4.4.3.1 Introduction

The transition to a net-zero carbon economy relies on financial markets adopting sustainable practices to unlock low-carbon opportunities, accelerate emissions reduction and nature conservation efforts, and mitigate societal and financial risks associated with carbon-stranded assets. The financial system must both finance the ‘green’ (the desirable) and stop financing the ‘dirty’ (the undesirable), while managing financial risk-adjusted returns as its primary function (fiduciary duty). However, financial markets tend to replicate by default the economy as it is, as they do not a priori ‘have a plan’ for the economy, whether high or low carbon. The existing economic framework largely operates within an accumulation paradigm driven by search for short-term profits, inadequate climate policy and unclear industrial priorities at both national and international levels. In this context, perpetuating historical patterns is still the best way to ensure profitability. Driven by backward-looking, climate-blind indicators and ignoring the complexity and systemic impacts of their investments on the environment (Chenet et al., 2021; Crona et al., 2021), financial actors are still allocating capital to fossil fuel assets, consolidating and even creating new carbon lock-ins (FTM, 2023), thereby constructing their own exposure to future climate-related financial risk. However, it is now clear that those investments are not ‘needed’ from an energy-demand perspective (IEA, 2023).

To be effective at accelerating the transition, financial markets need to be forced to move beyond their conventional emphasis on financial risk and return, short-term horizons, prevailing market rules and operations, and would need to integrate systemic sustainability considerations into regulation and market practices across the entire financial chain (including investors, financers, financial services, rating agencies and more). Progress thus far does not match the needed pace and depth of transformation. It has been essentially limited to reframing (such as addressing climate-related financial risk), repackaging (as seen in the case of green bonds) and disclosure (with the establishment of the Task Force on Climate-Related Disclosures (TCFD) and similar initiatives), and has not yet led to a significant reallocation of financial capital at global scale. However, the potential exists for swift and nonlinear changes that can drive transformative shifts within and beyond the financial sector. In this way, the financial system can be an enabler of positive tipping points in other sectoral systems, in the ‘real economy’, and may itself exhibit tipping point behaviours. 

On the positive side, the financial sector’s engagement with climate change has nevertheless undergone a significant evolution over the last decade. Key milestones, such as the 2015 Paris Agreement and Mark Carney’s (former Bank of England Governor) influential speech on climate-related financial risks, have catalysed a new discourse connecting finance and climate change and prompting financial actors to embark on a different path (Farmer et al., 2019). The formation of voluntary initiatives like the private-led Glasgow Financial Alliance for Net Zero (GFANZ) and the central bank-led Network of Central Banks and Supervisors for Greening the Financial System (NGFS), exemplifies the growing commitment of financial entities, from private institutions to public authorities, to align themselves with climate targets beyond their traditional perimeter. While not yet having led to transformative actions, these coalitions in their respective domains aim to achieve net-zero carbon emissions by 2050, which questions the role of finance in addressing the challenges posed by climate change – either by challenging the historical role and responsibilities of financial institutions vis-à-vis invested and financed companies, or through renewed approaches to financial supervision, credit and monetary policy (Chenet, 2023; Lamperti et al., 2021).

These shifts have the potential to surpass crucial thresholds or tipping points, where a small change can trigger a larger, irreversible transformation, with feedback effects acting as amplifiers. By influencing the allocation of capital to different sectors or activities, the financial system has the power to affect the evolution and composition of the real economy. Often, the financial system has functioned to amplify oscillations, whether positive or negative, through reinforcing feedback mechanisms such as the financial accelerator, contagion, bank runs and assets’ fire sales (Bernanke et al., 1999; Gatti et al., 2010). However, finance doesn’t just magnify economic shocks – it may also assume a crucial role in enabling technological revolutions (Perez, 2003). Financial actors – and public investors most prominently (Mazzucato, 2013) – actively contribute to the advancement and implementation of innovative technologies, extending their involvement beyond simply providing funds. In fact, they often take part in the management of the innovation process, assuming the role of financial entrepreneurs and ‘picking winners’, while other mechanisms can also operate concurrently. For instance, once a particular path is established, it can lead to a self-reinforcing cycle where the initial choice gains momentum and becomes increasingly difficult to change (Arthur, 1989). Finance, thus has the capacity to expedite or impede the dissemination of new products and technologies, particularly those of utmost importance for the transition to a low-carbon future.