What is net zero and what are the implications for financial regulation?

In the urgent pursuit of mitigating climate change and its far-reaching consequences, the concept of net zero has emerged as a central benchmark in global discussions. As nations, corporations, and individuals grapple with the imperative to reduce greenhouse gas emissions, net zero has gained both prominence and ambiguity.

An increasing number of governments are setting net zero goals, while prominent banks and investors pledge to make their portfolios net zero by 2050. Central banks and supervisors, as custodians of the financial system, must likewise establish clear strategies to aid the transition to net zero, advancing efforts to address climate change risks. However, the principles of net zero have been obfuscated by various actors, either by setting target deadlines far into the future or employing it as a means to delay meaningful action in the present.

What is net zero?

At its core, net zero refers to achieving a state where the net amount of greenhouse gases produced is balanced by an equivalent amount removed from the atmosphere. This equilibrium can be attained through a combination of emission reduction measures and implementing technologies that capture and store carbon dioxide. However, it is important to distinguish between gross emissions or the total amount released, and net emissions which are the balance between emissions released and emissions removed or offset.

Around 150 countries, which make up 92% of global GDP and contribute 88% of total emissions, have pledged to reach net zero emissions. Pledges differ in time horizons: the UK aims to reach it by 2050, while India’s goal is 2070. If the world continues at present emission levels, the IPCC predicts average global temperatures to rise between 3 and 6°C.

Pitfalls of net zero in climate transition strategies

As appreciation of climate risks and transition strategies grow, central banks face two key challenges. First, there’s the question of mitigating the risks of climate change to financial system stability and the broader economy by advancing a net zero economy. Central banks also need to consider how their actions can be aligned with government policies promoting net-zero objectives. To achieve this, institutions are committing to emission reduction pathways.

The ambitious pursuit of net zero in climate transition strategies is not without its challenges and pitfalls. One major concern is the potential for net zero to inadvertently result in a lack of action by creating the illusion that emissions need not be entirely eliminated. This is particularly true when strategies heavily rely on unproven or future technologies, allowing organisations to delay meaningful emission reductions in the present. Numerous studies have raised questions about the effectiveness of carbon capture technologies, and there is currently a bottleneck with scaling storage technologies in time to meet the goals of the Paris Agreement.

Additionally, an overemphasis on offsetting mechanisms can divert attention from systemic changes needed in sectors with high emissions. For instance, an energy company might invest heavily in forest conservation projects to offset emissions from its operations while continuing to rely predominantly on fossil fuels for energy production. Critics have described offsetting as “carbon accounting tricks” which are no substitute for the immediate reduction of emissions. As  economist Thierry Philipponnat has previously argued, the goal of net zero should be to decarbonise the real economy, not just financial portfolios.

Greenwashing and the net-zero illusion

Greenwashing refers to the deceptive practice of conveying a false impression of environmental responsibility. HSBC, for example, had some of their advertisements banned in the UK for misleading the public on their climate action.

The increase in net-zero pledges while carbon emissions are still being pumped into the atmosphere cast doubts on the integrity of those pledges. James Jackson of the Sustainable Consumption Institute at the University of Manchester told Green Central Banking: “Whilst the shift amongst financial institutions is a positive one, their commitments to net zero, which have tended to become couched within ESG assets, is littered with problems. Net zero, framed within the realm of ESG assets, faces criticism for being more politically appealing than scientifically sound. The consensus on achieving this goal by 2050 tends to promote a passive stance among regulators, investors and supervisors. They often rely on voluntary measures such as disclosures and marginally increased rates on credit provision to reflect the disproportionately greater risk.”

According to Jackson, this approach illuminates the prevailing faith in the financial system to internalise climate risk while continuing to yield economic returns. This subjects ESG and any other ‘green’ assets to the logic of financial materiality and, by extension, demotes environmental materiality in perpetuity.

The result, Jackson concludes, is that contrary to the belief that the transition is simply a case of access to financing, the financial system is in fact often a barrier to the transition.

Regulatory considerations in assessing transition plans

For regulators and supervisors tasked with evaluating climate transition plans, there are many aspects to consider. NGOs, academics, and institutions have provided a multitude of frameworks and recommendations. The latest of these is a net-zero framework for banks from the Institutional Investors Group on Climate Change (IIGCC). It outlines 10 standards that banks should live up to, including short, medium, and long-term targets for reducing emissions associated with both on and off-balance sheet financing activities.

Critically for decarbonisation strategies, the focus must be on financed or facilitated emissions, rather than operational emissions as these are much larger and more critical for keeping to a net zero pledge. The role of banks in capital markets is perhaps even more crucial. The Sierra Club recently revealed how the majority of financing for fossil fuel expansion comes from underwriting bonds and equities.

WWF published a comprehensive call to action detailing several recommendations that overlap with the IIGCC’s bank framework. The report emphasises three key points. Firstly, it calls for a transparent emissions reporting framework to ensure consistent measurement and comparison across industries. Secondly, it urges a focus on actual emission reductions rather than just offsetting methods, with central banks and regulators setting clear climate goals. Thirdly, it warns against relying too heavily on unproven technologies, favouring present-day strategies.

Furthermore, the report proposes strict measures for those involved with environmentally harmful activities, including higher capital and liquidity requirements, capital add-ons for concentration risk, and increased systemic risk buffers. It also calls for central banks to divest from harmful activities and encourages clean energy production through a “green dual rate” that offers interest rate discounts for clean energy initiatives.

In this area, the Grantham Institute called for “clear net zero criteria for collateral, refinancing and asset purchase programmes” in its 2021 net zero report.

The Grantham Institute also recommended exploring the implications of net zero for jobs and well-being, in addition to connecting central banks’ macrofinancial stability and employment objectives to the climate risk and net zero agenda.

Lastly, collaboration and knowledge-sharing among regulators globally are essential to develop a cohesive approach to evaluating net zero transition plans. This fosters consistency, minimises greenwashing, and ensures that the pursuit of net zero aligns with the urgency of climate action.

Reports have also shone light on how transition plans may be better designed. Darian McBain, visiting professor at the London School of Economics’ Grantham Institute says regulators must shift from a “data-driven to a human-centred approach”. Another paper expands on a “supervisory playbook for prudential authorities”, while Finance Watch offers several recommendations for non-financial corporate issuers, financiers and financial supervisors in order to tackle the race to net zero.