ClientEarth                                                                                                                                            FSUK0025

Written evidence submitted by ClientEarth

ClientEarth                                                                                                                                            FSUK0025

Contents

About ClientEarth

Executive summary

ClientEarth’s evidence

The scale of the problem: fossil fuel expansion

Preventing investment in new fossil fuels in practice

ClientEarth’s recommendations

(1) Regulatory objectives

(2) Accountability and enforcement by regulators, including greenwashing

(3) Climate-related disclosures

(4) Climate accounting

(5) UK Green Taxonomy

(6) Sustainable and transition bonds

(7) Transition plans

(8) Investor stewardship

(9) Capital requirements for banks and insurers

(10) Conditions for listing

On the EAC writing to UK-linked GFANZ signatories

About ClientEarth

ClientEarth is an international non-profit environmental law organisation headquartered in London. Our team of Climate Finance lawyers are global experts in the field, focusing on the legal implications of climate change-related risks and impacts for a wide spectrum of market participants, including banks, companies, investors, directors, professional advisers and regulators.

This document responds to the EAC’s call for evidence (EAC CfE) regarding the financial sector and the UK’s net zero transition.

ClientEarth has submitted written evidence and given oral evidence on a number of EAC inquiries.  We would welcome further discussion with the EAC on any of the topics below.

Executive summary

• While it is encouraging that many financial sector participants have signed up to voluntary, industry-led initiatives such as GFANZ, ClientEarth believes their success will depend on those firms setting sufficiently ambitious commitments and targets – which is not guaranteed where firms have vested interests and lobbying power can lead to watered down commitments.[1] In addition, some initiatives may feel that competition law prevents them from setting ambitious minimum commitments and targets for all members to adopt.[2]
• ClientEarth’s primary concern – based on evidence to date – is that the financial sector is not sufficiently motivated, or adequately encouraged by policymakers and regulators, to (1) stop financing activities incompatible with limiting warming to 1.5°C or (2) achieve emissions reductions across its portfolios (consequently encouraging and supporting the transition in the real economy) at the pace required.  ClientEarth believes the transition will not happen quickly enough without new laws and regulations, that are properly enforced.
• We set out 10 issues with recommendations, which we believe are important for the EAC to consider in this inquiry:
• Regulators must have appropriate objectives to support the transition (Recommendation 1), and properly enforce their rules and call out greenwashing (Recommendation 2).
• Investors need comprehensive information on the environmental impact of companies’ activities (as distinct from the impact of environmental factors like climate change on the company), to direct investment towards sustainable activities that support the transition. See our recommendations for the government and regulators on climate-related narrative disclosures (Recommendation 3), climate accounting (Recommendation 4), the UK Green Taxonomy (Recommendation 5) and sustainable and transition bonds (Recommendation 6).  In addition, new mandatory transition plan requirements would help direct finance away from activities that are not aligned with the UK’s climate commitments and towards those that support the transition (Recommendation 7).
• The FCA must be clear that investors must comply with their stewardship responsibilities on environmental issues (including on investee companies’ transition plans) and take enforcement action where firms’ failures to do so breach their existing duties (Recommendation 8).
• Banks and insurers should be (but are largely not, to date) implementing new policies to exclude financing and insurance for activities incompatible with 1.5°C and for companies without a credible Paris-aligned transition plan.  This needs to be encouraged by government and regulators through new rules requiring them to hold greater capital against exposures to new fossil fuel activities (Recommendation 9).
• Regulators and stock exchanges should impose new requirements to prevent companies without a credible transition plan from listing or issuing listed debt and equities (Recommendation 10).

ClientEarth’s evidence

The scale of the problem: fossil fuel expansion

1. The EAC CfE recognises the implications of the UNEP Production Gap reports and the IEA’s Pathway to Net Zero Emissions by 2050 (IEA NZE): emissions from existing and currently planned fossil fuel production will already exceed the global carbon budget for keeping temperature rise below 1.5°C.
2. This is the case even without new fossil fuel production, and so there must be no investment in new fossil fuel exploration, development or production, or related infrastructure.  Furthermore, the IPCC recognises that the decommissioning and reduced utilisation of existing fossil fuel installations in the power sector, and cancellation of new installations, will be required to align emissions with 1.5°C pathways.[3]
3. The idea of ‘net zero by 2050’ can be misleading; the key point is that decarbonisation must happen at the pace set by specific emissions reductions pathways that target 1.5°C (such as the IEA NZE), otherwise the remaining global carbon budget may be exhausted well before 2050.  This is why it is so important that there be no investment in new fossil fuel supply.
4. The severity of this problem, and its links to the financial sector, are exemplified by a landmark June 2022 study from think-tank Carbon Tracker,[4] which analyses the fossil fuel reserves of companies listed on global stock exchanges.  It finds that to limit warming to 1.5°C, 90% of fossil fuel reserves must remain in the ground as ‘unburnable carbon’.[5]  The majority of this unburnable carbon that can be influenced by investors is held by companies listed in four global financial centres – one of which is London.
5. The report finds that the carbon emissions that would result from London-listed companies’ use of their fossil fuel reserves (their ‘carbon potential’ or ‘embedded emissions’) is 30 times the potential emissions from reserves located in the UK itself, and ten times the UK’s official carbon budget for the next 15 years, meaning it plays an outsized role in the financing of fossil fuel projects around the world.  It also means that UK-listed companies are exposed to significant transition risks, including stranded asset risk (with knock-on consequences for investors, including UK retail investors and pension funds).
6. The report rightly recognises that these financial centres are enabling the extraction of fossil fuel in excess of climate limits, and calls on governments, regulators and investors to urgently act. These statistics should shock, and must prompt urgent action – not least in the UK, if London is to transform itself into a ‘net zero financial centre’.
7. We cannot overstate the severity of the climate emergency, and we submit this evidence to assist the EAC to properly evaluate whether the government and regulators are doing enough to meet the UK’s climate targets.  ClientEarth believes that the current behaviour and short-termism of (1) fossil fuel companies, (2) the financial institutions that invest in and support them, (3) the financial regulators, and (4) the government are fundamentally incompatible with limiting global warming to 1.5°C.

Preventing investment in new fossil fuels in practice

8. The IEA NZE’s findings are simple, vital and must be implemented immediately.[6]
9. Despite the IEA NZE’s publication and the creation of GFANZ over a year ago, there is still a clear disconnect between current financing activity and the conclusions of the IEA NZE.[7]  Few financial institutions currently use the IEA NZE as their scenario for decarbonising their portfolios,[8] nor do they have investment / financing policies that exclude companies that (1) are pursuing new fossil fuel projects (contrary to the IEA NZE) or (2) do not have credible Paris-aligned transition plans.[9]
10. We recognise that progress has been made in UK regulation over the last couple of years, particularly in relation to mandatory TCFD disclosures.  There have recently been indications that the government is willing to go further, with its intention for London to become the world’s first ‘net zero financial centre’ and its proposals for the mandatory disclosure of transition plans.
11. The combination of disclosures and voluntary industry-led regimes to set commitments will not be sufficient on their own to make the deep emissions cuts that are necessary to meet the UK’s climate goals and have a chance of keeping warming below 1.5°C.
12. The government and regulators need to shut the gate on activity which is incompatible with limiting temperature rise to 1.5°C, based on best available science, and encourage companies and financial institutions to transition to net zero early and in an orderly manner.[10]  There are already activities that the science tells us must not be funded – new fossil fuel exploration, development and production (and related infrastructure) being at the top of the list. 

ClientEarth’s recommendations

13. ClientEarth has recently submitted a comprehensive response to the government’s call for evidence on the update to the Green Finance Strategy, which covers many of the below recommendations in more detail.  In the interests of being concise, we provide a high level summary here, and provide cross-references to that submission so the EAC can find out more about these recommendations.

(1)        Regulatory objectives[11]

14. We recognise the EAC’s contribution through previous inquiries to ensuring HM Treasury updated regulators’ remits to refer to climate change and the net zero transition.  These were watered down this year when HM Treasury specifically recommended[12] regulators support the recently published British Energy Security Strategy.[13]  The government must send regulators a clear signal that they can take decisive action to support the transition, notwithstanding short term energy price volatility.
15. ClientEarth recommends that the upcoming Financial Services and Markets Bill be used to ensure that the statutory framework enables regulators to support the UK’s environmental goals through (1) an objective in relation to climate change which requires regulators to support all of the UK’s climate targets (including the 2030, 2035 and 2050 domestic emissions targets and the Paris Agreement goal to limit global warming to 1.5°C); and (2) a regulatory principle requiring regulators to take into account the conservation and restoration of nature and protection of biodiversity in a manner that respects the rights of affected local communities and indigenous peoples.
16. We would also suggest the EAC ask the government to clarify how it addresses the direct conflict between the British Energy Security Strategy’s position on oil and gas and the requirements of climate science and the net zero transition, and to consider if the recommendations to regulators should be updated to clarify this.

(2)        Accountability and enforcement by regulators, including greenwashing[14]

17. We have raised the lack of enforcement by regulators in previous evidence to the EAC and this issue persists.  In order for the UK to become a net zero financial centre, there must be proactive and robust accountability through enforcement action by regulators such as the FCA, to address non-compliance.
18. A particular concern is current “impact-washing” by financial sector actors: the conflation of ESG investing (generally understood to be consideration of financially material ESG factors) and vague and unsubstantiated claims of positive real world impact. These practices risk misleading investors (particularly retail investors) who want their investments to have real world impact[15], and act as a barrier to development of, and investment in, financial products that drive real world change.
19. ClientEarth recommends that the FCA and other regulators be adequately resourced and empowered to investigate and enforce against laggards on climate, and against firms that are greenwashing.  The current lack of enforcement by UK financial regulators is underscored by the steps being taken by non-financial regulators in the UK[16] and by overseas financial regulators alike.[17]
20. We would also suggest that the EAC ask the FCA whether it has ever carried out enforcement investigations or taken enforcement action based on a firm’s climate disclosures or potential greenwashing, and in what circumstances it would proceed with enforcement over the quality of a firm’s climate disclosures or accuracy of its green claims.

(3)        Climate-related disclosures[18]

21. ClientEarth recommends that the UK’s regime for climate-related narrative disclosures be enhanced in order to ensure that investors have the data they need to make informed decisions to invest in sustainable activities. In particular:
1. The FCA’s new TCFD disclosure rules for listed companies were introduced on a ‘comply or explain’ basis.[19] The rules should be mandatory.
2. There is no express requirement for listed companies to disclose their ‘scope 3’ supply chain emissions. These are the largest source of a company’s emissions in most sectors,[20] and it is estimated that financial institutions’ scope 3 emissions are over 700 times greater than their operational emissions.[21] However, currently companies are largely not disclosing scope 3 emissions.[22] Regulation must require companies to disclose scope 3 emissions, including financed and insured emissions for financial services firms (i.e. the emissions associated with the companies / activities they finance / insure).

(4)        Climate accounting[23]

22. Climate-related financial risks and impacts (including those identified during transition planning) need to be better reflected in the assumptions and estimates used in company financial statements, in order to ensure that they are effectively incorporated in financial decision-making, and to meet the requirements of existing accounting standards.
23. ClientEarth recommends that “Paris-aligned” accounting and audit should be mandated and built into the remit of the new corporate reporting and audit regulator, ARGA.  This means that companies should be required to state whether their accounts are based on estimates and assumptions which are aligned with limiting warming to 1.5°C and, if they are not, provide a sensitivity analysis showing what adjustments to the accounts would be required for them to be so aligned (including appropriate write downs for assets which cannot be economically exploited if transition is achieved). Auditors should be required to check these assumptions and raise concerns to investors.

(5)        UK Green Taxonomy[24]

24. Of vital importance will be ensuring a robust UK Green Taxonomy, as this will facilitate financial institutions and investors to direct financial flows towards sustainable activities.
25. ClientEarth recommends that it be properly science-based and reflect the precautionary principle, in order to accurately identify activities that are genuinely sustainable.  In line with the science, the taxonomy must not include activities based on gas as sustainable, which leaked information suggests may be the government’s intention.[25]

(6)        Sustainable and transition bonds[26]

26. ClientEarth recommends the implementation of a unified system of labelling and benchmarking for sustainable and transition investment products, as this will be essential to mobilise private investment into transition activities.

(7)        Transition plans[27]

27. Effective mandatory transition plan regulation is necessary to achieve the UK’s ambition to be a net-zero financial centre, reflecting the fact that the whole economy – and all companies – must transition to a low carbon economy.  Regulation should incorporate the hallmarks of credible transition planning identified by the Transition Plan Taskforce,[28] and regulators must police the quality of transition plans, not just their existence.
28. ClientEarth recommends that: (1) the rules must apply to all financial services firms, listed companies and large companies (as defined in the Companies Act 2006); (2) it must be mandatory for in-scope companies to adopt a transition plan aligned with limiting warming to 1.5°C; (3) financial services firms’ transition plans must include financed emissions and incorporate strategies in relation to the financing of carbon-intensive sectors that reflect science-based pathways (and in particular, reflect the IEA NZE); (4) in-scope companies should be required to disclose concrete plans of action and evidence that their plan is, in fact, being implemented; (5) carbon credits must be disclosed separately from the primary commitment to reduce emissions, and must not be relied upon to “offset” companies’ emissions within short-, medium- or long-term emissions reduction targets; (6) in order for the transition plan requirements to be effective, it is vital that they are backed up by effective accountability measures through which regulators and other stakeholders can call out instances of non-compliance; (7) transition plan rules must be introduced as soon as possible.
29. In light of this, we would suggest that the EAC ask the government to clarify the timeline for these vitally important rules being developed and entering into force, as they were not referred to in the Queen’s Speech.

(8)        Investor stewardship[29]

30. ClientEarth recommends that the FCA make clear that investors need to comply with their stewardship responsibilities in relation to environmental issues, and that failure to do so can breach existing duties.  The FCA should take enforcement action where firms breach such duties.

(9)        Capital requirements for banks and insurers[30]

31. ClientEarth recommends that the banking and insurance capital regimes[31] be enhanced in the UK to ensure that banks and insurers are sufficiently resilient to climate risks, and in particular hold capital equivalent to 100% of exposures where they decide to continue funding / insuring new exploration, expansion or development of fossil fuels and related infrastructure (contrary to the IEA NZE), so they can absorb the losses themselves if a full write-off of the exposure is necessary.
32. Such regulation would improve banks’ and insurers’ capital adequacy against climate-related losses and shocks, and drive behavioural change by disincentivising financial flows to assets exacerbating climate change. It would help correct the mispricing of climate-related risks and prevent the accumulation of assets which may: (a) become stranded, thereby causing direct financial losses to the firms holding those exposures; or (b) contribute to exacerbating climate change, leading to the build-up of systemic risks in the financial system.

(10)  Conditions for listing[32]

33. The June 2022 Carbon Tracker report[33] makes clear the role of listed companies in exacerbating climate change, and the London financial centre’s outsized role in this.  The listing process must be made consistent with UK climate commitments, and climate risk and transition plan disclosure requirements for listed companies, and protect the market from uncontrolled capital flows into climate-exposed companies which are not Paris-aligned.
34. ClientEarth recommends that companies applying for listing on the main market of the London Stock Exchange should be required to demonstrate that they have a credible transition plan in place, including restrictions on (1) activity known to be inconsistent with credible science-based pathways to achieve global climate goals (such as new fossil fuel production), and (2) the financing thereof.  Subsequent listings of equity and debt instruments should only be permitted if the proceeds will not be used for activity which is known to be incompatible with limiting warming to 1.5⁰C.

On the EAC writing to UK-linked GFANZ signatories

35. As a final point, ClientEarth would propose the following additional questions could be asked of GFANZ signatories:

• For banks (NZBA): for clients they continue to support on the basis that, although they pursue new fossil fuel activities, they are ‘transitioning to net zero’, what information are the banks collecting from clients on their (1) emissions, (2) transition plans, (3) new fossil fuel activities, in order to evaluate the credibility of their plans and 1.5°C-alignment of their activities before extending financing.
• For asset owners (NZAOA) / asset managers (NZAMI) / investors (PAII): what engagement are they doing with investee companies to challenge the credibility and implementation of their transition plans, and their fossil fuel expansion plans.
• For insurers (NZIA): what underwriting criteria will they be setting for carbon-intensive activities (including in relation to underwriting for new fossil fuel activities) that are aligned with climate science and a 1.5°C pathway, and how are they engaging with (potential) clients on their decarbonisation strategies and monitoring their progress.

• For financial services providers (NZFSPA): how do they intend to deliver on their commitment to “align all relevant services and products to achieve net zero greenhouse gas emissions by 2050 or sooner, scaling and mainstreaming Paris Agreement-alignment into the core of [their] business”, and how are they using their influence with clients to contribute to the transition to a low carbon economy.
• For all categories: what are their policies around lobbying on climate-related issues and of which trade associations are they members.

Megan Clay                                                        Jamie Sawyer

Acting Climate Finance Lead                            Lawyer, Climate Finance                           

www.clientearth.org                                           www.clientearth.org

June 2022