Sustainability commitments and incentives

So you have communicated your sustainability targets to the market – but how can you now ensure that you can steer your balance sheet towards those targets?

These goals now include a range of sustainability and climate-related ambitions (such as net zero and green funding targets) alongside the more traditional commitments to stakeholders such as shareholders, clients and staff members. Therefore, in order to bridge the gap between goals and behaviours, incentives for the Front Office must be changed to accommodate the additional sustainability targets.

Limit frameworks, capital attribution and transfer pricing are some of the potential approaches to incentivise the Front Office and in this video, we explore the mechanics of these and discuss the pros and cons, bringing perspectives from the 1^st line of defence and the 2^nd line of defence.

Sabina Munnelly, a Partner in our US Financial Service practice, chaired the discussion with her colleagues James Belmont, Head of Climate Risk and Daragh McDevitt from our UK Financial Services practice and an ex-Front Office trader and structurer.

Contact us to discuss in more detail how Baringa can help your organisation.

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Sabina Munnelly

Partner, expert in Financial Services

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Transcript

[Music]

hello all

this is Spina Binelli a partner in

Baringa

us talking to you from new york today

the topic for today is to focus

on how to take climate change

goals and targets that have been set

by your institution and translate that

into

action and change in behaviour I'm glad

to say I'm here today with two of our

senior leads

from our climate change practice James

Belmont

and Dara McDavid both are coming with

over 25 years

experience in the industry um James from

a corporate finance and risk perspective

and Dara from a front office

perspective they're going to give us a

balanced view

in regards to how this change will

impact

the first and second lines of defence

within your organization

um so I'm super excited about this

conversation today

um and look forward to a balanced

conversation

and from from uh about both James and

Dara

so with that being said um I'll

hand over to James and and ask the

question

what have you seen from a corporate

perspective

in regards to how organizations are

taking their

commitments and translating that into

action so uh banks have been

subject to external constraints on their

balance sheets and their p

l's for as long as they've existed

um associated with leverage they've had

cost income ratio targets

and they've had to achieve uh certain

returns on equity

and they will typically use some of

three tools

to trans transmit those

external constraints uh through to the

businesses

they've got limit frameworks they can

use um

capital attribution and transfer pricing

uh so limits if I'm somebody in the

organization and you're

limiting me that's a little bit daunting

explain to me how that works so

mechanically this is actually probably

the easiest thing to do

it's a slightly lazy option uh but but

there are plenty of limit frameworks

within banks

if a bank has already expressed

externally a target or a commitment

to harvest financed emissions by 2030

for example

then it could simply translate that into

internal limits that it applies to the

businesses

it is quite crude but it is mechanically

relatively easy to do

and Dara if you're sitting in the front

office

what what would that mean to you how

would how would that impact you

and the way in which the front office

would would behave

well look there's a lot of respect for

limits ultimately it's uh you know a

serious offence if you break the limit

so they're effective in other words if

the organization is just trying to

uh not have more carbon than x then

obviously allocating limits is an

effective tool to do that

I guess I guess from my perspective um

what tends to happen is if you think

about

this whole sphere it's a new

constraint and the organization clearly

isn't optimal in terms of it's not

managing that constraint to date you may

we're going to move on going forward

what tends to happen is you you allocate

the limits to people who've got

you know the the carbon let's say in

this case um so your starting point is

not

even trying to be the optimal one it's

kind of its way where you are which is

by definition not the optimal position

to be in so it's fairly blunt as far as

i'm concerned and there's no

efficiency to it there's no sort of

trading to it so the front of us

guy you know in reality we we we

arbitrage markets for a living let's say

we're certainly going to just

work out the limits could be used up

reasonably quickly we're going to try

and fill our boots

in the first quarter of the year

regardless how much money or you know

whether the relative return is higher

because I've got carbon or anything else

it's just a question of well there's a

limit i may as well use it

and i want to use it before someone else

uses it so that's kind of the response

that you get

yeah i mean James it sounds like a quite

a blunt

instrument uh to use it you mentioned

two other areas that capital allocation

been another what would be the the

benefits of

of using that approach um instead

yeah well as Dara says limits are pretty

crude and they don't incentivise

efficient use of the balance sheet they

just incent

in fact they probably incentivise

inefficient use as people fill their

boots in

in Darren's language um and so

you know as a second line guy I don't

much like limits either when a limit

becomes binding

it's sort of an admission that the other

incentives you have in your armoury have

failed

capital attribution on the other hand

rations out balance sheets

um in a way that potentially promotes

more efficient use of

of the constraints so if you think of a

bank already for example having

constraints on its rwas and its leverage

they might already be

um allocating out or attributing out

capital in the performance reporting

on a basis of some combination of rwas

and leverage

um you could extend that and attribute

out the capital

on the basis of some combination of

rwa's leverage

and financed emissions or whatever your

chosen

metric of um of greenness

is that is a that is definitely an

option

and our from from a front office

perspective um

looking at it from a capital uh lens

you know how would that be different or

would there be different behaviours that

that which

that would create in a positive way well

i think at the sort of the

um probably the death code level it it

works and so far as definitely

typically understand you know if you

communicate to them what good look good

looks like in terms of what a good

business looks like and how they should

contribute to the division

in terms of you know what extra return

they should expect on let's say carbon

or whatever

I think you know that's a

useful tool it's basically what it's

done is it basically takes some of the

burden away from the other constraints

like leverage and rwa and attributes it

to carbon

so ironically you actually may end up

with um you know you may be easy to do

trades with

without carbon obviously because you're

getting a lower hurdle return so

so that's arguably a positive and

i think that's

you know that's not an accident that's

deliberate in so far as you want to be

allocating capital to inverted commas

things that

are green or at least not brown and

thereby don't have

that negative carbon footprint so so

from my perspective

you know you haven't taken money away

from me you've basically just said we

expect certain things if you're going to

use carbon expect more return it's

logical

so yeah I mean I like it i guess the

critical thing is

again we're starting from an unknown

position therefore

using those tools getting it right so

you actually get the right number at the

end in terms of what your finance

commissions are whatever else you're

targeting

is uh you know is a

decent exercise to try and optimize one

of the things that

steers me away from uh a capital

attribution one of the things I don't

much like as a second line sort of

person

in here is the idea that by attributing

a greater share of capital to

um my sustainability commitment so I've

diluted

the rwa incentives that I had in place

or the leverage incentives that I had in

place so I'm having to trade off

which balance sheet constraints I really

uh transmit to the businesses because

I've only got a fixed amount of capital

I can

attribute out yeah and James

because the industry and the regulator

hasn't come out yet

with clear guidelines um in regard to

capital allocation and expectations

is is there challenges in then

implementing that across the

organization because

you know the mandate um doesn't exist

or are there other options for for

organizations to consider

well the other option is transfer

pricing so

banks will already transfer price the

funding that they provide when they

extend

the loan uh they transfer price on the

basis of the cost of

funding the loan and

you could quite conceivably transfer

price the

cost of carbon an internal cost of

carbon to your

to your front office um you might aim to

do that

in a way that was zero sum so you might

set the internal cost of carbon in a way

that meant that

net net your businesses on average

um had had a zero transfer price

but having a transfer pricing mechanism

gives you a lever which

if you if you wanted to you could pull

as hardly as

as hard as you needed in order to create

the incentives

to steer the balance sheet towards your

your external commitment so transfer

pricing

has some appeal to me from that

perspective

daryl what would that mean to the front

office it feels like a very fluid

um approach a little bit more less

constrained than

the limits and allocations and how do

you see the front office

embracing that method well I mean if

it's a

cost it generally goes down poorly um

because obviously it makes you look like

you've made less revenue and I think

um where where that cost is real in

other words let's say like like in cva

where you've actually got a cost of

credit i can go and take credit without

doing any deals

so it's a real thing and it represents

expected loss it's real

um likewise if my cost of credit is cost

of carbon is real

and it's something that the bank

actually needs to hedge by buying car

and credit their offsets etc than I have

then it's then then it should absolutely

be pushed down onto the desk

the issue is if it isn't real it's just

a lever to steer me towards a certain

thing

what then happens is you've effectively

created a cost which doesn't

which I've got which doesn't reflect the

cost of the business

and when you do that that's that's

actually really impactful because what

you've done is you've changed

the way I behave so you know there could

be situations where

the bank's making let's say 80 base

points running and we think that's

that's great

um but because the cost of carbon takes

away let's say 40 basis points of that

um I'm going to only see 40 and I've

still got risks for this

to this transaction so the bank thinks

it's a good trade releases the risk

because it's making 80 but me is the

person who's deciding whether to go

ahead and trade or not

i'm only seeing let's say 40 basis

points fat and it will therefore change

my decision as to

whether to do that deal or not so that's

the impact that's the sort of the major

difference between let's say the rate of

return and you know

greenhouse of arrays or whatever is

effectively just doing the same thing as

you just

you have actually taken the roe and

you've turned it into a

hurdle rate of return on or cost of

carbon if you like

um but here we've got a hard cost um it

will change my behaviour and it won't

therefore i think get the optimization

that do you desire

it sounds to me like there's uh some

some great pros and cons to

all of the options and potentially over

time a healthy tension that needs to

uh it needs to occur and we're

considering

um each of them from a corporate

perspective versus

versus a frontline perspective James is

there any

um experience that you could talk to in

regard to what you're seeing at clients

as to

you know what way they're looking across

these three dimensions

or others um whether that be hybrid or

or a single approach to this yeah I'd

say a couple of things

firstly you definitely don't want to do

transfer pricing and capital attribution

you'd simply be double counting and

creating unnecessary complexity having

both of those incentive mechanisms

but you might quite conceivably have one

of those

with some limits as a backstop that you

hope never to use

the other thing I think is that's going

to become clear is

banks are making these external

commitments

right now many of them before having

actually determined

internally how they're going to to

deliver on those

decarbonization commitments and

it would be quite possible quite

unsurprising if in a few years time

approaching a commitment they realize

that the external politics or the

technology change

that that is in the real economy just

hasn't been sufficient

to enable them to get particularly close

to their targets or their front office

haven't

haven't changed their their origination

enough to

to enable the bank to meet its targets

and so i think you'll start to find the

emergence of what I would call

contingency contingency emissions plans

a bit like a contingency funding plan

where you

pre-agree um or a recovery plan where

you

pre-agree and in a certain situation

what's the menu of options of actions

that your businesses could

potentially take to um deliver on

those targets what are the financial

trade-offs associated with taking those

transactions

and how what's the lead time associated

with those transact

those um those actions

and having that in your armory

up front before it becomes a real live

commercial issue I think is going to be

important for banks to enable them to

steer through to these targets um

in in the coming years I mean that

resonates with me as somebody

who has a healthy risk paranoia

having a contingency plan um you know

because the future

in this area is unknown um seems like a

great idea Dara from a front office

perspective

um you know recognizing some of this new

change coming down the line but it's not

new

um to people do you see the front office

already taking action

uh in this space ahead of um you know

some of these frameworks being

implemented

well I think that you know it's really a

mixed bag I think anywhere

again you've got a new constraint coming

in you you should take a hard long look

at your portfolio of investments and

whatever best would be project finance

or trading and say well you know which

of these

are the metrics going to change on

because again if if

let's say 200 base points was a good

with a good trade it's pretty

intensely looking to decarbonize and

then suddenly you've got

you know a loan to a um

elongated loan to a coal-fired power

station

then you can expect that to reprice if

you so so

if you if you leave it on the books fine

you don't take a loss but then

you know the opportunity cost is that

you could have done a new deal if you

wanted to or not that you would but to

a coalified power station let's say

and got a much higher return so so that

sort of concept of cleaning the decks

if you're getting ahead of the game

anticipating change I think is a really

powerful one

um and likewise you know what good looks

like is people looking for opportunities

you know do I chase after the green

you know you can imagine everyone rushes

the door to do green financing for

example in order to be seen to be um

uh you know adhering to that management

action uh obviously that can drive down

returns of those things which is

ultimately what we want right we want

the cost of financing of things which

will change the climate to be to be

lowered

but if you think that's going to become

more and more of a constraint then that

price is going to go down and down and

down and you want to do that early

and so again cleaning the decks

anticipating that and then potentially

taking from the lazy would be I would

say

you know the intelligent thing to do so

i suppose a few key takeaways that I

took from this conversation change is

coming um

in this um you know it really is now

about how to take action

there's a number of ways to do that um

that will

drive different um behaviours and

outcomes and

uh organizations have to look at it from

a balanced

and approach perspective so they get the

right outcomes front to back

in the organization um I love james's

point in regards to

have a contingency plan um you know

that there's something that you can fall

back on and then Dara's closing point

there

and in regard to the front office

getting ahead

um and and starting to look at their

portfolio now

as opposed to waiting for those um

actions or constraints and to come down

the line

I think there's lots more that we can

talk on this topic in regards to

the the detail of how you put processes

and

technology in place to support this we

won't have time today

but maybe we'll add that to our next

part of the series

with that being said we'll sign off

from this baringa podcast um and

closely thank you thank you

thanks everyone

you

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