Why Financial Sector Regulators Need to Embrace Net Zero Transition Planning
COP27 could not come at a more urgent time. Carbon emissions were at their highest ever in 2021. This is despite warnings from the United Nations’ Intergovernmental Panel on Climate Change that global emissions must be halved by 2030 to limit the rise in Earth’s temperature to 1.5 degrees Celsius. With so many more companies around the planet recognizing the need to reduce their carbon footprint, why is the world falling short?
The problem: We are missing a step. When it comes to emissions, countries and businesses are making promises that they haven’t figured out how to fulfill. The missing element is transition planning — a set of goals, actions, and accountability mechanisms to align with a pathway to net zero that can provide the details on how to proceed toward lower emissions, and ultimately, net zero. Without that step, investors, consumers, regulators, financial institutions, and even the companies themselves will have only a tenuous idea of whether progress on emissions is being made. And if we can’t assess progress, how can we make any?
We are coming to the painful recognition that pledges are not actions. The International Energy Agency identifies an “implementation gap” between government pledges made at 2021’s COP26 that would help limit warming to 1.7 degrees Celsius and current policies in place that would only curb it at 2.5 degrees. This is despite recent public policy supporting net zero objectives, such as REPowerEU, which provides accelerated energy transition strategies in response to the Ukraine invasion, and the landmark Inflation Reduction Act in the US.
Given the significant role that the financial sector can play in creating a net zero economy, financial regulators and supervisors must become champions of transition planning. They can do this by issuing guidance on what constitutes a viable transition plan. They can make such planning mandatory and/or embrace the information that transition plans can provide within their existing oversight framework. There are a variety of steps they can take, but the result must be to help the global economy move toward actual emissions reductions and not just promises of what will be done years from now.
Many will benefit. For instance, regulator-endorsed transition planning would help investors to identify firms with credible plans and then more effectively allocate capital to low-carbon investment opportunities. This can, in turn, help to scale up transition finance — growth that is very much needed if the global economy is to reach net zero.
According to the latest research from Bloomberg’s New Energy Finance, clean energy investment would need to be four times greater than current spending on fossil fuel development to reach the goals set by the 2015 Paris Agreement. Today, that ratio is closer to one-to-one. If regulators embrace transition planning — even by simply offering guidance on what constitutes a “credible” plan — they will provide clarity to investors on government expectations around transition finance and reduce fears of reputational risk or greenwashing accusations.
Several central banks have identified transition planning as key to managing climate-related financial risk and enabling an orderly transition to net zero.
Transition plans can also help financial regulators to deliver on their existing policy objectives. At a microprudential level, disclosures of corporate transition plans enable a clear view as to how a particular company will act in the face of climate-related risks, and which firms or sectors are left vulnerable. At a macroprudential level, widespread disclosures of corporate plans can create an understanding of potential systemic risk.
In fact, several central banks, including the Monetary Authority of Singapore, the European Central Bank, and the Bank of England, have identified transition planning as key to managing climate-related financial risk and enabling an orderly transition to net zero. And the Network for Greening the Financial System is exploring potential ways for supervisors to handle oversight of transition plans to better address transition risk.
Some jurisdictions are making positive momentum with mandatory transition planning. For instance, transition plans will be required in the United Kingdom and the European Union as part of the proposed Corporate Sustainability Reporting Directive. G-7 countries have agreed to make the Task Force on Climate-Related Financial Disclosures (TCFD) reporting mandatory, which also includes transition plans.
Yet in most jurisdictions, the need for transition planning is underestimated and often overlooked. This is a missed opportunity.
Financial regulators and supervisors need to appreciate the significance of the information these plans are providing, and how best to embed guidance on the type, granularity and frequency of information that transition plans should include. Indeed, regulators and supervisors have an early role to play in ensuring that the information transition plans provided can be actively used for risk management purposes to protect the global economy as it decarbonizes.
Foundation Being Laid
The good news is that regulators do not have to start from a blank sheet when drawing up guidance or requirements. For instance, in the run-up to COP27, the Glasgow Financial Alliance for Net Zero (GFANZ) released a transition planning framework that financial institutions of all kinds can use when creating their own plans. This framework could be embraced by governments and standard setters as they look to establish official guidance or requirements.
But GFANZ has company. The International Sustainability Standards Board and the G20 Sustainable Finance Working Group are offering guidance on transition planning disclosures and principles for transition finance, respectively.
Global coordination and interoperability of any requirements or guidance will be key to success. Financial regulators and supervisors must work together, in partnership with standard setters, to converge on how they can best embrace transition planning to support delivery of a net zero economy, within their mandate.
If the world is to rapidly decarbonize and limit temperature rises in line with the Paris Agreement, regulators around the globe need to better incorporate net zero oversight into their standing regulatory agenda. It has to become for regulators a corporate requirement as important and expected as filing quarterly reports.
While setting net zero targets and committing to reducing emissions is an obvious first step, regulators must support organizations to take the next step — ensuring that organizations have a clear and credible plan to reach net zero.