As Net Zero financial institutions raise their ambitions, they shouldn’t lose the forest for the trees
In brief: Financial institutions that specialize or focus their climate-related efforts too narrowly can see much more rapid diminishing returns on their efforts compared to those with a more systemic perspective. As an institution drills down into high-emitting sectors, they need to use what data are available to still consider how the rest of their customers’ activities could make decarbonization more or less challenging.
- Net Zero has quickly captured the attention of financial institutions and investors, but as the number of Net Zero pledges rises, expectations are rising that they should show a real economy impact.
- The lack of comprehensive data on emissions draws many financial institutions into focusing only on high-emitting sectors and trying to improve data & analytics for those sectors
- Although there’s an understandable desire to improve data quality and accessibility around customer emissions, a lot can still be achieved with just ‘order of magnitude’ estimates, and too narrow a focus on high-emitting sectors can overlook quick wins that benefit from financial institutions’ broad footprints
The role of the financial sector in achieving Net Zero alignment has shifted dramatically, and approaches such as portfolio decarbonization that were favored pre-COP 26 have been surpassed by new approaches. Underpinning the changes in how investors and financial institutions are approaching Net Zero have been three major initiatives, and many other financial sector stakeholder initiatives that are moving rapidly in the same direction.
Two of these initiatives have been covered in recent newsletters, namely the ISSB’s draft climate disclosure standard and the Science-Based Targets Initiative (SBTi) foundations paper on Net Zero for Financial Institutions. These are complemented by a discussion paper by the Financial Sector Expert Group (FSEG) of the UNFCCC’s Race to Zero exploring how Net Zero financial institutions can effect change in the real economy.
One of the motivations for evolving how financial institutions contribute towards Net Zero comes from the success in getting financial institutions to start thinking about their contributions. At the same time as more financial institutions think about, or pledge to reach, Net Zero by midcentury, it becomes more important to identify the connection between these long-term pledges and shorter-term changes within the real economy.
What has emerged is a concern about a disconnect between the speed of ambition that financial institutions are committing to, and the underlying speed of the real economy’s transition towards a low-carbon economy. The discussion paper links to concerns on this regard from the Net Zero Asset Owner Alliance. That investor group, in their target-setting guidance, note that “the real economy is not moving as fast as the science recommends and this departure creates a substantial challenge for Alliance members who are committed to holding a net-zero portfolio as well as investing in a net-zero world” (emphasis added).
The rationale for the alliance’s concerns is further articulated: “The likelihood of [sector weighting and best-in-class] strategies contributing to emissions reductions in the real economy remains uncertain as the empirical evidence is limited”. This echoes the concern of other financial sector stakeholder groups working on Net Zero finance around the far more limited impact that they can make to the real economy through “impact-aligned” strategies unless a much larger share of the financial sector adopts similar strategies.
The Race to Zero’s FSEG draws the distinction as follow:
- “Impact-aligned” in the context of Net Zero finance refers to those “seeking to increase portfolio exposures to companies and assets that create or are on a pathway to creating the impact a financial institution is seeking to have on the real world”.
- “Impact-generation” are those “seeking to drive real-world climate outcomes not just by investing in companies that are aligned but actively contributing to overall decarbonization objectives [among companies that are not currently aligned].”
For investors and financial institutions just putting together a strategy around emissions reduction or Net Zero, this distinction can seem small, but it gets to the heart of the question of how financial services respond to climate change. On the one hand, an ‘impact-aligned’ strategy results in greening portfolios immediately, or along a trajectory towards portfolio decarbonization by a target date. The method for evaluation is what degree of consistency there is between investees’ direct emissions and some climate pathway, such as below 2° C, a 1.5° C target, or global Net Zero by 2050.
The challenge of an ‘impact-aligned’ approach is that until there’s critical mass in the financial sector, one institution or investor’s decision to exclude high-emitting sectors doesn’t reduce that sector’s emissions and only marginally impacts its cost of capital. It’s only when action reaches breadth of scale like what has been seen with thermal coal, which is becoming uninvestable for many investors, where the cost of capital lever starts to change the real economy end of the equation. In the case of coal for power generation, this has been effective, but takes a long time and requires many other things to happen, such as the simultaneous fall in price of renewables.
Not all sectors are like coal in the relative ease at which they can be replaced by cleaner sources of energy (either renewables or other fossil fuels such as natural gas). In addition, the ability to achieve a Just Transition, particularly in emerging & developing markets, isn’t easy with coal, and will become significantly harder with other large sources of “hard-to-decarbonize” emissions. In many of these cases, the problem is a need for much more investment into the transition itself, and “impact aligned” strategies don’t work as well.
Therefore, the Road to Net Zero proposes ‘impact-generation’ as an alternative model, which focuses less on a financial institution’s current ‘financed emissions’ or ‘portfolio carbon intensity’. Instead the focus is on a theory of change for how an institution or investors’ governance and strategy lead to changes in the real economy towards Net Zero. Mirroring the Task Force on Climate-related Financial Disclosures (TCFD), it proposes that reporting of ‘impact-generation’ in a financial institution or by an investor follows a focus on Governance, Strategy, Execution, and Metrics & Targets using an iterative model that adapts to success or failure over time.
In this framework, the Net Zero targeting would be just the first step that comes from setting an objective. It would be followed by diagnosing a financial institution’s connection to the underlying real economy elements that are on or off a pathway towards the objective. From there, the institution develops a plan, takes action, and over time reviews and discloses its progress while also adjusting its plan as needed.
In our research on financed emissions in Islamic markets, the RFI Foundation has focused on the important role financial institutions play in the real economy’s emissions pathways because their investee companies are diverse, and not solely focused on one sector the way many non-financial businesses are. In one respect, the feature of financial institutions dilutes the amount that they can zoom in on a single high-emission sector’s decarbonization pathway. However, this limitation also provides an opportunity if the right perspective is taken on their financed emissions exposure.
If a financial institution focuses only on a high-emission sector in isolation (or in a silo, if it is one of several high-emission sectors focused on), there will be a tendency to focus too much on the availability of granular data. If this focus is too intense, it could end up losing the forest for the trees, and in the end focus on ‘impact-alignment’ by screening for the best-in-class among the high-emitting sectors with all the caveats mentioned before about the impact that’s possible.
However, if the sector focus on high-emitting sectors is done without leaving out the inter-relationships between those sectors and others that the financial institution finances, there is greater room for ‘impact-generation’. To take an example, in many emerging markets, electricity generation is one of the largest sources of emissions, and energy demand is also growing rapidly in line with economic growth. An ‘impact-aligned’ approach would be to either eliminate fossil fuel financing in favor of renewable energy, or to finance only projects that meet a certain emissions threshold per kWh of generated power.
The impact-aligned approach will make that financial institution’s current metrics look favorable to its peers, but won’t necessarily reduce the emissions in the sector except in the long-run if other investors follow the lead (the power generation company’s access of capital will be limited, and could become more costly over time).
An ‘impact-generation’ approach would focus differently. It could focus on reducing emissions at the dirtiest sources of generation (at a risk of lengthening their useful life, and locking in higher emissions). It could finance early retirement and replacement of the dirtiest (and capacity at most risk of becoming a stranded asset unable to service its debt). Each of these options is fraught with challenges either relating to emissions lock-in or to managing a somewhat novel process with adverse social impacts that are challenging to mitigate.
An easier option is to pair a sector focus on new installation of renewable energy capacity and finding financing opportunities through the rest of its portfolio to improve energy efficiency. The benefit is that every kWh of its customers’ electricity demand reduced increases the proportion of its renewable energy financing that is replacing a dirtier kW of capacity instead of just going to meet higher base load demand. The data needed to make this type of linkage seems complex and challenging to assemble because customers’ electricity demand (customers’ Scope 2 emissions) are part of the financial institution’s Scope 3 data, which are rarely collected comprehensively.
However, as the RFI Foundation has shown, ‘order of magnitude’ estimates can take a financial institution most of the way in understanding where to focus its efforts. Better data on impacts can be backfilled later to review and amend its plans on emissions reduction for the real economy, and it is important to not overly focus on precision (or lack of precise data) where decision-useful information is available.
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