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Sustainability
Closing the climate gap: the rise of green financeÂ
The financial sector has a crucial role to play in enabling the transition towards sustainable finance. So how can financial institutions establish themselves as drivers of the green transition rather than financers of polluting industries?Â
Until recently, the sustainability risks of banks and other financial institutions were assessed mostly on their internal activities and on possible impacts from outside their operations. Now, thanks to new regulations that take a wider view, these organizations are in the spotlight for downstream environmental risks related to the businesses they finance or invest in.
Financial institutions face growing challenges regarding the disclosure of their environmental and climate impacts. Regulatory changes mean it is no longer enough to report on internal sustainability without taking account of wider impacts and dependencies.
Adding to the pressure, banks and other financial institutions are under increasing pressure to elaborate on their disclosures, due to newly required so-called “double materiality”. This means that it is not just the risks that climate change may have on an organization that need to be disclosed in its accounts, but also the potential impacts that the organization itself may have on the climate through its operations.
Emissions disclosure is categorised by Scope, with Scope 1 being a company’s own operations emissions, Scope 2 those caused by the generation of purchased energy, and Scope 3 being those emissions caused by an organisation’s supply chain (upstream) and by distribution and use of its products or services (downstream). In the case of financial institutions, the so-called “financed emissions” (i.e. Scope 3 downstream) dwarf their own (Scope 1 and 2) emissions. Financed emissions include both those that are the product of an emitter in which a bank has invested or financing, and are regularly seven hundred times higher than “own emissions”.
The scope of the impacts that financial institutions are having to consider is expanding, and at the same time various climate tipping points are also being reached — or breached — affecting businesses in unpredictable ways. For example, historically, insurance companies could accommodate known cycles of storm seasons in their planning, but as these phenomena increase in frequency and severity, the risks they pose change too.
“Because of their existing disclosure obligations, banks and financial institutions are already very data-driven, but the range of categories and types of data is rapidly increasing.”
This complex network of potential threats is affecting the balance sheets of financiers, prompting central banks to declare climate to be a growing risk, even threatening the stability of the financial system. In recent years, there has been a significant increase in governmental commitment to tackling the physical and transitional risks of climate change and this is reflected in regulations in Europe and beyond. Across jurisdictions, regulatory enforcement and fines are on the rise, driving demand for solutions that enable financial institutions to monitor and manage sustainability risks in their portfolios and enable disclosures about their ESG-related performance.
The power of data
Because of their existing reporting obligations, banks and financial institutions are already very data driven, but the range of data categories they must consider are increasing significantly. The landscape of corporate sustainability is changing fast, and it is no longer enough for companies to buy carbon credits to offset their emissions and claim carbon neutral status. While offsetting may have a positive impact in the short term, businesses are — more importantly — expected to show actual reductions of emissions and of other negative impacts.
Financial institutions increasingly need to provide verifiable evidence of how they are transforming their business activities and providing more sustainable products, thereby reducing internal and downstream impacts. This will require processing exploding data volumes from own operations, investing and financing, and introducing client services for measuring, disclosing and reducing their climate and nature risks and exposure.
Moreover, as nature and biodiversity become global topics of concern, additional risk and impact categories need to be assessed and disclosed, meaning the financial industry has to step up its data collection efforts to account for sustainability impacts that were previously outside of their remit.
With growing disclosure obligations, the universe of organizations aiming to support these efforts is expanding. Big tech firms such as Microsoft, Amazon and Google are leveraging their cloud infrastructure and related expertise to help clients assess the emissions of their IT infrastructure. Other already established sources of expertise are larger financial and market data providers such as Morgan Stanley Capital International or Standard & Poor’s who, meanwhile, have thriving business areas in ESG data. Lastly, there is a fast-growing space of younger-technology and advisory firms who are often more specialized in niche areas, such as geospatial data for the assessment and monitoring of nature and biodiversity-related factors.
The rise of climate finance
In the context of a global push for sustainable financial solutions, new investment segments such as green finance, climate finance, and nature finance are gaining momentum as attractive investment segments. These address aspects of sustainability including climate change resilience, mitigation and adaptation, energy efficiency, conservation or restoration of biodiversity, transition to a regenerative agriculture or a low-emission transport system, and of course the continued decarbonization of energy production.
To date, the major share of climate finance has flown into projects addressing the transformation of early-known high-emitting industries, from renewable energy to transport electrification. This predominant carbon focus (i.e. the prevention of further global warming) is being complemented more and more by the consideration of associated yet more complex environmental challenges, such as the loss of nature and biodiversity. It is therefore expected that an increasing investment volume will target projects that allow for decarbonization and conservation agendas, e.g. such as aiming to transform agricultural practices.
The social impacts of climate change and of the loss of nature and biodiversity are also gaining acknowledgement in the discussion on green finance. The so-called Global South is more severely affected by climate change and environmental deterioration, while having contributed to them to a much lesser degree. And yet, at the same time countries in these regions are often those that are the least equipped to adapt. As such, there has been a broad acknowledgement of the need for not only strong North-South support but even for compensation; so-called Loss and Damages.
At the recent COP26, COP 27 and COP 28 climate-change conferences, governments around the globe committed in drastic fashion to increasing the financing of adaptation and resilience efforts in the Global South, not least to ensure that high population economies grow in a sustainable manner. While the actual release of the respective funds still drags behind expectations, the financial industry has firmly added social criteria to climate finance instruments.
Crucially, whichever sub-segment of climate or green finance that financial institutions choose to engage in, they need to be prepared to move fast and scale up their efforts quickly. According to the Climate Policy Initiative, in an average scenario, the annual climate finance needed through 2030 will increase steadily from $8.1 trillion to $9 trillion. After this, estimated needs are set to exceed US$10 trillion each year from 2031 to 2050. This means that climate finance must increase by at least five-fold annually, and as quickly as possible, to avoid the worst impacts of climate change.
The financial industry has an important role to play as a key lever in addressing climate change and loss of nature. Implementing comprehensive assessment, disclosure, and management of climate- and nature-related impacts and risks will stretch the capabilities of most banks and financial service providers, but the extent to which they step up to these newly formalized responsibilities will determine how quickly societies around the globe will be able to tackle the pressing challenges ahead.
Making debt sustainable through green bonds:
There has been a steady increase in the market share of sustainability-linked debt instruments over the last few years, specifically seen in the growing issuance of green or climate bonds.
- A green bond is an instrument by which an issuer (for example, a corporation) can raise capital for a sustainable outcome. The bond, as a so-called pay for performance bond, may incorporate a direct mechanism that links the interest to be paid to the level of achievement of the desired outcome. With the emergence of green digital (typically tokenized) bonds, the data leveraged to monitor use of funds and outcome can be certified and validated centrally as well.
- Climate bonds reached a cumulative volume of $4.2trillion for green, social, sustainability, and sustainability linked (GSS+) debt in 2023.
- While green and climate bonds currently have the largest share of the sustainable debt market, the social aspect of ESG is expected to increase its share significantly in this market in the future, especially given ongoing discussions about North-South loss-and-damage payments.
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