The first step toward mobilizing sufficient decarbonization capital is to understand and articulate the full range of current and future capital demand.
FSOs are already dedicating significant resources to meeting the demand for climate transition capital. So far, however, these efforts have typically been limited to project finance or renewables teams, focused on large corporates in carbon-intensive sectors. This represents only a fraction of the underlying demand for transition capital, most of which has not yet been articulated.
The sheer size of this latent and future demand is evident from many credible assessments of global need. These include estimates for annual investment ranging from $3.5t to $5.8t per year (IEA/EY), and total estimates for cumulative required investment of $100t (Carney/UN) and $110t (IRENA). Despite the ambitious goals set out by GFANZ members at COP 26, it’s clear that FSOs cannot fulfill these capital needs from existing financial resources. After all, the current total of global financial assets under professional management has been estimated at $87t (IRENA) and $103t (BCG).
Clearly, partnering with the public sector will be essential. Even so, FSOs are best placed to begin identifying and analyzing the problem. The challenge is to break down the big picture and articulate current and future capital needs in an actionable way. In our view, the first step is to view total capital demand through five categories of purpose, each with its own unique features.
The first two categories of purpose fall under the heading of climate change Adaptation, an area that received belated attention at COP26 and where private and public investors need to work together to fund:
- Resilience: Meeting the “loss and damage” costs for countries already suffering the physical effects of climate change — an urgent, but little discussed, category of need.
- Protection: Funding mechanisms that will protect climate defenses, such as forests and oceans — another unfamiliar goal for much of the financial industry.
In contrast, the second two categories of purpose comprise climate change mitigation activities with which many FSOs are increasingly familiar:
- Innovation: Developing novel climate solutions — the category of purpose that offers the highest potential returns to investors.
- Transitioning: Implementing decarbonization across the current global economy — the most intuitive category, but also the largest and most complex.
Finally, the fifth purpose underpins all the others:
- Enabling: Financing the enhancement of change capabilities, inside and outside the financial sector — a relatively small, but often overlooked, category of need.
Within these groupings, FSOs can then break down demand into more detailed subcategories. Understanding the needs and challenges of each will allow FSOs to begin identifying the data, processes and resources needed to fulfill those demands. One approach is to build sets of personas or archetypes that FSOs can use to channel capital to where it’s needed in the real economy. For example, businesses needing capital could be triaged as follows:
- Green natives: What insights or benchmarks can they offer to other businesses?
- Already transitioned: How can they continually improve and not misreport?
- Transitioning company: How can they appraise the progress of a multi-year journey?
- Transition project: How can they ensure effective management of transition risks?
- Yet to transition: How can they build confidence around commitments and objectives?
- Transition deniers: Where will future capital come from as risk premiums change?
- Stranded company: How can run-off and decommissioning risks best be managed?
As they work to articulate the need for climate transition capital, FSOs also need to keep their eyes on the big picture and push themselves to think laterally.
First, FSOs should look beyond their comfort zone of large, data-intensive businesses. Non-profits, public bodies, small and medium-sized enterprises, households and individual consumers all have unmet needs for transition finance. Each group needs to be broken down into subcategories based on its features.
Second, FSOs need to resist the temptation to concentrate their efforts and resources on the most developed economies and the most mature financial markets, ensuring that all countries receive a fair share of the benefits of investment and innovation.
Third, FSOs must work with other actors to stimulate demand for transition capital. No businesses or FSOs will succeed in meeting their net-zero commitments if the world doesn’t change with them. Public authorities are especially well placed to create grassroots demand for transition capital right across society. FSOs must engage with them to encourage the alignment of all stakeholders.