Financial institutions lagging behind investor expectations on climate risk and Net Zero alignment

Banks and other financial institutions are facing growing pressure from investors and regulators to offer details behind their Net Zero commitments. However, for many, there are analytical, data and other challenges that remain obstacles to demonstrating the short-, medium- and long-term paths to meeting their commitments.

• Investor focus on climate risks to the financial sector is moving beyond the existence of a long-term net-zero target
• Financial institutions are not yet equipped with sufficient methodologies to show that their alignments to Net Zero trajectories aren’t just reflecting ‘paper decarbonization’
• Regulators and investors are zooming in on climate as a key risk so financial institutions that aren’t focused on the issue may find the road ahead bumpier than expected.

As banks and other financial institutions make climate commitments, investors are digging into the details to see how much follow-through there is in translating long-term commitments into short-term tangible actions. A summary report by investor group IIGCC and Transition Pathway Initiative (TPI) of a pilot investigation of major global banks’ climate efforts shows some progress but many gaps even for the largest banks. The pilot study focuses on 27 international financial institutions, 12 of which each have assets in excess of $2 trillion.

The pilot study concludes that among these banks, net zero commitments have become commonplace but aren’t often met with short- and medium-term targets and don’t cover all the financial institutions’ activities. Similarly, governance to embed the commitments into operations is found widely across the sample of banks but there is a weak link between progress on net zero targets and remuneration policies.

In terms of decarbonization strategies, banks are making progress in disclosing publicly their expectations for phasing out coal finance and transition planning for high-emitting customers in several sectors. Yet gaps remain in these strategies, and importantly for investors, banks’ concerns about climate risk were infrequently translating into their own financial statements and audit scope.

The pilot study reinforces how much of a turning point the financial sector is facing at the moment on climate-related financial risk. Banks recognize that their stakeholders, including regulators, expect them to be thinking about how they are impacted by physical and transition risk. They are also expected to be able to clearly spell out what moves they have to make to mitigate these risks. Yet at the same time, methodologies for analyzing and disclosing appropriate metrics, and the data underpinning them, are much less robust when compared with expectations.

Even where most of the effort to date has been focused, on core financing activities, there are serious shortfalls. These come in a few areas where stronger disclosures are necessary:

• Short- and medium-term targets
• Clear data on financed emissions
• Scenario analysis results
• Audited financial statements that include climate-related matters.

Investor expectations are clearly moving rapidly. Net Zero for financial institutions moved to the forefront of financial sector discussion only after COP26 in the UK, when the Glasgow Financial Alliance for Net Zero (GFANZ) was launched. Since then, the ISSB’s draft climate standard, SBTi’s foundations paper on Net Zero, and the Basel Committee on Banking Supervision have weighed in with principles for effective climate-related financial risk management and supervision. In addition, the focus on ‘decarbonization’ has shifted dramatically in a way that impacts how banks develop their decarbonization strategies and target-setting.

Definitions of financial institutions’ activities that support net zero alignment have changed. Portfolio decarbonization, which the IIGCC called ‘paper decarbonization’, has become a much less favored way for banks to respond to climate risks. Although it is a way to lower the emissions intensity of a bank’s loan book, it doesn’t necessarily move the economy any closer to net zero alignment.

In addition to reducing reliance on decarbonization purely by moving high-emitting assets from one owner or financier to another, there has been a marked shift towards net zero alignment that reduces the reliance placed on carbon offsets. In the case of guidance developing from SBTi, long-term Net Zero is only able to rely on offsets for the residual 10% of emissions after the remainder is mitigated through other forms. For the ISSB standards and shorter-term SBTi target-setting, offsets aren’t excluded but are transitory mechanisms for mitigating emissions.

All of these changing expectations have made the process of short- to medium-term target-setting more difficult for financial institutions, while likely also helping them to avoid accusations of greenwashing. One of the other challenges that remains — which impacts their ability to develop effective decarbonization strategies, conduct scenario analysis that they then release, and estimates that will be reflected in their audited financial statements — is a lack of understanding of how their financed and facilitated emissions fit with national and international Net Zero trajectories.

There has been work on several methodologies to help address this analytical gap. For example, regulators are requiring stress-testing using common scenarios and providing feedback to banks during the stress tests. The PACTA methodology is helping banks to see the alignment or misalignment of their financing on short-term trajectories for high-emitting sectors.

Among the methodologies mentioned in the pilot test, IIGCC holds up Crédit Agricole’s P9XCA methodology, which quantifies “absolute emissions and transparently discloses the assumptions and variables used in its carbon accounting approach”. That methodology is what RFI Foundation has adapted for top-down estimates for emissions across the financial sector in Islamic markets to complement other methodologies and respond to the need for metrics that cover the entire economy’s emissions and links emissions throughout the financial value chain and within the economy, even where data are scarce.

The IIGCC and TPI pilot study will be further refined with a scoring / ranking system for the largest banks introduced by year-end. It provides the top-down market pressure for financial institutions to more credibly back up their net zero claims, starting with the largest institutions. However, the writing from investors is on the wall that they will eventually expand their review of net zero and climate reduction claims made by financial institutions to back up high-level claims and governance structures with interim targets and results. Just as regulators are zooming in on climate as a key risk, so are investors, and financial institutions that aren’t focused on the issue may find the road ahead bumpier than they thought.

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