By Zlata Huddleston, Partner & Sustainability Leader, IBM Consulting
Finance is a business like any other—it operates with the purpose of making a return. Investors commit money with the expectation of a positive result. Yet, the financial-performance result is not the only type of outcome investors should track in the new climate economy. As the world faces the existential threat of climate change and as we overhaul how we live and operate, a greener financial system should align environmental needs with financial objectives.
Green finance is blossoming, and globally the green-bond market could be worth $2.36 trillion by the end of next year; however, green finance is more than just funding or investing in sustainable-development objectives. Of late, the definition of green finance has morphed into any financial activity that takes the transition to the green economy into account.
Today, green finance includes not only the financial-services sector’s role in funding the reduction of global carbon emissions but also the identification, adaptation and mitigation of climate-change risk (aka, climate risk). Banks, in particular, must incorporate governance, strategy and risk-management frameworks into their operations to manage the climate risks inherent in their operations and portfolios effectively. In addition to being under pressure to finance their customers’ transitions to the green economy through sustainable-finance activity, banks are charged with understanding their financed emissions (or emissions of their borrowers). And there’s impetus: Failure to manage climate risk can put the bank’s assets and profitability in danger; failure to report on climate risk and financed emissions may jeopardize the bank’s relationship with shareholders and regulators; and failure to finance the industry’s transition to the green economy can drive the bank’s corporate and consumer customers away. All of this is essential for global economic activity to continue.
The industry needs to act and act quickly. This year’s IBM CEO Study reveals that executives in all industries feel pressured to act on sustainability amidst business challenges and uncertainty, but 59 percent of the world’s chief executive officers indicate that the unclear returns on investments (ROI) and economic benefits of enabling sustainability use cases are the biggest challenges in achieving their sustainability objectives. For sustainability to succeed, we need to see larger investments in data and exponential technologies that drive streamlining climate-risks and financed-emissions management and reporting as an integral part of the new sustainable infrastructure. But this investment needs to be fast—and consistent.
The risk of inertia
Regulatory disclosure and reporting requirements are a major driver of technology-enabled sustainability and climate-focused activities in banking today. Reporting standards are rapidly evolving worldwide for regulatory-, consumer- and investor-driven purposes.
- The U.S. Securities and Exchange Commission (SEC) will require registrants to disclose qualitative and quantitative climate-related risks and metrics;
- The European Financial Reporting Advisory Group’s Corporate Sustainability Reporting Directive (CSRD) will replace the current reporting directive and is part of the European Green Deal;
- The newly launched International Sustainability Standards Board (ISSB) is developing a harmonized sustainability reporting and disclosure standard; and
- The voluntary recommendations of the Financial Stability Board’s (FSB’s) Task Force on Climate-related Financial Disclosures (TCFD), published in 2017, are now forming the basis for the development of mandatory climate-disclosure rules by many regulators around the world.
Climate physical and transition risks are being described and quantified to generate a better understanding of the impact of climate change on banks and their customers. Those banks that don’t adopt and adapt can experience negative impacts on their operations, such as:
- Decreased profitability from high regulatory costs, possible fines resulting from noncompliance, high sudden and mandatory technology-integration costs;
- Credit losses resulting from a limited understanding of climate risks in the bank’s credit portfolios;
- Insufficient liquidity as a result of decreased credit ratings due to failure to meet strategic objectives and regulatory expectations;
- Negative impacts on capital adequacy because of new requirements for higher capital allocations.
Technology enables change
The TCFD requires banks to report both climate-change risks and climate-change opportunities. Sustainability is now seen as a differentiator and opportunity to expand banking services to corporate and retail clients. This is where demands for data and technology can provide useful insights leading to the right action being taken.
Technology is crucial for understanding climate-related data and the secure transfer of data required to model the climate risk of a portfolio and quantify that risk in financial terms. From data-management systems such as data fabric to artificial intelligence (AI) to blockchain, financial institutions must first invest in technology to make sure they can make strategic changes. Banks can also evaluate their infrastructures as part of their annual technology planning processes and begin mapping out how a hybrid-cloud architecture could take advantage of system improvements from a sustainability standpoint.
AI can help measure greenhouse gas (GHG) emissions reduction against set targets more accurately, improve analytics to predict the impacts of acute (floods, wildfires) or chronic (sea-level rises) climate events on the bank’s assets, assess the current state of low-carbon financing and model the bank’s lending book against its sustainable-finance framework prior to green-bond issuance.
It’s not perfect…yet
Increasingly, banks are becoming more aware of climate- and client-related data gaps, requiring the automation of estimation techniques to perform the required analytics. In addition, the lack of alignment across sustainable taxonomies for classification standards is a concern.
An example of a major data gap in client-related data required for financed-emissions calculations is the GHG emissions of a privately owned commercial borrower. AI-powered automation can help scale the modelling of estimation techniques. AI can also enable a bank’s financed-emissions and transition-risk measurements and sustainable-finance use cases with an industry classification standard that is scalable and adaptable across the entire banking enterprise.
Imperfect action is better than no action. It may begin with a blended approach, but small steps are better than no movement.
How to start?
Start with a centralized, enterprise-wide climate-data strategy to define key climate initiatives—identifying data requirements and internal and external data sources—and assess various technological tools. Your bank’s strategic focus should be on ingesting, processing and modelling climate and related data, identifying priority use cases, mapping data requirements, assessing data gaps and aligning all internal stakeholders on common principles, business architecture and the roadmap to a green-finance technology solution. Pay special attention to assessing data gaps, acquiring external data and addressing data-quality issues. Incorporate calculation and analysis into the technology architecture and bring in tools to support data consumption, including reporting. A hybrid-cloud approach would ensure the adaptability, flexibility and scalability needed as climate-regulatory guidance and regulations evolve. AI-based tooling can help drive consistency in climate taxonomies, such as industry classifications. Finally, integrating the output with the bank’s current processes and systems deserves its own strategic technology plan, as it could be accomplished through a range of solutions, from simple dashboarding to complex machine learning (ML) techniques.
The key is to get going and start with a technology-enablement strategy.
Conclusion
Sustainability is mainstream. Green finance is not just in the future; it’s happening now. Shareholders and society expect it, while more and more governments regulate it. Soon, the financial return will depend on the sustainability credentials of an investment. Financial institutions must work on their ability to identify climate risks, collaborate across the sector and act on data insights in real-time. Change is coming thick and fast. The right data and technology will empower green finance to thrive. Together they will enable the identification of climate risks and sustainable business interests as well as better, more efficient financial decisions.