Turning commitments into action on the 1.5⁰ pathway

More than 500 institutions within the Glasgow Financial Alliance for Net Zero (GFANZ) have committed to reducing their and their clients’ emissions to net zero by 2050—however, the time has now come for these commitments to be translated into action. In this episode, Mark Carney, co-chair of GFANZ, talks about GFANZ to our host Cindy Levy, a senior partner at McKinsey & Company. They discuss the challenges facing financial institutions on this journey and how GFANZ’s masterplan can help speed up the net-zero transition.

This podcast was recorded as part of the Transition Finance towards net-zero: Scaling blended finance conference held in Singapore on 4 October 2022. The event was organized by the Monetary Authority of Singapore.

Cindy Levy: Mark, thank you very much for being interviewed as part of the conference hosted by the Monetary Authority of Singapore and supported by GFANZ. Where is GFANZ now in terms of presence, shape, and geographic representation?

Mark Carney: We launched the Glasgow Financial Alliance for Net Zero (GFANZ) originally at President Biden’s climate summit in April 2021, which was the United States’ effort to accelerate climate action into the Glasgow Summit. The intention was to build up GFANZ—which at the time had around $30 trillion in assets—in Glasgow, and span all financial institutions: banks, insurers, asset managers, asset owners, key providers of financial market infrastructure, export credit agencies, and others. We wanted all aspects of finance, not just scale, but breadth as well, to focus on developing the tools, frameworks, and markets for the financial system to provide capital to get emissions down on the path to 1.5⁰.

At Glasgow, we launched with about 450 institutions and we have over 500 now; then, we had about 45 countries and it’s almost 50 now. Most variables and measurements in the financial system have gone down over the past several months, however, the GFANZ assets still exceed $130 trillion. The important thing to recognize is that these institutions all have made commitments that the emissions of their clients and their investments will be at net zero by 2050, but also bringing that forward, that they will contribute to the almost 50 percent emissions reduction that the world needs to accomplish by 2030.

We’re looking to grow GFANZ, as you would expect, and we are focused on making sure that it is tailored to different regions. But we also need to turn the commitments into action, and that requires a series of measures to operationalize those commitments. This hasn’t been done before, and it needs to be done rapidly.

Cindy Levy: There was a series of publications released recently that covered the GFANZ masterplan—the sectoral pathways, guidance for transition planning for financial institutions, portfolio alignment measurement, and managed phaseout as a net-zero tool. How do these fit together?

Mark Carney: We need all these components to work together to make up an effective masterplan. The financial institutions have made a commitment that they will manage their financed emissions (that is, of their clients and their investments) toward and then ultimately on a pathway consistent with the world’s goal of limiting global warming to 1.5⁰. So those financial institutions need net-zero transition plans for themselves, too. There are different types of financial institutions in GFANZ, from banks to asset owners, insurers, and everybody in between, and we want to have a shared level to those plans in terms of the type of information and governance, so that they’re consistent across all stakeholders.

But, of course, finance is not an end in itself; it exists to serve others in the real economy like companies and governments. What do financial institutions that are committing to trying to manage their clients’ emissions towards net zero want with those entities? In many ways, this is the transition plan analog of the Task Force for Climate Related Financial Disclosures (TCFD), where the aim was to focus on decision-useful information—that is information to make judgments about climate risk. It’s an efficient and effective process.

Sectoral pathways relate to things like science-based targets for certain sectors—the steel sector, transport, certain elements of the transportation sector, for example. The key point here is we need to have some consensus about how to use those pathways. GFANZ is not reinventing these; we’re rather letting the experts provide the pathways, and we give guidance on how to use them.

The next point is managed phaseout. We’re all aware that if we’re going to reach the 1.5⁰ objective, there will be substantial stranded assets. We see it most obviously in fossil-fuel generation such as coal, but there will be other examples. The issue here is that we need a framework so that responsible financial institutions (like the GFANZ members who are looking to be part of the solution) can finance the wind-down of those assets. In other words, keep those assets in the system. There’s financing that can help support the sectoral pathways’ just transitions.

The last element of this framework is how to bring all the parts together, which is to do an assessment of what’s called portfolio alignment. Because ultimately, whether you're a bank, insurance company, or asset manager, you will be judged over time as to what extent your financing portfolio is aligned with the transition to 1.5⁰.

Cindy Levy: Sectoral pathways are meant to bridge the gap between the science and the industrial action that every sector should be taking to decarbonize. Could you talk about the application of sectoral pathways, in particular in Asia?

Mark Carney: First, not all sectoral pathways are the same. There are regional differences in terms of starting positions, and this needs to be recognized so that the incentives are aligned to let finance flow into action.

Second, there are some sectors that are not yet covered or are covered to different degrees by sectoral pathways. Let me explain: in some of the hard-to-abate sectors there are science-based pathways by people such as the Transition Pathway Initiative or Science Based Target’s (SBTi) net-zero standards. But in other industries, for example the oil and gas sector, there is not one of those pathways. We have higher-level macroeconomic sectoral pathways that are driven by the carbon budget, not by the technological frontier. It’s critical to map those into pathways that can be used by the financial sector. GFANZ will soon publish initial guidance—not the final word, by any stretch of imagination, but initial guidance around these issues to help develop a consensus.

Third, there are opportunities to improve the sectoral pathways, and this can relate to Asia. There are a variety of pathways out there and we need to standardize and clarify the definitions that different pathway developers use for assumptions about carbon pricing or emissions covered. Next, we need greater clarity around to what extent decarbonization in a certain sector is dependent on other sectors, which is very often the case. Finally, access to underlying data and assumptions used for the pathway is critical.

Fourth, there needs to be additional granularity across pathways to cover time intervals and regions. For example, the outlook for a pathway in the power-generation sector in Europe or in the United States is different than that of other regions and countries. We need that level of granularity of the pathways within Asia. It’s part of the role of bodies such as GFANZ’s Asia-Pacific network to create tools tailored to Asian financial institutions, to make sure that they have the guidance for the transition, for example, in the power sector. I’d argue as well with respect to Asia, that the Just Energy Transition Partnership (JETP) that some countries will pursue can play a very important role here.

Cindy Levy: What do you see now as the real challenges for financial institutions, and how ambitious should they be with their transition plans?

Mark Carney: Part of the challenge for financial institutions is that they do not just need to get their own plans in order, but they are also dependent on their portfolio companies’ plans, if they do indeed have them. This is an iterative process of asking the right questions, seeing what’s expected of companies, including tailoring them by region, and mainstreaming those expectations. Then there’s the process of engagement and judgment that comes with that information, and it will take a couple of turns over the next few years to really get traction on this.

Now there are always leaders in every sector. There have been companies which have been SBTi signatories for a few years or have been part of other major initiatives so they’ve got a head start. But we need to get all companies moving on this and this is why, in our opinion, this overall initiative (the masterplan) is so important in clarifying expectations to make sure the process is as efficient as possible.

The second issue, which is critical to nail down, is being absolutely clear about what we mean collectively by transition finance. There are, in our judgment, in order to decarbonize, four strategies. There’s clearly climate solutions, whether it’s clean energy or things that enable clean energy, which are entities or assets that are already aligned to that 1.5⁰ pathway. Critically, there are also those entities and assets that are transitioning or aligning with that 1.5⁰ pathway. In other words, they don’t just have a plan, they have access to finance and a credible prospect of implementing that plan. Then there is the accelerated and managed phaseout of high-emitting assets. Here, we need to make sure that financial institutions understand all those strategies. It’s for them to choose which ones to put greater weight on, and then execute against that.

And then there are always issues with data, including climate data, which is why we want consistency here. And particularly, we want to break the logjam around Scope 3 data where my Scope 3 emissions are someone else’s Scope 1 and Scope 2 emissions. But if we’re all together in this, the data problem starts to solve itself.

Cindy Levy: There are 5,500 operational coal mines in Asia, many of which are early in their natural life. How do we get managed phaseout legitimized as a net-zero tool and what are the types of financial structures that need to be established?

Mark Carney: There are a couple of reasons why we want to legitimize it and why we think managed phaseout is essential. In the end, this is all about the real world—decarbonization, the carbon market, greenhouse gases, and their impact.

The ultimate test for companies and financial institutions is what happens to actual emissions. The easiest thing in some respects can be to divest assets and move carbon off your balance sheet, so it becomes someone else’s problem. If you look at GFANZ, if 40 percent of the world’s financial assets are in it, it means that 60 percent are not. This leaves a very large pool of potential owners who could be managing assets with a different degree of focus on sustainability.

In addition, we think that it should be part of the responsibility of a current owner or financier of a high-emission asset to know what will happen to that asset if they sell it. What do you think is going to happen to the asset, particularly if you’re a private owner of the asset? Are you selling it to somebody who sees value in the asset because they are going to buy a coal plant and extend its life, thereby causing greater real-world emissions?

If you are going to be a responsible owner, some of these stranded assets need to be phased out. What’s the time horizon over which you’re phasing them out? Are you participating in a phaseout that is consistent with the 1.5⁰ pathway? And how does this fit back together with the sectoral alignment? Transparency is critical here.

Cindy Levy: In the governance of managed phaseout assets and transparency, what do you say about the reliable energy security associated with phasing out that asset early, and the just transition? How do you make managed phaseout truly economically viable?

Mark Carney: There are two elements to it. One is ultimately having greater energy security by increasing the proportion of clean energy, which creates energy security in and of itself. But there is the near-term issue, which is reliable access. That’s where energy transition plans come into play. How do you get from energy security today to energy security and sustainability tomorrow? A big element of this is managed phaseout, which in any economy has to be a just transition. There are people affected by those stranded assets, and they need to be retrained and redeployed into industries of the future. Some of that financing will naturally come from governments, so it must be a coordinated process.

Then there’s financing for the replacement—replacement generation in this example—and the winding down of existing infrastructure. A coherent energy transition managed phaseout has to be consistent with what needs to happen on the ground, and also whether or not it’s going to happen. And though I don’t want to overburden it, that’s an essential component of JETP partnerships—external capital coming into a country to be part of this solution.

Cindy Levy: What role does GFANZ see NGOs and policymakers playing in supporting both managed phaseout and at-scale transition finance?

Mark Carney: First, from the policymakers’ perspective, and one which is examined by NGOs, we need credible energy transitions that are consistent with climate goals, and have a just transition component. The policymaking framework for those is essential. That includes support for workers and communities, and the fundamental enabling environment for the investment—a generic enabling environment but also the very specific economics and incentives of sectors. For example, in the power sector, both positive incentives for cleaner energy and punitive incentives for existing fossil fuels need to be established, obviously built over time.

Second are the roles that philanthropic and concessional capital, whether they are domestic or foreign, can play to help build capacity in economies for the types of financing that are required. Some of the most catalytic financing in a number of countries is financing for project preparation. It’s relatively small compared to the overall amount of the financing that is required for multiple mega-gigawatts of clean energy, but it’s essential because it is the risky part of the process. And it really can unlock broader financing.

Third, I think the development of high-integrity carbon credit markets is important, relating to two things. One is the accelerated phaseout of polluting generation, so coal generation. Of those 5,500 coal plants that you referenced earlier, many of them are relatively young and could run for 30 or 40 years. We can’t afford that if we’re going to address climate change. An incentive to phase them out early can be enhanced by the fact that an accelerated phaseout creates avoided emissions. That can potentially create carbon credits. Now it has to meet the tests of the ICBCMI in terms of the supply of those credits, and of the BCMI in terms of demand. These two groups have worked very well together with complementary recommendations.

The last big thing I’d highlight for policymakers is around financial sector policy and standards. A huge amount of work has gone into the GFANZ initiatives with the various components of transition plans, managed phaseout, portfolio alignment, and aligning transition finance. Many institutions from around the world have had input into public consultation development—over 1,000 submissions. But ultimately, these are voluntary approaches. And from experience with climate disclosure and other critical standards for financial institutions, ultimately you would want a mandatory approach and associated coverage. This has two advantages. One, we can’t wait; time is precious. Two, by doing so, we think we have a pretty good approach here. Authorities in different jurisdictions when adopting them might want to adjust them, that's natural. Ultimately, a policymaker’s role is to translate the voluntary into mandatory and ensure that the coverage is comprehensive.

Cindy Levy: There are two things we hear from individual banks around blended finance transactions—that they are risky and that the returns are not great. Do banks just need to keep pushing on these landmark transactions deal after deal until there’s scale? Or is there something else that needs to happen to get the blended finance to flow at much greater magnitudes?

Mark Carney: The feedback you’re getting from banks and others tells us that in many cases we don’t have the right blended finance models. In some cases, perhaps the public sector is not necessarily shouldering the risks that it should. Secondly, I note the macro numbers that blended finance has crowded in less than one dollar for each dollar of official capital, and that’s not great leverage. This suggests that the instruments need to be improved and become more effective.

So what can be done about that? I think being very disciplined is the charge for concessional capital providers, for the multilateral development banks, and the development finance institutions; to ensure that what you are doing is really scaling the flows of capital in aggregate which is needed by emerging and developing economies and needed now, and this is not something that private financial institutions can do. So it’s a challenge to the shareholders and the donor governments whether your incentive structure includes the aggregate amount of financing that is catalyzed—how do you measure that? Is it a performance indicator? So that’s on a macro basis.

The second issue is around what are the types of activities that have the highest return. Again, for overall flow, I mentioned project preparation earlier—relatively small amounts of dollars, but key dollars, and not often or not quickly enough is this money spent by the private sector. Often, that needs to be developed around a series of very important technical issues about enabling environments in economies.

Third, with regard to the official component of blended finance, what risks are they absorbing, and or do they have that catalytic impact? Is it political risk insurance, or is it an element of foreign exchange risk? Can the risks of those be appropriately diversified amongst official sector actors by pooling official finance as much as possible?

The next point I’d make is that we do have an opportunity if— and it’s an if—we can execute some of the JETP partnerships. The point of these partnerships is to bring together a number of the themes and other actions we’ve been discussing—managed phaseout, and accelerated phaseout of coal generation, replaced, obviously, by clean energy. And in the middle, there is the financing of the just transition elements for individuals, communities, and the overall adjustment. Some of that obviously lends itself to official finance. Some of it lends itself to clean energy, particularly private finance. Some of it—potentially the phaseout of coal—lends itself to new markets, such as what we discussed around carbon credits. The elements of the middle, including the phaseout of coal, could lend itself to blended finance as well.

Looking at something that large scale with that high ambition, the whole package could align with where Indonesia needs to go for the 1.5⁰ pathway. It’s within an overall financing envelope, with a certain amount of official capital, and with the difference made up from private capital. This process can then accelerate.

I think part of what we can do is to operationalize this through actual financings on the ground that are part of discrete large financings at a country level. The models that come out of that would be blended finance ones that we could replicate more broadly.

Cindy Levy: GFANZ has ensured it has vehicles for emerging markets and developing economies to bring in financing. How would you like this to play out? Is it that the JETP structure will continue to be replicated in more markets? And what might success look like to really make this happen?

Mark Carney: Before I answer the core of your question, I would like to say that we’re also working on a series of initiatives to get money flowing to projects that pay to establish best practices in-country. Many will be familiar with the Climate Finance Leadership Initiative (CFLI), which fosters an ecosystem of net-zero line projects in countries in which it operates. CFLI and related initiatives—for example, fast infrastructure—get funding for specific projects and provide, if you will, bottom-up models that can be replicated and therefore scaled. They involve much less due diligence than would be required going forward, but they at least provide a way to get out of the gate. An appropriately aggressive JETP would take $10 billion to $20 billion of finance. And to do that, an agreement is required in which money actually flows and things happen, like coal plants are shut off and renewables are built on an accelerated basis. A successful JETP needs to be a deal that sees finance flow and emissions reduce as consequences.

In doing so, I think we can force some decisions that otherwise are part of the conference circuit—discussions around blended finance, carbon markets, and different ideas around those that don’t necessarily lead to the kind of action that the net-zero transition requires.

Cindy Levy: If you were to roll forward a year, what are some of the hallmarks you’d like to see?

Mark Carney: I think that a year from now we should be in a position where the bulk of GFANZ members have released the first iteration of their net-zero transition plans.

Then, the net-zero public data utility should be up and running by the end of next year. And it should be populated with emissions data. The net-zero plan data for financial institutions and companies are a way to compare whether there is consistency with the transition across those institutions.

Thirdly, we very much want to see, from the bottom up, more successful CFLI projects from India to Colombia, and a number of countries in between. We would like to have at least one concrete JETP agreement with financing—so not just announcements about housing financing, but real financing that’s backing up high ambition, like JETPs. And as part of that process, we’d like to see that consensus is developing around what constitutes a high-integrity carbon credit market on the ground. We need to see that we are moving a number of things forward from concept to reality.

In the run up to COP26, there was a lot of work done on the plumbing of the financial system by the official sector, and concepts were moved to commitments for the financial sector from sustainability to net-zero commitments. Now we’ve been working on operationalizing those commitments, and as financial institutions are operationalizing, companies are also coming to grips with the transition.