By Anindita Pal, Director of Financial Services, Baringa
The urgency of action needed to combat climate change has been further amplified by recently released reports from IPCC (Sixth Assessment Report on Climate Change) and IEA (Global Energy Review – CO2 emissions in 2021). Against the alarming backdrop of some of the already irreversible impacts from rise in weather and climate extremes, what is notable is that global CO2 emissions rebounded to their highest level in history in 2021, more than reversing the pandemic-induced decline experienced in 2020.
If we are to have any chance of staying on the already narrow pathway of net-zero by 2050, both the public and private sectors will need to act collaboratively and with urgency. The transition will require massive deployment of clean energy technologies, leaps in energy innovation and low-carbon infrastructure, and this will require many trillions of dollars of investment this decade and beyond.
Financial services are uniquely positioned to finance a large proportion of this investment and can, and must, be at the heart of this change. Doing so effectively will require financial services firms to make some important strategic choices.
Become your client’s transition partner
A fundamental priority for financial services firms needs to be their lending and investments related Scope 3 emissions, making customer engagement and supporting decarbonisation efforts of customers a key lever for transition.
Tackling the harder-to-abate sectors such as heavy industry and heavy-duty-transport will be a key challenge due to higher abatement cost associated with technological solutions – it is these sectors that will require the most transition finance to enable them to scale up clean technologies and reach net-zero targets in a cost-effective way. Some firms may be tempted to consider divestment from carbon intensive clients in hard-to-abate sectors as an easier route to get to net-zero, however this is likely to be counter-productive for many sectors and will not enable the global economy to get to net-zero.
Where there is general agreement on the need for robust transition plans at the individual company level, recent reports from CDP on climate transition plans and The Climate Policy Initiative’s (CPI) Net Zero Finance Tracker suggest that most firms do not yet have credible transition plans place to deliver on their Net Zero commitments. This highlights a mismatch between actual actions being taken and expectations of investors and other stakeholders. There are multiple dimensions to credibility assessment, with considerations ranging from whether plans are grounded in science-based pathways, disclosed and monitored effectively to whether they are supported by the right level of funding, policies and governance. This makes it all the more critical for financial services firms to support their clients with their transition plans through education, tools and tailored financing solutions.
Having said that, financial services firms will also need to be prepared to make some difficult trade-offs. If a client that is profitable is simply not willing to transition, despite significant engagement and support, banks may need to withdraw from that business, with the view to re-directing capital to clients that are actively transitioning or looking to transition.
Embrace product innovation with care
Following on from gaining an understanding of the level of portfolio steering they will need to do, banks can seize the opportunity to provide green, sustainable and transition finance products to meet their client’s needs. We have seen significant growth in green and sustainable bonds and sustainability linked loans in recent years. The profitability of these products will undoubtedly vary, as will the risk / return profile of some of the emerging investment opportunities. Products such as transition bonds are emerging as a new asset class to support carbon-intensive industries.
On the other hand, we are also witnessing increasing investor concerns linked to green washing. Guidance on product classification and eligibility, such as EU taxonomy on sustainable finance, is fast emerging to help alleviate some of these concerns and support scaling up of such investments. Firms should take latest guidance into account as part of their efforts to implement appropriate governance and controls around such products.
Prepare for regulations and frameworks
In recent years, there has been a huge development in regulatory standards and frameworks in the area of GHG emissions measurement, sustainable finance and climate risk.
Standards such as The Partnership for Carbon Financials (PCAF), widely used by financial institutions to determine baseline emissions, are also evolving. PCAF are looking to broaden coverage of asset classes and inclusion of facilitated emissions relating to capital markets activities by the end of 2022.
Supervisors such as European Central Bank (ECB) and Bank of England have indicated that climate capital requirements are expected to be formalized, with further guidance expected later in 2022. As such, financial institutions will need to prepare themselves for such requirements.
As standards and disclosure rules develop further, there will need to be greater harmonization of requirements and less fragmentation across jurisdiction. While there continues to be some uncertainty in how regulation might evolve in some regions, firms shouldn’t delay their efforts in adopting available best-practice frameworks.
Invest in data, processes, policies, and people
The transition will also require significant investments in data, models, tools and people – and, over time, a re-wiring of a firm’s operating model.
Currently, most financial institutions are not at the point where net-zero and climate risk considerations are operationalized in their client-deal making processes, policies and risk appetite. Banks have not been traditionally run with carbon as a constraint for instance. There needs to be a clear shift in this, starting with management creating the right incentives to prioritise green and transition investments, while penalizing brown deals, such as through internal mechanisms to charge for cost of carbon.
Also, importantly, firms must ensure that their sector policies and position-statements are aligned with recommendations of leading authorities such as IEA, especially in the case of fossil-fuels.
Investing in scenario analysis and modelling capabilities will also be critical to establishing science-based targets and associated financial implications. Climate modelling is also significantly different from traditional financial risk modelling. Climate data is still nascent, and most firms are grappling with gaps in availability and quality of data, especially external data such as company level emissions.
With increasing disclosure requirements in many jurisdictions such as TCFD, we can expect to see better climate data published by listed or large companies. However, banks with significant SME portfolios concentrated in developing markets are likely to continue to face challenges in this area in the near to medium term and will need to consider innovative approaches to improve their data strategies.
The general steer from regulators is for firms to not wait for the perfect models and tools to make a start but to actively invest in these capabilities in the near-term. Such capabilities will come under even more focus as supervisors look to incorporate climate into capital requirements so firms will need to get prepared to raise their game.
Another pillar that will require significant prioritisation is training and upskilling of employees – from educating front-line staff on sector and client-level risk and opportunity assessment, to training risk and finance teams on new metrics and KPIs in risk appetite and financial planning, to sharing knowledge across the entire organisation to create the right culture shifts required to operationalize the transition.
Advocate to accelerate
Boards and executives of financial institutions are increasingly realising that committing to net-zero and acting on these commitments is fast becoming fundamental to their growth strategy. We are starting to see a shift away from solely thinking about what they shouldn’t be doing, for example, investing in coal-mining or coal-fired power, and starting to act upon what they should be doing more to accelerate decarbonisation efforts.
A key consideration that is fast emerging is the need for a just and fair transition for those countries and communities that are likely to be more adversely impacted by transition. As an example, while achieving a global transition hinges significantly on the ability to phase out coal power, the majority of coal- fired facilities can be found in developing countries. On the other hand, these countries have competing development priorities such as need for basic infrastructure and lack the funding and capacity needed to make the energy transition. These countries will need assistance, including from financial services firms, in the form of lower financing costs associated with deployment of large-scale renewable energy infrastructure and creation of “green jobs” for impacted workers.
Beyond mobilising capital, financial institutions should aim to use their influence to advocate for supportive policy action through collaboration with public sector and policy makers.
Those firms that see the bigger picture and make the right strategic choices will turn the formidable climate challenge into a real opportunity for themselves and the broader economy.