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Podcast: Brain Food for General Counsel

Could the financial system be rewired to tackle the climate emergency?


Our global financial infrastructure is a WWII legacy, designed to create national interdependency and avert future wars in Europe. We hear how it could direct the world's financial firepower at the climate emergency instead.

Tom Tayler of Aviva Investors and Euan McVicar of Pinsent Masons explain how the systems that govern the whole world's financial activity can be re-tooled to help create political, social and economic stability in the future, which means tacking climate action.

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Matthew Magee:

Hello and welcome from me, Matthew Magee a journalist at professional services firm Pinsent Masons, to Brain Food For General Counsel, a podcast that asks the big questions that help you understand the world and steer your organisation through it.

And they don’t come much bigger than this: what is the global financial system for? What purpose is served by those acronym-heavy bodies that sit in the very deep background of the financial world?

You might think: to process payments; to enable trade; to make capitalism work. But you’d be wrong. It turns out the World Bank, the International Monetary Fund, the DOSDLSDLKKL all exist for one purpose – to create stability.

We’ll find out later a bit more about their creation in the shadow of the second world war, but that purpose remains in place. And even with Russia’s invasion of Ukraine the main threat to global stability is no longer war in Europe but the climate emergency. So that financial system must adapt so that it deals with the threat as it is now, not as it was 80 years ago.

At least that is the view of Tom Tayler and his colleagues at Aviva Investors, one of a number of organisations promoting radical change in the way our financial world is structured to incentivise actions in the real economy which will help keep global temperatures to a manageable level.

We know that business and economics has a major role to play in addressing the climate crisis. Unless we change our buying habits, the way we make stuff, the amount of stuff we make and sell and our expectations around economic growth itself we simply will not meet the challenge of the climate crisis.

But what Tom – and people like US secretary of the treasury Janet Yellen and former Bank of England governor Mark Carney – are saying is that this behaviour won’t just happen because it’s not what our systems are set out to encourage, track and reward. The answer? Change the systems.

So what, exactly, is the global financial system? I’ve been a business journalist for 25 years and I’m ashamed to say I didn’t know the right answer. So I asked Tom, who is a senior manager at Aviva Investors’ Sustainable Finance Centre for Excellence, to tell me.

Tom Tayler:

Essentially there are three main limbs if you like, interconnected limbs of the financial system that relate to what we call the real economy. Goods produced, services given to us as members of the public and consumers.

Those three limbs are investment, banking and insurance. All of that is regulated by the national central bank. The central bank will often have a direct or a dotted line to the finance ministry and all of those finance ministries themselves will take a steer from global standard setters. So all the securities regulators who look at public markets for the investment element of the sort of three-legged stool that makes up finance will generally be part of the International Organization of Securities Commissioners or IOSCO.  You have got an equivalent for pensions, which is the International Organization of Pension Supervisors.  You have got it again for insurance, the same International Association of Insurance Regulators and Supervisors, and they are very important in setting key standards for how insurance is run.  Similarly for banking, you have got the Basel Committee, and since the 2008 financial crisis we have something called the Financial Stability Board, which brings together a lot of those central banks, finance ministries and regulators, particularly looking at financial stability areas.  And then there are some of the of the multilateral organisations, like the International Monetary Fund, the OECD and the World Bank.  So all of that makes up what we describe as the international financial architecture that all oversees the way that that three‑legged stool of insurance, banking, and investment is overseen and run, and that in turn influences how both businesses and individuals access banking, insurance and investment services.  So it is a very complicated system, all intended to create a stable financial system that we believe needs to be reoriented to also, in link to that stability, create a more sustainable financial system.

This system didn’t just appear or develop organically. It was invented, and in a particular time to suit a particular need.


After the Second World War, the US hosted what is known as the Bretton Woods Conference and that saw the creation of the International Monetary Fund, and what was called the International Bank for Reconstruction and Development, which is now part of the of the World Bank, and that is why, because it comes from that conference.  That is why those big multilateral organisations are known as the Bretton Woods Institutions.  And unlike the Versailles treaty after World War One, which saw sort of … if you like … a punitive regime imposed on Germany that ultimately led to the rise of fascism and Hitler and the Second World War, the intention was to put in a system of governance and global financial co‑operation.  So mutual economic interest meant that countries would not ever go to war at the scale of World War Two again, and whilst there have been conflicts in the interim, and of course we have got conflicts going on.  But in Europe and in other places in the world now, we have not had a global conflict on that scale since that multilateral co‑dependent and co-beneficial framework was put in place.


Why is all this financial history relevant to climate? Because if we understand the motivations behind the establishment of these bodies and processes then we might be less likely to see them just as monolithic, unchanging blocks of invisible bureaucracy and begin to see them as tools that can be used to our advantage.

That means explicitly using them to change the way that capital and money and investment works in the world economy.


The market is allocating capital in a way that is actually undermining the long‑term future and stability of the market, and that is because the market is beset by market failures.  So a market failure is …. the market really exists to support society in allocating capital to where it is needed.  So if you have a market failure, then the efficient … or the allocation of capital that best supports society is not happening, and therefore you need corrective action and the corrective action should be taken by regulators and governments, and that is where that architecture we talked about comes in.  Because within that architecture are those with the power to direct how the market is corrected, so governments can do that and must do that.  The biggest role here has to come from government.  They cannot just devolve dealing with the climate crisis onto financial markets, but what they can do is they can make the conditions so that finance actually is harnessed to deliver the political aims that they have got and that they have signed up to in the Paris Agreement, which is a slightly different thing.

So if they take steps to correct market failures, if it becomes more profitable for companies to stop polluting than it is for them to pollute, then that is what they will do, is kind of like follow the money.  So that is why we believe reforming the way that finance is governed and overseen is an absolutely crucial part of this tricky conundrum that we find ourselves in.  Because if money starts to flow, as the Paris Agreement … you know, 197 countries have signed up to it … part of the Paris Agreement says that financial flows need to align with low greenhouse gas, sustainable development, and that is not what's happening at the moment. So finding a way to close that gap through the way that finance is regulated is utterly critical.


Because while government subsidy and action is really important, Pinsent Masons climate and sustainability expert Euan McVicar says the job simply cannot be done without mobilising the massive amounts of private capital out there looking to be invested.

Euan McVicar:

A really huge part of when we talk about the global financial system and dealing with climate sustainability issues is, we needed to be funding through the private sector, these initiatives.  The amount of private sector capital that’s available to offset the public sector capital that is available for these purposes.  And so, setting things up in a way which encourages private sector investors to get involved and direct their available capital to investments that will be profitable, but also help deal with climate sustainability issues is critical.  The Paris Agreement target requires a massive amount of capital.  That capital is not going to come from governments alone, it simply will not.  Private sector capital has to be mobilised.  And I think, in the context as well, of the amount of climate finance from developed countries, governments to be made available to the developing world did not meet the ambitions of the developing world.  That is where we can start to see the role of private sector being really emphasized.  And I think we see an increasing pressure from governments and an increasing trend to regulation to make sure that the providers of private sector capital are really incentivized to be doing the right things and making money available for  things that will help with fighting climate change.

Tom agrees, and says the sums needed can easily be provided if private investment is mobilised.


And one of the reasons for finance being such a key part of this is that the transition that we need to make is going to require a lot of investment.  So we sometimes hear that framed as being a cost, but actually I think it is better to think of it as an investment, because a lot of this will actually see benefits and financial returns.  And equally, if we do not do things, we will see a lot of value destroyed.  Given that there is $500 trillion embedded in the financial system, estimates range between probably one and five trillion dollars of investment a year between now and 2050 to make this transition work.  The money is there; it is just not going to the right places at the moment.  Can the financial system be used?  Well, the money is embedded in the financial system, but at the moment the incentives and the way in which that money is allocated is not aligned with a sustainable future.  So as capital is being allocated, as choices are being made by banks, by insurers, by investors, it is not aligning with a one-and-a-half-degree world, and so finding ways to shift those incentives is absolutely crucial.


Let’s remind ourselves of the stakes. If we don’t use every tool at our disposal, including the global financial system, to tackle the climate emergency then the impact on all of us will be severe: mass migration as people move from areas no longer fit for human habitation; disruption to food supplies; flooding and extreme weather. Life on Earth will be fundamentally altered.


The climate crisis is an enormous global security risk.  We are going to see social impacts.  So we have seen extreme heat in, for example, India and Pakistan over the last few weeks, temperatures touching 50 degrees centigrade, and at that temperature the human body outside cannot function.  It is too hot for us to cool our bodies via sweating, and the body starts to shut down.  And in a lot of countries, it is just not feasible to avoid the midday sun.  You do not have air‑conditioned buildings to go into, and so ultimately if that happened regularly, people are going to have to move where they live.  The Intergovernmental Panel on Climate Change the climate scientists' latest report estimates that under a business as usual scenario, if we do not change course, 75% of the world population will be exposed to life threatening climatic conditions by the end of the century.  So if you have to move 75% of the world's population to somewhere else, there is clearly going to be huge instability.  So as well as the,if you like, the moral reasons for addressing climate change, the economic reasons for addressing climate change  from a pure stability, avoiding future wars point of view, changing course is an absolute imperative because there is not going to be a realistic way to avoid wars if 75% of the world population are moving.


Some of the biggest voices in finance are now speaking out to encourage structural change to direct investment towards climate solutions, including former Bank of England governor Mark Carney and US treasury secretary Janet Yellen. So what is the mechanism that will bring this change to bear on the financial system. How will it actually happen? Relatively informal groupings of rich nations will be the key, says Tom.


Finance will take its lead from those who regulate it, and that will shift the system.  At the moment, it is nobody's job; nobody specifically is told ‘you know, if we are not aligning the financial system with one-and-a-half-degrees who is not doing their job?’ and that job therefore needs to be given to these bigger organisations, and in the main, they take their lead from the G20 countries, so the 20 biggest global economies.  So for example, the FSB being set up after the 2008 financial crisis, that was set up using the power of the G20, the governments and the TCFE so the task force for climate‑related financial disclosures, which has pretty much become the gold standard for how companies and finance report on their climate‑related financial risks, that again came from a G20 communique saying the FSB should look at disclosure, and so it did.  So getting the biggest governments to say to these regulators ‘yes, we need you to change what you are doing, review how you are governing finance and make it more closely aligned to one-and-a-half-degrees’ is really important.


These changes will filter down into the organisations businesses and consumers deal with – investment and retail banks. Euan says that the financial services industry will be used as an engine for change.


There is a number of programs underway where financial constitutions can take different steps to help align with that 1.5 degree target.  A large part will be making available capital in the developing world for the transition activities that need to be financed.  It perhaps seems unlikely that the climate finance ambitions of developing countries will be met through handouts from the developed world.  Particularly, as we enter a period of economic difficulty on a global basis.  The pressures on developed world economies are going to continue to grow and I think making available of government finance to solve some of these problems is going to remain a sticking point.  The private sector has a big role to play, and we definitely see governments and international institutions almost making the financial services sector the policemen for the climate change agenda.  By regulation and increase in transparency requirements being imposed on them, asking them to do that heavy lifting on climate change.


This might involve creating new ways of investing or even entire new organisations to create the change that is needed. Euan worked for one of those, the UK’s Green Investment Bank, and says that they have an important and evolving role in directing investment but also in proving that this can deliver returns to investors.


The investment bank will set up as policy device to help deal with perceived lack of lucidity in financial markets following the financial crash of 2008 and the consequent recalls of that crash and a lack of lucidity in the finance market for green infrastructure for various source.  As a policy instrument, the bank will set up to make funds available under certain circumstances.  But fortunately, it was set up in a way that it was able to invest anywhere in the capital structure because it became clear that, actually, the main issue was not availability of senior debt because international banks bounced back quicker than people expected them to.  But is was actually a lack of equity because equity investors were not comfortable with the risks alone dis-emerging asset class of offshore wind.  The demonstration impact is the other aspect because the bank had to operate in a way where it was making good commercial sound investments on the same terms as commercial investors would, were they in the market.  That was two fall, one to comply with statutory drills but also to show to the market that these investments were good, sensible commercial investments that would make a profit.  Therefore, to encourage and crowd more capital into those markets and to have a demonstrator effect in the market.


This isn’t to say that governments are off the hook for climate action though. They are critical agents for mobilising private finance to act. Governments need to create the conditions under which the financial system accepts responsibility for action, and to do this they need to work together, says Tom.


It is all hands on deck, in essence.  You know, there is no point in one country happily saying, ‘well, we are carbon‑neutral,’ because greenhouse gases do not respect borders, global warming doesn't respect borders.  So it is a ‘we are all in this together’ type situation.  And you are right, you know, you have got global finance … we need global co-operation at the political level.  We also, as a regulated business, hugely react to the signals that we get from regulators in terms of how we should behave, and we are already seeing some of this, sort of within the mandates that the regulators have.  So the regulators have said, you know, that regulated firms in finance need to address climate‑related risks in the way that they manage their business, for example.  Although that is sort of happening, it is not happening at the pace that it is needed, and it is also not aligned with a mandate given to those regulators, saying "we need you to regulate the financial system so that we end up with a financial system that is aligning with the net zero transition."  That is, at the moment, not written into what their job is.  So governments have signed up at the international treaty level in the Paris Agreement, so we will align financial flows.  The next bit that they have not done and that we think they should do is say to these multilateral institutions and regulators "we need you to help us fulfil our commitments, because as you say, finance is global, governed globally as well," and so put into the mandates of those regulators and multilateral organisations that part of your job is moving us towards that one-and-a-half-degree future.  And if that suddenly becomes a core part of their mandate, as opposed to something they do a little bit off the side of their desk, then finance will take its lead from those who regulate it, and that will shift the system.


One of the most successful tools being used is transparency. Customers, regulators and investors are increasingly demanding to know what the source of funds is and what projects it will be invested in. Euan says that regulators are policing ever more keenly acts of greenwashing – making misleading claims that investments are ecologically sound – and behaviour is changing radically because of this. And Tom tells us that Aviva Investors and others are creating bodies to promote this radical transparency, such as the International Platform for Climate Finance.


But that transparency around risk management is the driver for change because as institutions become more transparent about this.  Those who are seen as being transparent and open and having the best processes in place will start to see the advantages of that.  Whereas those who are lagging behind will be seen as not having the right risk management processes in place.  If you do not have right risk management processes in place in respect of climate risks, which is an increasingly important risk, what does that say about your overall attitude to the management of risks and what will the market make of that?  So, we will start to become a tag of being slightly less professional than those who are ahead of the curve. 


We were with part of a coalition that we have convened that has a lot of different types of organisations in it: financial institutions, think tanks, NGOs, policymakers, law firms, who are all talking about these issues.  So the group in the coalition is the coalition for an international platform on climate finance, and that exists to advocate for reform of the international financial architecture, to align it with one and half degrees.  We believe that within a reformed financial architecture, if you look at it, there are gaps.  And one of the gaps is: how do you help, in particular developing countries, access private finance at scale, to help fund their sustainable development.  And so having a new body or repurposing one of the existing institutions to take on the role of this IPCF to provide developing countries with the insights and the technical assistance they need to finance their climate and development commitments and help bring them together with private finance is, if you like, a really, really important role that we think would be needed within a reformed and repurposed architecture.


This transparency, plus consumer and investor pressure, is welcome and important. But to make real, lasting, global change it looks like there has to be willingness across the world to make conscious use of the structures at the heart of the financial world to counter the threat not of war in Europe, but climate emergency around the world.

Matthew Magee:

Thank you for joining us for the latest Brain Food for General Counsel podcast. Remember you can keep up to date wit hour-by-hour coverage of Business Law news by the outlaw reporting team at pinsentmasons.com. Do not forget to subscribe to us wherever you get your podcasts, and if you have enjoyed this or past programs, please do link them. It helps us to reach other people who might also be interested. Until next time, goodbye.


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