How Financial Services Firms Shape the Real Economy
By Anindita Paldirector of financial services, baringa
JThe urgency for action to tackle climate change has been further amplified by the recently released reports from the IPCC (Sixth Assessment Report on Climate Change) and the IEA (Global Energy Review – CO2 emissions in 2021) . Against the alarming backdrop of some of the already irreversible impacts of increasing weather and climate extremes, what is remarkable is that global CO2 emissions have rebounded to an all-time high in 2021, more than reverse the pandemic-induced decline recorded in 2020.
If we are to have any chance of staying on the already narrow path to net zero by 2050, the public and private sectors will need to act collaboratively and urgently. The transition will require a massive deployment of clean energy technologies, leaps in energy innovation and low-carbon infrastructure, and it will require multi-trillions of dollars of investment over this decade and beyond.
Financial services are uniquely positioned to fund much of this investment and can, and must, be at the heart of this change. To do this effectively, financial services firms will need to make important strategic choices.
Become your client’s transition partner
A fundamental priority for financial services firms must be their scope 3 emissions related to lending and investing, making customer engagement and supporting customer decarbonization efforts a key enabler of the transition.
Tackling the hardest-to-reduce sectors such as heavy industry and heavy transport will be a major challenge due to the higher cost of reduction associated with technological solutions – these are the sectors that will require the most transition funding to enable them to develop clean technologies and achieve net zero goals in a cost-effective way. Some companies may be tempted to see divestment from carbon-intensive customers in hard-to-reduce sectors as an easier way to reach net zero, but this is likely to be counterproductive for many sectors and will not help. not for the global economy to get to net-zero.
Where there is general agreement on the need for robust transition plans at individual company level, recent reports from CDP on climate transition plans and Climate Policy Initiative (CPI) Net Zero Finance Tracker suggest that most companies do not yet have credible transition plans in place to meet their Net Zero commitments. This highlights a mismatch between the actions actually taken and the expectations of investors and other stakeholders. Assessing credibility has several dimensions, with considerations ranging from whether the plans are science-based, effectively disclosed and monitored, to whether they are backed by the right level of funding, policies and governance. It is therefore all the more essential for financial services companies to support their clients in their transition plans through training, tools and tailor-made financing solutions.
That said, financial services firms will also need to be prepared to make tough trade-offs. If a profitable customer is simply unwilling to transition, despite significant commitment and support, banks may have to withdraw from this business, with the aim of redirecting capital to customers who are actively transitioning or who seek to do so.
Embrace product innovation with care
After gaining an understanding of the level of portfolio steering they will need to perform, banks can seize the opportunity to provide green, sustainable and transitional finance products to meet the needs of their customers. We have seen significant growth in green and sustainability bonds and sustainability-related loans in recent years. The profitability of these products will no doubt vary, as will the risk/reward profile of some 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 growing investor concerns related to green washing. Guidance on product classification and eligibility, such as the EU taxonomy on sustainable finance, is rapidly emerging to help alleviate some of these concerns and support the scaling up of these investments. Companies should consider the latest guidance as part of their efforts to implement proper governance and controls around these products.
Prepare for regulations and frameworks
In recent years, standards and regulatory frameworks have evolved considerably in the area of measuring GHG emissions, sustainable finance and climate risk.
standards such as The Partnership for Carbon Finance (PCAF), widely used by financial institutions to determine benchmark emissions, are also changing. The PCAF seeks to broaden the coverage of asset classes and the inclusion of facilitated issues related to capital markets activities by the end of 2022.
Supervisors such as the European Central Bank (ECB) and the Bank of England have indicated that climate capital requirements should be formalized, with further guidance expected later in 2022. As such, financial institutions will need to prepare to these requirements.
As standards and disclosure rules develop, there will need to be greater harmonization of requirements and less fragmentation across jurisdictions. While there remains some uncertainty as to how regulation may evolve in some regions, companies should not delay their efforts to adopt 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 rewiring of a company’s operating model.
Currently, most financial institutions are not at the point where net zero and climate risk considerations are operationalized in their customer transaction processes, policies and risk appetite. Banks have not traditionally been managed with carbon as a constraint, for example. There needs to be a clear shift in this regard, starting with management creating the right incentives to prioritize green and transitional investments, while penalizing brown transactions, for example through internal mechanisms to charge the cost of carbon.
Additionally, it is important for companies to ensure that their sector policies and position statements are aligned with the recommendations of key authorities such as the IEA, particularly in the case of fossil fuels.
Investing in scenario analysis and modeling capabilities will also be essential in establishing scientific objectives and the associated financial implications. Climate modeling is also very different from traditional financial risk modeling. Climate data is still nascent, and most companies struggle with gaps in data availability and quality, especially external data such as company-level emissions.
With increased disclosure requirements in many jurisdictions such as TCFD, we can expect to see better climate data released by listed companies or large corporations. However, banks with large SME portfolios focused on developing markets will likely continue to face challenges in this area in the short to medium term and will need to consider innovative approaches to improve their data strategies.
The general direction from regulators is that companies don’t wait for the perfect models and tools to start with, but actively invest in those near-term capabilities. These capabilities will be further targeted as supervisors seek to build climate into capital requirements, so companies will need to be prepared to up their game.
Another pillar that will require significant prioritization is employee training and development – from educating front-line staff on assessing risks and opportunities at the industry and client level, to training management teams of risk and finance on new metrics and key performance indicators for risk appetite and financial planning, to share knowledge across the organization to create the right culture changes needed to operationalization of the transition.
Plea to accelerate
Boards and executives of financial institutions are increasingly realizing that committing to net zero and acting on those commitments is quickly becoming fundamental to their growth strategy. We are starting to see a shift away from just thinking about what they shouldn’t be doing, for example, investing in coal mining or coal-fired power generation, and starting to act on what they should do more to accelerate decarbonization efforts.
A key consideration that is rapidly emerging is the need for a just and equitable transition for countries and communities likely to be hardest hit by the transition. For example, while achieving a global transition largely depends on the ability to phase out coal-fired power, the majority of coal-fired power plants are in developing countries. On the other hand, these countries have competing development priorities such as the need for basic infrastructure and lack the financing and capacity needed to make the energy transition. These countries will need help, including from financial services firms, in the form of reduced financing costs associated with the deployment of large-scale renewable energy infrastructure and the creation of “green jobs” for the workers concerned.
Beyond raising capital, financial institutions should aim to use their influence to advocate for supportive political action through engagement with the public sector and policy makers.
Companies that see the big picture and make the right strategic choices will turn the formidable climate challenge into a real opportunity for themselves and for the wider economy.