Authored by Livia Miethke Morais

The financial sector is waking up to the challenge of climate change and taking part in its solution. Since 2015, when the Paris Agreement was adopted, actions mobilising the financing sector have been unfolding. As recognised in the Paris Agreement itself, finance is a critical enabling factor for the low-carbon transition. Nevertheless, progress on aligning financial flows with low greenhouse gas (GHG) emissions pathways remains slow. According to the IPCC, Climate Change 2022: Mitigation of Climate Change-Working Group III, there is a climate financing gap which reflects a persistent misallocation of global capital, and climate-related financial risks remain greatly underestimated by financial institutions and markets.

Climate Risk is Financial Risk

In 2017, the Financial Stability Board (FSB) created the Task Force for Climate-related Financial Disclosure (TCFD) to develop recommendations on the types of information that companies should disclose to support investors, lenders, and insurance underwriters in appropriately assessing and pricing a specific set of risks: the risks related to climate change. This exercise aims to help companies to provide better information to support informed capital allocation, closing the gap warned by the IPCC report.

The disclosure recommendations are centred on four thematic areas representing the core elements of how companies operate: governance, strategy, risk management, and metrics and targets. These four broad areas are further broken down into 11 recommended disclosures, informed by the needs of investors to understand how reporting organisations think about and assess climate-related risks and opportunities. The reporting is to be presented in tandem with the usual financial reporting of organisations. Progressively, through widespread adoption, climate change must become a natural part of companies’ risk management and strategic planning processes.

In its 5th annual status report, the TCFD noted an encouraging trend in mainstreaming climate change implications throughout the financial markets since 2017. An increasing number of companies are publicly committing to net-zero emissions transition plans. This is a result of organisations understanding that climate risks represent business risks and, consequently, financial risks.

More than 3,800 companies have continued to increase their TCFD-aligned reporting, complemented by much-needed action from regulators, jurisdictions, and international standard-setters to use the TCFD recommendations in developing climate-related reporting requirements and standards — including the U.S. Securities and Exchange Commission, the International Sustainability Standards Board, and the European Financial Reporting Advisory Group. Such coordinated public sector action is vital to reinforce the importance and urgency of climate action guided by data.

From Climate Risk to Mitigation Commitments

The Glasgow Financial Alliance for Net Zero (GFANZ), the world’s largest coalition of financial institutions committed to transitioning the global economy to net-zero GHG emissions, was launched in April 2021. It is intertwined with Race To Zero, a global campaign by the UNFCCC to rally leadership and support from diverse stakeholders for net-zero initiatives.

Under GFANZ, several Alliances have been formed, from Net-Zero Asset Owner Alliance (NZAOA), Net-Zero Asset Managers Initiative (NZAM), Net-Zero Insurance Alliance (NZIA), the Net-Zero Banking Alliance (NZBA), among others. These sector-specific alliances aim to adjust the financial flows to be consistent with a pathway towards low greenhouse gas emission and climate-resilient development, as defined in Article 2.1c of the Paris Agreement. 

The industry-led, UN-convened Net-Zero Banking Alliance brings together a global group of banks, currently representing about 40 percent of global banking assets and over 110 banks, to decarbonise their loan and investment portfolios.

Becoming a signatory of the NZBA requires banks to set and disclose their first targets for priority sectors within the period of 18 months. Guidelines for Climate Target Setting have been published by UNEP-FI, providing banks with the frameworks in their Net Zero pathway. It includes a four-step rationale: understanding the landscape, measuring and disclosing financed emissions, setting robust science-based targets, and implementing the targets. The banks are to keep track of their portfolio emissions, with a special focus on the high-emitting sectors of agriculture, aluminium, cement, coal, commercial and residential real estate, iron and steel, oil and gas, power generation, and transport. 

The emission portfolio assessment requires a good level of clients’ data, which is not yet readily available for many banks. The methodology proposed by the Partnership for Carbon Accounting Financials (PCAF) has been the unanimous choice of financial institutions to calculate financed emissions. The methodology can also be applied in extreme cases of low data availability through conversion factor proxies for sector emissions. Nevertheless, the improvement of data quality is highly encouraged, being the best option, the collection of emissions accounting reported by every client and, ideally, verified by an independent entity.

In order to set robust science-based targets, the banks rely on Net Zero scenarios for the pathways that the different sectors need to take for keeping global warming limited to 1.5 degrees, modelled by international organisations, such as the IPCC, the International Energy Agency (IEA) with their Net Zero by 2050: A roadmap for the global energy sector report, the Network for Greening the Financial System  (NGFS) or others. Those scenarios need to be taken as references since the vast majority of countries do not have policies and plans in place that indicate ambitious enough emissions reduction (as highlighted by the NDC analysis report by the UNFCCC). The granularity of data and applicability of those pathways for the different countries and regions in the world is another challenge banks continue to face. 

On the other hand, individual sectors are also coming together and engaging in their reduction of emissions. Six industries (steel, cement, aluminium, oil, natural gas and ammonia), that are major emitters, have their transition closely tracked by initiatives such as the Net Zero Industry Tracker of the World Economic Forum (WEF). This transition also requires finance and the close involvement of financial institutions.

This leaves financial institutions with the last and most exciting step: to develop their transition plans for the implementation of emission reduction targets for the delivery of their commitments. Bringing science targets for a Net Zero future into reality requires deep transformations: changing businesses operation, internal processes, incentives and structures from the financial institutions themselves, which will reflect changes in the real economy. Collaboration is a key concept in the transition plan, as the targets will only be achieved when financial institutions work together with industry sectors’ initiatives, policy-makers and other organisations. Luckily, there is also a lot of science behind the transition process as well, and there are low-hanging fruits out there to pick to tackle climate change.

Mitigation through energy efficiency

As it is now widely acknowledged, the energy sector is responsible for three-quarters of global emissions; transforming this industry is critical to tackling the climate crisis.

In the Net Zero emissions pathway presented by the IEA, the world economy in 2030 will be 40 percent larger than today, but use 7 percent less energy. This requires a major worldwide push to increase energy efficiency, resulting in the annual rate of energy intensity improvements averaging 4 percent to 2030 – about three times the average rate achieved over the last two decades, according to the IEA. Energy efficiency is commonly referred to as the “first fuel” and can support net zero energy goals at lower costs, beyond delivering a wide array of benefits for society. Mobilising finance for it is a low-hanging fruit for financial institutions to take up. To better understand how this can be done, banks learn about the basic concepts in the International Energy Efficiency Financing Protocol (IEEFP), developed by the Efficiency Valuation Organization (EVO).

Financing mechanisms have been long developed, tested and implemented, demonstrating the effectiveness of energy efficiency in reaching emission reductions. Climate finance experts been working with a number of multilateral development banks, development agencies, commercial banks and other organisations around the world in the past 20 years in this field, rolling out mechanisms such as on-bill and on-wage financing, the energy savings insurance model, energy efficiency through servitisation or tapping into remittances financial flows. Now, it is time to scale them up, and there is plenty of room for more innovative business models and financing mechanisms to mobilise the so-needed financial flows towards energy efficiency.

With Climate comes Nature

All mobilisation of financial institutions to act on climate change is indisputably crucial. Nevertheless, we should not forget the other pressing environmental problems, especially the loss of biodiversity. Nature-based solutions (NbS) are well-needed to contribute to carbon storage over the long term. Ecosystems can provide a wide range of other social and environmental benefits beyond carbon, including biodiversity. For these reasons, the protection and restoration of ecosystems must be rapidly scaled up, irrespective of any carbon benefits they may or may not provide, according to the Oxford Offsetting Principles.

Following the TCFD path for integration of disclosure and reporting, the Taskforce for Nature-related Financial Disclosure (TNFD) was established in 2021 in response to the growing need to factor nature into financial and business decisions. It has just published the latest version of its framework, which will be completed in September 2023, and it remains open for consultation until 14 February 2023.