Climate finance

There’s no real denying it any more: climate change is a serious threat. A long-term shift in the Earth’s weather patterns means hotter temperatures, more rain, and rising sea levels, amongst many other things. And research has shown that we humans are largely to blame: our burning of fossil fuels releases greenhouse gasses into the atmosphere, trapping in heat and warming the planet.

But the consequences of climate change are more than just environmental: they’re financial too. Normal people, companies of all sizes, and economies will likely be affected. As crazy weather events become more common, for instance, insurance companies might find themselves forking out more cash for claims. Changes in weather patterns can also affect the production and transportation of raw materials, leading to supply chain disruptions and higher inflation.

Which is where climate finance comes in. In a nutshell, it’s funding – drawn from various public and private sources – that supports projects tackling climate change or helps us adapt to it. In recent years, green finance products have taken the stage, driving the hefty investments needed for eco-friendly and sustainable activities. These are things like green bonds and sustainability link loans, where the financial terms of the loan are tied to the borrower’s ability to meet sustainability targets. They encourage firms to meet climate-related goals and offer attractive returns at the same time.

Understanding both climate change and how climate finance works isn’t just for the experts. It’s important for everyone who makes decisions on where to invest and how to handle risks to understand. Hopefully, this guide will help you make more informed choices.

The role of regulation in climate change

Regulation is key to getting countries worldwide on the same page against climate change. And it’s not just a nice-to-have: climate disclosures are mandatory in many regions. For example, reporting by the Task Force on Climate-Related Financial Disclosures (TCFD) – once a voluntary measure – has evolved into a requirement for both small listed firms and large businesses. But complying with these regulations has business benefits too: robust climate risk management is increasingly correlated with better lending terms and improved access to capital.

European Union (EU) initiatives, like the EU Taxonomy for Sustainable Activities and Corporate Sustainability Reporting Directive, place mandatory emphasis on Environmental [1], Social, and Governance (ESG) considerations. And the Sustainable Finance Disclosure Regulation (SFDR) aims to make it more transparent how financial entities consider environmental risks in investments and the environmental effects of financial products. This helps prevent misleading claims about environmental friendliness, known as “greenwashing.”

The regulatory landscape will likely only get more stringent and comprehensive. This means that it’ll be increasingly important for financial professionals to maintain a robust understanding of the financial ramifications of these regulations as they unfold.

Sustainable business models for a greener tomorrow

Sustainable business models are an important part of mitigating climate change: they centre sustainability in all aspects of a business. This approach benefits various stakeholders both in the organisation and beyond, extending to the value chain – a fancy term for the whole lifecycle of a product or service from concept through to delivery and after-sales support – and the overall economy. There are four key pillars to a sustainable business model:

Sustainability: It all starts with placing sustainability at the core of all business functions. This means setting goals, finding green solutions, and making sure the company makes money without wrecking the planet.

People: Talented people are needed for any sustainable business model to be viable. It’s important to maintain a positive corporate culture and an inclusive workplace, as well as to keep stakeholders happy.

Economic Value: To keep the lights on, a company has to deliver value to customers and everyone invested in the business.

Process and Systems: Running a sustainable ship means having smooth processes and systems that align with eco-friendly goals.

To have a sustainable business model, you need a sustainable value chain. It’s not just about the company in question being green: everyone involved has to be on board. 

How to assess climate risk in your investments

If you look at the professionals for inspiration, they take a comprehensive approach, integrating climate risk considerations through their entire investment process. This typically consists of three stages: research and idea generation, company or asset valuation, and portfolio construction.

In the first stage, professional investors carefully examine a company by taking into account both the risks and opportunities related to climate factors. They often use tools like scorecards and red flags. The former grades a company’s efforts on carbon and climate, where only the high scorers make it into the investment shortlist, while the latter points out what’s missing – like good climate governance or equal voting rights. This checkup goes hand in hand with more standard research on the company’s finances and where it stands in its industry.

Moving to the second stage, these savvy climate investors often integrate climate-related factors into how they value companies. This could involve adjusting sales, margins, and balance sheets, or modifying assumptions – like cost of capital and sales growth – to reflect firms’ climate risks and opportunities.

In the final step, when putting together an investment mix, more professional investors may tweak their choices. They might use a few different strategies – like tracking popular indexes or focusing on certain themes. These adjustments could involve excluding certain investments or increasing the emphasis on specific themes. This helps investors better understand the risks and rewards of the investments they’re considering.

Crucially, when it comes to climate finance, it’s all about picking investments that fight the battle we face against climate change. Making small changes is often the best way, so even if it feels overwhelming, taking little steps can make big differences to both your portfolio of investments as well as the world we live in.