Without businesses achieving and maintaining net zero, society will not meet the goals of the Paris Agreement. To ensure companies play their part, we must be much clearer about their obligations and how these relate to the roles of financial institutions and other actors, particularly governments.
Net zero is a necessary condition for climate stability, but it is insufficient on its own to achieve the Paris Agreement’s aim of keeping global warming well below 2C and pursuing efforts to limit it to 1.5C. To do this, the stock of cumulative emissions needs to stay within the global carbon budgets for these warming thresholds. Net zero alone is not enough; it is the pathway to reaching that goal, combined with the deployment and appropriate use of durable carbon removals that scrub emissions from the atmosphere.
We must also recognise that the speed at which a company can decarbonise depends on several factors, including economic feasibility, the availability of new technologies and market conditions. Companies’ ability to deploy net-zero solutions will be shaped by these forces, along with consumer demand for sustainable products. Coherent and supportive regulations will play an essential role in accelerating progress, while inconsistent or unclear policy environments will slow it down.
The role of financial institutions
Given this, what should the primary role of financial institutions be in helping companies achieve net zero?
The answer is more complex than simply pursuing portfolio decarbonisation or focusing on the “temperature alignment” of portfolios. While these strategies have some merit as part of climate-related risk management, they do little to solve the underlying problem. Much of the focus on portfolio decarbonisation has resulted in what can be termed “paper decarbonisation”, where portfolios appear aligned with climate goals but the real-world impact is minimal, if not negative.
Transferring ownership of high-carbon assets to others who may be less willing or well-placed to bear the risk or phase out their use may exacerbate the climate crisis. Worse still, this approach may lead to “false positives”, such as divesting from high-emission companies that are integral to the energy transition, or “false negatives”, where firms with seemingly low emissions create long-term carbon lock-in through their business models.
Transition finance, transition plans and pathways
So what should financial institutions do in addition, or instead?
First and foremost, financial institutions must efficiently and effectively provide transition finance – the capital and financial products that enable companies to implement credible transition plans. These plans should ensure companies reach net zero as quickly as is reasonably possible.
The role of financial institutions in providing this finance will vary according to their specific function in the financial system, asset class and geography, requiring a high degree of specialisation. A key form of transition finance will likely come from well-designed sustainability-linked bonds and loans.
Transition plans are the foundation of corporate decarbonisation strategies, and thus central to transition finance. These plans outline a clear, step-by-step path to net zero, guiding investment decisions and operational changes. Importantly, transition plans provide the transparency needed for stakeholders – including financial institutions and governments – to monitor progress and hold companies accountable. They also offer a framework for assessing what is reasonable as market conditions evolve.
To ensure the credibility of these transition plans, it is essential to have high-ambition yet realistic sectoral net-zero pathways. These regularly updated pathways will help assess whether companies are decarbonising as quickly as they reasonably can.
In addition to sector-specific, bottom-up pathways, we also need overarching, top-down pathways aligned with the Paris Agreement’s goal of keeping global warming well below 2C, with efforts to limit it to 1.5C.
Without both of these pathways – ambitious sectoral bottom-up pathways and Paris-aligned top-down targets – it will be difficult to hold companies accountable or evaluate their contribution to climate goals. The former helps assess whether companies are decarbonising at an ambitious yet achievable pace, while the latter enables policymakers to gauge the gap between current progress and what is needed to meet the Paris goals.
As carbon budgets shrink, the gap between these two pathways will likely widen, making it crucial to clarify which pathways are being used to assess progress.
All financial institutions need to rapidly determine how they will efficiently and effectively provide the transition finance needed by their clients and investee companies without inadvertently enabling greenwashing. While challenging, this is absolutely essential.
Other levers to drive change
Second, beyond providing capital and financial products, financial institutions have the ability – and the responsibility – to ensure companies are decarbonising as quickly as possible. This can be achieved by using the levers at their disposal, particularly stewardship and engagement. Financial institutions need to hold management accountable for delivering credible transition plans.
However, stewardship and engagement efforts today are still only scratching the surface of what is possible. The influence that investors can wield to drive decarbonisation is far greater than what is currently realised in practice.
Finally, financial institutions also have a key role to play in advocating for stronger government policies and regulations that will enable companies to meet net-zero targets. This includes pushing for policy frameworks that close the gap between what is currently possible and what is necessary to meet the aims of the Paris Agreement. Clear, supportive regulatory environments are critical for enabling faster decarbonisation.
Crucially, and relatedly, financial institutions should now also advocate for new legal duties that require companies to reach net zero as soon as is reasonably possible. The transition from voluntary to mandatory climate commitments is necessary and inevitable. While voluntary corporate climate pledges have been a useful starting point, they are insufficient, and there is a risk that companies will abandon these commitments too readily.
New legal duty for companies to achieve net zero
Introducing new legal duties for companies to achieve net zero as quickly as reasonably possible would create stronger alignment between the roles of companies, financial institutions and governments. These duties can be embedded into existing legal frameworks, such as the UK Companies Act, and extended to other jurisdictions.
The concept of reasonableness is well-established in law. In the context of decarbonisation, it means that a company must act with care and diligence in reducing emissions, while taking into account its specific circumstances, industry sector and market conditions. What is considered reasonable will evolve as companies gain experience, new technologies emerge, policies become more ambitious and the economic environment shifts.
While some might argue that such duties could be inferred under existing laws, explicitly codifying them would provide the clarity and accountability necessary to drive progress at the pace required.
Incorporating reasonable efforts at the entity level would not conflict with other directors’ duties. For example, directors are bound by the UK Companies Act 2006 to promote the success of the company, considering factors like long-term consequences, employee interests and environmental impact, all while exercising reasonable care, skill and diligence. A reasonable efforts standard aligns well with these duties.
However, higher standards to achieve net zero (or related climate objectives) – such as best efforts or all reasonable efforts – can still be applied at the activity, transaction or private contract level, or in other policies and regulations.
For example, this could involve requiring credible transition plan delivery in private common law contracts, public procurement, access to public finance, risk-based financial supervision, licencing, planning, access to subsidies and market access requirements such as carbon border adjustment mechanisms (CBAMs).
The legal duty to achieve net zero as quickly as reasonably possible at the entity-level respects the diversity of industries and the distinct challenges faced by each business. This approach empowers boards and management to take ownership of their decarbonisation strategies, fostering innovation and allowing businesses to adapt their approaches to their specific contexts.
Combining new entity-level duties with activity, transaction or private contract level requirements could create a holistic “surround sound” effect, making the delivery of credible transition plans a no-brainer for the private sector.
Enforcement of new duties and obligations will be critical and should leverage existing legal processes, including courts and arbitration panels. Specialised net-zero arbitration panels could be established to provide rapid, expert assessments of whether companies are fulfilling their duties, offering clarity and efficient dispute resolution.
Financial institutions leading the transition
Unfortunately, the debate surrounding corporate climate action is often muddled, with expectations placed on companies that they cannot realistically meet alone.
Financial institutions have a critical role to play in bridging the gap between corporate action and global climate goals. By providing transition finance, holding management accountable through stewardship and advocating for stronger policy frameworks, financial institutions can drive real-world decarbonisation at the pace required.
Putting the clear onus on companies through new legal duties also has the benefit of clarifying the role of governments, as well as the role of financial institutions. New legal duties for companies to reach net zero as quickly as reasonably possible, paired with the right financial products and regulatory support, could dramatically accelerate climate action.
The transition to a net-zero economy is both a financial and moral imperative, and financial institutions are uniquely positioned to help lead the way if they refocus efforts on what will actually make a difference and articulate this more clearly.
Dr Ben Caldecott is founding director of the Oxford Sustainable Finance Group and the Lombard Odier associate professor of sustainable finance at the University of Oxford. He is also co-head of the Transition Plan Taskforce (TPT) Secretariat and serves on the expert panel of the Transition Finance Market Review.
