Countdown to COP26 | Financing the transition to net zero

The number of countries announcing ambitious climate targets in the run up to COP26 continues to grow. The question then arises – how will the transition to net zero be financed? The answer to this question plays a huge part in assessing the attainability of climate targets, and is a central area of focus as the November conference approaches.

Osborne Clarke explored this issue in a recent webinar – the third in a series of Countdown to COP26 webinars – held in partnership with our Scottish friends, Harper MacLeod. You can find out more about the first webinar which looked at the significance of COP26, and the second webinar which looked at nature-based solutions and land use.

What has changed recently?

Over the past three months we have seen mounting political will to take action on climate change on an international scale, with a number of countries continuing to make promising climate commitments in the run up to COP26.
In the sixth Carbon Budget last month, we saw the UK government commit to reducing greenhouse gas emissions (including the UK's share of aviation and shipping emissions) by 78% by 2035, as compared with 1990 levels. A similar theme emerged at the Climate Leaders' Summit, which concluded with all of the G7 countries having committed to making significant emissions cuts over the next decade.

As cooperation amongst countries throughout the developed world continues to build, we are now seeing increased emphasis on the need to mobilise finance commitments to assist developing countries in mitigating, and adapting to a reduction in, greenhouse gas emissions.

The ESG agenda

Throughout the finance industry, we have seen a shift in decision-making, with criteria linked to ESG (environmental, social, governance) becoming more important. The pivotal role of non-financial performance indicators in investment decision-making is set to retain its prominence in UK investment markets. Companies will be driven by a commitment to future-proof their businesses (and ultimately their reputations) by aligning their values with those of their stakeholders, who are increasingly aware of the climate risks we face as a society. Consideration of "E" criteria will shortly become mandatory, with the UK government expected to start implementing the recommendations of the Task Force for Climate-related Financial Disclosures in 2022. From a lending perspective, this alignment of values is anticipated to translate into declining funding options for those businesses that fail to appropriately consider ESG in their decision-making.

As the emphasis on ESG continues to grow, there are increasing calls for improved data management and reporting standards to assist with the quality and consistency of reporting on investments. In the absence of consistent reporting standards and guidance, there remains scope for confusion and uncertainty around how "green" certain initiatives actually are, prompting anxiety among investors.

We have however already seen some movement in the right direction with the development of the Green Finance Research Centre and the Green Finance Education Charter, both of which aim to equip investors and financial institutions with the necessary information and guidance to better evaluate climate risks.

Financing green

Over the past 12 months, the UK has created a number of initiatives to fund projects exploring how we might be able to effectively decarbonise our society through investment in new technology and energy efficiency measures. The Ten Point Plan clearly pointed to the intention to allocate significant public spending to encourage private investment into projects that will help us reach net zero, with grants such as those allocated under the Industrial Strategy Challenge Fund helping to kick-start this. However, funders need to understand the longevity and nature of government investment in order to quantify (and mitigate) the risks on return.

Institutions such as the UK Infrastructure Bank (UKIB) are now being called upon to bridge the gap between ad hoc funding and long-term bankable investments by providing mezzanine finance, guarantees, or some other form of support to projects where commercial lenders and traditional investors are currently unable to commit to funding alone, usually due to technology risk or an irregular cashflow profile.

With appropriate endorsement of the UKIB, funding a wide range of low carbon projects as well as offering a raft of green finance products could become an increasingly prevalent feature of the commercial financing sector.

How can the UK become a leader in green finance?

The upcoming issuance of the UK's first green sovereign bond is a welcome step forward for the green finance sector. A continued programme of green bond issuances, intended to establish a green curve of ongoing supply and demand for green issuances, can help the UK to demonstrate leadership on the green finance agenda in the run up to COP26.

Once established, the UK's sovereign green bond framework could have a catalytic effect on the wider sovereign bond market and attract new investors, further fuelling the increasing interest in ESG investments from the general public and diversifying the UK's investor base.

There are obstacles to the government's plan to position itself as a green finance leader. The lack of clarity on what constitutes a legitimately green investment and the absence of detailed guidance on green financing remain significant challenges to overcome. The appetite for increased green financing is there, but more action is needed for the UK to fulfil its green finance ambitions.