future risks (1). It is self-evident that the financial system cannot diversify its way out of this risk. As the pandemic has revealed, the interconnections between the real economy and the financial system run deep. And just like Covid-19, climate change is a far-reaching, system-wide risk that affects the whole economy, from which the financial system is not immune and indeed cannot hide. As the CEO of Morgan Stanley remarked to Congress, “It’s hard to have financial stability if you don’t have a planet.” So if financial risk is to be reduced, then the underlying climate risks in the real economy must be managed. And fixing this collective action problem is a shared responsibility across financial institutions and regulators. The public and private sectors need to work together to solve it, and that means developing the necessary risk management expertise rapidly. That expertise is needed because it is challenging to assess financial risks in the normal way. As emphasised by the TCFD, it means that disclosures need to go beyond the static (what a company’s emissions are today) to the strategic (what their plans are for their emissions tomorrow). That means assessing the resilience of firms’ strategies to transition risks. This will be the principle focus of the new climate stress testing regime of central banks. At present, led by the Banque de France, the Nederlands Bank and the Bank of England, 16 central banks and supervisors will stress test their systems against different climate scenarios for a smooth transition to net zero to business-as-usual hothouse earth.

Returns Financial participants increasingly recognise that sustainable investment brings enormous opportunities ranging from transforming energy to reinventing protein.

While green investment products, such as green, sustainable and transition bonds are important catalysts to developing a new financial system, they will not be sufficient to finance the transition to a low carbon future. We need to mobilise mainstream finance to help support all companies in the economy to adjust business models to align with net zero pathways. Value will be driven by identifying the leaders and laggards, as well as the most important general-purpose technologies that will overcome choke points in the transition. That means having a more sophisticated understanding of how companies are working to transition from brown to green, not just where they are at a single point in time. Thus far, the approaches to doing so have been inadequate. Scores that combine E, S and G to give a single ESG metric—while worthy—are dominated by the S and the G. Carbon footprints are not forward-looking. And the impact of shareholder engagement is hard to measure. Moreover, a whole economy transition isn’t about funding only deep green activities or blacklisting dark brown ones. We need fifty shades of green to catalyse and support all companies towards net zero and be able to assess collectively whether we’re “Paris aligned.” That means investors must be able to assess the credibility of company transition plans. Transition planning is nascent and of varying quality among companies. Some have a stated net zero objective, but are yet to set out a credible strategy or tactics to achieving it. Others have fully integrated climate strategies, governance and investments. Emerging best practice transition plans include: - Defining net zero objective in terms of Scope 1, 2 and 3 emissions; - Outlining clear short term milestones and metrics that senior management uses to monitor progress and gauge success; - Board level governance; and - Embedding metrics in executive compensation. Schemes such as the Science Based Targets Initiative and Transition Pathway Initiative are already supporting companies to develop transition plans and certifying them when they meet appropriate thresholds. An emerging differentiator in the investment community will need to make these critical judgments. Over time, investors will not just judge company transition plans, they too shall be judged. Investors should be obliged to alignment of their portfolios with the transition and disclose their position in a readily understandable and impactful manner. There are several ways to do this. At the most basic end of the spectrum, investors could calculate the percentage of assets that have a net zero target. However, as disclosures improve in the real economy, a more sophisticated option is to calculate the degree warming potential of assets in a portfolio. A “warming potential” calculation – or Implied Temperature Rise – estimates the global temperature rise associated with emissions by the companies in an investment portfolio. For example, one of the world’s largest insurers, AXA, estimates that its assets are currently consistent with a 3.1 degree path, and it has developed an innovative climate Value-at-Risk model to measure the opportunities as well as risks from the climate-related exposures of its investments. Rating the warming potential of assets and portfolios has a number of ancillary benefits, including signaling to governments the transition path of the economy, and therefore the effectiveness of their policies; and empowering consumers to give them more choice in how to invest to support the transition. After all, with our citizens, particularly the young, demanding climate action, it is becoming essential for asset owners to disclose the extent to which their clients’ money is being invest- ed in line with their values.

Conclusion A financial market in the transition to a 1.5 degree world is being built, but we need to accelerate the pace on the road to Glasgow. Now is the time for a step change to bring the reporting, risk management and return optimisation of sustainable finance into everyday financial decision making.

This will require new data sets from scope 3 emissions to exposures to climate transition risk, and new financial skills from scenario analysis to assessing implied temperature warming. The common theme will be determining who is on the right and wrong side of climate history. In that way, private finance can bend the arc of that history towards climate justice.

Endnote

1 UNEP Emissions Gap Report, 2019.