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How COP26 will be relevant to future financings: Reflections on COP

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Conduit Tim
Tim Conduit

Partner

London

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Scott Neilson

Partner

Tokyo

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Yannis Manuelides

Partner

London

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Rachel O'Reilly

Counsel

London

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Sauzay Arthur
Arthur Sauzay

Counsel

Paris

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18 November 2021

Following all the hope, the pictures of dignitaries drinking Irn Bru and the hype surrounding COP26, one of the key questions is whether the negotiations will make a tangible difference to the financing of climate mitigation and adaptation actions. One of the key points coming out of the summit was the need to align financing with the Paris Agreement, and particularly the urgent need for action towards net zero greenhouse gas emissions by mid century. At lot will need to be done between now and 2030 to “keep 1.5 alive.”

The financing required for the transition is not the same in all cases. Different contexts result in different financing needs. In addition, “financing” is a very broad term in this context. Hence many different concepts are combined into brief statements in the final text coming out of COP26, which may leave you wondering what was actually being said.  You are not alone. 

We explain what is behind the statements in the final Glasgow Climate Pact, what needs to be done and what it means for you.

What are the financing needs?

The financing needs are different for different countries, sectors and outcomes. Is what is being financed an asset with cash flow revenue derived directly from it (like a solar power project in California) or not (like a sea wall in Manila)? Who is the borrower (is it an energy tech start-up, a project company or a municipality or the government of a whole country?), what is the credit of the borrower and what is the political risk attached to it?  Is the technology tried and tested or emerging? You will have a lot more trouble finding financing for a hydrogen project in Yemen than you will for a solar project in California. Who finances the need and the type of finance all varies. None of this is rocket science but it all gets mixed up when people talk about “climate finance”.

In addition, is it “climate finance” in a developed country (which may be easier) or a developing country (which may have more risks), is it for “mitigation” (reducing greenhouse gas emissions) or “adaption” (improving resilience like building that sea wall in Manila). 

In a specific section devoted to adaptation finance, the Glasgow Climate Pact notes with concern that current provision of climate finance for adaptation remains insufficient, and urges parties to achieve a balance between adaptation and mitigation funding, doubling provision by 2025. Developing countries are calling for adaption financing because they are not in control of the outcome of climate change, they don’t produce much in the way of emissions (the G20 produce about 80%) and they are the countries which more often than not are more vulnerable and will suffer the consequences of climate change the most. 

They also have to pay much higher interest on loans than developing countries and it eats into their budgets for health, education and shelter. That is why they want more in the way of grants and other “highly concessional forms of finance” (especially as they did not cause the problem). There are increasing calls by developing countries for “compensation” and the language of the Glasgow Climate Pact uses the language of damages and compensation (“loss and damage”). 

Likewise there is the $100 billion per year pledge by developed countries which has never been met (with only $79.6 billion achieved in 2019) but the text coming out of COP26 was watered down (from saying it will be met from “2023 at the latest”) to urge developed countries to deliver on the $100 billion “urgently and through to 2025”. This money is essentially multilateral (i.e. IFC, EBRD, ADB) and bilateral financing from public development banks and export credit agencies. Importantly the final text emphasises the importance of transparency in implementation, which has been lacking. Some countries have resprayed their development budgets as contributions to the $100 billion, which was not the idea. The idea was that the $100 billion was additional to the funds countries were already providing for development.

So you can understand the gap between the $100 billion per annum and the ask from developing countries, a representative group of developing countries requested $1.3 trillion per year (being half of the estimated $2.6 trillion per year needed for transition) with 10% in grants and a 50/50 split of the rest between mitigation and adaption. This was rejected.

What are the financing channels and issues with them?

The financing channels available to meet the climate financing needs of developed countries are in place, with the key change coming out of COP26 being increased alignment of banks and private credit with the Paris Agreement.

However, as a consequence of the Global Financial Crisis, the rules around the level of capital banks have to carry (called the capital adequacy or Basel rules) were changed in a way that penalised banks for long term financings.  This has had a negative impact on the financing of energy and infrastructure projects, which are underpinned by longer term revenue streams and therefore financings. These rules constrain banks helping to finance the transition in an economical way (as they need to pass on their increased cost of capital associated with longer-term debt). Long-term debt also brings forward future issues because they are a risk to the recovery of the debt. This brings rigour to risk analysis by the banks, which are well equipped to channel financing to big global efforts in shifting the global energy mix and the infrastructure needed to support the transition. Not focusing on this is an opportunity lost and will only serve to push financings to the capital markets, which are less prepared to finance these kinds of projects in developing countries as matters stand. Insurance companies (under the EU’s Solvency II) and other buyers of long term debt in the capital markets are not subject to the same capital adequacy constraints as banks (under Basel III). No wonder the multilateral agencies and bilaterals are having trouble mobilising private financing.

Multilateral agencies and bilateral public financiers (like development banks and export credit agencies) are a key channel for financing in developing countries. However, even if all financing from the multilaterals was dedicated to decarbonisation and resilience, only 4% of the financing needs for full climate transformation would be covered, so the bilateral public financiers, banks and private credit also need to be brought along. Unfortunately, to date, this kind of financing has been more focused on specific projects than on systematic intervention. There are also less “good” bankable projects than there is money. More needs to be done to catalyse projects and support private sector financing into them as a result. This can be done through the multilaterals focusing on systematic interventions such as bolstering the ability for governments in developing countries to prioritise projects, de-risk them (i.e. through feasibility studies, reducing viability gaps, lending in local currency and adding first loss layers of debt) and improve their risk allocation (including supporting governments with funds for high quality advisors). 

However, it appears that governments have not fully integrated the activities of their export credit agencies, which play a key role in developing countries, in their commitments towards the Paris Agreement and the Sustainable Development Goals. At a time when the activities of public finance institutions and instruments are increasingly scrutinised for their alignment with the global goals, this gap stands out.

How can the system be adapted to bring it all together?

None of these pledges or the cash committed will be delivered unless they can be properly harnessed to robustly promote climate mitigation and adaptation. This will only be achieved over time through measures such as climate stress testing for financial institutions, climate-related disclosures across the economy based on internationally consistent standards such as the Taskforce for Climate-Related Disclosures and asset managers disclosing how their portfolios align with net zero. These don’t hit the headlines like a $100bn pledge, but they will almost certainly determine whether climate finance becomes an international reality.

Mark Carney, UN special envoy for climate action and now chair of the G-FANZ (not, as its name might imply, the next K-Pop phenomenon, but the Glasgow Financial Alliance for Net Zero) underscored this when he said “These seemingly arcane - but essential - changes to the plumbing of finance are moving climate change from the fringes to the forefront, and they will transform the financial system in the process.”

Disclosure and harmonisation is an essential step to the mobilisation of funds by investors for climate finance.

As a starting point, we need to know what climate finance is – and what it isn’t. The final COP26 decision on Matters relating to the Standing Committee on Finance bemoans “the lack of a multilaterally agreed definition of climate finance”. The EU has its Taxonomy, which will help identify “environmentally sustainable” activities in detail and objectively, with several other countries implementing or considering their own taxonomies. At COP26, the EU, China and other countries accounting for 55% of global emissions have been discussing a “common ground taxonomy” with the goal of creating a common set of features for classification frameworks. The recent announcement from the International Financial Reporting Standards to launch the International Sustainability Standards Board represents an attempt to create a globally accepted baseline for climate change reporting. The stage is set for a battle of definitional influence.

In terms of the capital adequacy rules for banks, the EU’s suggestion of a “green supporting factor” in the capital adequacy rules for banks and insurance companies is still a long way from reality.

Also important is a clear process to move away from existing fossil fuel investments. The historic commitment from 20 countries at COP26 not to finance new international fossil fuel assets is only one side of the coin. The other is to set targets, as Mark Carney said, “for winding down stranded [fossil fuel] assets” to allow for an orderly transition of the global financial system away from those investments.

The plumbing of this new system will only work if it is, and it is seen to be, robust and transparent.  The recently issued EU Green Bond Standard hard-wires a requirement for third party verification of a bond’s green classification, and sustainability claims in relation to investment products will need to substantiated under the new UK proposals.  Independent assessments by auditors of corporate disclosures were highlighted by the Financial Times as the front line of this work. Arcane? Maybe, but with investor scrutiny moving from public companies to private capital too, more essential than ever.

What will be the challenges for financiers going forward?

As countries legislate their net zero targets as, for example, the UK, the EU and South Korea have already done, a growing wave of regulation will wash over financiers and their global operations. This will be a growing tsunami as countries are coming at the issue from many different angles and, so far, we are seeing different countries take different approaches even on the same topic. You are going to need a lot of help with this and getting up the curve earlier will be better so that you can adjust your business in advance and not be forever trying to catch up with an ever increasing regulatory burden. This will also present opportunities for legal tech developers, as we are already seeing (with for instance, Greenomy, a start-up with technology to help clients comply with their sustainability disclosure obligations).

In addition, financiers will face increasing uncertainty with their asset portfolios as costs are increased for some businesses or projects (think the introduction of carbon taxes and border adjustment mechanisms) or be left with stranded assets as a result of hard deadlines to phase out certain technologies (the internal combustion engine or coal fired power plants), or fundamental decline in the market for their products or services. Coal fired power plants will become a domestic business, with international players having to withdraw. Likewise some businesses will be catalysed by subsidies. Imagine if the $5 trillion in fossil fuel subsidies per annum (per the IMF) are reallocated away from fossil fuels and aligned with the Paris Agreement goals as the draft text from COP26 calls for and the final text kind of, sort of, calls for. That is a very real possibility over the next 8 years.

Development banks and export credit agencies will be come under increasing pressure to align their financing with the Paris Agreement goals and be transparent about what is “climate finance” and “non-climate finance.” What’s in a name as Shakespeare said centuries ago!

Campaigners who were involved in the ruling by the Hague District Court against Shell in May 2021 ordering Shell to align its business strategy on the Paris Agreement goals have threatened to start also litigating against the financial institutions that make emissions and fossil fuel projects possible. Are you ready for that?

An agreement on the “rule book” for carbon markets will unlock carbon markets. 

Let us know if you need help navigating the increasingly potholed road forward.