Through Anindita PalFinancial Services Director, baringa
TThe urgency of action to tackle climate change has been reinforced by 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 effects of the increase in weather and climate extremes, it is noteworthy that global CO2 emissions have returned to their highest levels in history in 2021 and more than reversed the pandemic-induced decline in 2020 to have.
If we are to have any chance of staying on the already narrow path to net zero by 2050, both the public and private sectors must act together and urgently. The transition will require massive deployment of clean energy technologies, leaps in energy innovation, and low-carbon infrastructure, and these will require many trillions of dollars of investment over this decade and beyond.
Financial services are uniquely positioned to fund a large portion of these investments and can and must be at the heart of this shift. To do this effectively, financial services companies must make some key strategic decisions.
Become your customer’s transition partner
A fundamental priority for financial services companies must have their lending and investments related to Scope 3 emissions, making customer retention and supporting customers’ decarbonization efforts a key lever in the transition.
Tackling the harder-to-reduce sectors such as heavy industry and heavy-duty transport will be a key challenge due to the higher abatement costs associated with technological solutions – these sectors will need the most transitional financing to enable their expansion with clean technologies and to reach net-zero targets in a cost efficient way. Some companies may be tempted to consider divesting high-carbon customers in hard-to-reduce sectors as an easier route to net-zero. However, this is likely to be counterproductive for many sectors and will not allow the global economy to reach net zero.
Where there is general agreement on the need for sound transition plans at the individual company level, recent reports from CDP on climate protection plans and The Climate Policy Initiative (CPI) Net Zero Finance Tracker. indicate that most companies do not yet have credible transition plans to meet their net zero commitments. This highlights a discrepancy between the actions actually taken and the expectations of investors and other stakeholders. Credibility assessment encompasses multiple dimensions, ranging from whether plans are based on science-based pathways, are disclosed and effectively monitored, or are supported by the right level of funding, policies and governance. It is all the more important for financial services companies to support their customers in their transition plans with training, tools and tailor-made financing solutions.
However, financial services firms must also be prepared to make some difficult trade-offs. When a profitable customer, despite significant commitment and support, is simply unwilling to convert, banks may need to pull out of the business to reallocate capital to customers who are actively converting or are looking to convert.
Embrace product innovation with care
After gaining an understanding of the scope of portfolio management required, banks can seize the opportunity to offer green, sustainable and transitional finance products to meet the needs of their customers. We have seen significant growth in green and sustainable bonds and sustainability-linked lending in recent years. The profitability of these products will no doubt vary, as will the risk/reward profile of some of the emerging investment opportunities. Products like transition bonds are emerging as a new asset class to support high-carbon industries.
On the other hand, we are also seeing increasing investor concerns related to green washing. Product classification and eligibility guidelines, such as Other tools, such as the EU taxonomy for sustainable finance, are rapidly emerging to help address some of these concerns and support the scale-up of such investments. Organizations should consider the latest guidance as part of their efforts to implement appropriate governance and controls around such products.
Prepare for regulations and framework conditions
In recent years there has been an enormous development in regulatory standards and frameworks in the areas of measuring greenhouse gas emissions, sustainable finance and climate risks.
standards such as The Partnership for Carbon Financials (PCAF), commonly used by financial institutions to determine base emissions, are also evolving. PCAF aims to expand asset class coverage and include facilitated issuance related to capital markets activities by the end of 2022.
Regulators such as the European Central Bank (ECB) and the Bank of England have indicated that climate capital requirements are likely to be formalised, with further guidance expected throughout 2022. Therefore, financial institutions need to prepare for such requirements.
As standards and disclosure requirements evolve, requirements need to be more harmonized and fragmentation across jurisdictions reduced. While some uncertainty remains about how regulation might evolve in some regions, companies should not delay their efforts to adopt available best practice frameworks.
Invest in data, process, policy and people
The transition will also require significant investments in data, models, tools, and people—and rewiring an organization’s operating model over time.
Currently, most financial institutions are not at the point where net-zero and climate risk considerations are operationalized in their client business processes, policies and risk appetite. Banks, for example, have traditionally not been operated with CO2 as a constraint. There needs to be a clear shift here, starting with management creating the right incentives to prioritize green and transitional investments while penalizing brown deals, for example through internal carbon cost charging mechanisms.
Also, companies need to ensure their sector policies and position statements are aligned with the recommendations of leading authorities such as the IEA, particularly in the case of fossil fuels.
Investing in scenario analysis and modeling capabilities will also be critical to setting science-based targets and the associated financial implications. Climate modeling also differs significantly from traditional financial risk modelling. Climate data is still emerging, and most companies struggle with data availability and quality gaps, especially for external data such as company-level emissions.
With increasing disclosure requirements in many jurisdictions like TCFD, we can expect public or large companies to release better climate data. However, banks with significant 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 guidance from regulators is that companies don’t wait for the perfect models and tools to get started, but actively invest in those skills in the short-term. Such capabilities will come even more into focus as regulators seek to factor climate into capital requirements, requiring companies to prepare to up their game.
Another pillar that requires clear prioritization is employee training and upskilling – from training frontline workers to assessing risk and opportunity at the industry and customer levels, to training risk and finance teams on new metrics and KPIs related to risk appetite and financial planning Share knowledge across the organization to drive the right cultural shifts needed to operationalize the transition.
Stand up for acceleration
Boards and executives of financial institutions are increasingly recognizing that the commitment to net zero and the execution of those commitments are fast becoming a fundamental foundation of their growth strategy. We’re starting to see a shift away from just thinking about what not to do, e.g. B. investing in coal mining or coal power plants, and are beginning to act on what more they should be doing to accelerate decarbonization efforts.
A key consideration that is quickly emerging is the need for a just and fair transition for those countries and communities that are likely to be more affected by the transition. For example, while achieving a global transition is critically dependent on the ability to phase out coal power, the majority of coal-fired assets are in developing countries. On the other hand, these countries have competing development priorities, such as B. the need for basic infrastructure and they lack the financing and capacity needed for the energy transition. These countries need support, including from financial services companies, in the form of lower financing costs related to building large-scale renewable energy infrastructure and creating “green jobs” for affected workers.
Beyond mobilizing capital, financial institutions should aim to use their leverage to advocate for supportive policies through collaboration with the public sector and policymakers.
Those companies that see the big picture and make the right strategic decisions will turn the daunting climate challenge into a real opportunity for themselves and the economy at large.
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