Faulty climate targets imperil more than banks' sustainability credentials

Portfolio alignment strategies that don't translate to actual decarbonisation leave lenders exposed to heightened physical and transition risks, as well as reputational damage

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The effort to create a climate-friendly financial system risks emulating the fate of the Tower of Babel. Advocates may be united in their desire to subordinate the flow of capital to the goal of a net zero carbon future. But they are divided by fundamental disagreements over how financial institutions affect change in the real economy, and what targets and measurements most honestly reflect their contribution to decarbonisation.

Such rows have led to the fragmentation and multiplication of climate finance initiatives. Top green banks subscribe to so many multilateral schemes that whole sections of their climate-related disclosures read like roll calls. UK lender Standard Chartered, for example, lists itself as a member of: UNEP FI, the Katowice Agreement, the Science Based Targets Initiative, the Coalition for Climate Resilient Investment, the University of Cambridge Banking Environment Initiative, the Asia Sustainable Finance Initiative, the Global Commission on Adaptation, and the PRA/FCA Climate Financial Risk Forum.

That a myriad initiatives exist is not a problem in and of itself. But from a climate risk management standpoint, it presents plenty of pitfalls. Institutions are exposed to reputational risks if the actual reduction of financed emissions they achieve falls short of the amount promised through membership of these schemes. This is also true where firms convey the intent to reduce real-world greenhouse gas (GHG) emissions but use metrics and targets that show nothing of the sort.

Goodwill isn’t the only thing at stake, either. A mismatch between words and actions may cause institutions to underestimate climate-related credit and market risks, too. For example, the sudden imposition of a high carbon tax could obliterate the viability of thousands of corporate borrowers. If a lender’s exposure to actual GHG emissions is higher than the amount of financed emissions it’s estimated, then it stands to lose more than anticipated. 

What’s in a name?

It’s against this backdrop that the split between 2 Degrees Investing (2DII), a leading climate finance think-tank, and the Science Based Targets Initiative (SBTI) should be framed. 

Last week, 2DII published the results of a consultation, encompassing almost 60 organisations, on the framework proposed by the SBTI for financial institutions. In February this year, 2DII formally left the project after 18 months of collaboration “due to the inability to agree with the partners on the fundamental principles governing the methodological development”.

At the root of the conflict is a disagreement over what constitutes a ‘science based’ target. The Initiative’s own website states that targets are “considered “science-based” if they are in line with what the latest climate science says is necessary to meet the goals of the Paris Agreement”. 2DII contends that this means SBTI targets are limited to those which “reduce GHG emissions in the real economy by a certain amount (quantified) that is sufficient to meet climate targets.” Most of its survey respondents agree.

Source: 2DII

Reasonable enough, until one considers that when it comes to financial institutions, establishing a clear link between lending and investing decisions and real economy GHG emissions is excruciatingly difficult. A bank may be able to estimate its financed emissions (using the Partnership for Carbon Accounting Financials methodology, for instance). It may even be able to reduce these by changing its portfolio mix to invest less in ‘carbon hogs’ and more in sustainable companies. But this doesn’t change the fact that financed emissions and real economy emissions are two different things — and that reducing the former does not necessarily affect the latter.

2DII cites a review of the academic literature by Kölbel et al which “found no study that establishes a direct link between capital allocation by SI [sustainable investing] investors and a change in company activities”. Put simply, exclusion policies and climate aligned portfolio strategies that prohibit the financing of carbon-intensive industries may affect asset prices (making it more expensive for ‘carbon hogs’ to access capital) but no studies show that these also affect companies’ operational practices. 

This all sounds fairly innocuous — obvious, even. If Bank X lends $Y million to Coal Mining Firm Z one year, and zero the next, its financed emissions related to that account will also fall to zero. However, this does not mean that Coal Mining Firm Z’s real GHG emissions fall to zero, or even by an amount proportionate to the quantity of financing formerly extended by Bank X. Coal Mining Firm Z may well be able to replace Bank X as a funding source without skipping a beat. If not, it may elect to cut costs — including those related to sustainability — to make up the difference: actually increasing its carbon footprint.

Still, pointing out this disconnect between financed and real emissions undermines the marketing case for legions of sustainability-focused financial institutions, which like to claim their investment choices translate into a quantifiable amount of emissions abatement.

It also invalidates the use of portfolio alignment as a means for financial institutions to achieve real economy GHG emission reduction goals. This conclusion is what caused 2DII to part ways with the SBTI. The group devised a framework under which financial institutions set ‘science based’ targets using Paris Agreement-aligned climate scenarios to inform their portfolio composition. This proved too much for the think-tank, which believed the SBTI should hold itself to a higher standard by ensuring its methodology produced measurable real emissions reductions. 

Today, the SBTI draft guidance says “Financial institutions that set science-based targets commit to align their lending and investment portfolios with the level of ambition required to achieve the goals of the Paris agreement.” This is certainly a less clear-cut statement than that articulated by 2DII: “... the target-setter company has decided to reduce GHG emissions in the real economy by a certain amount (quantified) that is considered sufficient to meet climate targets.”

Alignment is not enough

Some survey respondents claim that 2DII’s definition of a valid ‘science based’ target is too strict to aid the cause of climate-friendly finance.

One said: “I think you are letting perfect be the enemy of the good … it would be exceedingly burdensome for banks to have to justify with every client that our engagement is helping to reduce emissions in the real world”.

He’s not wrong. To do this, a bank would need a time series of data on each client’s ex-post emissions showing a downward trajectory, and evidence its actions contributed to the decline — and will continue to have an affect going forward. Few large corporations gather and report this data to reliable standards, and it’s even rarer across small and medium-sized enterprises.

A lender would also have to actively engage with each client so that all financing was tied to measurable GHG reduction targets.

From an investor relations standpoint, certainly this sounds excessive. From a climate risk management perspective, however, it may be essential. Without quantifiable emissions reductions, lenders are vulnerable to claims of “greenwashing”. Even worse, failure to actively contribute to a real fall in GHG emissions means lenders aren’t working to head off physical risks, whereas an undercount of the actual GHG financed through their portfolios could exacerbate transition-related shocks, such as the imposition of a carbon tax.

What’s to be done? The Kölbel paper cited by 2DII may hold the key. Though it concluded that capital allocation decisions cannot produce real emissions reductions, shareholder engagements do:

“[I]nvestors who want to stimulate real-world impact can roll out shareholder engagement throughout their portfolio. Ideally, investors should focus on requests that have a good chance of success and yield substantial improvements in company impact. In addition, investors can pool their shareholder rights with like-minded investors to increase their influence, and outsource the engagement mandate to specialized firms.”

It stands to reason that banks can exert similar pressures using lending terms, by imposing GHG-related covenants and variable repayment conditions on clients. Ending the provision of bonds and loans for “general corporate purposes” and replacing these with sustainability-linked loans (SLL) could go a long way towards achieving real-world change. Climate-friendly banks could even team up to create new, uniform SLL protocols that all members would adhere to, thereby sharing the burden of product innovation and promoting standardisation.

Certainly, this would mean banks need legions of trained loan officers fluent in climate-related finance. Many are already on the case. Wells Fargo, for instance, trained up 2,300 employees on climate change impacts in 2018 and 2019. Barclays held over 4,500 meetings with clients of its corporate bank in 2019 “on the Green agenda”. Financial institutions are also used to having to suddenly load up on employees with new skills. Post financial crisis, banks sent out a call for thousands of regulatory and compliance professionals to help them navigate the new laws restricting their behaviours.

Of course, what matters more than the quantity of climate-related staff and meetings are where they are having an impact. Climate conversations cannot be tangential to loan agreements. They need to actively shape the final form of lending term sheets and securities prospectuses. Climate-trained employees cannot all be in investor relations and marketing — but within the risk management function and on the front lines of loan origination. Some banks already recognise this, but not all.

In addition, and somewhat at odds with the ‘logic’ of portfolio alignment, to best achieve real economy GHG reductions it may make more sense for climate-friendly banks to hang onto their carbon intensive exposures instead of dumping them.

Why? Because a lender can only exert pressure on a ‘carbon hog’ if it’s in a financial relationship with them. Remember, Bank X may divest from Coal Mining Firm Z, but if it does it cannot stop Coal Mining Firm Z going to Hedge Fund A or Family Office B for replacement funding without any sustainability conditions applied. Yes, a cost-conscious fossil fuel firm may want to escape a bank lending relationship anyway if it thinks the costs of compliance with GHG-reducing conditions are too high. But as long as a bank has skin-in-the-game, it has the opportunity to change the emitting behaviour of a client.

Furthermore, if enough climate-conscious banks take this approach to lending, than a client that spurns one spurns them all, shutting off its access to bank lending and degrading its social licence to operate.

Undoubtedly, a financial institution wanting to set a ‘science based’ target, according to 2DII’s definition, would have its work cut out. The data collection challenge involved would be monumental, and the processes — and employees — needed to coax borrowers to lower their real-world emissions would have to be legion. Without a regulatory mandate, getting a large number of banks to do the work may be too much to ask.

Still, firms wanting to create the ‘gold standard’ of climate finance initiatives should recognise the importance of putting real-world emissions reductions front and centre.

As another respondent to the 2DII consultation explained: “The real economy is the only relevant arena for making climate impacts; measuring emissions outside of this arena is irrelevant.”

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