The widespread extreme climate events we have experienced over the past months and years are the devastating consequences of global warming. The world looked to the COP26 summit to create a robust plan to tackle climate change by reducing emissions on greenhouse gases. This will influence our path forward for decades to come.
More and more companies are pledging to transition to net zero (a balance between the amount of CO2 emissions produced and the amount removed from the atmosphere). This shift presents the financial services industry with real challenges and opportunities.
Rewiring the way of thinking and working in financial services for net zero
The transition to net zero is a huge undertaking. The Paris Agreement aims to limit global warming to well below 2°C, preferably below 1.5°C, compared to pre-industrial levels. It also highlights the critical role for financial assistance to meet these targets. We will hopefully see COP26 accelerating action towards these goals.
To meet the net zero goal by 2050, emissions caused by human activity must fall by 7% every year. This will require a paradigm shift in our social and economic systems. The world will have to entirely rethink how to produce and consume energy. We must completely rewire our businesses from front to back.
The bad news is that current global government pledges and national climate plans fall short of the net zero target. It is only through system-wide collaboration between major corporates, governments and financial services that we can create more sustainable businesses.
The good news is that financial services firms can help bridge the gap. They can play a leading role in the transition to net zero. How? By prioritising their lending and investment where it is most needed for decarbonising heavy polluting sectors and funding the greener ones.
This is not just about financial services companies doing the right thing. There is a fundamental opportunity for firms to increase profitability and growth, and reduce risk. The BlackRock Investment Institute estimates that the net zero energy transition will drive a 25% increase in macroeconomic output by 2040.
The true scope for financial services to help the world meet net zero is orders of magnitude larger than firms had previously imagined. Firms need to start seeing the bigger picture – and the bigger opportunity.
The right course of action
How do banks reduce the emissions they finance? The first step is to measure and establish a baseline. Assessing financed emissions requires detailed data from internal and external sources. Furthermore, a consistent methodology must be applied to define the baseline. The Partnership for Carbon Financials (PCAF) is a commonly used standard adopted by the financial sector. This is a complex process but a critical one to start to understand your baseline emissions.
What comes next? Figuring out what the future holds for the baselined portfolio. Scenario analysis is a key tool to understand how the portfolio will need to change if global temperature rises are limited to 1.5°C. The International Energy Agency’s ‘Net Zero by 2050’ scenario authoritative is a benchmark with which to carry out scenario-based analysis.
Banks will then need to zoom in to see what change is required at the individual counterparty level. There is no one-size-fits-all solution here. Each company will have their unique transition path to net zero, driven by their business model, sector, region and climate commitment. Firms need to get to know each counterparty’s processes and technologies inside out, to understand what is viable. By engaging with clients in this way, banks can offer the appropriate support and incentives to meet net zero targets and commitments.
But we must look beyond the current emissions of the clients. For instance, there are some companies with high levels of CO2 emissions that have a clear transition strategy which will require financing. Other companies, meanwhile, may have stronger starting positions, but no clear plan to move to net zero.
Become part of the solution
Firms might be tempted to simply reduce their exposure to high-emitting clients. But that will not help the world reach net zero. The goal should not be to penalise but instead to become part of the solution. Banks should set internal targets that encourage teams to release finance in a way that sustainably accelerates transition to net zero.
Financial services firms have a huge opportunity to develop targeted products around green lending and transition financing, such as sustainability bonds. Carbon credits and carbon offsets may form part of their strategy. This will depend on each firm’s risk appetite because these techniques may not offer proven, long-term results.
The bottom line? Firms need to shift from solely thinking about what they shouldn’t be doing (e.g. investing in fossil fuels) and start acting upon what they should be doing to finance the transition to net zero.
Inaction is no longer an option
We work with executives of banks, insurers and asset managers across the world and over the last couple of years, we have seen a paradigm shift in attitudes. Uncertainty and paralysis are fading away. Financial services executives are realising that they have no choice but to act on climate change.
Why? For starters, the risks of inaction are far too high. If firms bury their heads in the sand and continue to invest in high polluting industries, they could end up writing off loans which are secured on stranded assets. As the gap between a firm's capital allocation, broader policy and environmental drivers grows, it creates huge uncertainty.
On top of this, more regulators around the world are mandating climate stress tests to protect investors and increase transparency. And in 2021 alone, more than 1,000 companies have expressed support for the reporting and disclosure of climate risks, as advocated by the Task Force on Climate-Related Financial Disclosures (TCFD).
With all this in mind, there are five key actions for financial services firms setting out on the road to net zero:
- Stop hesitating. Data on climate risk isn’t perfect, and standards are evolving but the most important thing is to make a start and develop your net zero ambition
- Talk to clients and develop strategies and metrics that are counterparty-specific and sector-specific. For some industries, you will want to set an emissions intensity target. For others, an absolute emissions limit is necessary.
- Set appropriate targets to measure your success in reducing financed emissions, supported by robust analysis of scenarios aligned to Net Zero by 2050.
- Be ready to make tough decisions. If, despite significant engagement and incentives, a client is simply not demonstrating the right kind of strategy, you may have to withdraw from that business as a last resort. Your capital could be deployed more effectively elsewhere.
- Engage your clients and broader market participants now to respond and take action together on the biggest challenge of our time, resulting in more strategic and trusted relationships
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