The world is on the brink of change. Extreme weather, energy security concerns, scientific calls for climate action and increasing regulatory pressure are all combining to change the way in which business views its role in the world.
It has also forced financial institutions to think about their role in achieving net zero. The question is whether the setting of targets is actually driving capital towards sustainable action.
The Paris Agreement calls for net-zero emissions by 2050, a target that itself calls for emissions reduction of 45% by 2030.
Focus on resource scarcity and the potential impact of biodiversity loss are seeing increasing attention at an international level and as voluntary targets increase, mandatory targets are not likely to be far behind.
This has focused investor awareness on net zero, as climate change is also a risk multiplier for the environmental, social and economic impacts we face.
Sustainable finance key to net-zero transition
The IPCC’s Sixth Annual Assessment report was published in April 2022 and dedicated a chapter to the understanding of financial risk in terms of climate change, as well as the strategies that investors, banks and regulators have been using to manage climate risk.
Not only did the report call for a significant increase in climate-related investment but warned that there is a problem with “the systemic underpricing of climate risk.” It also reiterated the need for regulators to demand transparency in terms of investment decisions. Given the rapid growth in mandatory climate disclosure, this looks likely to accelerate.
Not only are the recommendations of the Task Force on Climate Related Disclosure (TCFD) being adopted around the world, but the SEC has now released its own proposal on how to report on and manage climate risk as a significant issue.
It’s widely accepted that financial services companies are going to play a critical role in the transition to a low-carbon future. BlackRock, the largest asset manager in the world, recently wrote in a client letter that “the issue … is no longer whether the net-zero transition will happen, but how.”
Estimates suggest that clean energy investment alone needs to triple to $4 trillion by 2030, and that will only happen if financial flows are realigned. Financial institutions are increasingly committing to net-zero goals, but they need to find a way to translate rhetoric into action.
One of the biggest challenges lies in identifying what type of support a financial institution provides – is it loan or asset finance, equity investment, asset management or even advisory services?
There are numerous examples of the disconnect between targets and actions.
Many members of the Glasgow Financial Alliance for Net Zero still finance fossil fuels
At COP26, the Glasgow Financial Alliance for Net Zero (GRANZ) announced that 450 banks, insurers and asset managers, with $130 trillion under management, had committed to a net-zero future. Members of the coalition members committed to science-based targets, including net zero by 2050 and 50% emissions reductions from pre-industrial levels by 2030.
They pledged to review their targets every five years, with annual progress reports. Yet many of its members are still financing fossil fuels at a significant level and a report from think-tank Reclaim Finance points out that many members don’t yet have a scope 3 emissions target or require one from their investees.
With finance, it’s not simply a question of where you’re spending your money operationally, but where influence exists in the market. With banks having provided over $4 trillion in loads and funding since the signing of the Paris Agreement, it’s difficult to identify exactly what such investors are doing to address the challenge.
Members of the Net-Zero Banking Alliance in fossil fuel financing
The Net-Zero Banking Alliance (NZBA) is another coalition of banks targeting net zero, but 2021 research from the Rainforest Action Network found the NZBA members included the 13 top fossil fuel funding banks in the world since Paris, and 21 of the top 23.
Altogether, the 39 NZBA signatories that are among the world’s 60 largest banks accounted for $3.1 trillion in fossil fuel financing from 2016-2020, 82% of total financing. In 2020 alone, 39 NZBA banks provided a total of $575 billion in lending and underwriting to the fossil fuel industry, with clients including Exxon, Shell and Saudi Aramco.
What is missing from both coalitions are concrete guidelines and agreements on what they need to be doing to achieve net-zero goals. This is especially important with regard to the fossil fuel industry.
Is it time to move towards sustainable investing?
Critics of sustainable investing have argued that investing in fossil fuels is necessary given the current energy crisis, not simply to find new sources of fuel supply but also in terms of the return on investment. This is an incredibly short-sighted view, ignoring as it does the impact of physical climate risk, and transition risk in terms of regulation or carbon.
If the world is to reach its 2050 goals, research by financial think-tank Carbon Tracker says that up to 80% of all coal, half of all known oil reserves and a third of natural gas must stay in the ground.
A 2021 research paper in academic journal Nature updated this to 60% of oil and gas and 90% of coal.
UN Secretary-General António Guterres has said: “Investing in new fossil fuels infrastructure is moral and economic madness.” Yet a May 2022 Guardian assessment reported that the dozen largest oil companies are planning on spending $103 million a day for the rest of the decade – the decade titled one of ‘action’ on climate change by the UN.
While two of the world’s largest fossil fuel financing banks may be in China, finance is flowing from everywhere. Activists are demanding action, and shareholders have called for resolutions to stop such finance at banks such as Goldman Sachs, Wells Fargo, Bank of American and Citigroup.
These resolutions failed despite the stated alignment with net-zero goals but pressure is building across the board as a spotlight is being shone on banking activities. Norway, for example, whose $1.2 trillion sovereign fund was built on oil and gas revenues, committed to fossil fuel divestment in 2019 – and has continued to grow.
Net zero: From paper to actions
What’s most interesting is the disconnect between financial institutions effectively addressing net-zero goals in operations and portfolio, and the overall growth of green finance.
Projections for annual issuance of $5 trillion in green bonds by 2025 looks to be on track, with Climate Bonds Market Intelligence reporting growth in the green bond market in 2021 to over half a trillion, at $517.4 billion of new debt.
The green debt market has shown an impressive growth rate of over 50% in the last five years and the cumulative size of the market was over $1.5 trillion by December 2021. There is, however, a long way to go, as recent analysis from McKinsey suggests a total of $9 trillion in green investment will be needed each year to reach net-zero by 2050.
Ian Borman, partner at international law firm Winston & Strawn, says that change is happening at an increasingly rapid rate.
He says: “In the lending space, we have been surprised that regulated lenders (banks) have adopted ESG provisions in loan documents at least as quickly as direct lenders. Until we looked into developments we thought that private investors in funds were driving adoption of ESG provisions, but it seems that statements by regulators and governments have been enough to cause banks swiftly to adopt ESG policies.”
The Science Based Targets Initiative (SBTI), which launched its corporate net-zero standard in October 2022, recently launched its New Foundations Paper on Net-Zero for Financial Institutions to tackle key issues for the financial sector, including defining net-zero, the use of offsets and fossil fuel phase-out.
The aim is to provide the financial sector with the concepts needed to transform net-zero targets into robust targets and action. It outlines four principles that ensure that financial sector net-zero targets are consistent with the necessary actions.
Financial institutions should set an example
Financial institutions should ensure that all relevant activities and emissions should be aligned with net-zero goals – and that means lending and capital markets activities should be included.
That means that financial institutions themselves should transition, and align their financing activities with the latest science on how to achieve net-zero goals.
They should also leverage their ability to influence and engage other actors, and the mitigation strategies used by a financial institution should promote the financing of decarbonisation efforts along appropriate sector pathways.
Overall, that means that financial institutions should not be financing fossil fuels.
One of the most important shifts is going to be the widespread adoption of programmes addressing climate risk by central banks and regulators.
The Financial Stability Board (FSB) and the European Central Bank (ECB) as well as governments in the US, Canada, France and the UK have all implemented regulatory programmes.
It is clear that the widespread acceptance of the need for net-zero targets is having an impact. Many companies have adopted targets as a result of investor pressure for transparency. What we need to see now is financial institutions following suit in defining their goals, strategies and approaches to finance.