The role financial institutions play in environmental sustainability is coming under greater scrutiny. Governments, NGOs, and even consumers turn to them to influence the sustainability practices of companies they invest in and lend to. And as the role financial institutions play gets fine-tuned, its impact undoubtedly will cascade down to businesses and their supply chains.
The pressure on financial firms to have sound environmental, social, and governance (ESG) policies is not new, but the pace is quickening and the focus is becoming sharper. A look at President Joe Biden’s top economic team makes it clear that “he has placed the longer-running climate challenge at the center of his administration’s economic priorities,” according to a December article in The New York Times. Many believe that economic policymakers, from the Federal Reserve to the Securities and Exchange Commission, will take a more active role in climate change policies.
Controversy and Commitment
While the United Kingdom and the European Union are leading in the endeavor to prepare financial institutions for a greater role in ESG, the United States is catching up. Many believe the writing is on the wall – that financial institutions will be required at some level in the near future to account for the sustainability impact of their investments and loans, in both the consumer and commercial asset classes. It’s also clear that as the focus on this issue takes shape, financial institutions will reach out to their business clients to provide information about sustainability risks in their supply chains.
Of course, the concept is not without controversy. Writing about possible SEC rules around financial disclosure, Marten Law, an environmental and energy law firm, noted that critics claim it is “simply an exercise in shaming companies” and that requiring disclosures would “force companies to report highly speculative and unreliable forecasts of future climate-related risks and liabilities.”
In late May, Axios reported that 15 Republican state treasurers are “threatening to pull assets from large financial institutions if they agree to decarbonize their lending and investment portfolios.”
However, recent comments from U.S. Treasury Secretary Janet Yellen make it quite clear that the Biden administration is driving climate change reporting throughout the economy. In comments made to the Institute of International Finance in April, Yellen said she understands that climate change science is new to financial institutions and regulators and that it won’t be easy translating changes in climate – and climate policy – into economic and financial projections.
Acknowledging the argument that for those reasons the government should move slowly and be tentative in its action, she emphatically stated, “This is completely wrong in my view. This is a major problem that must be tackled now.”
Recent statements, commitments, and policy guidelines from economic leaders and financial institution executives offer further insight into the momentum building for banks and investment firms to better manage climate risk.
Securities and Exchange Commission. In February, the SEC announced it is reviewing its 2010 guidance to public companies regarding disclosure requirements as they apply to climate change matters. “Ensuring compliance with the rules on the books and updating existing guidance are immediate steps the agency can take on the path to developing a more comprehensive framework that produces consistent, comparable, and reliable climate-related disclosures.”
Treasury Department. In April, John Morton was named to head the department’s new “climate hub.” The hub will “seek to understand and mitigate the risks that climate change poses to financial system stability and promote globally consistent approaches to assess those risks,” the department said.
In Yellen’s April speech she also:
- Discussed her plan for a “whole-of-economy” approach for the department, which recognizes the “financial sector has an opportunity to play an important role in financing and leading the transition of the global economy to a net-zero economy.”
- Expressed her support for the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD,) noting that the TCFD has done “important work to improve the information that financial institutions and investors have when they decide how to allocate capital.”
- Confirmed the department’s support for the International Financial Reporting Standards Foundation establishing a Sustainability Standards Board that will focus first on developing a climate disclosure standard.
- Announced that the department is co-chairing the newly relaunched G20 Sustainable Finance Working Group, which will consider 1) how to improve existing international initiatives and approaches to sustainability disclosures, 2) build on TCFD, and 3) coordinate approaches to identifying investments as climate-aligned or sustainable.
U.S. Banks. In March, Wells Fargo became the last of the six large U.S. banks to commit to a carbon-neutral future, stating, “climate change is one of the most urgent environmental and social issues of our time.” The bank joins Goldman Sachs, Citigroup, Bank of America, JPMorgan Chase, and Morgan Stanley in an effort to align their operations with targets in the Paris Agreement, according to Fortune.
“For banks, the most crucial aspect of reaching net-zero isn’t about achieving carbon neutrality in their own operations,” the Fortune article points out, “But rather about ensuring the businesses they finance are carbon-neutral too.” The pledge “puts the onus” on bank customers to begin or improve their plans for carbon neutrality.
Investment Firms. In his 2021 letter to CEOs, Larry Fink, chairman and CEO of BlackRock, noted that better technology and data are enabling asset managers to customize index portfolios to a broader group of investors and that more investors are “tilting their investments toward sustainability-focus companies.” He added: “Every management team and board will need to consider how this will impact their company’s stock.” Last year, BlackRock asked companies to report in alignment with the recommendations of the TCFD, calling it the “global standard for helping investors understand the most material climate-related risks that companies face, and how companies are managing them.”
In late April, Reuters reported that Credit Suisse investors “called on the bank to take a tougher stance on coal financing, amid concerns its current policies are too lax.” The action is an example of how investors and policymakers are focusing on the role lenders play in “financing activities of companies responsible for the major share of greenhouse gas emissions.”
Fossil Fuel Investment Still Strong
Interestingly, these actions are taking place against the backdrop of the March 2021 release of Banking on Climate Chaos 2021, a report published by a collection of climate organizations. The report shows that the world’s 60 largest banks have collectively financed US$3.8 trillion in fossil fuel companies between 2016 and 2020. The detailed report names international and U.S. banks that invest the most in fossil fuels, as well as those that fund fossil fuel expansion, and support oil and gas fracking companies.
Why are banks investing billions in fossil fuels? This is how Charles Donovan, executive director for the Centre for Climate Finance explained it in a Forbes.com interview. “We can’t expect that U.S. banks are going to just walk away from this business – not until the clean energy sector can absorb the volume of capital that banks want to throw at them. Getting to that next stage quickly will require government action to increase the supply of new energy projects and make sensible changes in the U.S. tax code that will level the playing field for new energy investors.”
The Banking on Climate Chaos 2021 report calls on financial institutions to take action to limit global warming. A look at the demands in the report offers insight into the risks businesses could face in the future if banks follow such guidelines and pull or tighten commercial lines of credit to companies closely tied to fossil fuels.
Some of the demands listed in the report include prohibiting all financing for all fossil fuel expansion projects along the value chain; committing to phasing out all financing for “fossil fuel extraction, combustion and infrastructure … starting with coal mining and coal power;” committing to measure, disclose and set targets to zero out the absolute climate impact of their overall financing activities; and fully respecting all human rights while prohibiting financing for projects and companies that abuse those rights.
While it’s clear there is an impetus for climate-change financial disclosures, how it will take shape and what its impact on businesses and their supply chains will be remains hazy. Many experts believe banks will reach out and rely heavily on business partners for the information needed for financial disclosure.
The Scope of the Challenge
A report examining climate change notes that “infrastructure sits at the very center of development pathways and underpins economic growth, productivity, and well-being.” It points out that the Organisation for Economic Co-operation and Development (OECD) estimates that US$6.9 trillion is needed up to 2030 to meet climate and development objectives.
Financing Climate Futures: Rethinking Infrastructure reports that current energy, transport, building, and water infrastructure make up more than 60 percent of global greenhouse gas emissions. Although the report doesn't specify exactly what infrastructure projects need to be addressed, it states that “aligning financial flows with low-emission, resilient development pathways is more critical now than ever.”
The report highlights six areas for transformation:
- Plan infrastructure for a low-emission and resilient future.
- Unleash innovation to accelerate the transition.
- Ensure fiscal sustainability for a low-emission, resilient future.
- Reset the financial system in line with long-term climate risks and opportunities.
- Rethink development finance for climate by ensuring that development finance institutions have the resources.
- Empower city governments to build low-emission and resilient urban societies.
Assessing Impact on Supply Chains
A look at what some financial institutions are currently discussing with and asking of business clients offers a hint of what might be coming in the years ahead.
One area of concern is the risk that climate change poses to supply chains, an area business and supply chain leaders probably will have to address in greater detail in the future. A 2020 report, Improving Supply Chain Resilience to Manage Climate Change Risks, notes that “a business that fails to adapt its supply chain risk management strategy to account for climate change, in fact, may be putting a significant portion of its corporate value at risk.”
The report by HSBC and The Sustainability Consortium, which was co-authored by Kevin Dooley, Ph.D., an Arizona State University professor and researcher for CAPS Research, states that climate change will create new risks for supply chains. Among those risks are 1) more frequent, severe, and longer disruptions, 2) disruptions in more places, 3) the need for structural changes in the supply chain, 4) the need to incentivize buyers and suppliers to more seriously consider contractual terms regarding force majeure, and 5) focus more investor attention on a company’s supply chain-related greenhouse gas emissions.
Industries expected to be most impacted by climate change include the transportation, energy, materials and building, and agriculture, food, and forest product sectors.
The report offers two ways companies can strengthen their supply chains in the face of climate change. It suggests using “bridging strategies” to help suppliers handle risks and recover faster from disruptions, providing financing or expertise; and “buffering strategies” such as inventory buffers, capacity buffers, or cost buffers to protect companies from supplier failures or disruptions.
How Financial Institutions Can Drive Change
What steps might financial institutions take to drive and accelerate ESG reporting and encourage policies and procedures around climate change? An article from Treasury and Trade Solutions at Citi offers a look at products or initiatives that might be used to encourage sustainability performance. They include:
- Raising or lowering a borrower’s interest rate depending on whether the company meets agreed-upon sustainability targets.
- Developing a sustainability scoring mechanism for supply chains, evaluating ESG component metrics.
- Using supply chain finance to “help incentivize suppliers to adopt more sustainable practices, helping to meet corporates’ ESG objectives.”
- Using an independent auditor’s assessment of a supplier to qualify it for preferential pricing, encouraging better ESG behaviors.
As the push for financial institutions to drive sustainability and strive for a net-zero economy increases, many questions remain, especially in the areas of gathering data, disclosure reporting, risk management, and even incentivizing and penalizing companies for their ESG practices.
To help with some of these challenges, the Partnership for Carbon Accounting Financials (PCAF) developed the Strategic Framework for Paris Alignment. Its goal is to “help financial institutions understand the process of Paris alignment and to navigate through the cluster of climate initiatives to understand their purpose, focus, and the role in each step of the journey.” The PCAF believes that “understanding the landscape will help financial institutions at different levels of progress to identify the most efficient support available to scale their climate efforts.”
The road toward climate-aligned finance is being forged, and finance, business, and supply chain leaders should be aware of the path they may need to follow. As John Kerry, U.S. special envoy for climate, said, “No government is going to be able to save us from this (climate) crisis. The only way we get there is by having the private sector moving in the right direction.”