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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.
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.
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.
A step-change: how a systemic risk buffer could benefit transition finance
The financial consequences of climate change and the necessary transition to global Net Zero by 2050 have made it difficult for financial institutions to change the way they make decisions quickly enough. A working paper published by researchers at the European Central Bank provides evidence for how the financial sector could be insulated from any losses by creating a systemic risk for the entire sector.
Until now, most of the regulatory responses to the risks associated with climate change have been incentives for non-financial companies to make green investments, greater disclosure by corporations and financial institutions about their financed emissions, and climate stress-testing exercises by central banks and supervisors.
The Systemic Risk Buffer was developed to reflect the overall level of near-term transition risk exposure of the financial institution – within the coming three years — and not be linked to individual green or dirty assets. Instead of adjusting the risk weighting of individual exposures, as a green supporting factor or dirty penalizing factor would do, it groups financial institutions into buckets based on the potential transition risk relative to their risk-weighted assets.
Using the collected data for calibrating a systemic risk buffer provides a tangible use for the stress tests and a data-guided way to balance the risk of financing climate-exposed sectors with the short-term gain that banks have by continuing to provide financing. Transition risk buckets offers substantial leeway for banks to finance companies transitioning activities from unsustainable to sustainable activities without facing increases in their capital requirement.
Funding Credible And Bankable Transition Finance After COP28
Following the conclusion of COP 28 last year, OIC financial institutions should now focus on how the final declaration points towards key risks and opportunities arising from climate transition risks, as well as the role they can play within the energy transition. One of the most important elements of financial institutions’ strategies across OIC countries will be the role of transition finance.
This has been a hotly debated issue, all but overlooked by binary green/not-green taxonomies. For emerging markets & developing economies it is a critical piece of amassing enough funding to be able to transform economies in a way that will over time promote economic growth while reducing emissions along science-based pathways.