The IIF Challenges The Finance-Centric ‘Theory Of Change’

Last month the Institute of International Finance (IIF) published a very thoughtful staff paper titled “Resetting the Debate on the Role of Private Finance in the NZ Transition.” The views of the IIF are important. It is the global association of the financial industry, with about 400 members (including commercial and investment banks, asset managers, insurance companies, professional services firms, exchanges, sovereign wealth funds, hedge funds, central banks and development banks) from more than 60 countries. “Its mission is to support the financial industry in the prudent management of risks; to develop sound industry practices; and to advocate for regulatory, financial and economic policies that are in the broad interests of its members and foster global financial stability and sustainable economic growth.” Given the central importance of the role the financial sector plays in climate change I was very interested in reading this report.

The report begins with eight key messages to policymakers:

· It is essential to achieve a just transition towards a net-zero economy to limit global warming.

· Policy measures are a fundamental pre-condition for a pro-growth, net-zero transition.

· Decarbonization will be enormously expensive, and the financial sector can support this but only when the economics make sense.

· These realities are not always reflected in what people expect from the financial sector.

· The prevailing finance-centric “theory of change” for the net-zero transition needs to be reassessed.

· Regulatory and supervisory approaches based on this theory of change can actually impede what the financial sector can do. Of special concern are these three trends:

1. Differences in approaches to transition finance

2. Conflation of financial sector activities to support the transition with climate-related financial risk

3. Overreliance on metrics based on financed emissions as risk indicators

· It’s time to reset the debate on what needs to be done to enable net zero-aligned business opportunities to develop and be financed.

· The emphasis should be on scaling up transition activity and demand for transition finance across the real economy.

The IIF then proposes three key priorities for moving forward:

“1. Strengthening real economy policy frameworks and developing national-level transition strategies

2. Ensuring that financial sector policy remains risk-based, and that it is not used as a substitute for broader net-zero policy measures

3. Enhancing the international financial architecture in support of transition finance in EMDEs.”

This is a seminal report, and I couldn’t agree with it more. With respect to the IIR’s point about the “conflation of financial sector activities to support the transition with climate-related financial risk” I’ve written about this problem. I think that “climate risk is financial risk” has become a sloppy, hand-waving invocation for a range of activities like some shareholder proposals and castigating investors who do not support them.

I’ve also written about some high-level differences between liberals and conservatives about how to deal with climate change. The former see the financial sector as leading the energy transition, a fundamental problem addressed by this report. The latter place more emphasis on technology and innovation in the real economy across a broad range of technologies beyond renewables, such as carbon capture utilization and storage (and see this interview with Claude LeTourneau, the CEO of Svante), direct air capture (see Part 1 and Part 2 interviews I did with Brian Marrs of Microsoft), geothermal, and small modular reactors. Neither side—and it’s admittedly an oversimplification to state this in a binary way—has all the right answers. Rather, it’s important that those with different theories of change work together to create stable, bipartisan solutions to create the appropriate regulatory environment that the IFF is calling for.

In that spirit, I’d like to give some examples of where these bipartisan conversations would be useful, although admittedly difficult to and to varying degrees. I will focus on a few examples of organizations—two of which are associations of financial institutions and two of which are NGOs—that strike me as being grounded in the “finance-centric” theory of change. I suspect that engagement with the investor associations will be easier than the NGOs but that doesn’t mean the effort shouldn’t be made.

The Glasgow Financial Alliance for Net Zero

The Glasgow Financial Alliance for Net Zero (GFANZ) is focused on ensuring the success of the Paris Agreement which is to keep global warming below 1.5°C. It is comprised of eight alliances across various roles institutions have in the financial sector (e.g., asset managers, asset owners, banks, and insurance companies) and has over 700 member firms in some 50 countries. It has very distinguished leadership. The Co-Chairs are Mike Bloomberg and Mark Carney, and the Vice Chair is Mary Schapiro. While I completely subscribe to the net-zero by 2050 goal, I am dubious that the way to get there is through net-zero targets by financial institutions and companies, many of whom are wondering just how to get there after signing up. I also think we should be realistic and just admit, which many climate scientists do, that we aren’t going to stay below 1.5°C and have a more honest discussion.

Over the past few years GFANZ and some of its alliance members have been targeted by some right-wing politicians for being part of a “climate cartel” and members voluntarily leaving the group. This is unhelpful political theater. Some members have voluntarily left the alliance they belong to. Reasons for firms are nuanced. Political pressure has probably played a role in some cases. In others the members may have decided they simply aren’t getting value from their membership. Simply castigating these firms for this decision by saying they no longer serious about climate change, as some NGOs have done, is equally unproductive.

Climate Action 100+

Climate Action 100+ “is an investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take appropriate action on climate change in order to mitigate financial risk and to maximize the long-term value of assets.” It is comprised of over 600 asset managers and asset owners and focused on 170 of the world’s largest greenhouse gas emitting companies. It has developed a Net Zero Company Benchmark tool which is uses to make an annual assessment of its focus companies. The group calls for “limiting global average temperature increase to well below 2°C above pre-industrial levels, aiming for 1.5°C” so a bit more nuanced than GFANZ.

But, like GFANZ, it has been attacked by right-wing politicians and called into various hearings in the House of Representatives regarding “climate cartels.” For example, “House Judiciary Committee Chairman Jim Jordan (R-OH) and Subcommittee on the Administrative State, Regulatory Reform, and Antitrust Chairman Thomas Massie (R-KY) demanded information from more than 130 U.S.-based companies, retirement systems, and government pension programs about their involvement with the woke ESG cartel Climate Action 100+.” While I’m not naïve enough to believe that engaging with conservatives focused on climate change would keep the politicians from having their fun, I’m sure these discussions would be a lot more constructive.

The Sierra Club

The Sierra Club describes itself as “the most enduring and influential grassroots environmental organization in the United States.” Here is its Mission Statement:

• “To explore, enjoy, and protect the wild places of the earth;
• To practice and promote the responsible use of the earth’s ecosystems and resources;
• To educate and enlist humanity to protect and restore the quality of the natural and human environment; and to use all lawful means to carry out these objectives.”

The organization calls on its millions of members to “to speak up and shout out” and suggests a number of ways it can do such as supporting pro-environmental legislation and regulation, letter writing, supporting campaigns, volunteering, and donating money.

It also conducts studies and writes reports, some of which are grounded in the finance-centric theory of change. One is a recent analysis,“LEADERS OR LAGGARDS? Analyzing major US banks’ net-zero commitments,” of the six major U.S. banks — JPMorgan Chase, Bank of America, Citi, Wells Fargo, Goldman Sachs, and Morgan Stanley — which have committed to reaching net-zero emissions across their financial portfolios by 2050. It also evaluates the banks’ 2030 emissions targets and exclusion policies. For the latter to be considered robust they must meet the following criteria:

· “Policy rules out project-level financing for any oil and gas projects

· Policy excludes corporate-level financing for companies expanding oil and gas, as defined in the Global Oil and Gas Exit List

· Policy phases out financing for the oil and gas sector overall on a 1.5°C-aligned timeline”

The report states that all six banks “are falling short in implementing best practices for interim emissions targets, exclusion policies, and disclosures to demonstrate alignment with their commitments to net-zero emissions by 2050” and are behind global peers. It concludes with making three recommendations: (1) raise ambition of 2030 targets, (2) strengthen sectoral exclusion policies, and (3) improve comprehensiveness and transparency of disclosures. All three of these are based on a very strict finance-centric theory of change which is to withhold bank capital from fossil fuel companies. It is difficult to see how banks can adhere to their fiduciary duty by withholding capital for economically sensible projects.

350.org

350.org was founded by climate activist Bill McKibben and “a group of university friends.” It has a twofold strategy of “resisting fossil fuel projects and its enablers, and advocating for a world powered by the sun, wind and people” and means to accomplish this strategy by stopping fossil fuel projects everywhere, financing renewable solutions, and powering up just and accessible renewables. In order to stop fossil fuel projects the group puts pressure on investors not to invest in these companies and banks not to provide them financing. For example, its “Fossil Fuel Divest Harvard” campaign “won a major victory in 2021 when we got Harvard to divest its endowment from fossil fuels. But we are still fighting for Harvard to become a true climate leader.”

McKibben has also played a major role in organizing faculty and students at a number of universities to put pressure on the asset manager TIAA with assets under management of around $1.35 billion. It manages the retirement accounts of over five million employed and retired university faculty. A group of 800 faculty have organized TIAA Divest! (“It’s time for TIAA to divest from climate catastrophe”) and wrote a letter to the U.N.-backed Principles for Responsible Investment demanding their membership be rescinded. The request was rejected. Calls for divestment are another strong version of the finance-centric theory of change, here focused on investors. I am not aware of any studies that show that divestment has had a material impact on global warming by preventing fossil fuel projects that make economic sense.

Conclusion

At its core the finance-centric theory of change argues that the financial sector can lead the energy transition by how it allocates and withholds capital. For investors it has a heavy focus on net-zero targets, both for themselves and for the companies in their portfolios, and engagement for encouraging companies to reduce their carbon emissions. In some cases exclusion and divestment is preferred. The NGOs are all about exclusion and divestment in fossil fuel companies. Outside of renewable energy, the finance-centric theory of change doesn’t pay much attention to other technologies.

As the IIF report points out, the financial sector has to follow, not lead, the real economy. Policies are important. One I favor and have written about is a global price on common. I think this would be more effective in reducing carbon emissions than targets and disclosures, although both of these can play a role. While not easy by any means, I think there is a path to a bipartisan agreement on pricing carbon. The challenge here is whether the types of organizations I’ve reviewed here would be willing to participate in this conversation. Continuing to demonize the fossil fuel industry can mobilize those who share this view. It will simply meet resistance by those who don’t want to hold it to account at all. Nothing good can come of this. Better is that everyone read the balanced and thoughtful IIF report and act accordingly.