Tipping the global financial system

January 25, 2024|Written by Jamie Rickman
A woman standing in a field of small bushes, holding several green seed pods in her hands. Behind stand two solar panels.
A tipping point for solar energy may already have been crossed, triggering exponential growth in investment. © Nabin Baral / IWMI

By continuing to finance the fossil fuel economy, the financial sector is fuelling its own demise. Fossil fuel emissions are driving Earth systems past negative tipping points such as the collapse of Greenland’s ice sheet or the death of coral reefs, beyond which abrupt and irreversible changes are inevitable. What’s worse, the crossing of one negative tipping point can trigger others in a domino-effect, accelerating the breakdown of our planet’s life-support systems.

On our current trajectory, sea-level rise and the loss of critical natural systems will cause societal collapse – and with it the collapse of the global financial system – by the end of the century.

Time is running out. Instead of driving us towards negative tipping points, positive tipping points must be activated in financial markets to secure a livable future. The interconnected nature of human and Earth systems means that a shift in the activity of financial markets could trigger a cascade of positive tipping points across socio-economic and technological systems, knocking us back onto a temperature trajectory in line with the Paris target of 1.5°C of global heating.

Positive tipping points may already have been crossed

Triggering these positive tipping points means kicking countries out of high-emitting, business-as-usual economic activities and initiating rapid growth in low-carbon sectors. A positive tipping point may have already been crossed in financial markets for solar energy, as policy support and subsidies have driven down the cost of solar and triggered exponential investment growth in emerging Asian economies such as the Philippines, Indonesia, India, China and Japan.

This, in turn, drives transformation in other sectors in mutually reinforcing positive feedback loops. For example, by encouraging investment in renewables infrastructure, boosting technological progress through “learning by doing”, and shifting social norms that encourage “contagion” in the uptake of domestic solar installations.

However, what constitutes a positive tipping point is controversial, as evidenced by tensions at Cop28 in December. The decline of fossil fuel industries will create winners and losers, with fossil-fuel exporting countries such as the conference’s host nation, the United Arab Emirates, taking the greatest hit.

Tensions notwithstanding, the final communique from Cop28 was the first to explicitly state the need for a “transition away from fossil fuels in energy systems” in a “just, orderly and equitable” manner, recognising the differential economic consequences of the transition across regions.

It is now up to the governments, central banks and regulators, as well as the private sector, to change the rules of the game. Financial markets must be disincentivised from funding high-emitting sectors and encouraged into low-carbon sectors. This will mean incorporating short-term and long-term climate risks into financial decision making, while at the same time creating an enabling environment for low-carbon investment.

Despite the growth of the sustainable finance narrative within the private finance community, investment decisions continue to be based on risk-return calculations that use short-term horizons and climate-blind metrics, in direct opposition to the long-term vision required to activate positive tipping points.

Mark Carney’s influential speech on climate-related financial risk in 2015 catalysed a new discourse on the role of the financial sector in climate action and the need for the disclosure of climate-related risks. In exposing the risks of high-carbon assets and the opportunities of climate-resilient low-carbon assets, disclosure initiatives promised to redirect capital from the former to the latter.

However, disclosure can only be effective in coordination with steadfast domestic and international climate policy. Conservatism in financial markets due to an uncertain policy environment has only been compounded by the proliferation of investment taxonomies and a lack of credible, international oversight of their application.

So far, there is little evidence to suggest that disclosure initiatives can, on their own, shift financial capital from high-carbon to low-carbon sectors at the scale needed. A review by the ECB in 2022 concluded that none of the 109 banks under its supervision met its disclosure expectations and instead accusations of greenwashing abound.

Taking a precautionary approach

The failure of private initiatives demands stronger interventions by central banks and regulators. Changes to microprudential regulation via capital requirements rules, for example, could be used to upweight the risk of fossil fuel assets and reduce bank lending to the fossil fuel sector, which is currently its main source of fundraising.

However, central bankers are used to making regulation based only on the latest crisis, not anticipating unprecedented events such as cascades of negative tipping points and climate breakdown. Indeed, capital regulatory frameworks use methodologies with only one-year foresight.

The Climate Safe Lending Network is calling for central bankers to change course and take a more precautionary and proactive approach in the face of a possible “climate Lehman moment“. In addition to amending capital regulatory frameworks to reflect medium and long-term climate risks, this could involve developing green collateral frameworks and using green quantitative easing to enable positive tipping points in low-carbon financial markets.

Inequities in access to finance must be addressed if positive tipping points are to be crossed in a just and equitable manner. Developing countries in particular struggle to finance their low-carbon transitions. International financial institutions, such as multilateral development banks (MDBs) and development finance institutions (DFIs), will be critical to trigger positive tipping points in developing countries. Public finance should aim to build investment track records and strengthen renewables markets where private finance is unwilling to go, in order to initiate positive feedback loops of technological and financial learning and crowd-in the private sector.

Critically, MDBs and DFIs must provide quality finance (long-term and low-cost) that does not increase the debt distress of developing countries. Centring equity in the delivery of international climate finance will require a suite of reforms to international climate finance architectures, such as those put forward in the Bridgetown Initiative.

Central banks, regulators and international financial institutions will play a critical role in this decisive decade. If climate catastrophe is to be avoided, the material risks posed by negative tipping points in planetary systems and the opportunities posed by activation of positive tipping points in the financial sector must be recognised and reflected in financial policy and regulation. Regulatory levers must be pulled to tip the risk/reward balance in favor of low-carbon assets, in combination with clear and steadfast transition plans that signal to investors where their money will be profitable and future-proof.

This page was last updated January 25, 2024

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