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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.
IMF report examines climate & stranded asset risks facing banks in MENA and Central Asia
A research paper written by an IMF team examines the readiness, risk and opportunities for the financial sector in the Middle East & North Africa (MENA) and Central Asia and identifies some areas that need particular focus. The evaluation of the region’s preparedness for the climate transition starts by looking at the sources of physical climate risk, transition risk, and the risk related to stranded assets on the region as a whole, including some that have been identified by financial sector supervisors and central bank Financial Stability Reports.