Why should financial institutions be on a mission to reduce emissions?

The geopolitical and economic upheavals of the past year have forced some FIs to change their decarbonization approach, but very few have altered their long-term goals or halted existing plans. Even so, progress toward a 1.5˚C path has been frustratingly slow. To change this, FIs need to take the next step on their decarbonization journey.

That requires a fundamental shift: embedding decarbonization into capital allocation mechanisms, balance sheet management and investment and lending strategies and portfolio structures. Incorporating emissions reduction into capital allocation decisions highlights the difficult trade-offs that decarbonization demands – such as balancing lower short-term returns with longer-term gains or increasing near-term financed emissions to achieve faster real-world decarbonization.

Achieving the mindset required to manage these trade-offs and prioritize long-term sustainability will require investment, leadership and cultural change. The right KPIs and reward structures will be crucial to aligning decision-makers’ incentives with the right long-term goals. Firms will also need to overcome persistent technical obstacles, such as unreliable data.

Firms’ efforts continue to be hampered by patchy national policies and inconsistent government support. Analysis from Climate Action Tracker shows that while net-zero targets have been set by countries accounting for 90% of global emissions, almost three-quarters of these targets are vague or inadequate. Critically, they also lack sufficiently ambitious near-term targets to make them credible. This adds to the complexity of the environment in which FIs need to develop robust, near and long-term decarbonization pathways.

• Linking net-zero, business and risk strategies: Reviewing key strategies and strategy-setting processes; aligning risk appetite and business goals with decarbonization plans; integrating emissions into planning and stress testing activities.
• Methodology and standard evolution: Ensuring that sector pathways are up to date with the latest methodological guidance e.g., Science Based Targets Initiative (SBTi) Financial Institutions Net-Zero (FINZ). Beyond target-setting, ensuring that firms focus on emissions reduction as well as portfolio transition alignment — continuing to evolve their approaches as methodologies, data, guidance, and standards develop.
• Engaging with policy makers: Working with policymakers on areas of greatest urgency and materiality, especially where FIs cannot succeed without public sector policy action or partnership.
• Operationalization: Implementing suitable KPIs and incentives; creating management frameworks for products and services; monitoring emission performance to date and planning an emissions trajectory for 1.5˚C alignment; establishing the data capabilities to support monitoring and decarbonization; investing in talent development; and establishing the governance required to deliver tangible action.

As they work to embed decarbonization, FIs will need to focus on more than Greenhouse Gas (GHG) emissions alone if they are to achieve a real-world transition. We now take a closer look at two important topics that firms should incorporate into their strategies if decarbonization is to be effective and enduring.

1. Integrating climate and nature

Mitigating threats to nature is central to credible decarbonization. We can’t reach net-zero without protecting nature, and we can’t restore nature without stabilizing the climate. Conservation and climate mitigation are mutually reinforcing.

Incorporating nature-based goals into decarbonization frameworks will help FIs to address the current shortfall of up to US$800m a year in biodiversity financing.⁵ Key steps include assessing the materiality of nature-related risks and opportunities, prioritizing areas of focus (such as use changes in terrestrial, freshwater or marine ecosystems), and planning the required responses, resourcing, and disclosures.

FIs don’t need to start from scratch when it comes to assessing nature-based dependencies or valuing nature-based risks. In particular, the Taskforce on Nature-related Financial Disclosures (TNFD) provides a framework for incorporating nature into risk management and disclosure. The TNFD is voluntary but looks set to gain influence — the European Financial Reporting Advisory Group (EFRAG) and the ISSB are already working toward alignment with it.

The TNFD’s core “LEAP” approach to implementation guides companies through locating their key interactions with nature; evaluating their dependencies and impacts; assessing the risks and opportunities that arise; and preparing to respond and to make suitable disclosures. There is also a tailored LEAP-FI approach that helps FIs to incorporate nature-based factors into existing risk management systems.

Frameworks like TNFD can help FIs to accelerate nature-positive approaches to decarbonization such as nature-based solutions, sustainable supply chains or exclusion policies. Even so — as with decarbonization in general — firms will face tricky decisions over trade-offs between nature, climate, and performance.

2. Just transition

The concept of just transition is that decarbonization should not harm workers or communities, but also that the benefits are shared widely and equitably. The concept recognizes the importance of fairness and social stability as foundational to a successful net-zero transition.

Potential threats to a just transition include asset stranding, higher energy costs and job losses. Risks often disproportionally impact specific assets, industries, localities and regions, and populations.

So far, regulation has put little emphasis on just transition. Even so, an increasing number of FIs are making just transition commitments. Many are now signatories to the Principles for Responsible Banking, Responsible Investment or Sustainable Insurance, which call for close social engagement. This is focusing debate on the challenges of incorporating just transition into decarbonization and there are practical obstacles too, such as:

• Identifying and measuring the social effects of decarbonization
• Incorporating social factors into policies, e.g., the KPIs asset managers use for stewardship
• Monitoring ongoing activities underwritten by insurers or financed by banks

Tools to help FIs achieve a just transition include frameworks provided by the Financing Just Transition Alliance (FJTA) and the Taskforce on Inequality-related Financial Disclosures (TIFD). Frameworks like these can help FIs to develop tailored plans to integrate a just transition into their decarbonization efforts.

Using the energy transition as an example, the mining sector illustrates where just transition considerations are particularly important. 

However, mining’s impact also needs to be considered in the context of local community impact, including: displacement of people; indigenous trust and reconciliation; and the disproportionate impact of the location of mines on rural families and economies. It is estimated that in a period of 50 years, mining has displaced over 1.5 million people in India alone. ⁶  Many of the ESG risks for the sector are attracting investor and stakeholder attention. Therefore, while it is widely understood that the mining sector will play a key role in the energy transition, a vital consideration throughout this will be to protect local communities and habitats, to ensure they are protected in parallel with the transition. FIs financing the energy transition will need to consider the wider impacts of these activities on communities and people.

Given the need for a rapid and targeted approach to decarbonizing, we have highlighted four priority areas that FIs should focus their efforts on.

1. Finance the transition: Given that half of the technologies required for net-zero are yet to reach commercial stage, firms should consider the scale of their commitment to climate solutions, including nature-based solutions.  Additionally, they should be looking to finance the net-zero transition of companies, while supporting a managed phase-out of non-transitional assets.
   
   
2. Engage and advocate: Actively engaging with clients and investees to support their transition will be key, as well as engaging with governments and regulators to strengthen and clarify national decarbonization targets and policies. FIs may begin to explore innovative ways to support the transition, including through financing (e.g., public or private) and non-financing partnerships.
   
   
3. Measure and steer: FIs should adopt suitable decarbonization targets and KPIs for financing and facilitation activities, covering both portfolio alignment and emissions reduction, to ensure that incentives are aligned. This should happen while measuring decarbonization progress to date and quantifying the required acceleration, ensuring that portfolio coverage is controlled and aligned to best practice. The next step is embedding carbon as a constraint into capital allocation, balance sheet and portfolio management, including, for example, the development of an internal carbon price, and where possible, incorporating nature and just transition into decarbonization plans.
   
   
4. Operationalize and embed: An enterprise-wide implementation framework for decarbonization should be developed, along with effective governance and oversight, with incentives aligned to real progress on transition. This will help demonstrate clarity and clear, committed leadership, aligning decarbonization goals with other strategic priorities. To do this, FIs may think about making strategic investments in data, technology and talent, and be flexible in evolving them as practices mature.