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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. 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”.
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.
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.
What banks are (and are not) disclosing in their transition plans
The Sustainable Finance Observatory (formerly 2°Investing Initiative) released a report evaluating some of what can be expected to be in the forthcoming reports, and what may be missing. Their analysis is based on the disclosures to date made under transition plan guidance for signatories to the Net Zero Asset Management and Banking Alliances.
For investors and financial institutions in OIC markets with less robust non-financial transition plans and sustainability reporting, the gaps are surely wider, even as a successful climate transition carries a significant opportunity (and risk mitigation) outcome for the economy and financial sector. These will be compounded by an increased focus not only on the ‘credibility’ of transition plans, but also on the alignment of transition plans with Just Transition principles.
For resource-intensive economies, physical and transition risks could drive a ‘climate change risk trap’
On a global level, and in guidance for financial sector regulators, climate change actions are often presented as a sliding scale between climate mitigation – efforts to reduce emissions – and climate adaptation – efforts to make countries more resilient to the impacts of climate change. The dichotomy arises within the financial sector through a similar sliding scale between different scenarios.
Many OIC countries face a different outlook, however, where higher transition and physical risks coexist, especially at the sub-national level. A new paper terms this outcome a ‘climate change risk trap’, and evaluates it by considering the impacts of climate change physical and transition risks on Kuwait following the release of the country’s first flash flood hazard map.
Governments, regulators and financial institutions will all have to chart their own path to respond to the elevated risks of climate change where this 'risk trap' is most likely to be present. The impact on a response to climate change goes beyond mitigation and increases the benefits of domestic financial sector development and efforts to produce a Just Transition.
Will climate financial stability risk assessment produce headwinds for climate finance in emerging markets?
The Financial Stability Board is developing an assessment framework to evaluate the risks to financial stability relating to climate change. In broad terms, it will translate a conceptual framework for how climate risks generate financial risks, and how these could cascade into a systemic risk.
Many of the risk metrics are being developed with reference to developed economies and specifically reference the way that “global financial stability risks may arise from climate shocks in EMDEs [including those that] originate in the real economy and transmit internationally [such as] in some EMDEs that provide agricultural and mining products to the rest of the world”.
There is a clear connection between economic shocks in large EMDEs and global financial institutions and markets. Climate-related risks are among the types of risks that can spill over widely into global markets. However, often the application of macroeconomic metrics to identify sources of risks to global financial stability can have the impact – even if unintended – of raising barriers to flows of climate finance to EMDEs.
Investing in responsible finance will pay dividends
Looking ahead in 2025, the growing acknowledgement of sustainability as a key issue, both globally and within OIC markets, has pivoted from expanding to new areas of sustainability towards working out ways to implement what is already on the table. Institutions that take the challenge seriously now stand to come out ahead as the impacts of climate change and the climate transition grow.
Regardless of the speed of implementation, the upcoming adoption of IFRS sustainability reporting standards will force financial institutions to prepare to incorporate the resulting disclosures into their decision-making processes. The standard-setting landscape for sustainability has experienced some consolidation with the formation of the International Standards Setting Board (ISSB) and the launch of the IFRS Sustainability Reporting Standards.
With a shift deeper into the implementation of sustainability in core financing operations, as well as various policy and physical risk shocks, the points of differentiation between different institutions are likely to become much clearer. Being caught off-guard by policy developments needed to achieve national carbon targets, or not anticipating physical climate risks, or ignoring stakeholder involvement in transition plan implementation, will have tangible impacts on the bottom line and on financial institutions’ relationships with their stakeholders.
The full story of climate data for financial institutions isn’t just the numbers
The Network for Greening the Financial System has released a detailed overview of the state of emissions data and ways to improve them. It is much more important than it may appear at first glance. That’s because measurement and reporting are designed to guide how the data are being used, but no single metric or methodology provides a complete guide to Net Zero or Paris-alignment.
The purpose of climate disclosures is to help users of its reporting to evaluate the degree to which the entity is protecting itself against future risks associated with its greenhouse gas (GHG) emissions from climate change, nature loss, and the achievement or failure to see through a Just Transition. The numbers only tell one part of that story, even if they are perfectly consistent in what is being reported between different entities.
The much more important information comes through identifying how much an entity can and expects to be involved in influencing changes to the emissions it reports today for future periods. If they can clearly break down the emissions they report into buckets of emissions based on what they can and cannot influence, and then explain how they plan to influence others to reduce in line with their targets, then the report data become much more powerful.
Instead of being just another metric to report, it becomes enriched with both information about the present and guidance about the future, which brings both value creation potential and accountability.