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Innovative decarbonization strategies linked to clients’ transition pathways are becoming vital to success.
In brief
- Financial institutions can leverage a four-step framework to help achieve their net-zero targets.
- The implementation stage is expected to emerge as the toughest challenge, requiring subjective choices and trade-offs.
- Instead of “divest or engage”, firms may need innovative approaches – including a deep understanding of key sectors’ transition pathways.
COP26 saw a step change in the financial industry’s involvement in the fight against climate change. More than 450 financial institutions, acting together as part of the Glasgow Financial Alliance for Net Zero (GFANZ), committed to align over US$130t of capital with Paris Agreement targets.
In the run-up to COP26, EY teams set out a structured approach to decarbonization which financial institutions could use to achieve their journey to net zero. This provides firms with four practical steps to measure and reduce financed emissions, working with customers, investors and other stakeholders. These steps can be iterated over time as firms dynamically re-evaluate their goals in the light of progress made, and in response to the ongoing changes in technology and strategy. They are:
- Mapping: understanding and measuring current financed emissions
- Target setting: developing science-based ambitions across the organization
- Implementing: designing and applying a detailed strategy
- Communicating: reporting on processes and outcomes to stakeholders
More than half a year since Glasgow – and over halfway to COP27 – the need for financial services to decarbonize is clearer than ever. However, institutions working to deliver on their net-zero commitments often find turning theory into practice even harder than they expected.
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Chapter 1
The challenges of decarbonization are getting clearer
Complexity is growing, and external scrutiny is becoming fierce.
Each of the four steps in EY’s decarbonization approach poses major challenges for financial firms. To date, there has been significant focus on developing technical standards around baselining, target setting and reporting. Partnership for Carbon Accounting Financials (PCAF), a partnership aiming to establish common standards for gauging financed emissions based on carbon accounting, is a prime example. These activities rely on access to suitable data, appropriate methodologies and the right skills – all of which, while developing rapidly, still lag behind market demand.
In response, financial firms, companies, investors, data providers and public bodies are investing time and money on a range of initiatives. These include developing global carbon accounting standards; tackling challenging areas such as whether and how to include Scope 31 emissions; increasing the granularity of net-zero scenarios that can be used to set targets; and enhancing accreditation methodologies such as science-based targets. In addition to the requirement that GFANZ members have to publish transition plans within a year of announcing membership, a number of regulators are now considering whether or not to mandate the need to publish transitions plans.
Arguably though, it’s the implementation stage – where the industry’s actions have the greatest real-world impact – that’s the toughest step. Implementation requires difficult choices over how firms encourage their clients and investee companies to decarbonize existing activities, to scale climate solutions including new technologies and activities, and to ensure that executives throughout organizations are equipped to make informed decisions.
None of this is easy. Developing an informed and credible climate strategy requires financial firms to be able to form a view on:
- The current and future transition status of clients, investee companies and assets. To inform risk management and financing decisions, firms need structured frameworks that can help them decide whether a business is a green native, on a credible path to transition, a transition denier, or a potential stranded asset.
- The trade-offs between short and long-term economic, environmental and social considerations – illustrated by increasing awareness of the need for a “just transition.”
- The knock-on effects of decarbonization decisions on client relationships, business performance, growth strategies and brand reputation.
A number of external stakeholders including investors and NGOs are also applying scrutiny to financial institutions’ decision-making. For example, one recent report2 calls on leading tech companies to reduce the emissions they indirectly finance through their bank deposits.
In the US, Texas, West Virginia and Idaho are among the states seeking to boycott financial firms that divest from fossil fuels3, while Californian lawmakers want to do the opposite. The enduring prevalence of coal in some APAC portfolios can also give rise to over-ambitious net-zero targets.
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Chapter 2
Nuanced implementation techniques are vital to success
Sophisticated decarbonization strategies are key, along with a dynamic view of key sectors’ transition pathways.
The growing challenges of decarbonization could mean that industry debate over implementation is becoming increasingly heated. In recent years, this has often been presented as a choice between divestment and engagement. However, conversations with financial institutions suggest that “divest or engage” is increasingly seen as too blunt a tool. After all, today’s high-carbon industries need to transition; the largest players have the scale and mass to pivot toward low-carbon solutions, but they will need transition capital to do so. Set against that, continuing to finance businesses that are persistently unable or unwilling to produce a credible transition plan might do little to support net-zero ambitions.
A more sophisticated approach may be required. Financial firms, investors and corporates increasingly recognize that making genuine reductions in real-world emissions may require time and patience. Companies could develop clear transition pathways, while financial institutions and investors must be willing to collaborate with current high-carbon businesses on solutions and ongoing investment – while keeping a firm emphasis on net zero.
Firms are therefore developing more nuanced approaches to decarbonization, based on growing awareness that divestment and engagement represent the end points of a spectrum which includes financing climate solutions, scaling new asset classes and giving structured but firm support to companies on a transition journey. Engagement keeps communication channels open and avoids taking sides in contentious situations, while divestment can be retained as an option of last resort when needed.
There are also a number of emerging developments that financial institutions can harness as they develop more sophisticated decarbonization strategies. These include:
- Using multi-asset strategies: Equity is often seen as the primary route for financial engagement on climate change, but its permanence can make engagement a slow process. In contrast, debt is emerging as powerful lever of decarbonization. This is illustrated by the recent collaboration between the Net-Zero Asset Owner Alliance and think-tank The Anthropocene Fixed Income Institute, aimed at promoting net-zero alignment in global bond markets. Refinancing debt is a business-critical issue, and issuers are finding they can now sell green and sustainability-linked bonds more cheaply than conventional debt. The potential for patient private equity to fund multi-year transformation is another argument in favor of multi-asset strategies.
- Engaging collectively: Engagement becomes a much more effective tool when it is part of a broader movement. While collective engagement is not permitted in all jurisdictions, investor coalitions such as the Net Zero Asset Managers initiative and Climate Action 100+ are rapidly gaining influence around the world. Setting shared expectations for disclosure, governance and emissions reductions helps financial institutions to accelerate decarbonization in the real economy.
- Pursuing innovation: Financial institutions are increasingly willing to think creatively about using entirely new approaches to mobilize capital for the net-zero transition. One possible area of innovation could be for firms to integrate the intelligent sharing of standardized data across specific sectors into supply chain finance.
Above all however, the ability of financial institutions to refine their implementation techniques depends on a deep understanding of key industries’ transition pathways. These are increasingly clear and well advanced for some sectors, but other industries have much more to do to model the nature and timing of their transition. That includes assessing the drivers of change, the role of governments and consumers, and the potential influence of technology.
The ability to map sectors’ future decarbonization pathways is vital if financial institutions are to identify their financing challenges and needs. That in turn will allow firms to protect assets, minimize liabilities and finance new opportunities. We have already published research on the importance of transition pathways, and this is a topic we plan to return to in the months leading up to COP27.
Summary
The reality of decarbonization is becoming increasingly complex and subjective for financial institutions. Firms face many difficult decisions as they seek to move beyond target setting and into implementation.
In response, firms are expected to think ahead and stay abreast of the latest thinking on sustainable finance. That includes being ready for heightened external scrutiny; maximizing flexibility and collaboration; and applying more innovative and sophisticated approaches to their decarbonization strategy.
Most importantly, financial institutions can consider basing their own practical decarbonization strategies on a deep, dynamic understanding of their clients’ evolving transition pathways. This is a topic we will return to in the months leading up to COP 27.
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