Financial institutions and the transition to a low-carbon economy
While climate change poses risks for the stability of the financial system, the sector plays a critical role in decarbonising and delivering an equitable society. This is a unique opportunity for the capital markets to achieve the goals of the Paris Climate Agreement and change our global trajectory.
On the global stage, the 26th Conference of the Parties (COP26) marked a turning point in the sector’s commitment to net-zero and highlighted the challenges faced. It was announced that 450 firms, representing over US$130 trillion of financial assets, joined the newly launched Glasgow Financial Alliance for Net Zero (GFANZ) with a commitment to aligning business activities with ambitious, science-based targets1. GFANZ is the leading global coalition of top financial institutions in the UN’s Race to Zero campaign which bolsters climate action amongst non-state actors to accelerate and mainstream the decarbonisation of the world economy. The practitioner-led forum allows collaboration between financial firms on substantive, cross-sector issues to coordinate efforts of aligning financing activities towards companies, organisations, and countries that are set to achieve net-zero emissions by 2050.
In November 2022, COP27 built on this momentum as the UK announced that its export credit agencies will enable vulnerable countries hit by climate disasters to defer debt repayments, freeing up funds for emergency relief1. More importantly, financial institutions will not only accelerate the low-carbon transition but also future-proof their own business operations against climate-related impacts. Failing to act on climate change could reduce global GDP by US$23 trillion by 20502. Hence, financial institutions also have the responsibility to manage both the physical and transition risks that are most likely to impact shareholder returns. Physical risks encompass weather- and climate-related changes that can have an influence on the economy, whilst transition risks arise from the challenges resulting from the transformation to a low-carbon economy4.
Bank of England, 2019
It’s not that policies stemming from deals like the Paris Climate Agreement are bad for our economy – in fact, the risk of delaying action altogether would be far worse. Rather, it’s about the speed of transition to a greener economy – and how this affects certain sectors and financial stability.
How can the financial sector support the transition to the low-carbon economy and become more resilient?
Having a decarbonisation strategy can enable financial institutions to effectively review their investment and lending activities. According to a 2021 report by the not-for-profit CDP (formerly known as the Carbon Disclosure Project) the greenhouse gas (GHG) emissions associated with financial institutions’ investing, lending and underwriting activities are on average over 700 times higher than their Scope 1, 2 and 3 emissions. Less than 50% of banks, asset owners and managers take steps to decarbonise their investment portfolios in line with the goal of the Paris Climate Agreement. The risks of climate change are also frequently underestimated5.
Aligning net-zero targets to the latest climate science allows financial institutions to have a standardised and consistent approach to reach net-zero and enhance climate resilience6. Financial institutions also can engage with customers on their own targets through the following options set out by guidance including the Science Based Targets initiative (SBTi).
Source: SBTi Financial Institutions Training Modules11
Due to increased pressure in the UK and EU from policymakers, financial institutions will need to strengthen their stakeholder communications and responses to climate risk through public disclosure, reporting and transparency. The Task Force for Climate-Related Disclosures (TCFD) is an important framework that enables stakeholders to assess the climate-related financial risks of to all businesses, including those in the financial sector5. It is critical to consider existing organisational processes, including risk management, governance structures (such as audit and risk committees) and tools for the gathering and reporting of climate-related information6.
Innovating financing alternatives through credible green bonds
The first green bond was issued in 2007 by the European Investment Bank and since then green bonds have become an important tool in addressing the impact of climate change, biodiversity loss and other related challenges. These bonds are financial instruments that provide a way to raise funds which are allocated exclusively towards projects that deliver, foster and achieve environmental and sustainable benefits12. Currently, ‘green’ bonds help finance projects on renewable energy, sustainable resource use, clean transportation and adaptation to climate change. Investing in these projects can come in the form of fixed income securities, government bond issuances, mutual funds and exchange-traded funds (ETFs)14. Ultimately, green bonds provide opportunities for investors to contribute positively to the environment and attract investment into the green economy.
The market for these styled bonds is growing exponentially, recently hitting the milestone of US$2 trillion in total issuance across green, sustainability, sustainability-linked and transition labelled bonds13. However, green bonds are not exempt from ‘greenwashing’, defined as the superficial display of concern for the environment. Launched by the International Capital Market Association (ICMA) to ensure credibility of all parties involved in these transactions, the Green Bond Principles (GBP) can provide issuers with guidance on launching bonds with a measurable benefit. Investors can request specific terms and conditions and demand financial institutions to bid on the funds when holding their money in green bonds8,10.
Whilst divesting from high-emitting assets has become a heavily debated topic, a managed phaseout approach may present a better alternative. If high-emitting assets are moved to lenders, investors or insurers with a less stringent attitude to climate resilience, divesting may extend the life of those assets and their overall carbon impact. While sustainable alternatives to replace them are implemented, high-emitting assets might need to be used temporarily10.
The purpose of the managed phaseout approach is to engage with companies in high-emitting sectors and support them through a net-zero-aligned strategy. GFANZ suggests incorporating a Just Transition plan that assesses the social implications of phasing out high-emitting assets to ensure the successful financing and delivery of the managed phaseout approach10.
Although there are no easy solutions, shifting to a low-carbon economy can ensure the financial sector’s climate resilience while fostering stakeholder trust, competitive advantage, and value creation.
Author: Maria Serrano, Consultant at Simply Sustainable
1. Glasgow Financial Alliance for Net Zero’s COP26 Statement. UN COP26
2. Cop27 Finance Day: building resilience for countries hit by natural disasters. GOV UK
3. Climate action. Swiss Re Group
4. Climate change: what are the risks to financial stability? Bank of England
5. Finance sector’s funded emissions over 700 times greater than its own. CDP
6. Foundations for Science-based Net-Zero target setting in the financial sector. SBTi
7. Task Force on Climate-related Financial Disclosures. UNEP FI
8. Green Bond Principles. ICMA
9. The Carbon Bankroll
10. The managed phaseout of high-emitting assets. GFANZ
11. SBTi Financial Institutions Training Materials. SBTi
12. What you need to know about the IFC’s Green Bonds. The World Bank
13. Green bond market hits USD2tn milestone at end of Q3 2022. Climate Bonds Initiative
14. What are green bonds and what are they for? Iberdrola
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