Commit and align with purpose
Developing a climate strategy can be a challenging process which has to balance various, in some cases competing, stakeholder interests across the entire financial institution. Therefore, it is crucial that the process is also driven top-down by the Board of Directors and Executive Committee to define the overall ambition level and commit to it.
There are a variety of motivations to be considered when defining a firm’s commitment. A firm may intend to reduce climate-related risks, systematically identify climate-related opportunities, reduce its own and its clients carbon footprint as well as to generally align its business strategy with carbon reduction pathways or also further environmental and societal goals as set out in the UN Sustainable Development Goals. The ambition level regarding these questions should be defined and provide guiding principles for a climate strategy. Firms should also align their commitments with their desired positioning amongst peers, compliance with upcoming hard and soft law standards, already communicated commitments (e.g., PRB, PRI, TCFD and various net zero alliances) and in general the climate-related risks and opportunities relevant for their business model.
The ability to directly tie net zero targets to board-level ambitions and the firm’s wider ESG commitments is central to credible transition planning. Net zero targets also need to flow through the organization and be represented in all strategic priorities from a functional (e.g., risk and finance) and business perspective. Key stakeholders must be clear on the risks being managed, but also on the opportunities associated with credible transition planning. Communicating net zero ambitions and commitments may help sending a clear message to various stakeholders that a particular financial institution intends to play a role in solving the challenges of the climate crisis and that it manages the topic well.
Measure and understand
Measuring GHG emissions and related KPIs like financed emissions and carbon intensity is key because only what gets measured, gets managed. This is particularly challenging with regard to financed emissions and e.g., investments. The carbon footprint of investments expresses the amount of annual GHG emissions which can be allocated to the investor per amount invested in a portfolio. Carbon intensity of an investment portfolio is measuring how carbon-efficient the portfolio is in producing revenue through its investee companies. Both KPIs do not measure climate risks and opportunities of investments directly, but they are good indicators to understand the respective exposure. Establishing the principles of carbon accounting upfront will help to determine which data can be collected from counterparties, which must be estimated and which methodology to use (if proxies, are needed). Firms must consider which measuring approach to apply and what they aim to measure. The industry-led Partnership for Carbon Accounting Financials (PCAF) has issued guidance for the financial sector that refers to best practice Carbon Accounting standards based on the well-established GHG Protocol in this regard. Most financial institutes already have a good understanding of their operational GHG emissions – but these account for a small part of the total GHG footprint. Financed emissions are much more relevant and need to be better understood. However, various challenges are associated with measuring financed emissions. For example, the availability of data must be assessed per asset class. While data on listed equities and bonds is relatively broadly available, it is harder to access for other asset classes (e.g., missing information on energy efficiency of buildings for the calculation of financed emissions from mortgages). Besides data availability, the quality and granularity of data can also pose pitfalls. The use of approximations (e.g., sectoral or regional approximations) addresses the challenges in the short term and allows for an initial estimate, but it is important to drive ongoing improvements in data availability, quality, granularity and robustness to increase the accuracy of measures going forward. The Finance function is becoming increasingly important in this regard as non-financial (ESG) data should become as robust as financial data and embedded in the same sound control frameworks.
The related scope of internal and external commitments is essential and should include scope 3 financed emissions (e.g. investments and loans) of the firm and clients as this is the most significant part of their GHG emissions inventory and therefore key leverage to have an impact as a financial institute. For financial institutions it is key to better understand their financed emissions and their exposure towards climate-related topics. Only this will allow them to systematically identify and manage climate-related risks and opportunities, monitor emissions reduction goals, act to reduce their portfolio footprint and accordingly disclose progress. The scope of internal assessment and commitment may go beyond external commitments and should also include investments of clients to provide insightful information relevant for decision making .
Analyze scenarios and take forward looking view
Visible effects of climate change such as extreme weather events show the impact climate change is having and will increasingly have on the value of financial institutions portfolios. On the other hand, the said necessity to act accelerates innovative solutions. The transformation of whole economic sectors also provides huge investment opportunities.
Climate risks need to be taken into consideration more systematically. Conducting climate risk-related analyses is an integral part of a climate strategy enabling a company to identify on-balance sheet risk exposures to physical and transitional risks and corresponding hotspots which then can be accordingly addressed. There are various approaches that can be applied to perform climate risk assessments. The choice of an approach is typically driven by the scope and goal of the analysis and by data availability. Historical data is needed to assess if and how quickly a company is evolving. In order to model the future impact of climate on a financial institutions’ balance sheet, a forward-looking approach has to be applied through the use of scenarios. Various providers such as the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) or the International Energy Agency (IEA) have established scenarios and tools to perform scenario analyses. Each of them covers different sets of risk types, portfolio scopes and underlying assumptions about how economic, social and environmental dynamics will play out in coming years. When it comes to identifying the respective opportunities of the big transformation financial institution also need to take a forward-looking approach and need to monitor whether their investee companies are well positioned for the transformation and are transitioning at the right speed with ambitious, sound, and credible transition plans.
Target setting is a crucial step in the definition process of a climate strategy. If targets are established in a structured approach, they allow for progress tracking and activities steering, which could serve as an incentive to the management responsible for target achievement. What the right targets are will vary across institutions depending on their level of ambition and their business model. Despite potential divergence in terms of target scope and content, it is viewed as best practice for all financial services providers committing to net zero to establish several more granular interim milestones in addition to high-level long-term goals. For instance, interim milestones may focus on specific locations, financed sectors, asset classes, financial products, or emission scopes.
The Science Based Targets initiative’s (SBTi) new framework provides best practice guidance and allows financial institutions – including banks, investors, insurance companies, pension funds and others – to set officially validated science-based targets to align their lending and investment activities with the Paris Agreement.
Financial institutions need to accept that setting net zero targets means that these targets are not fully within their control. They can decide where and how to provide finance, but they cannot directly influence the actions of governments and consumers or the pace of innovation. They should therefore be clear on their assumptions about future developments in policy, technology and public behavior – while remaining focused on their own role as facilitators of clients’ transitions. If an institution is not (yet) willing to make external (interim) commitments, targets should still be set internally and also include short to mid-term targets for sectors and asset classes.
For financial institutions, it is difficult to prove that they cause real world change, but their clear intention to have a real world impact should also be a core element of implementing a climate strategy and setting respective targets. A positive contribution or additionality can mainly be achieved via direct capital allocation (e.g., private equity), engagement dialogue with investee companies (e.g., public equity) and through broad stewardship activities by influencing other stakeholders (e.g., policy makers). Further, it is imperative that the transition towards a net zero economy should also be a just transition and should not neglect social and other ESG aspects.
The reporting landscape is currently fragmented but evolving to become more harmonized, driven by the efforts of various regulations (e.g., CSRD, EU Taxonomy, SFDR), standards and initiatives (e.g., TCFD, GRI, SASB). International investors with global investment portfolios are increasingly calling for high quality, transparent, reliable and comparable reporting by companies on climate and other ESG matters. The latest global development in this regard is the announcement on 3 November 2021 by the IFRS Foundation Trustees of the creation of a new standard-setting board—the International Sustainability Standards Board (ISSB)—to help meet this demand.
Financial institutions can build confidence around their ability to deliver emissions reductions by framing their performance reporting within a wider stakeholder communication effort setting out their decarbonization strategy, its underlying rationale, and its resulting real-world impact. Measurable goals should be part of this reporting this will allow easy tracking of the respective progress and the subsequent development of further goals.
Engage and act
Engagement on climate topics can take various forms depending on the depth of engagement sought (e.g., proxy voting, shareholder dialogue, engagement through alliances such as Climate Action 100+) and can also result in a broader stewardship role with regard to further stakeholders like policy makers and peers (e.g., being a leading voice in public consultations).
Reducing direct emissions from operations (e.g., energy efficiency measures in office buildings) is the first relatively easy step when it comes to reducing a firm’s company footprint. Setting an effective decarbonization strategy regarding financed emissions is a more difficult task and should start with the assessment of suitable decarbonization approaches for all the activities in a given portfolio. Firms should compile a longlist of potential levers to pull across different business units, sectors or asset classes, grouped into three categories:
- Where can the institution engage?
- Where can the institution make exclusion choices or under weigh laggards in the climate transition in a given sector?
- Where can the institution scale-up climate solutions?
Implementing the levers, tracking their effects and subsequent re-iteration needs to be managed within a sound governance and frameworks and should have the ultimate goal to have real world impact.