Banking in 2021 and beyond: Climate change drives policies

The banking sector is experiencing commercial, regulatory and societal pressure to adapt to climate risks.

How will the banks respond and thrive in a world that needs more green finance? What type of leadership and new skills are needed to protect both balance sheets and the environment?

Climate change has been described by esteemed UK economist Nicholas Stern “as the greatest market failure the world has seen”¹. However, in spite of increased alarm from the worlds leading climatologists, climate action amongst the banking sector continues to be insufficient. Recently, BlackRock chief executive Larry Fink, who manages $7.8tn of assets wrote that “we are on the edge of a fundamental reshaping of finance”²^.Mark Carney, the former Bank of England governor, warned in 2015 that “once climate change becomes a defining issue for financial stability, it may already be too late.” His comments appear to be all the more prescient now given the escalation in weather events, increasing loss of habitats and species that we are witnessing. Costs to the market for weather disasters alone in 2020 were an eye-watering $150bn³.

So why is it worth looking more deeply at the banking sectors response to climate change? There are several reasons:

Banks play a critical role in stabilizing the transition to a low carbon world.

Climate change poses a profound risk on banks’ ability to operate, most notably on their monetary and financial stability. They have many economic and policy instruments to affect the allocation of capital towards green investment.

The cost to transition to a low carbon world. How to pay for it all?

Research suggests that investing between 1 per cent and 4 per cent of the combined GDP of all nations would be needed to limit carbon emissions to a level whereby temperatures rise by less than 2°C on average⁴. Annual adaptation costs in developing countries alone are estimated at $70 billion. These figures could reach up to $300 billion per annum in 2030 and up to $500 billion per annum in 2050. The annual gap in the amount of investment needed to achieve the UN Global Goals is currently estimated to be totalling $2 trillion. It is essential for the financial sector to accelerate and scale up its involvement. However, scaling is only possible when financial institutions, the private sector, and governments collaborate as partners⁵.

Moral verse amoral money: Banking is undergoing an identity crisis.

Two heavyweight central bank Presidents are squaring up for a fight over climate change and how the sector should respond to it. The disagreement is whether the European Central Bank (ECB) asset purchase programmes should be biased towards ‘green’ or should be market neutral. In this faceoff, we have in the green corner, ECB president Christine Lagarde who has promised that climate change will be a central part of the bank’s strategic review of its remit and tools.

In the ‘brown’, or more accurately the ‘light green’ corner, we find Jens Weidman, President of Deutsche Bundesbank, the German central bank, who writes in the Financial Times: “It is not up to us to correct market distortions and political actions or emissions”. Governments have the tools to address climate change, such as taxes and cap-and-trade, and have the political mandate to do so and Weidman argues that whilst central banks have a role to play with respect to climate change that it should be limited to ensuring transparency and proper consideration of climate risk⁶. While this identity crisis works itself out, those in favour of greening the banking sector are not hanging around waiting for directions.

In early January, members of the Environmental Audit Committee (EAC) wrote to the governor of the Bank of England (BoE), demanding the central bank show “leadership” on climate change by taking swift action. The EAC instructed the BoE that changes had to start “as a matter of urgency” and ahead of COP26, the international climate summit which will be held later this year in the UK⁷.

Earlier this month, the BoE told UK banks and businesses that in order to achieve targets in the Paris Agreement to limit global warming to below 2 degrees Celsius, that they need to be prepared to pay much more for polluting. The senior BoE official stated that carbon prices may rise from the current market price of $40 a ton to up to $100 a ton if the transition to a low carbon economy is abrupt, or bumpy⁸. Last week, the Banque de France pledged to make a “definitive exit” from all companies with coal-related activities before the end of 2024⁹.

Banking models are flawed for the crisis we face. Banks need a new way to see the world.

The business models on which mainstream banking are fundamentally flawed with respect to sustainability. The World Bank Group have stated that traditional approaches to modelling strategic asset allocation fail to counter climate change risks⁸. They are focused on short-term profit maximisation. The majority of financial models are applied selectively, neglect context, and are ill-designed for attention to systemic effects and overall integration. As a result, such models provide little useful information about finance’s sustainability effect. Standard financial market models, exclusively use financial indicators such as past performance, momentum, book-to-market value, and others to calculate the market value of a firm⁹. Indicators such as positive and negative social and environmental impacts of a company’s business are not components of these models, but rather externalities.

Why might banks change their ways? Short answer: external pressure from shareholders and regulators

If banks thought the world was moving in a low‐carbon direction (whether by choice or necessity), then positioning themselves to take advantage of this shift might be profitable¹⁰. While there may be money to be made in producing goods for a low greenhouse gas economy, the problem is that currently there is still money to be made in climate‐unfriendly activities. Despite decades of investor-driven efforts aimed at enhancing climate-related transparency, both regulators and market participants are still flying almost entirely blind¹¹. Take, for example, the financial sector’s financing of carbon emissions. Since 2016 alone, 37 global banks have invested more than $2.7 trillion into the fossil fuel sector. Additionally, bank financing of fossil fuels has been increasing¹².

However, regulatory and commercial pressure is increasing. In jurisdictions all around the world, banks are experiencing commercial and regulatory imperatives to reduce the climate risk of their portfolios. Rating agencies are incorporating climate factors into their assessments. Standard & Poor’s have observed the rating impact of environmental and climate factors increase by 140 per cent over two years amid a high volume of activity in the energy sector¹³.

Making money while greening the planet.

Climate change is real and requires a global response by individual businesses and citizens to act. There is uncertainty regarding what the negative economic costs of climate change will be¹⁰. On the flip side, it’s difficult to estimate what the economic benefits of investing in climate solutions will be. Is there an opportunity for banks to make higher returns on green projects?

Low-carbon projects face some challenges that need to be addressed by policymakers to facilitate the transition toward a more sustainable and resilient economy¹⁴,¹⁵. Under a low-cost emission scenario, low-carbon projects have long-term payback, which is not always attractive for private financial agents focusing on short-term risk-return profiles, essentially exposing the tension between economising and ecologizing values¹⁶.

Recent studies indicate not only that green assets can be less risky, but that financial markets are starting to reflect these risk differentials¹⁷. There may be some upside for banks to green their portfolios, especially if a major market shock were to happen. Research published in 2019 by the European Commission as part of its EU strategy for sustainable finance, found that the market sees value in investing in greener assets as a hedging strategy towards worst-case environmental outcomes. This research indicated that green portfolios would have outperformed brown portfolios, offering a 20 per cent return compared with a return of just 12 per cent for a portfolio of brown assets over the period 2006-18, under which these heightened risk scenarios were simulated¹⁸.

Investing in a resilient recovery has never been in closer reach. During the past 10 years, onshore wind energy prices fell 70 per cent and solar photovoltaics by 89 per cent. Energy storage technologies are on a similar trajectory. Major investors have set their sights on net-zero emissions, including an alliance of large asset owners with $4.6tn under management¹⁹.

Former Bank of England governor Mark Carney, who is the UN special envoy for climate finance, has thrown his weight behind efforts to create a global carbon offset market to help reduce emissions. “This is an imperative, which is why we are putting so many resources into it.” He added: “This needs to be a $50-100bn per annum market”. Mr Carney, along with Standard Chartered chief executive Bill Winters, recently co-founded the Task Force on Scaling Voluntary Carbon Markets, a private sector initiative backed by more than 40 organisations, which is working on a blueprint for the new market²⁰. Carney has warned that the global financial system is backing carbon-producing projects that will raise the temperature of the planet by over 4C and has spoken at length historically about the need for the financial system to accelerate its efforts to tackle the climate emergency, warning that firms that ignore the crisis will go bankrupt²¹.

Adapting to a new world: Banking promoting sustainability and green finance

The global banking sector is highly fragmented, operates across numerous complex jurisdictions and has no single governing body to set policy and drive compliance. However, recent years have seen an intensifying of discussion on the role of central banks in addressing risks associated with climate change and in supporting the development of green finance²². A growing number of central banks have already adopted green finance policies, or have started to incorporate climate risk into their macroprudential frameworks²³. As a result, there have been numerous initiatives launched, such as the Sustainable Banking Network (SBN) and the Central Banks and Supervisors Network for Greening the Financial System (NGFS). Climate risks will almost invariably have a direct impact on central banks and will drive a review of their traditional responsibilities and role in society as a governor of monetary and financial stability. Research carried out by SOAS University of London into this topic surveyed 135 central banks globally and found that 52 per cent have already committed to the sustainability of growth within their countries. The other 48 per cent of central banks while having no explicit or implicit sustainability objectives, were found to have begun to incorporate environmental and climate change-related risks into their core policies²⁴. Central banks, through their regulatory oversight over money, credit, and the financial system, are in a powerful position to support the development of green finance models and enforce adequate pricing of environmental and carbon risk by financial institutions²⁴.

Executing a fundamental shift, starting with talent acquisition

In shifting to a low-carbon economy, the breadth of risk is potentially vast. A study by the Network of Central Banks and Supervisors for Greening the Financial System estimates the losses associated with the devaluation of assets as a result of transitioning to a low-carbon economy could be as much as US$20t²⁵.

Banking executives need to alter practices, standards and build new skills. The professional bodies mentioned above can lead in developing more adaptive capacity by building new courses on sustainable finance. The Big 4 consulting firms are gearing up to service this gap in knowledge and in skills through an increase in their recruiting for sustainability and ESG professionals²⁶.

In a survey with banking leaders on the topic of sustainable finance, respondents cited that one of their main challenges in developing sustainable finance solutions was lack of available talent²⁷. Banking CEO’s have stated in a study from 2020 that increases in automation, changes in demographics and new regulations will make it much harder for organisations to attract and retain the global talent they need to keep pace with the speed of technological change. Candidates possessing STEM (science, technology, engineering, math) skills and the uniquely human skills (e.g., creativity, empathy, collaboration) which are increasingly prized in today’s job market, will be exceptionally difficult and unlikely to keep up with demand. Furthermore, a profound demographic dilemma of a rapidly ageing workforce will see many skilled leaders and experts leave the banking sector in the coming years²⁸. Offsetting this crisis will be an increase in job automation. However, in the short to medium term, hiring AI and machine learning professionals will also present a significant challenge to retool banking processes and client experiences.

In summary, looking to the future:

The Paris Agreement requires all its signatories to plan and implement adaptation measures through many methods, including investment in a green future. The UNEP Adaptation Gap Report 2020 finds that such action is lagging far behind. It finds that while nations have advanced in planning and implementation, huge gaps remain, particularly in finance for developing countries and bringing adaptation projects to the stage where they bring real reductions in climate risks²⁶. Finance for nature-based solutions should be strengthened and diversified²⁶. The extent to which a central bank adopts a more activist approach to support a government’s sustainability objectives is ultimately a political decision. Nevertheless, it should be clear that climate change and mitigation policies will have very profound impacts on economies, with potentially significant implications for macroeconomic and financial stability. These need to be tackled by central banks and commercial banks as part of their core responsibilities. A bank that does not address climate risk is failing to do its job²⁷. Banking leaders will need to respond rapidly to these challenges. They can do this by building purpose and organisational capacity through reskilling and hiring the right mix of sector leaders to drive change and resilience into their businesses.