What would a green financial system that encourages net zero greenhouse gas emissions look like?

It would have to reduce the risks of high-carbon assets while simultaneously scaling up capital for the low-carbon transition. But who would set the ground rules, and what role would there be for investors? It would mean a rechanneling of trillions of dollars of private capital. Can this be done in a way that doesn’t threaten the world economy?

These are key questions in an ongoing dialogue among global business leaders. The discussion became public last month at a one-day summit meeting here that showcased solutions and highlighted actions taken by a growing number of pioneering bankers, insurers and institutional investors. They had come together under the auspices of the United Nations and the French government to suggest low-carbon policies. Then they were asked how the new policies might work if they were applied together.

“The question is how to shift trillions,” was the way France’s finance minister, Michel Sapin, put it in his opening speech.

At this meeting, unlike at climate change meetings in previous years, there was a new array of policy tools to draw upon. They ranged from placing “green financing” on balance sheets to getting banks to set up strategies for “environmental risk management” and pushing the insurance sector to pay closer attention to climate risks in its investment portfolios.

Public authorities are doing their part, insisted Sapin, citing a decision by the Group of 20 major economies to set up climate risk analyses of the financial sector as an important indicator of how attitudes have shifted. The U.N. Green Climate Fund has signed up $4 billion in contributions, with the 50 percent threshold for triggering payouts sure to be reached before the U.N. climate conference convenes in Paris in December. As for the French government, Sapin took evident pride in announcing the passage of an energy transition bill mandating the measurement of carbon footprints for all institutional investors in France.

French insurer gets applause

Observers are calling the new French law a potential game-changer. Yet the loudest applause was reserved for Henri de Castries, chairman of Axa, who announced the withdrawal of the company’s investments in coal by the end of the year. France’s biggest insurer will publish by 2016 the carbon footprint of its assets, estimated at €600 billion ($656 billion). Castries also pledged to triple the amount of green investments over the next five years to €3 billion ($3.28 billion).

This is the kind of action organizers of the summit were looking for. Still, if Axa gave an example of how to move beyond dialogue, it’s also clear that far more is needed.

The World Bank estimates that over the next 15 years, the global economy will require $89 trillion in infrastructure investments across cities, energy and land-use systems, and $4.1 trillion in incremental investment for the low-carbon transition to keep within the internationally agreed limit of a 2-degree-Celsius temperature rise.

However daunting the task may be, the steps to take are now fairly clear and well-understood.

One step would be stress testing, engaging pension funds and companies to examine if they hold carbon-intensive assets on their books, said Martin Skancke, who spoke on the first panel and is chairman of the Advisory Council of Principles for Responsible Investing, a U.N.-supported initiative that has helped formulate a widely followed voluntary protocol of responsible investment criteria.

Next, divest where appropriate from high-cost, high-carbon assets and reinvest in new instruments like “green bonds” or equity indexes that exclude companies with carbon exposure.

This stripped-down framework—to measure and disclose, engage, mitigate and invest—is largely noncontroversial.

“We have been doing that at AP4,” said panelist Mats Andersson of the Swedish National Pension Fund (AP4). Since 2012, the fund has reduced its carbon footprint by 3 percent by customizing a low-carbon equity index that jettisoned the 150 worst polluters. This is not divestment, as some would call it, but rather is a more gradual approach to excluding companies with carbon exposure.

Exposing ‘carbon bubbles’

The big challenge—and a critically important first step goal—is the “hardwiring of climate risk into governance structures.” The panelists said it is “remarkable” that there does not yet exist a consistent format by which emitters lay out their assessment of their physical, technical and regulatory risks.

A Climate Disclosure Framework offered up by the CDP and World Resources Institute, and backed by the five major accounting firms, is gaining ground, but falls short of what the French have done: the mandatory reporting of Scope 1 and Scope 2 emissions. Thus, a company like Exxon or Shell can mislead investors by applying a $60 carbon price based only on emissions linked to the operation of its facilities, and not to its product, explained Anthony Hobley, president of the think tank Carbon Tracker.

A London-based group that applies financial analysis to environmental issues, Carbon Tracker has spent the last three years highlighting the risk of overvalued energy companies that might be stuck with “stranded assets.”

“Yes, a carbon price is important to drive the scale we need,” said Hobley. “And, yes, there is a moral and ethical issue, but also there’s a financial risk issue under current policy.”

So far, divestment has been limited to coal mining stocks, which are an easy target because they make up less than 1 percent of the global market value of fossil fuel stocks, according to FTSE. Oil stocks, by contrast, are a part of most investor portfolios. A purge of these stocks has yet to occur, but with the plunge in oil prices, a slew of projects now look to be unprofitable, arousing fears of a panicked reaction among capital markets.

“It doesn’t represent risk today,” said Hobley of the carbon bubble concept. “There is no carbon bubble bursting today that would create a financial crisis.”

Yet, he continued, there is a “huge risk” to value, as well as a closing window within which to act in an orderly manner. “We are at the last possible moment to exercise that choice,” warned Hobley.

“We can choose an orderly transition over the next 20 to 30 years … while smartly growing the clean side, or we can put off action as we did at the 2009 U.N. climate talks in Copenhagen and kick the can down the road.”

Hobley advocated for continued shareholder engagement, but only with the threat of divestment as a necessary alternative.

“It’s important to understand that if you talk about ‘divestment,’ it’s useful at the level of individual portfolios,” said Skancke. The threat to asset value is real, he added, but all investors cannot divest simultaneously. “It requires someone at the other end buying those assets,” he said.

Skancke pointed to successful shareholder resolutions requiring BP and Statoil to stress-test portfolios against the 2-degree target.

“Engagement is about engaging on capital structure and individual policies that directly affect their investment policy,” said Skancke. “This is not a revolutionary concept. This has been at the center of corporate governance for 400 years. We’re just now applying it to a new set of problems.”

Using green bonds and modified insurance portfolios
If the top financial layer includes big institutional investors and banks, then a second tier of untapped finance lies with insurance companies extending policies to the most vulnerable populations in the developing world.

Through the use of mobile phone-based services and micro-credit institutions, a great deal of insurance has already been extended to what Jim Roth of LeapFrog Investments calls the “emerging consumer.” Over the past eight years, the social investment fund has backed a portfolio of companies selling insurance products totaling $40 million, of which $33 million went to low-income consumers in Africa and Asia.

“It’s an optimistic story,” said Roth, noting that the vast majority of those consumers had never owned insurance before.

“A key difference is they have less money. So the kinds of insurance policies they can buy tend to have lower premiums and less benefits.”

Governments in the developing world are also now pooling their resources into sovereign insurance funds that make payouts for climate adaptation programs, said Fatima Kassam of the African Risk Capacity Insurance Co., a specialized agency of the African Union. Niger received a $25 million payout last year, having paid in with a $3 million premium. “Governments are coming together to change the model on disaster management,” said Kassam.

As for green bonds, an exponential growth in low-carbon investments is possible, but risks abound in how the ramp-up is managed. Greenwashing is one potential problem, noted Thomas Vellacott, CEO of WWF Switzerland. The bonds have to be labeled correctly, with standards still to be worked out.

Second, the segment has to move beyond niche status. It’s a challenge that requires the mainstreaming of environmental and social criteria, as well as tracking finances and the correct pricing of risk. Last is the issue of incumbents not transforming their models fast enough to provide the necessary finances and the tangential impact that has in attracting new market entrants.

“The scale of finance we need lies in the trillions,” said Jonathan Taylor, vice-president of the European Investment Bank (EIB), currently the world’s largest financier of renewable energy. Thus far, the EIB has raised €9 billion in green bonds, financed partly with investments from pension funds and insurers.

“Public finance can play a key catalytic role,” added Taylor. “But we also need private-sector flows.”