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Better emissions data won't compensate for insufficient understanding of physical climate risks in companies' value chains
There is a tug-of-war underway in sustainability that strongly impacts responsible finance. What is the appropriate balance between data availability and standardization and action on topics like climate change? Often, the relationship is viewed as complementary: mandating stronger data disclosure requirements is seen as strengthening the ability of companies and their stakeholders to advance action on issues that are material to their businesses.
Transparency is valuable for supporting more informed decision-making relating to climate change, as it is in many other fields. The advance in better data availability comes with a cost, however, in how to responsibly gather, validate and report the data. This has led to efforts to weaken or streamline reporting requirements, depending on your perspective, as has been proposed in the EU Omnibus, for example.
‘Reporting fatigue’ has been widely shared among smaller companies, those based in emerging markets, and startups, and it impacts large companies as well.
Most of those expressing concern about reporting burdens are not pushing back on the financial importance of climate, nature and other ESG issues. The concern is often about whether particular reporting requirements strike the right balance between comprehensiveness and data quality (often pressed by users of the data) and efficiency in producing and disclosing the data (often heard from those reporting the data). But this is not a two-dimensional game of push and pull, and the right level of disclosure is not categorized as ‘more’ or ‘less’ of existing disclosures.
The context in which this is occurring overlaps with a global coordination problem centered on climate change and nature loss in a way that has huge economic implications. These issues care not about the volume of data produced; the only thing that matters is whether the right decisions for the future are made today, even if they are made using imperfect or incomplete data. Having more high-quality data is not enough if it doesn’t measure the right things, or lead to the right decisions.
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.
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.
OIC banks can improve their climate impact by learning from the challenges of global banks
In the face of rising concerns over greenwashing, OIC banks have an opportunity to enhance their climate impact by learning from global banks' challenges. While the pace of responsible finance targets has quickened, so has the scrutiny from stakeholders and regulators. An analysis by RepRisk indicates that greenwashing risks for companies have fallen for the first time since 2019, highlighting the evolving landscape financial institutions must navigate. With an increasing emphasis on transparent and actionable climate targets, OIC banks can draw valuable insights from the Transition Pathways Initiative's (TPI) recent report on transition in the banking system, which underscores the importance of comprehensive target-setting and decarbonization planning.
The report sheds light on the pitfalls faced by larger banks, such as overly narrow climate targets and the lack of comprehensive disclosures on capital market activities. As OIC financial institutions and those in Islamic finance aim to decarbonize their portfolios, they must consider sectoral relevance, the materiality of emissions, and the integration of broader metrics like the Energy Supply Financing Ratio. Ultimately, the focus should shift from merely disclosing targets to implementing strategies that drive real-world economic changes, thereby aligning with global efforts to limit warming and promote a Just Transition.
Banks in the GCC region are tackling climate transition risk, but it remains a ‘work-in-progress’
Standard & Poor’s Ratings has this week addressed frequently asked questions about climate transition risk facing banks in the Gulf Cooperation Council (GCC) countries, describing banks’ efforts in measuring the risk to date as a ‘work-in-progress’. On financed emissions, like those covered by RFI Foundation’s financed emissions database, S&P highlighted that “banks' difficulties with measuring scope 3 emissions come up regularly in our discussions”. This is understandable because emissions measurement is an almost universal challenge for banks globally.
This context of data gaps was a motivating factor for the way RFI undertook its financed emissions work, which is catalogued in an open-access database with five years of data covering banks and financial markets in the six GCC countries and five other OIC markets. The financial sector plays a key role in financing the transition and will need substantial new capabilities beyond what they have now to understand the many types of climate transition risk they face from the activities they finance.
Is It Possible To Define Criteria For Net Zero Credibility For Financial Institutions?
SBTi’s document is the latest step in the process of creating a financial institution Net Zero (FINZ) standard to be released in 2024
The criteria outlined are ambitious in their coverage of financed and facilitated emissions, which are defined as “Category 15+”, referring to the GHG Protocol’s substantially narrower definition of financed emissions
It will remain challenging to develop a consistent framework for forward-looking Net Zero plans that incentivize investment in transition activities while avoiding easier but less meaningful ‘portfolio decarbonization’