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No payout for polluters

Could banks be the trump card in the fight against climate change?

  • Banks provide huge amounts of funding for environmentally harmful activities outside their own industry
  • Sustainable finance initiatives are putting pressure on banks to transform their business models

  • Financing services must be geared more firmly towards providing the right incentives

  • Opportunities are to be found in new, sustainable market segments

The fight against climate change needs the backing of banks

Could banks become the unlikely heroes in the epic battle against climate change? Could they perhaps even be trailblazers for sustainability? At the moment, that sounds unlikely. The industry’s track record on social matters1 and corporate governance2 is marred by serious controversies and failures. But now, financial institutions have the opportunity to shine in a different area of sustainability. They could be the trump card in the fight to stop climate change. At present, companies that are significant contributors to the enormous volume of carbon emissions worldwide still receive support from banks in the form of loans and underwriting services for their bond placements.3 But ever more stringent regulation and pressure to mitigate climate change are forcing the sector to rethink and adjust its business models. As providers of capital, banks have very effective leverage that they could use to promote the much-needed transition to a largely decarbonised economy. If they use their power strategically in order to incentivise polluters in their customer base to transform their businesses, they could become real catalysts in the fight against climate change across many economic sectors. Can it work? In what ways will the banks themselves need to transform in the process? And how can we tell if they are doing so successfully?

Regulation drives shift to a more sustainable mindset

Building on the 2015 Paris climate agreement, policymakers in Europe developed and implemented a fundamental action plan and a new strategy over the following years that are geared towards the green transformation of the financial sector. But those who are driving these policy measures have always been keenly aware that public sector funding programmes and recommendations for action alone cannot cover the enormous cost of decarbonising the economy. One central pillar of the policy plans is therefore to provide support for private investment that focuses specifically on sustainable projects, with the banking sector playing a pivotal role as an intermediary. Bringing banks on board and supporting them is essential for success in the fight against climate change. To this end, a regulatory ‘ecosystem’ needs to be put in place that provides clear and transparent rules and definitions for sustainable products and projects. This benefits both the companies operating in financial markets and consumers. An important policy tool that should be mentioned in this context is the 2018 EU Action Plan on Financing Sustainable Growth4. It comprises ten measures that can be grouped into three main categories:

  • Redirecting the flow of funding towards more sustainable economic practices, for example by establishing a detailed EU taxonomy5 for the transparent classification of sustainable business activities and developing a voluntary EU green bond standard.

  • Increasing the extent to which financial institutions and rating agencies take sustainability criteria into account in risk assessments.

  • Improving and expanding the reporting on sustainability-related activities, including outside the financial sector, and enhancing the transparency of reporting.

This action plan (along with further supplementary frameworks) has put in place much-needed regulatory foundations for companies and paved the way for a broad-based data compilation and transparency drive. After all, large volumes of measurable data will be essential for the development of clear and consistent decarbonisation strategies that are fit for purpose.

Banks are facing a Herculean task

The financial industry, and banks in particular, have been under pressure to adapt for quite some time. Shrinking margins, changes in the way that customers interact with banks, growing digital and global competition and ever more complex processes require an enormous willingness to adjust.

This openness to change will be indispensable going forward, because the aforementioned agreements and action plans also require banks to do their bit to reduce global carbon emissions to ‘net zero’ by 2050. To this end, banks will need to go beyond cutting their own emissions (commonly referred to as ‘scope 1’ and ‘scope 2’ emissions). Crucially, carbon emissions resulting from the activities facilitated by loans and other forms of funding that banks extend to companies (scope 3)6 must also be taken into account and reduced. Simply put, transforming the banking industry is about much more than switching a few data centres and fleet vehicles over to green electricity. The banks’ most effective source of leverage for positive change in favour of sustainability is their loan book. Figure 1 uses data from four European banks to illustrate that scope 3 emissions make up around 95 per cent of the total carbon emissions in their value chain. These sample cases show that banks in any country need to consider the intended use and incentive effects of the financial services and products they provide and take account of their implications, including those for the bank’s own carbon footprint.

Figure 1: Relative share of scope 1, 2 and 3 emissions in the carbon footprint of selected European banks

Figure 1
Sources: Exane, KBW and Union Investment Research.

Exploiting the way other parts of the economy respond to changes in the banking sector’s policies and practices is therefore crucial to success in our bid to achieve the Paris climate goals.

The aim: decarbonising with the help of the banking sector

It is therefore of paramount importance to the decarbonisation of the economy that banks have a clear understanding of their scope 3 emissions and the associated carbon footprint of their loan and financing portfolio. Networks such as the Partnership for Carbon Accounting Financials (PCAF) have been formed in recent years with the aim of tackling this problem and improving the availability of reliable data.7 Other initiatives such as PACTA build on these foundations by providing support and possible solutions for mapping out a pathway to a carbon-neutral future8 that is underpinned by science. Models like these enable companies and investors to understand whether the envisaged course is ambitious enough to ensure that the milestones and final goals on the road to net zero carbon emissions will be reached.

A two-pronged approach is generally the best way of ensuring that decarbonisation strategies for banks can be successful. Firstly, sustainable finance criteria – with a focus on green and taxonomy-compliant investment – need to be taken into account in the provision of new loans. And secondly, lending to and doing business with companies from sectors that are particularly harmful to the climate must be gradually phased out. Ultimately, sustainable transformation strategies are doomed to fail until and unless the banking sector turns off the funding tap for major polluters.

Some sectors may find it difficult to access funding in future

The task ahead for banks is to assess their partners and clients in the lending and bond issuance business based on certain climate criteria and to assign them to one of the following three categories:

  • Companies with a clearly sustainable business model: These include, for example, businesses in the renewable energy sector that are on track to achieve the Paris climate goals. Business activities in this category should be expanded from an environmental perspective.

  • Companies with a clearly unsustainable business model: Prime examples in this category are businesses in the coal industry. In the long term, oil and gas companies must also be classed as unsustainable unless they are pursuing a genuinely credible transformation strategy.9 Consequently, business activities with companies in this category should be progressively reduced from an environmental standpoint.

  • So-called ‘hard-to-abate’ companies that can be found in various sectors and for which a swift and substantial reduction of carbon emissions can be challenging due to the nature of their process landscape: Often, these companies supply products that are essential to the wider economy and currently have a large carbon footprint, but are generally transformable. Examples include many businesses in the chemical and utility sectors.10 When it comes to conducting business with companies in this category, banks need to review on a case-by-case basis whether the funding they provide will definitely be used for purposes that contribute to the reduction of greenhouse gas emissions. Consequently, there are two possible outcomes for companies in this category: Business relationships with successful transformation candidates can be maintained or even expanded. But the provision of funding to companies that fail to take the pathway towards transformation, either in general or with respect to specific projects, must be scrutinised from a sustainability perspective and terminated if necessary.

For the banks concerned, some uncomfortable decisions lie ahead. Reducing business activities in sectors that lack transformation potential or sufficiently ambitious climate strategies will have an adverse impact on their operating performance. As a result, some banks are shying away from hasty steps to cut ties with environmentally harmful sectors.11

For banks, there is simply no alternative to decarbonising their books in the long term. Asset managers and other investors will, in turn, be called upon to assess whether – and to what extent – individual banks are really putting their reduction strategies into practice.

Transformation progress needs to be monitored and assessed

Union Investment uses specific key performance indicators (KPIs) to assess the transformation processes of banks:

  • Quality of the sustainability strategy (KPI 1): Key topics for the future must be embedded in the transformation strategy of the analysed company in a transparent and credible manner. Milestones and final goals must be clearly defined and based on scientific reasoning. BNP Paribas, for example, has set itself ambitious and transparent goals for phasing out its funding of thermal coal. Figure 2 shows that the reduction trajectory pursued by BNP Paribas (blue line) has been below the sustainable development scenario (SDS – grey line) mapped out by the International Energy Agency (IEA) for several years. The envisaged reduction targets (dashed line) are ambitious and the company reports relevant data in a transparent manner. This will make it possible to carry out a meaningful review of these

Figure 2: Example of a reduction path for the thermal coal industry

Figure 2
Source: BNP Paribas, as at October 2020. *Data based on 80 per cent of the coal capacity of BNP Paribas' portfolio at the end of 2019 (data used for the calculation of the Group's electricity mix); the trajectory is based on the underlying assumption of a full exit for each parameter and does not take into account any commitments that terminate after the exit dates.
  • Reduction of carbon emissions on the bank’s books (KPI 2): A firm, transparent roadmap for phasing out business relationships with the most environmentally harmful sectors – especially in the fossil fuel sector, but also with selected steel and cement manufacturers – must be set and adhered to. ING from the Netherlands, for example, uses the PACTA approach to analyse its portfolios and define appropriate reduction paths, meaning that it has a credible transformation strategy in place.
  • Further development of a sustainable finance strategy (KPI 3): What areas does the bank want to particularly focus on in the future? Transparent communication on time frames and the envisaged scope of planned programmes contributes to the score for this indicator. Increased loan commitments to companies from the renewable energies sector, for instance, will have a positive impact. In addition, the quality and reliability of information on green issuance and/or lending volumes announced by banks will be reviewed independently. Are all relevant business segments included in these plans? Has the volume been artificially inflated? Union Investment’s analysts calculate individual scores that allow them to rank and compare the different transformation strategies. The sustainable finance commitments announced by BNP Paribas, for example, are quite conservative, which lends them credibility.

  • Sustainability criteria in corporate governance (KPI 4): Executive remuneration should be linked to the company’s transformation strategy in a meaningful way. Crédit Agricole and Societe Generale are two financial institutions whose remuneration concepts are suitable in this respect.

Long-established business segments are becoming riskier

The practical implementation of transformation strategies has important implications for the capital markets, entailing both risks and opportunities. The necessary decarbonisation of the books does affect operating performance in the short term as banks terminate what have been profitable business activities and consequently lose market share. This primarily affects the following two banking segments:

  • In the investment banking business, income may decline when banks withdraw (too) quickly from providing underwriting services to problematic issuers and investment advice on their securities. According to an analysis by Bloomberg, the total volume of bonds issued by companies from the fossil fuel sector in 2020 came to US$ 257 billion.

  • In the lending business, income could also dip during an initial adjustment period as the business strategy is fundamentally transformed with the objective of achieving a carbon-neutral loan portfolio by 2050 at the latest.

Over the long term, however, being too slow and insufficiently ambitious about transforming will actually become the greater source of risk for banks, for example in the following scenarios:

  • As the fight against climate change intensifies, investments in certain sectors and companies will become stranded assets. Banks that hold such investments could suffer painful losses as their value plummets.

  • Continued funding support for environmentally harmful industries could damage both the public image of affected banks and their reputation among sustainability-oriented investors. These banks could also be exposed to rising climate litigation risk. As supporters of companies that continue to generate high volumes of carbon emissions, they could attract growing attention from activist investors.

  • Regulation could become even stricter and further-reaching. The European Commission and the European Banking Authority are already working on rules in connection with a green asset ratio (GAR). Under these rules, banks in the EU would be required to disclose by the end of 2022 what proportion of their financing transactions conforms with the EU taxonomy. As a result, banks with a poorer GAR would be at risk of falling behind their industry peers.

Seizing opportunities in new lines of business from the outset

For banks that embark on a decarbonisation strategy early on and in a credible way, the medium- and long-term capital market outlook is bright despite the short-term risks:

  • Banks will need to make up for the declining volume of bond issues from companies in environmentally harmful industries. This will effectively force them to get more involved in bond issuance in other sectors and to broaden their customer base. The green bond segment is a very promising alternative option. According to data from Bloomberg, the cumulative volume of placements of this particular bond type rose to nearly US$ 1.5 trillion over the period from 2007 to June 2021. In the first half of 2021 alone, green bonds worth US$ 294 billion were issued. Financial institutions themselves accounted for almost US$ 97 billion of that volume and thus made a substantial contribution to the growth of the segment. And the data available so far shows that this trend is continuing in the second half of the year. Sustainable and climate-friendly bond segments clearly do offer green opportunities.

  • Lending to companies that seek funding for a specific, environmentally friendly objective (so-called ‘green loans’) has also been growing robustly in recent years, albeit not quite at the same level as green underwriting activities. Demand for these loans mostly comes from businesses in the renewable energies sector and the real estate sector. But new regulatory requirements could boost the profile of green loans – for instance, if the aforementioned green asset ratio requires banks to disclose explicitly what proportion of their balance sheet conforms with sustainability criteria. In this scenario, a large portfolio of green loans would have a positive impact on the bank’s reported carbon footprint.

  • In addition, comprehensive and credible sustainability concepts support efforts to (re)build trust among capital market participants and investors. This, in turn, will help banks to improve their own appeal as an investment target in the eyes of investors. Moreover, rising inflows into sustainable investment products could benefit the asset management business of banks, provided they offer appropriate products.

Conclusion

Banks have an opportunity to greatly improve their tarnished public image. How? It’s really quite simple: They can become the game changer for other economic sectors in the fight against climate change and play a pivotal agenda-setting role.

But to do this, the banks themselves need to undergo a credible transformation. They need to ensure that a significant proportion of their financial services and product offers are compatible with the criteria of ever expanding sustainable finance initiatives. In many cases, this will require banks to cut ties with some long-standing business partners and profitable sectors. But the opportunities awaiting them in new, sustainability-oriented lines of business are promising. After all, vast amounts of funding from banks will be required in order to achieve the transformation to a decarbonised economy. The slogan ‘doing well by doing good’ could become a recipe for success for banks.

On a positive note, a few European banks have already positioned themselves very well in the sustainable finance market and also compare very favourably with international peers. What enabled them to gain this position was primarily a policy of early adaptation and diligent implementation of the targets and agreements that resulted from various climate conventions and regulatory frameworks in recent years.

Union Investment is supporting banks on their individual transformation journeys. We use our dedicated KPIs to closely monitor their progress towards achieving sustainability goals, always focusing firmly on the bank’s individual CO2 reduction trajectory. Our objective is to conduct a comprehensive climate risk assessment of banks’ balance sheets upfront in order to be able to take relevant risks into account in our investment decisions. When it comes to sustainability, investors should know exactly which banks are merely talking the talk and which are walking the walk.

  1. 1 Misconduct in dealings with customers has resulted in reputational damage, for example in connection with foreclosures against private homeowners in the aftermath of the subprime mortgage crisis and the collapse of Lehman Brothers in the US.
  2. 2 Among the most high-profile cases in Germany were the Wirecard and Greensill Bank scandals. International cases that hit the headlines included allegations of money laundering at several Scandinavian banks and the collapse of the Asian hedge fund Archegos.
  3. 3 According to Bloomberg, banks made total funding of around US$ 3.6 trillion available to companies in the fossil fuel sector in the period between the signing of the Paris climate agreement in 2015 and May 2021.
  4. 4 This document published by the European Commission provides a basic overview and visual outline of the most important objectives of the action plan.
  5. 5 Detailed background information on the taxonomy regulation and its design and development can be accessed, for example, from this website of the European Commission.
  6. 6 Scope 1 comprises emissions that arise directly from the operating processes of a sector. Scope 2 comprises any emissions attributable to the sector in connection with the purchase and use of energy and heat. Scope 3 emissions are generated outside the sector in question, mainly through the provision of funding for investments. The ways in which this funding is used to realise investment projects frequently involve the generation of carbon emissions, resulting in a carbon footprint.
  7. 7 PCAF is a worldwide network of more than 140 financial institutions. Further information and a detailed description of the PCAF’s objectives are available on the network’s website.
  8. 8 PACTA (Paris Alignment Capital Transition Assessment) is a tool that can be used to analyse and evaluate different transformation pathways. It provides banks with a means of assessing the composition of their individual loan portfolio in the context of various different climate change scenarios.
  9. 9 For further information on the transformation of the oil and gas sector, see the study paper Staring down the barrel.
  10. 10 For further information on the transformation processes required in the chemical and utility sectors, see also the study papers From black sheep to green champions and A wind of change brings green energy in sight.
  11. 11 A recent study published by the non-profit organisation ShareAction confirms these findings. In Europe, a growing number of banks are pledging to reduce their greenhouse gas emissions to zero by 2050. But few of the analysed banks have so far taken concrete steps in this direction. Further information on the findings of ShareAction’s study and the objectives of the organisation can be found here.

Authors:

Johannes Böhm, Mathias Christmann

As at: 21 October 2021