Financial institutions can reduce their climate-driven uncertainty

Financial institutions face expectations for robust, data-driven action in the short-term but in many cases these can be seen as being in conflict. The faster the risks evolve, and the more uncertainty there is about future economic, social and environmental conditions, accelerated action becomes still more important.

• A high-level expert group convened by the UN Secretary-General has produced 10 recommendations to reduce greenwashing in Net Zero commitments
• The recommendations push ‘non-state actors’ such as financial institutions to take more immediate action on climate change, despite the challenges many will face, particularly when it comes to financed and facilitated emissions
• Financial institutions should recognize the importance of rapid action because the uncertainty they will face will rise sharply due to inaction on climate change, and therefore doing more (action) with less (data) is likely to produce a better outcome for everyone

A High-Level Expert Group (HLEG) convened by UN Secretary-General António Guterres to evaluate greenwashing risks in Net Zero pledges has released 10 recommendations for non-state actors including financial institutions. The recommendations to exclude “slow movers, fake movers or any form of greenwashing” include some important considerations for financial institutions.

Since COP26, financial institutions have faced growing pressure from stakeholders, including regulators, to take action on climate change as a risk to financial stability. They have at the same time been pushed by real-economy stakeholders who see their financing & investment as a critical contribution to global decarbonization efforts.

Yet there have been fits and starts for the financial sector in mobilizing its connections into other sectors of the economy in a concerted way to support global Net Zero. Two reports released during COP27 highlight some of the key issues yet to be faced about Net Zero and the international financial architecture, including some topics covered by the HLEG’s recommendations.

One report, which aims to provide the blueprint for a reimagining of the international financial architecture laid down nearly 80 years ago at Bretton Woods, puts forward a ‘paradigm-shifting reorientation of the system, designed with a just transition to net zero by 2050 at its heart’. The other, a progress report from the Net-Zero Banking Alliance, shows some progress but also significant gaps between ambition and execution.

One of the fundamental challenges behind the gaps facing financial institutions is that ambition has been defined largely in terms of items and targets to be met in 2030 or the years after, while execution is defined on a shorter timeframe. The UN HLEG’s recommendation centers on ensuring that ‘non-state actors’ including financial institutions work in ways that are consistent across the short-, medium- and long-term. It outlines expectations that reporting from the private sector will inform the next milestone for the Paris Agreement, the Global Stocktake coming up in 2025.

The focus on the short-term is important because that is the period where financial institutions’ contributions to global Net Zero will be initiated. Longer-term targets are important to understand whether they are on the right road towards Net Zero or not, but shorter-term targets are a better indicator of the intentionality that financial institutions bring to the problem.

This importance is summarized in the five principles behind the HLEG’s work: near- and medium-term action; integrity through aligning commitments with actions & investments; radical transparency; credibility through science and third-party accountability; and showing a commitment to equity and justice in the actions that result from Net Zero commitments.

Where this becomes a challenge for financial institutions — reflected in some of the detailed recommendations — is that most of the emissions from financial institutions come from their financed and facilitated emissions. These include not only their operational emissions, but also their customers’ emissions, whether or not they are financing customers or otherwise involved (such as underwriting capital market issuance).

This encompasses a huge range of relevant stakeholders, all of whom have provided or will need to provide data if the financial institutions want to make ‘data-guided’ decisions. The problem with that, especially for financial institutions in emerging and developing countries, is that there is little conceivable expectation that enough of the data will be accessible and reliable enough in time to remain consistent with the ambitions for near-term emissions reductions.

That puts financial institutions in the difficult position of balancing the financial considerations of regulators and other stakeholders’ interests in Net Zero without having the accurate and comprehensive data needed to make key decisions. However, regulators have been clear that some action using incomplete data is better than no action until the data are available. And the pace at which climate change impacts has accelerated, making it clear that nature will not wait until we have the data to understand it.

Under those conditions, the weight of the evidence should push financial institutions towards doing more (action) with less (data). Data are not irrelevant, but even having precise data about emissions will not provide precision on the evolving risks that will materialize for financial institutions as a result of climate change.

The science is clear on the major sources of environmental impact of climate change, but the transmission of these risks into the economy and financial sector is becoming less predictable. That change of predictability of risks should alter the trade-off between more robust action sooner with less data or greater delay of action once better data are available but where the risks and uncertainty will have grown.

The financial sector is constantly impacted by changing economic and social changes that introduce new risks. It is a sector defined by making calculated decisions that are impacted, or even defined, by the uncertainty and lack of information available when the decision is made. Climate change is no different, except to add further systemic complications from environmental factors, which will amplify the degree of uncertainty and cause it to increase over time.

Financial institutions that are rationally responding to the risks they see in front of them should take every effort and use every piece of data they can to front-load their climate actions. A delayed response will only bring more uncertainty, greater risk and ultimately more economic, social and environmental losses.

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