7 August 2022

The latest publications from GFANZ expose the limitations of the project. Is there an opportunity to reframe its objectives?

GFANZ (Glasgow Financial Alliance for Net Zero) was announced with great fanfare at COP26 in Glasgow, and now boasts 450 members with $130 Trillion in assets under management. The launch press release boldly claimed that the “amount of finance committed to achieving 1.5°C [is] now at [the] scale needed to deliver the transition”. Explicitly making comparison with estimates of the required infrastructure investment to hit net zero, the press release claimed that: 

“Today, through the Glasgow Financial Alliance for Net Zero (GFANZ), over $130 trillion of private capital is committed to transforming the economy for net zero.  These commitments, from over 450 firms across 45 countries, can deliver the estimated $100 trillion of finance needed for net zero over the next three decades.”

Readers could be forgiven for thinking that GFANZ had the finance to deliver the net zero transition sitting ready to be invested. Not everyone was convinced, with one activist calling the commitments “a mile wide and an inch deep”. Larry Fink was reported as conceding that deploying the capital will be far harder than securing the commitments.

 To give the commitments the sense of greater teeth, GFANZ aligned itself Race to Zero, a UN-backed campaign in support of 2050 net zero goals. In a recent update, Race to Zero toughened requirements for accredited organisations. These now require members to produce a net zero plan within a year of joining, set clearer expectations on phase out of unabated fossil fuels, and require a positive advocacy stance on climate policy. In a final, but important detail, the pathway should be consistent with warming of at most 1.5-degrees with no or limited overshoot. According to the AR6 report of the International Panel on Climate Change (IPCC), this requires approximately a halving of global emissions by 2030. 

Putting flesh on the bones

In July 2022, GFANZ published a suite of publications that aim to put more flesh on the bones of these commitments. In over 200 pages these documents set out:

• Recommendations and guidance for finance sector net zero transition plans;

• Guidance on use of sectoral pathways;

• A note on expectations for real-economy transition plans in investee or client companies;

• A concept note on work to be done on portfolio alignment measurement; and

• A concept note on dealing with phase-out of high emitting assets.

I won’t attempt to summarise these documents in this article. Instead, I’ll focus on what they imply for the status of the GFANZ initiative, especially as it applies to the asset management industry (that is, the Net Zero Asset Manager – NZAM – subgroup of GFANZ).

What’s not in the document

What is missing is as interesting as what is contained in the documents.

First, there is no discussion of the potential conflict between GFANZ commitments and financial institutions’ fiduciary duty to clients. I have written elsewhere that asset manager members of NZAM face a looming conflict with fiduciary duty. As the likelihood of limiting global warming to 1.5°C with no or limited overshoot falls with every passing year, investing in alignment with this scenario becomes inconsistent with clients’ financial interests.

Second, there is no mention of adaptation finance, beyond noting its omission. Yet this will play a crucial role in any transition, and is becoming more urgent the longer governments delay action on abatement.

Third, the discussion about transition plans for existing companies dwarfs discussion of funding the innovation and disruption that will be required for a successful transition, including development of blended finance and other venture finance at scale for risky emerging technologies. The low numbers quoted in the case studies on these initiatives emphasise how limited action is in this area.

What’s in the documents

What is in the documents also highlights some of the problems faced in putting the detail into the GFANZ project. The difficulties in specifying a robust and meaningful transition plan or portfolio decarbonisation measure for an investor or bank are laid bare. It is not clear that these are just teething problems. Rather they are inherent in the nature of the task.

The methodologies adopted are founded on science-based targets and industry pathways. In essence these map the net zero pathways of different industries in a way that enables economy-wide decarbonisation by 2050. This is an immensely useful exercise that identifies key pinch points, interdependencies, and priority areas for investments. 

However, as a methodology for measuring and directing individual institutional action on net zero it is much more questionable. To use it in this way requires allocation of carbon budgets to sectors and companies without regard to their long-term potential to contribute to the transition nor the dynamic nature of business. One thing we can be sure of is that if we are successful in transitioning to net zero, it will not be achieved in the smooth and linear manner assumed by science-based targets. Instead, it will be a highly non-linear process driven by innovation and disruption. Companies that don’t yet exist are at least as important as the existing stock of companies for which science-based targets are being set – after all the average lifespan of an S&P 500 company is now less than 20 years.

The concept note on portfolio alignment metrics identifies the range of unresolved issues: which climate pathway scenario to use; how to project emissions at the portfolio company level; how to measure alignment with the net-zero goal; how to deal with retained versus divested emissions; ambiguity over timelines; the sheer number and significance of assumptions required.  Therefore, in an example of Goodhart’s law in action, while such portfolio alignment metrics may be one of a number of useful metrics to inform progress and guide action, they are almost certainly not effective as a target to determine action.

This seems to me to be an insuperable problem with the underlying organising principle of GFANZ, which is the adoption and policing of net-zero plans at the company and portfolio level by financial institutions in a manner that calls to mind the allocation of multi-year production targets in communist central planning. Combining multiple information sources to sort the right solutions to climate change can only be achieved by markets. But markets can only do their job with appropriate guardrails from governments. Institution and company-level net zero planning seems doomed to failure in this task without appropriate regulation.

This does not mean that companies and institutions should not be scenario planning the opportunities and risks of climate change for their business. Of course they should. It does not mean that these plans and metrics contain no information. Of course they do. These scenarios can inform investments and strategies. But that is very different from using these metrics to try to direct investment and manage the transition, as is currently implied by how they are incorporated into GFANZ commitments. Unfortunately the concept of a portfolio that is aligned with net zero over any defined timescale is inherently ill-defined.

Not all bad

This is not to say that GFANZ is entirely a waste of time. Important groundwork is being laid, particularly around disclosure standards, data and methodologies that will help the finance industry move quicker if government ever acts. The mere existence of the initiative helps move the Overton window a little bit, creating circumstances in which governments can regulate. Putting climate change on the agenda is forcing companies and investors to consider more deeply what it means for them. 

So the idea that GFANZ is just a smokescreen thrown up by the industry to distract governments from the real change required seems unfair. The GFANZ working papers illustrate that work has been done in good faith and with good intent to make real the commitments made.

But it is becoming clear that the central foundation of GFANZ – institution, portfolio, and company-level net zero plans aligned with limiting global warming to 1.5°C with no or limited overshoot – is both flawed as a mechanism for driving the transition to net zero but also leading to an inevitable conflict with institutions’ fiduciary duty to clients as that 1.5°C scenario becomes ever less probable.

We should not kid ourselves. The pace of change will be determined by governments not the finance industry. The GFANZ PR machine got ahead of itself at COP-26 and set expectations that could never be met. Financial fiduciaries will be incredibly effective at directing capital to drive change once governments align economic incentives with net zero goals. But until then, they will have limited impact on the curve of global warming.

Don’t throw the baby out with the bath water 

It is easy to throw stones and be critical. At least GFANZ is doing something! And a lot of the work being done will be useful if regulatory action on climate picks up pace. So let’s not throw the baby out with the bathwater.

But there is a risk that GFANZ becomes less useful as members are held ever more specifically to the commitments made in November 2021, as GFANZ is incapable of managing the world to net zero via a massive central planning effort. So in this context is there a reframing of GFANZ’s commitments that is more helpful?

A revised set of commitments should recognise more explicitly that asset managers and owners can only go at the pace determined by their clients and beneficiaries and by governments. This will create a complex patchwork around the world, but is the reality.

An alternative set of commitments would also place less emphasis on net zero commitments aligned to the specific scenario of limiting warming to 1.5°C with no or limited overshoot. Such quantitative commitments are both methodologically questionable and problematic from a fiduciary duty perspective. Although these appeared to give necessary objectivity and accountability, it increasingly seems that they may do more harm than good and are absorbing a lot of intellectual bandwidth and resources for limited benefits. Instead the commitments should focus on the distinctive contribution the investment industry can make in the context of government action.

In the context of the investment industry, a principles-based approach would focus on where the investment industry can actually make a difference:

• Development of informed client engagement and mandates that clearly set out expectations on both sides relating to climate change.

• Working constructively with governments to support and enable their own net-zero plans and commitments.

• Collaboration to develop data and methodologies relating to measurement of climate impact and decarbonisation for monitoring and information purposes.

• Engaging with portfolio firms in high emitting industries and supporting them to adapt to business models with lower negative climate impact.

• Encouragement of the highest standards of climate-related disclosure from investee companies.

• Development of vehicles for funding new technologies particularly in higher risk contexts including blended finance.

• Development of vehicles for funding adaptation.

• Support for robust institutions and well-formed regulation, including aligning lobbying activities with science-based climate policy, and encouragement of similar alignment amongst portfolio scompanies.

• Transparent and authentic behaviour, setting out how climate change is factored into the investment process and products, and openly disclosing progress using a range of metrics and perspectives.

This more principles-based approach would place greater emphasis on actions that reflect the investment industry’s proper role in the climate transition and less on methodologically problematic and probably meaningless asset manager net-zero and portfolio decarbonisation plans. GFANZ is doing much of this work already, and that should be applauded. GFANZ has energised an impressive group of experts to undertake good and important work which will be helpful in the fight against climate change. But it is in danger of being distracted and derailed by the commitment to inherently problematic targets that are difficult to measure and define.

The finance industry needs to be clear about the limits of what it can do, and the nature of its obligations to clients. The GFANZ commitments should be reframed accordingly, so the industry can play its proper role supporting th transition to net zero.