Responding to climate change – the “net-zero aligned” financial institution

This article is jointly authored by Chris Dodwell

Against a backdrop of rising pressure to respond to climate change, financial institutions, including asset owners and asset managers, (“FIs”) are facing calls to declare themselves as net zero (“NZ”).?But what does this mean, exactly???As we argue below, a literal interpretation based on a mathematical calculation is probably impossible to do correctly and is likely to have serious, unintended consequences.?

By contrast, a better approach for FIs is to aim to become “net-zero aligned”, integrating climate change issues fully into their business planning, committing to transparent communication with stakeholders, and engaging with policymakers and regulators to support the development of effective, efficient and equitable climate policy.

Following the declaration by several countries of NZ targets there’s been a rush to pressure companies to adopt NZ targets too; a natural extension of this has been the call for net-zero financial institutions.?Although there’s no standard definition of a NZFI, proposed frameworks are generally centred on requiring FIs to adopt an explicit decarbonisation target or trajectory.

In the context of the global effort to reduce emissions, turning a spotlight on the role of FIs is certainly helpful.?Trustees and management teams who are obliged to address the issue are likely to take early, “no regrets” actions that improve their own expected outcomes while also bringing emissions down, as well as raising their awareness of potential investment opportunities arising from the transition to NZ.?However, a literal interpretation of the NZ challenge is likely to be counterproductive.

The drawbacks of net zero for financial institutions

In a previous blog we set out the drawbacks of the seemingly attractive concept of “corporate net zero”, particularly the challenges of definitions, capital inefficiency, skills gaps, value chain impacts and timescales for management.?As the balance sheets and activity of most financial institutions reflect direct or indirect exposure to a set of companies, it’s therefore no surprise that the idea of a net-zero financial institution poses significant problems, particularly in three areas.

• First, the “garbage” problem. With exposure to securities from a wide range of issuers, a typical FI will struggle to aggregate data from its portfolios into a credible, forward-looking, emissions profile.?Even if standards emerge for corporate NZ reporting, given the breadth of corporate activity across the economy, the ambiguity around the scope of emissions and the unavoidable uncertainty in the raw data will hamper the creation of a meaningful composite picture.
• Second, the management of trade-offs.?A rigid commitment by an FI to achieve a target portfolio with a net-zero emissions profile and/or a target percentage allocation to “climate solutions” will have consequences for both risk and investment returns.?Simply put, such a portfolio will have biases with respect to its profile relative to the overall market, for example by sector and/or by company size; similarly, by mandating the sale or purchase of certain securities at a time when many others are doing the same, the FI will likely face unattractive prices.?Those responsible for the FI’s fiduciary management face a daunting task in both meeting multiple objectives, particularly their core obligation to achieve expected, risk-adjusted financial returns, as well as prescribed climate goals.
• And third, the “irrelevance” question.?The idea that all the capital directed at the corporate sector originates from FIs that could be minded to adopt a NZ target is fanciful.?An asset sold by an FI aiming to meet a NZ target is likely to be bought by an FI that doesn’t have such a target and encouraged to continue trading.?Similarly, a company with high emissions that is facing calls from financiers to cut emissions may simply cede market share to a competitor.?A probable outcome for the target-seeking FI is that it achieves its goal at increased cost and risk to itself, but that progress towards mobilising the funding needed to achieve the overall societal/planetary objective is minimal.

The net-zero aligned financial institution

We believe that a better approach would be to ask that FIs become “net-zero aligned”, or “climate resilient” by taking three steps.

First, and most importantly, a commitment to the enhanced analysis and management of risk and opportunity, reflective of the new issues/factors arising from climate change.?To this end, the Task Force on Climate-related Financial Disclosures (TCFD) framework is helpful, providing it’s implemented objectively:

• Governance:?the FI should examine its investment beliefs, return objectives, risk appetite and decision-making processes to ensure that climate change issues are managed effectively.?This should include the appointment of internal champions, representatives and specialists, training (particularly of senior management and those with fiduciary responsibility) and a commitment to periodic reviews and adjustment.-
• Strategy and risk:?the FI should assess the impact of climate change on its business plan by using scenario analysis and standardised stress tests.?As proposed in the TCFD’s latest consultation, FIs should develop transition plans linked to individual scenarios which explain clearly how the institution intends to respond to the evolution (and possible step changes) in policy, technology and consumer preferences and thereby minimise risks and increase opportunities.?Risk analysis should focus on factors that stress financial statements directly, e.g. taxes, carbon prices or falling consumer demand, rather than on indirect effects such as CO2 emissions.?Post-investment, the FI should enhance its stewardship and engagement activity to encourage the boards and managers of portfolio companies to assess their own climate change risks and opportunities, and optimise accordingly, capturing and communicating the results in their own transition plans.
• Targets and metrics.?As set out above, we do not recommend that an FI should explicitly seek to achieve a net-zero emissions portfolio by a certain date.?By contrast, the FI should strive to optimise its “climate resilience” in line with its own investment beliefs and mindful of the trade-offs.?The institution should describe how it has incorporated climate change into its business planning and operations using metrics that are both in line with emerging standards and also likely to be useful to recipients.

Second, a commitment to transparent communication with its stakeholders on climate change issues and the progress of its programmes in this area.?Greater communication with clients, regulators and shareholders is essential, both to build trust and support for what’s likely to be an effort lasting decades, but also to share technical and financial information, insights and advice. Moreover, given the growing calls for the universal adoption of mandatory disclosure in line with TCFD, FIs would be wise to improve their reporting now to gear up for likely regulatory requirements.?

And third, engaging with policymakers and regulators, either directly or through industry/sector associations, to support the development of effective, efficient and equitable public policy that addresses climate change.?In our view, this is at the heart of the essential, rapid transition to an economy with a stable climate.?Greenhouse gases are “pollution”; pollution can be reduced by the application of effective and efficient technologies and changes to consumer behaviour within low carbon markets; and governments can accelerate the development of such markets through policy interventions, particularly carbon pricing, product standards and support for market development.?

Net-zero objectives and programmes make sense at a national level; but corporates and financial institutions who are tempted to interpret the net-zero challenge literally are likely to misfire, potentially harming themselves and their stakeholders in the process.