Pressure on the financial sector to better manage climate-related risks could result in the implementation of more stringent lending and investment screening policies next year.
Financial institutions are increasingly exposed to climate risks connected with their loans and investments. As a result, regulators and investors are stressing the importance of shifting financing away from companies or projects that contribute to climate change and setting goals to reduce greenhouse gases (GHG) emissions.
Throughout 2020, several guidelines and reports have been published by industry-led organizations and financial regulators to help the financial sector better understand and manage climate risks. These documents are not mandatory, but they provide recommendations that could lead to significant changes in banks’ lending and risk management practices.
Accounting for ‘Financed Emissions’
Like other companies, financial institutions emit GHG from their direct operations, such as office buildings. However, they also finance emissions generated by other companies through loans and investments. These “financed emissions” can be significant, and for a financial institution to successfully address its carbon footprint, they need to be addressed. The first step in reducing financed emissions is being able to quantify them.
The Partnership for Carbon Accounting Financials (PCAF), an industry-led partnership of financial institutions, published a draft Global Carbon Accounting Standard in August to standardize methodologies that all financial institutions can use to measure their financed emissions. The standard helps institutions measure the carbon emissions of their portfolios and disclose their financed emissions. At the center of this draft standard is the concept that in order to effectively manage climate risks, financial institutions need to know and measure the emissions caused by their loans and investments.
The standard acknowledges that lack of data is one of the main challenges in measuring financed emissions, but stresses that this should not stop financial institutions from trying. In certain circumstances, if the institutions cannot collect emissions data directly from their borrower or investee companies, they can follow the recommendations outlined in the standard to use data provided by third-party providers, such as Bloomberg LP, MSCI Inc., and CDP (formerly the Carbon Disclosure Project).
So far, 82 financial institutions have adopted this draft standard, including U.S. financial institutions such as Bank of America, Citigroup Inc., and Morgan Stanley. The consultation phase of this draft ended in September, and the PCAF plans to release the standard on Nov. 18.
Increased Screening and Lending Oversight
To successfully manage their own climate risks, financial institutions may need to increase the oversight they have over the companies they lend to and invest in.
Ceres, a sustainability nonprofit organization, released in October a report that it developed with representatives from several major financial institutions and other organizations to provide recommendations for banks to measure and address climate risk. The report emphasizes the relationship banks have with their clients. It encourages banks to engage their clients on carbon reduction issues, and to leverage those relationships to encourage their clients to submit a plan explaining how they will reduce carbon emissions going forward. The report goes so far as to suggest that banks “wind down” relationships with clients that do not have plans in place.
In the European Union, the European Central Bank (ECB) released draft guidelines in May outlining 13 expectations on how significant institutions (i.e., the largest financial institutions supervised by the ECB directly) should consider climate-related and environmental risks in their governance, risk management, and disclosure practices. For example, it recommends that significant institutions evaluate where their borrowers are particularly susceptible to climate risks before entering into a loan agreement or increasing a current loan amount.
It should be noted that although the guidelines are not technically binding, the ECB expects that significant institutions will promptly start assessing their current practices against the expectations outlined in the guidelines, and will be able to explain to the ECB any deviations from the guidelines, starting from the end of 2020. The guidelines will become effective on the publication date, although the exact date has not been announced.
The Need for Climate Disclosure
An effective climate risk management program requires the availability of quality climate-related data. However, the lack of such data still poses a big challenge to the management of climate risks. Increasingly, regulators are recommending mandatory climate disclosures to increase the availability of quality climate-related data.
For example, Bloomberg Law in September analyzed key findings from a report released by a U.S. Commodity Futures Trading Commission (CFTC) subcommittee, which recommends the adoption of mandatory climate disclosures in the U.S. and urges the Securities and Exchange Commission (SEC) to update its Guidance Regarding Disclosure Related to Climate Change.
New Zealand is the first country to propose legislation to require the financial sector to disclose climate risks, in alignment with the Task Force on Climate-related Financial Disclosures (TCFD) recommendations, starting in 2023. According to the TCFD, its recommendations can be adopted by both financial and non-financial firms, globally. Other jurisdictions, such as Canada, U.K., and the EU, are also considering adopting some forms of climate disclosure requirements, although the scope of their applicability will likely vary. (Bloomberg Law is operated by entities controlled by Michael Bloomberg, who is chair of the TCFD and co-chair of the Risky Business Project, as well as founder of Bloomberg Philanthropies.)
Key CEO-led organizations are also supporting climate disclosure. For example, the Business Roundtable in September issued a statement to support climate disclosure. It emphasizes the need for companies to appropriately disclose material risks driven by climate change, and it suggests that “[e]ffective disclosures should focus on the company’s approach to risk management and its connection to the company’s strategy and governance.”
The World Business Council for Sustainable Development (WBCSD), a CEO-led organization with more than 200 member companies around the world, including those from the financial sector, published in October its five new membership conditions, which include a requirement for member companies to "[o]perate at the highest level of transparency by disclosing material sustainability information in line with the TCFD[.]” WBCSD-member companies are expected to adhere to these criteria by the end of 2022. The WBCSD will start monitoring and assessing its member companies’ reports against these criteria annually, from 2023.
Future Pressures for the Financial Sector
It is likely that the financial sector will continue to be pressured to better manage emerging climate-related financial risks. Several regulatory recommendations and other voluntary guidelines signal the likelihood of more stringent lending or investment screening policies from financial institutions, while lack of quality data may continue to be a major barrier. Companies, meanwhile, are encouraged to engage with their financial institutions to understand their expectations, share their emissions data, and start developing their own carbon reduction goals and plans.
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