OIC financial institutions need a comprehensive approach to align with COP 28 outcomes

Since the Paris Agreement was signed at COP 21, one of the most important issues has been defining how the world makes “finance flows consistent with a pathway towards low greenhouse gas (GHG) emissions and climate-resilient development”. The global stocktake released at the end of COP 28 provides updates on the activities the financial sector will need to align in order to mitigate climate change by 2030.

These include:

• Tripling renewable energy capacity
• Doubling the rate of energy efficiency improvements
• Phasing down coal and moving towards net-zero-emission energy systems
• Following a just transition away from fossil fuels in energy systems
• Accelerating reduction of methane emissions
• Accelerating reduction of emissions from road transport through infrastructure and zero emission vehicles
• Accelerating increases in zero emissions technologies, particularly for hard-to-abate sectors
• Phasing out fossil fuel subsidies apart from those that address energy poverty and just transitions

Many OIC countries are emerging markets and developing economies (EMDEs), where financing all these activities is not possible using domestic resources alone and attracting external financing to implement many of these efforts at the scale required is challenging. Some countries are already facing high public debt levels that constrain their ability to access financing on terms that make these efforts feasible, while others find less sustainable options more feasible in the short-run regardless of the long-term negative impact that unmitigated climate change will have.

For financial institutions active in these markets, the need to support and remain resilient as the economy moves towards a just transition away from fossil fuels will be associated with a difficult mix of risks to manage. These financial institutions will be exposed to high-emitting assets facing transition risk directly from wider global efforts to align financial flows with an orderly transition to maintain the prospects of 1.5° C.

They also face physical risk to the assets they finance from the impacts of climate change and nature risk even during the transition. Their customers may find it challenging to maintain affordable access to the insurance coverage that often underpins that financing. Finally, banks and other investors rely on maintaining a social license to operate that is put at risk if they are not seen as promoting a just and orderly transition.

These transition risks, physical climate risks, social risks, and nature risks are not always in sync with each other. Unfortunately for financial institutions, there is no easy option such as increasing the share of renewable energy financing or commitment to end coal finance that will check all the boxes, even though both may be part of the solution. Banks’ approaches to sustainability and climate have unfortunately often been defined in silos based on sector-based approaches.

Each sector may have a different decarbonization pathway that a bank or investor may want to align with in order to measure progress against targets which are science-based, but the strategy for following the respective pathways may require considering a wider systemic perspective. To take an example, a bank may have a solar power construction project that it can finance as a contribution to the needed renewable energy capacity, which may provide it with a green asset on its balance sheet, but this will not contribute on aggregate to reducing emissions from electricity generation in the wider economy.

The reason new renewable energy could co-exist with increased emissions is that in many EMDEs, economic growth has been associated with rising electricity demand (often at mid-single-digit rates). Banks may be contributing to even higher demand growth rates with their green financing of electric vehicles not withstanding their relevance for economic decarbonization. However, the necessary investments in electrification will add a couple of percentage points to the electricity demand growth.

So, it’s not only ‘paper decarbonization’ (where high-emitting assets are divested by one entity with an emissions target only to be added to the balance sheet of an entity without such a target) that creates the situation where the trajectory of a bank’s own-financed emissions is out of line with the trajectory in the wider economy. The systemic impact of economic growth and electrification makes the emissions-reduction impact of renewable energy projects less effective for economic decarbonization on their own.

That doesn’t mean it’s not important for banks to finance renewable projects, but banks need to look at all the points where they can impact decarbonization of the wider economy, as well as their own balance sheet. Many different parts of their balance sheet may need to be involved in financing a ‘just’ transition that increases renewable energy on an absolute basis as well as a share of the economy’s energy systems, while also reducing the cost of dislocation that people face from the reallocation of economic activities it will entail.

Returning to the text of the global stocktake from COP 28, that means financial institutions working towards the Paris Agreement should:

• continue to expand financing of renewable energy
• look for financing opportunities of energy efficiency improvements
• develop just transition plans for exposures in regions and sectors dependent on coal (not just divestment from coal mining & electricity)
• make investments to lower methane emissions associated with agriculture, forestry, oil & gas, and waste management exposures
• increase financing for zero emission vehicles, including mobility options other than cars
• finance new investment in zero emissions technologies, particularly for hard-to-abate sectors, and
• evaluate the risks and mitigation options for customers whose economic viability depends on fossil fuel subsidies.

RFI has been working to produce information to guide these decisions with the release before COP 28 of an expansion of our financed emissions database. The database is open-access and we are also interested to discuss with banks, investors and other stakeholders how the estimates we have produced to fill data gaps across the GCC, Türkiye, Pakistan, Bangladesh, Malaysia and Indonesia can be used in practice.

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