This article was first published by Oliver Wyman here.
COP27 focused on actioning key financial commitments.
Energy security, enhanced data and voluntary carbon markets will all feed into actioning financial strategies discussed at COP27.
Investors and financial institutions need to find the opportunities and navigate the risks a complex energy transition and changing world presents.
The mood at COP27 was subdued. The Ukrainian war, the energy crisis, rampant inflation, summer droughts and the sharp increase in the costs of capital for projects all weighed on investors' and business leaders’ expectations. Underlying this was concern that the ambition to limit global warming to 1.5 degrees Celsius is at risk.
Last year, at COP26, finance took centre stage with Mark Carney announcing an alliance of 450 banks, investors and other financial institutions' commitment to Net Zero. This year the story was more about implementation with a few new initiatives, such as the Indonesia programme, being announced. I saw three financial themes emerge:
1. Using Energy Security To Drive Green Policies
Investors and companies tried to unpick what the war in Ukraine and the energy crisis meant for the green agenda and investment opportunities. The US Inflation Reduction Act (IRA) looks likely to be a huge accelerant of a shift to cleaner energy. We know the package has put $374 billion at stake, but I suspect consensus might still underestimate the potential impact overall.
The money at stake is far higher. There is closer to $1 trillion of tax measures and related lending incentives to support energy security and a faster roll-out of renewables from all programmes, according to Kaya Advisory. What’s more, there is a 10-year clarity on incentives. The US is fast becoming one of the most attractive places to develop renewable technologies. Nearly every renewable company I met with is rewriting its medium-term plan — including a more resilient supply chain — to take advantage. Private equity and banks are starting to pivot hard towards investment opportunities.
While each country will make different trade-offs between energy security, energy affordability and environmental considerations, the focus on energy security is accelerating the dash to renewables in Europe, Japan and Australia. (We have seen a five-fold increase in the ambition of the European Union for this decade, although Europe was originally hostile to the US IRA.) But as many investors expect de-globalisation, continued geopolitical risks and European balance sheets to be extended, the US is winning out. Europe is well down the shopping list.
Although the dash to clean energy is not without obstacles. One wind power veteran told me he expects fewer deals closed this year in Europe than last, as companies haggle over overpaying for the prospective field and struggling to get attractive financing. This is far from ideal for Europe. There were tentative signs of using the EU’s strategic budgets to bridge these gaps — or risk projects unravelling.
Energy security means there has been a major re-assessment of the need for continuing fossil fuel investment during the transition. “One step back, but two steps forward due to energy security,” one CEO said. While climate campaigners challenged banks and investors still financing fossil fuels, what’s not often discussed is governments are often the first to lean on banks to keep funding them or even provide guarantees and funding themselves.
2. We Need Better Metrics
Rapid decarbonization requires sweeping changes, transforming industries and processes. Have we got the right measures to guard portfolios against transition risk and align to shifting opportunities and meet regulatory requirements?
Many investors and financiers are worried that initial measures and frameworks are struggling to keep pace with the change we need and won’t make the most of all the new data.
For instance, the penny has dropped that finance needs to finance emissions reduction, rather than simply have rough top-down nominal targets of falling financed emissions, which may indirectly push loans or investments into the shadows. “Real world, not paper portfolio, emissions reduction” was the mantra for many. But many early risk metrics may prompt the wrong behaviour. For instance, the EU green asset ratio, which divides loans into green or not green, misses the nuance of the transition and may inadvertently discourage the type of finance required.
Another challenge is shaping a set of metrics that can understand risks better or show progress on change, as well as ward off greenwashing. Many wondered if the UN high-level report scrutinising voluntary Net Zero commitments was so challenging that it may have the unintended consequence of stalling growth in public commitments on climate ambition by firms.
Conversations were alight with what might work. Investors debated what climate-aware metrics might support the transition and be consistent with domestic regulatory frameworks within which their firms operated. In a world where 80% of energy is still from fossil fuels, helping traditional emitters to transition their operations and supply chains is key. That’s why a focus on 'khaki finance,' or the greening of the grey, is crucial. In this vein, the idea presented by CPP Investments’ Richard Manley to divide a company’s emissions into three: those that are technically and economically feasible now; those that are technically, but not yet economically feasible; and, what is not abatable.
3. Voluntary Carbon Markets Could Boom
At COP27, I also detected a welcome sense of urgency about the need to establish carbon credits that are robust, tradeable and insurable, thereby generating reliable sources of revenue that can be channelled back into the financing of mitigation and adaptation efforts. A legitimate, credible and efficient market for carbon offsets would be a powerful way to drive more capital to projects that cut emissions or prevent them.
A key strand of conversations was how to overcome the limitations of today’s voluntary carbon markets and drive a larger market. Credits worth $2 billion traded in 2021 — almost four times the previous year — with around 500 million credits representing 500 million tonnes of CO2 equivalent changing hands, according to Ecosystem Marketplace.
Thus far, the buying and selling of these credits have been opaque. Prices aren’t standardised. Many projects don’t deliver what they promise. Buyers can’t be sure what they’re getting is real and sellers can’t be held accountable.
Competing bodies and narratives were on display. The Integrity Council for the Voluntary Carbon Market and the Voluntary Carbon Markets Integrity Initiative are trying to shape workable standards. Meanwhile, the McKenna report, which was extremely tough on corporate greenwashing, struck a more positive tone on carbon offsets. At COP27, Michael Bloomberg announced the Global Carbon Trust to help standardise credits.
Aside from philosophical and practical arguments about integrity or carbon credits — and exchange rates — it was striking that there was far more interest in carbon credits this year, especially for hard-to-abate activities. It will be intriguing to see how much finance leans into this potential growth. That said, there is recognition that this will be a small part of helping the $2 trillion in financing that emerging markets may need, according to a new report by Lord Nicholas Stern.
What Wasn't Discussed — The Dog That Didn't Bark
Finance and business were far quieter this year about targets and progress, which some campaigners put down to green-hushing. It also reflects the complexity of the trade-offs firms are trying to navigate, in building out data sets, as well as the ongoing distrust between finance and society.Mark Carney's alliance helped bring climate risk into bank and asset managers’ boardrooms and their day-to-day risk management processes, but it’s too easy to forget that no banks had science-based 2030 targets last year. Now 53 banks have them, although plenty of work lies ahead.Bottom line: in the last year there has been a profound shift in finance’s understanding of seizing the opportunities whilst navigating the risks of the energy transition, but a lot more is being done below the radar.
In 2022 macro — fueled by huge macro swings and policy inflexions — came back with a vengeance. This also means a huge repricing of climate-aware projects, despite the secular opportunity turbocharged by energy security policies. The energy crisis of the 1970s had long-lasting impacts. No doubt so too will today's. The key is to find the opportunities and navigate the risks a complex energy transition and changing world presents.