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Short-term climate scenarios can provide an input to help rewire the financial system
The Network for Greening the Financial System (NGFS) has released its first short-term climate scenarios. These are designed as a tool to evaluate the impact of climate change on the financial sector over a period that is in line with the policy and planning horizons for most businesses and governments.
The dynamic of climate change as a source of economic and financial risk did not emerge naturally. It arose as a result of two hundred years of historical emissions, and the process of generating those emissions involved significantly unequal sharing of the benefits. For the process of addressing the impacts of climate change, the costs should be similarly skewed towards developed countries to produce an equitable outcome for humanity.
Although there are some limitations of short-term climate scenarios in capturing the most likely outcome, they can be useful if users acknowledge the limitations and don’t allow their expectations of future climate risk to be anchored to either the most optimistic or pessimistic scenarios. These tools also shouldn’t be used in a vacuum because they could create unintended consequences for OIC markets and other emerging & developing markets by inhibiting flows of investment and climate finance that are already insufficient.
If short-term scenario analysis is instead viewed as a way to prioritise projects based on their ability to mitigate climate change, support the transition or invest in adaptation, then it may be able to play a more constructive role. The efforts to ‘rewire finance’ will still be necessary to reduce barriers to the flow of finance to OIC markets and others that are EMDEs, and efforts to improve the realism of outcomes covered by short-term climate scenarios will be more fruitful in directing capital where it can be most effective.
Making sustainability work for OIC financial institutions & Islamic finance
Systemiq Ltd. released a “Blue Whale Inquiry” seeking to combine insights into the current challenges facing sustainability gathered from 50 leaders. The resulting report outlines a range of changes across business, governments, NGOs and the financial sector to reinvigorate sustainability for the next stage of advancement towards global goals. It also includes a frank discussion of the challenges, but also potential breakthrough areas where past efforts could bear fruit even in an environment full of headwinds.
For the financial sector, three of the key catalysts highlighted are breaking the hold of short-term financial returns on decision-making, leadership among the Global South countries through adoption and delivery on more sustainable economic models, and the use of technology including AI to avoid “being trapped in an acronym-heavy compliance regime” that has developed within ESG.
For financial institutions in OIC markets seeing recalibration of externally imposed sustainability disclosure standards, there may be value in concentrating efforts on practices that provide a better balance between investor expectations and other stakeholder needs. For Islamic Finance, the greatest opportunity may lie in leaning into the discussion of ethics that other financial sector stakeholders are wary of tackling. It may be more advantageous to be able to talk authentically about ‘just’ outcomes as the economy-wide climate transition accelerates, as our planetary debts come due.
Better emissions data won't compensate for insufficient understanding of physical climate risks in companies' value chains
There is a tug-of-war underway in sustainability that strongly impacts responsible finance. What is the appropriate balance between data availability and standardization and action on topics like climate change? Often, the relationship is viewed as complementary: mandating stronger data disclosure requirements is seen as strengthening the ability of companies and their stakeholders to advance action on issues that are material to their businesses.
Transparency is valuable for supporting more informed decision-making relating to climate change, as it is in many other fields. The advance in better data availability comes with a cost, however, in how to responsibly gather, validate and report the data. This has led to efforts to weaken or streamline reporting requirements, depending on your perspective, as has been proposed in the EU Omnibus, for example.
‘Reporting fatigue’ has been widely shared among smaller companies, those based in emerging markets, and startups, and it impacts large companies as well.
Most of those expressing concern about reporting burdens are not pushing back on the financial importance of climate, nature and other ESG issues. The concern is often about whether particular reporting requirements strike the right balance between comprehensiveness and data quality (often pressed by users of the data) and efficiency in producing and disclosing the data (often heard from those reporting the data). But this is not a two-dimensional game of push and pull, and the right level of disclosure is not categorized as ‘more’ or ‘less’ of existing disclosures.
The context in which this is occurring overlaps with a global coordination problem centered on climate change and nature loss in a way that has huge economic implications. These issues care not about the volume of data produced; the only thing that matters is whether the right decisions for the future are made today, even if they are made using imperfect or incomplete data. Having more high-quality data is not enough if it doesn’t measure the right things, or lead to the right decisions.
What do banks gain by pursuing Net Zero objectives?
Net zero financial institution alliances have been shaken up in recent months, with some banks, particularly those from the United States, withdrawing from alliances or pulling back on their commitments. In this context, a recent research paper explores the economic case for Net Zero banking, and explains why banks' self-interest, quite apart from ethical obligations to stakeholders, supports continued efforts in transitioning towards Net Zero goals.
The paper highlights two key ways in which banks gain from pursuing a Net Zero objective: reducing risks (default risk in particular); and capturing opportunities for financing growth in expanding segments related to decarbonization. The greatest challenge to banks’ efforts on decarbonisation is an underlying tension around both types of Net Zero financing.
Financing the decarbonisation of existing high-carbon companies can be associated with “exposure to stranded assets, green regulations, and carbon-emitting sectors [that] may mean greater risk for bank lending portfolios”. Meanwhile, financing new decarbonisation technology “might be seen as riskier, with growth orientations rather than stability properties”.
As regulators increase their focus on the impact of climate-related risks on financial stability, they will produce incentives for banks that over time help to resolve the tension in risk properties. Although this isn’t the focus of the research, which centres around economic incentives for banks to support the transition to Net Zero, the regulatory benefit of being able to demonstrate your preparation to manage climate risks is something—along with banks limiting their exposure to areas with high physical climate risk—that helps banks prepare for future policy changes and other climate-related risks.
Each bank will approach the transition with different opportunities to pursue based on the heterogeneous characteristics of different institutions, and there won’t be a single, one-size-fits-all approach. This is likely to be particularly true with markets, such as many within the OIC, where transition risks intersect with physical risks, as well as with regulatory risks originating locally and those connected with key export markets.
What banks are (and are not) disclosing in their transition plans
The Sustainable Finance Observatory (formerly 2°Investing Initiative) released a report evaluating some of what can be expected to be in the forthcoming reports, and what may be missing. Their analysis is based on the disclosures to date made under transition plan guidance for signatories to the Net Zero Asset Management and Banking Alliances.
For investors and financial institutions in OIC markets with less robust non-financial transition plans and sustainability reporting, the gaps are surely wider, even as a successful climate transition carries a significant opportunity (and risk mitigation) outcome for the economy and financial sector. These will be compounded by an increased focus not only on the ‘credibility’ of transition plans, but also on the alignment of transition plans with Just Transition principles.
For resource-intensive economies, physical and transition risks could drive a ‘climate change risk trap’
On a global level, and in guidance for financial sector regulators, climate change actions are often presented as a sliding scale between climate mitigation – efforts to reduce emissions – and climate adaptation – efforts to make countries more resilient to the impacts of climate change. The dichotomy arises within the financial sector through a similar sliding scale between different scenarios.
Many OIC countries face a different outlook, however, where higher transition and physical risks coexist, especially at the sub-national level. A new paper terms this outcome a ‘climate change risk trap’, and evaluates it by considering the impacts of climate change physical and transition risks on Kuwait following the release of the country’s first flash flood hazard map.
Governments, regulators and financial institutions will all have to chart their own path to respond to the elevated risks of climate change where this 'risk trap' is most likely to be present. The impact on a response to climate change goes beyond mitigation and increases the benefits of domestic financial sector development and efforts to produce a Just Transition.