How can sustainable finance support the road to net-zero? How can sustainable finance support the road to net-zero?

Authors
Brandon Sutcliffe

EY Americas Financial Services Sustainable Finance Leader

Sustainability leader. Risk and regulatory professional. Advocate for action on climate change. A passionate supporter of heart health. Avid skier. Football fan. Lacrosse enthusiast.

Gill Lofts

EY Global Financial Services Sustainable Finance Leader, EY Financial Services Wealth & Asset Management Leader, Ernst & Young LLP United Kingdom

UK Wealth & Asset Management Leader and Global Financial Services Sustainable Finance Leader. Passionate about creating a legacy in the Financial Services industry and proud mother of two daughters.

Mark Watson

EY Americas Financial Services Managing Director and Board Matters Deputy Leader

Transformational leader. Advisor on matters delivering global impact and strong governance. Passionate about sound public policy. Avid moviegoer. Electronic dance music fan. Proud Anglo-American.

9 minute read 19 Jan 2021

Sustainable finance has become an urgent priority across financial services – thanks to the goal of net-zero carbon emissions by 2050. 

In brief
  • There is no road to a net-zero economy without financial services, as companies need funding and insurance to manage physical and transition risks.
  • Financial services organizations need clear, forward-looking strategies for sustainable finance and for their role in the transition to net-zero.
  • The right strategy is essential because greening the economy has huge potential upside and may be “the greatest commercial opportunity of our age.”

In light of increasing pressure from investors, regulators and society, sustainable finance is gathering significant momentum globally. Once regarded as a niche and futuristic concept within aspects of the investment community, it is rapidly becoming an immediate-term strategic priority and operational reality for all types of financial services players. Putting COVID-19 aside, over the next decade, sustainable finance might become the most pressing challenge and opportunity for the industry. 

Sustainable finance can mean different things in different contexts. EY defines sustainable finance as any form of financial service that incentivizes the integration of long-term environmental, social and governance (ESG) criteria into business decisions, with the goal of providing more equitable, sustainable and inclusive benefits to companies, communities and society. Embedding ESG concepts into investing is perhaps the highest-profile manifestation of sustainable finance, alongside the rising prominence of stakeholder or inclusive capitalism. Sustainable finance also has a critical role to play relative to climate change in financing the transition to net-zero carbon emissions by 2050.

The magnitude of climate change globally presents an enormous range of potential risks, starting with floods, wildfires, super-storms and other physical events that not only disrupt economic activity on a broad scale, but the operations of individual companies. Changing weather patterns globally had already started to show the fragility of supply chains for certain industries; COVID-19 certainly exposed that even more. So-called transition risks are equally important. They involve the financial and commercial impacts of the shift to a greener economy (e.g., oil and gas companies affected by limits on fossil fuels). While physical risk is more visible and present today, the growing effects of transition risk over the coming decade and beyond must also be taken into account. 

There is no road to a net-zero economy without financial services. Other sectors will need support – such as insurance and funding – to manage the impact of physical risks, and more importantly to change their strategies, business models and operations to make the transition. Brown only turns to green with finance. The financing needs are enormous. Conversely, companies not making the transition will find it harder to gain funding and attract investments. Customers will also be affected, especially those in areas that are subject to the increasing effects of extreme weather.

Considering these risks, as well as the compelling opportunities, this article addresses the necessity for financial services organizations to set a clear and forward-looking business strategy for sustainable finance and their role in the transition to net-zero. While there are many important actions to be taken (including data gathering and the development of modeling and reporting capabilities), it’s critical that banks, insurers and asset managers first establish a big-picture vision for what’s ahead. 

Reflection of wind turbines at sunset in car side mirror
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Chapter 1

Where we are today: increasing commitment, attention and investment

Private sector leadership will be imperative in the move to net-zero carbon emissions.

At least 125 countries, including half of the G20, have committed to net-zero carbon emissions by 2050. The goal is to limit temperature increases to two degrees or less in the next 30 years, in line with targets set out by the 2015 Paris Agreement and supported by the United Nation (UN) and a range of industry groups. Regardless of the politics surrounding climate change, the UN’s ambitious sustainable development goals (SDGs) have become the global framework within which progress toward arresting or reversing climate change (as well as other significant issues) is being judged.

Progress relies on coordinated action across public and private sectors. National and regional governments play a critical role in marshalling resources, establishing regulatory and fiscal conditions, and fostering – and, in some cases, leading – change. But the private sector is key and within uncertain political and economic conditions, even more so. COVID-19 has wreaked havoc on economies and public budgets, such that many international leaders have voiced major concerns that COVID-19 has materially set back on progress on the SDGs. This places more emphasis on the need for private sector leadership, even as governments around the world formulate “build back better” policies.

As with other industries, most of the initial attention on climate change was on the risks presented by extreme weather events and the direct threats to specific types of businesses (e.g., oil and gas producers, airlines, automotive manufacturers). Financial services firms amplified existing efforts to strengthen operational resilience and third-party risk management.

Increasingly, leading banks, insurers and asset managers have committed publicly to redirect resources toward achieving net-zero and other SDGs. Only recently has the huge upside potential come fully into view. Indeed, as Mark Carney, former head of the Bank of England and now a US Special UN Envoy, has suggested, “the transition to net zero is creating the greatest commercial opportunity of our age.” Others have likened the scale and scope of opportunity to the industrial revolution.

In this context, leading firms are marshaling their resources and reshaping their strategies to prepare for the road to net-zero, with the knowledge that sustainable finance will be essential to traversing that road effectively. Leaders in those organizations are not viewing sustainability as a compliance exercise or simply a major risk (although it has become major compliance and risk elements), but as an opportunity to seize the significant upside opportunities that will accompany the major macroeconomic shifts already underway.

Such foresight is necessary given the clear trend from voluntary measures to more tangible actions in pursuit of specific carbon-related goals. More regulatory mandates are a certainty. The development of strategic objectives and metrics to track progress against those objectives should be the priority – the first step for firms that want to chart a relatively smooth and profitable course to a more sustainable future. Financial services firms should be the partner for industries and companies treading the pathway to net-zero.

Asian woman standing in tropical rainforest
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Chapter 2

Defining an authentic, achievable and meaningful sustainability strategy

Where to invest time and resources to manage physical and transitional risks should be top-of-mind.

Setting the right strategy starts with defining just where and how financial institutions should engage on sustainability. It’s not just a matter of figuring out the right policies, but of identifying the right actions to make sustainable finance a lever for growth. Among the key questions financial institutions should ask:

  • Should leadership on environmental (or social) issues be an essential part of purpose, as it is for several automotive and consumer goods companies? Is our engagement on environmental (and social) issues authentic to our culture, brand and products?
  • How do we play an active supporting role in transitioning to net-zero?
  • How does sustainability intersect with or influence the business strategy and operational models?
  • How do we determine how climate change will impact our strategy and operations, and change market demand for our products and services?
  • With whom, and how, should we collaborate to facilitate systemic change?
  • What is most important to our stakeholders regarding what we do to address climate change?

These questions may lead boards and senior management of financial institutions to think about purpose and the organizational mission. The right answers will help define sustainability goals that suit the organization – that is, those that are authentic, achievable and meaningful, and aligned with stakeholder needs. Further, the most successful strategies will be those that are embedded into the very core of the business, with the right level of leadership and advocacy from the C-suite.

A strong sustainability strategy will ensure that both physical and transition risks are built into corporate risk and compliance frameworks, product development, underwriting and pricing decisions, and other key management decision-making processes. Physical risks may be more relevant to operational resilience, as well as credit, liquidity and balance sheet risk. Some suppliers and outsourcing vendors providing critical services (e.g., call center or technology support) were not ready for the sudden shift to virtual operations. Financial services companies must assess their capacity to sustain operations, as well as that of the businesses they finance and cover, as they assess potential disruptions from climate change. This may present tough decisions on the mix of off-shore, near-shore or onshore operations and third parties.

Transition risks are where sustainability intersects with product and customer strategies. This crosses retail, institutional and corporate clients. For example, companies that aren’t prepared or can’t find a viable transition pathway to net-zero may struggle to survive, especially if their financial services providers do not support the transition. For consumers, the challenges will be getting housing, finance, and insurance in areas adversely affected by climate change.

For banks and asset managers, it’s a question of defining the segments that are worth extending credit to and investing in. For insurers, it’s a matter of adjusting underwriting and pricing models based on more flooding, wildfires and the like – efforts that have already begun. As a whole, the financial services sector should be under no illusion that it can support the transition without financing carbon-intensive industries in the short and medium terms. In reality, brown industries and companies need financing to get to green.

A major challenge for financial services firms will be deciding if, or how, to support the transition. Some financial services firms have decided to stop working with, or investing in, certain sectors or companies. This has been done out of principle or to reduce associated reputational risks. Other firms have decided their role is to support the transition by incentivizing and financing necessary changes. They believe that is more in line with their principles and that the risks can be managed. It’s a tough decision for firms.

Sustainability strategies will balance divestments from some sectors with increasing commitment to others. Again, it’s a matter of asking the right questions:

  • What is our pathway to supporting our customers and clients as they transition to net-zero?
  • How are we making decisions on where to invest and provide financing? How do those decisions align with our purpose and strategy?
  • Which new technologies offer the most promise for the transition to net-zero, and thus are worth financing or investing in? Which sectors or companies are developing or using these technologies?
  • What new risk-mitigation products and services can be developed to support customers and clients? What risk or portfolio modeling services do our customers and clients need?

In the context of climate change, there are trillions of dollars to be made via the right investments, with opportunities across many sectors, from renewable energy sources and green housing, to alternative food sources, to smart packaging technologies. For example, the International Energy Agency projects the need for $3.5t in annual global investments to build the infrastructure for a green economy.1

Given the broad consensus that the pace of investment has been too slow, first-mover and fast-follower advantage is still available for investors that make the right moves in the near term. A recent Harvard Business Review report2 confirmed the importance of robust strategies: “Investors are increasingly asking … not whether a company has good intentions, but whether it has the strategic vision and capabilities to achieve and maintain strong ESG performance.” If this is true from an investment angle, it is true in terms of how financial services firms make decisions on whether to fund or ensure that firms are taking climate change seriously.

What financial institutions should do now:

  • Identify the link between sustainable finance, net zero and the organizational mission or purpose.
  • Map the risks and opportunities related to climate change by business unit, product line and geography.
  • Define a clear strategy and vision for sustainable finance – what the organization hopes to achieve and how it will meet its objectives.
  • Identify the right organizational structure, including accountable senior executives and board oversight.
  • Communicate the sustainability vision and strategy to employees, investors and other stakeholders.

The bottom line: envisioning the long road ahead

Setting a strategic context for climate change should be a near-term priority because sustainable finance is very much a long-term game. Banks, insurers and asset managers should participate in ongoing industry efforts to establish data and disclosure standards. But, establishing the bigger-picture strategic context for the business must be a priority, as it holds the key to navigating the most significant risks and seizing the upside.

Additional Contributor: Judy LJ Li, EY APAC Financial Services Sustainable Finance Leader.

Summary

As stakeholders and society increase pressure on businesses relative to climate change, financial institutions must decide how to engage on sustainability and the transition to net-zero. It’s not just a matter of setting policies, meeting regulatory mandates and avoiding “brown” industries, but rather of making sustainable finance a lever for growth.

About this article

Authors
Brandon Sutcliffe

EY Americas Financial Services Sustainable Finance Leader

Sustainability leader. Risk and regulatory professional. Advocate for action on climate change. A passionate supporter of heart health. Avid skier. Football fan. Lacrosse enthusiast.

Gill Lofts

EY Global Financial Services Sustainable Finance Leader, EY Financial Services Wealth & Asset Management Leader, Ernst & Young LLP United Kingdom

UK Wealth & Asset Management Leader and Global Financial Services Sustainable Finance Leader. Passionate about creating a legacy in the Financial Services industry and proud mother of two daughters.

Mark Watson

EY Americas Financial Services Managing Director and Board Matters Deputy Leader

Transformational leader. Advisor on matters delivering global impact and strong governance. Passionate about sound public policy. Avid moviegoer. Electronic dance music fan. Proud Anglo-American.