What do banks gain by pursuing Net Zero objectives?

Net zero financial institution alliances have been shaken up in recent months, with some banks, particularly those from the United States, withdrawing from alliances or pulling back on their commitments. In this context, a recent research paper explores the economic case for Net Zero banking, and explains why banks’ self-interest, quite apart from ethical obligations to stakeholders, supports continued efforts in transitioning towards Net Zero goals.

The paper highlights two key ways in which banks gain from pursuing a Net Zero objective: reducing risks (default risk in particular); and capturing opportunities for financing growth in expanding segments related to decarbonization. Within the context of reducing climate-related risks, the paper notes widespread evidence that most banks are not primarily doing this through divestment.

The decision between divestment and engagement is not across the board, but divestment is used less frequently. For example, studies have found that loan supply is impacted by banks’ prohibition of financing certain activities, often related to coal mining or coal-fired power plants, especially for larger banks.

In these situations, the impact on decarbonisation is greater when bank financing from one institution is not easily substituted by financing from another (whether due to cost or availability). This makes the decision-making process different for banks than equity investors because the latter can be more easily substituted in response to divestment than bank financing.

Banks, however, have a stronger informational advantage about their clients that has been built up over several years. More of these relationships focus on the more carbon-intensive businesses, which historically have been “fixed asset intensive, with cash flow and cash buffer properties that make them attractive for bank lending”. This makes engagement and pricing more common levers than divestment for influencing companies’ behaviour in support of decarbonisation and climate-related risk mitigation.

In some cases, the impact of pricing or updated risk evaluation by banks will result in loan rationing. Rather than being explicit decisions to undertake divestment, incorporating climate-related risk metrics can lead to a gap between the financing cost that meets the return threshold for the company and the bank’s risk appetite.

In addition to efforts to reduce risk, banks are also pursuing Net Zero efforts in order to expand their access to future financing growth by expanding with clients scaling up decarbonizing technology. Different banks will pursue different strategies around risk mitigation or pursuing opportunities for financing growth that will be relatively path-dependent on historical activities in a way that allows them to leverage their experience and footprint in particular sectors.

The greatest challenge to banks’ efforts on decarbonisation is an underlying tension around both types of Net Zero financing. Financing the decarbonisation of existing high-carbon companies can be associated with “exposure to stranded assets, green regulations, and carbon-emitting sectors [that] may mean greater risk for bank lending portfolios”. Meanwhile, financing new decarbonisation technology “might be seen as riskier, with growth orientations rather than stability properties”.

This combination can produce instability in risk properties throughout the transition. The paper concludes: “…it is possible that transition can be very risky in the short run and have lower risk in the long run”. Although the research focuses on economic incentives that drive banks’ actions in support of Net Zero, it operates within a wider context that includes the regulation of safety and soundness.

As regulators increase their focus on the impact of climate-related risks on financial stability, they will produce incentives for banks that over time help to resolve the tension in risk properties. Although this isn’t the focus of the research, which centres around economic incentives for banks to support the transition to Net Zero, the regulatory benefit of being able to demonstrate your preparation to manage climate risks is something — along with banks limiting their exposure to areas with high physical climate risk — that helps banks prepare for future policy changes and other climate-related risks.

The research around banks’ incentives in the transition to Net Zero suggests that not every bank will approach it in the same way. Each bank will approach the transition with different opportunities to pursue based on the heterogeneous characteristics of different institutions, and there won’t be a single, one-size-fits-all approach. This is likely to be particularly true with markets, such as many within the OIC, where transition risks intersect with physical risks, as well as with regulatory risks originating locally and those connected with key export markets.