By Rick Lacaille, Global Head of ESG, State Street
There have always been multiple pressures on the world’s banks—from shareholders, creditors, customers, policymakers and civil society groups. But climate change has turned up the heat.
Listening to activists, one might believe that the path forward is simple. To enable the transition to net zero, some might say, simply dispose of investments in fossil-fuel companies and stop lending them money.
But the transition from high greenhouse gas (GHG) production and consumption energy systems to renewable and net-zero emissions systems is a massive undertaking. It will impact millions of people and their livelihoods around the world and, by some estimates, require an additional $3 trillion in capital spending each year on physical assets across energy and land-use systems to reach net-zero emissions by 2050.1 It will necessitate a decrease in the supply of fossil fuels, as renewables continue to offer a compelling cost story, but, importantly, also a corresponding decline in the demand for fossil fuels. Banks will likely have exposures to demand and supply sides, both subject to the risk of dislocation arising from an “unbalanced” transition.
Banks have critical roles in the energy transition—not only allocating capital to fund the energy transition and generating new investment opportunities but also assessing the significant transition and physical risks associated with a warming planet that are creating material risks to the creditworthiness of borrowers as well as affecting asset values.
Indeed, most banks have complex, multi-decade relationships with corporate clients that require prudent management under any circumstance. But the climate transition represents a clear opportunity for some sectors of the economy and a significant disruption for others. Clients in the most sensitive sectors will continue to need their existing businesses to be financed while they manage the transition to their long-term “low carbon future”. Along the way, we are likely to see an increasing pace of policy intervention, the latest being the extensive provisions of US President Joe Biden’s administration’s Inflation Reduction Act of 2022 (IRA), with significant international implications while transforming the economics of some business activities seeking funding.
At the same time, competition from non-bank financial entities has also created a more complex environment for decision-making. For example, borrowers in some geographies have an increasing array of options for financing, generating competition for traditional banks and even cherry-picking. Simultaneously, the trend of ownership shifting from public-listed entities to private ones is continuing.
So, how do banks navigate the global energy transition? The answer is “carefully”, as boards of directors must respond to the competing demands of stakeholders.
One important resource in this regard is the Task Force on Climate-related Financial Disclosures (TCFD), which has become a well-established framework around the world for incorporating climate-related financial risks into governance, strategy, risk management and disclosure.2 Increasingly, regulators across major regions are using the TCFD framework when setting policies for climate-related financial disclosures.
But there are other resources for banks to consider. A number of analyses from the Sustainable Markets Initiative (SMI), a network of chief executive officers (CEOs) across industries concerned with promoting sustainable economies that was launched by His Majesty King Charles III three years ago, may also be helpful.
The first SMI analysis offers important insights into what investors expect from banks during the transition.3 The second is a transition-finance framework to scale sustainable solutions.4 And the third is a framework for transitioning companies.5 The first two publications are the work of the SMI’s Asset Manager and Asset Owner Task Force (AMAO), led by State Street’s chairman and CEO, Ron O’Hanley. The third is the work of the SMI’s Energy Transition Task Force (ETTF).
The SMI’s work outlining investors’ expectations of banks highlights three areas to which they should pay attention in the energy transition:
First, strategy. Banks need to specify their exposures to climate risks at both the group and business levels and set out clear roadmaps tailored proportionally to their business models and revenue streams to address those risks. Strategy plans should also address the opportunities the global transition to a low-carbon economy provides. The Biden Administration’s Inflation Reduction Act offers a textbook example of how developments in this area can provide opportunities for banks with strategies that include expanding lending in areas essential for the climate transition.
Second, disclosure. By providing transparent disclosures of climate risks, banks can engage with all stakeholders to identify concrete actions. At a minimum, banks should disclose their target and transition plans and their alignment with the TCFD recommendations.
Third, governance. The bank’s strategy should be supervised by the board, supported by management leadership and incorporated into its culture.
These recommendations from the SMI were intended to serve as an example of best practice and were not intended to be overly prescriptive or exhaustive.
In practice, net-zero commitments from banks need to be artfully executed. On the one hand, they need to help finance CapEx (capital expenditure) and other requirements that will position the business for the future. On the other hand, they need to help taper the threats to the bank of climate exposures from unmitigated physical or transition risks.
Banks that take a more binary view and abruptly constrain finance to clients in high-emitting sectors might appear to be avoiding stranded asset risks, but the assets in question might be necessary for some time to come—i.e., not necessarily stranded, and avoiding them might result in a more concentrated set of risk exposures elsewhere if net interest margin (NIM) and income levels are to be maintained. In addition, it might be important to commit further funds to secure the ability of existing assets to manage a transition successfully. It is, therefore, important for banks to understand what sort of assets might need financing for some time and how best to manage the transitions of businesses in these areas. And that’s where the SMI’s publication outlining the transition-finance framework can help.
The framework aims to help investors utilise and adopt the categorisation as an enhancement to existing net-zero strategies, as this could guide effective and meaningful transition investments through general portfolios or specific vehicles that fund pathways to net zero in critical industries.
This work identifies a decision tree that may support banks as they assess their investment and lending practices. Five transition categories capture the characteristics of companies associated with the five high-emitting sectors that need to transition (power, buildings, mobility, industry and agriculture). These transition categories include:
- Is the asset at or near net-zero emissions, or does it have a deliverable Paris-aligned pathway as it currently exists?
- Committed to transition. Is the asset committed to net zero, and does it have a plan for evolving its business model to achieve a Paris-aligned pathway via investment in technology or alternative business models?
- Transition enabler. Is the asset needed for transitions in other sectors, and is it prepared to invest to achieve net zero? Is the asset an input into infrastructure or products critical for a net-zero economy?
- Interim or phase out? Is the asset necessary for a period but with no role beyond 2050, or is the accelerated phase-out of the asset necessary for net zero?
- Aiming toward transition. Is the asset committed to reducing emissions but without a clear pathway to net zero as it currently exists?
In the SMI’s framework, if the asset does not qualify for one of the five categories, it will likely be stranded in the future.
Finally, the SMI’s Energy Transition Task Force’s categorisation of transitioning companies may also be useful for banks. It informs stakeholders about performance and progress with the goal of mobilising capital into not only green but also transitioning companies.
The SMI uses a series of indicators to determine a company’s position on the transition spectrum based on three attributes: 1) emissions ambition, 2) emissions reductions and 3) financial (the proportion of annual investment into decarbonising and green activities or products, as well as the earnings that come from these areas over time).
The resources and publications mentioned in this article are just a few examples of the important work being completed across the financial industry to promote sustainable economies.
Investors and other stakeholders are taking an increasingly sophisticated approach to the transition, as it is widely recognised that combining a sense of urgency with the need to keep the lights on is necessary. Banks are central to this balance, as they judge the future shape of the economy as well as the risks arising from legacy and novel industries and their paramount needs for safety and soundness.
1 McKinsey & Company: “The Net Zero Transition: What it would cost, what it could bring,” January 25, 2022.
2 Task Force on Climate-related Financial Disclosures (TCFD): Final Report: “Recommendations of the Task Force on Climate-related Financial Disclosures,” June 29, 2017.
3 Sustainable Markets Initiative (SMI): “Investor Expectations for Banking Transition to Net Zero Emissions,” Asset Manager and Asset Owner Task Force (AMAO), March 23, 2022.
4 Sustainable Markets Initiative (SMI): “Transition Categorisation Framework,” Asset Manager and Asset Owner Task Force (AMAO), January 2023.
5 Sustainable Markets Initiative (SMI): “SMI Publishes Framework and Sustainable Fitch to Provide Independent Transition Assessment to Mobilise Capital into Transitioning Companies and Accelerate Global Progress to Net Zero,” Framework for Transitioning Companies, Energy Transition Task Force (ETTF), November 7, 2022.