The latest science shows that global emissions must reach “net-zero” by midcentury to prevent the worst effects of climate change. Finance — including from the banking sector — will play a key role in getting there. Climate action requires major investments, while at the same time, financial flows must shift away from climate-harmful activities.
Several banks are starting to make net-zero emissions commitments, but it’s a nascent field. Many don’t know what net-zero commitments really entail, or how to turn pledges into real change throughout their business model.
While there isn’t yet a standard definition for net-zero finance, we know enough for banks to start pursuing these commitments in a meaningful way. We explain how here and in our research paper, Banking Beyond Climate Commitments.
What Do “Net-zero” and “Paris-aligned” Finance Mean?
The international Paris Agreement on climate change mentions three long-term goals: The first two focus on climate mitigation and adaptation, while the third is “to make all financial flows consistent with a pathway towards low-emissions, climate-resilient development.”
This third goal recognizes the key role that financial institutions, including private sector banks, play in realizing the Paris Climate Agreement — including the need to achieve net-zero emissions by mid-century and reduce emissions 50% by 2030.
Getting finance right is crucial because of the unique influence banks and other financial institutions have on other actors through their investment, lending and advisory services. Greenhouse gas accounting standards like the Greenhouse Gas Protocol and the Partnership for Carbon Accounting Financials recognize the need for corporate commitments to use “Scope 3” accounting, in which actors take responsibility for emissions not only from their own operations and supply chains, but also from users of their products. This logic is especially important in finance, where Scope 3 emissions far outstrip emissions within a firm’s immediate operations. For example, a bank that finances a fossil fuel project is responsible for emissions associated with that project.
When banks make a commitment to achieve net-zero or Paris-aligned emissions in their portfolio, they are promising to reduce and eliminate those financed emissions over time. Commitments are “net” zero in recognition of the likelihood that any remaining greenhouse gas emissions will need to be balanced out by removing greenhouse gases from the atmosphere, a process known as carbon removal.
Are Banks Making Progress Toward Paris-aligned Investments?
Major banks have been making commitments to sustainable finance since before the Paris Agreement. While these commitments were welcome, they were also not entirely difficult: Climate action represents a massive commercial opportunity.
Since the Paris Agreement was established in 2015, banks have recognized the need to go even further with net-zero commitments. The Glasgow Financial Alliance for Net Zero and the Net-Zero Banking Alliance launched in April 2021 to great fanfare. The six most prominent U.S. banks — JPMorgan Chase, Bank of America, Wells Fargo, Citibank, Goldman Sachs and Morgan Stanley — all committed to net-zero, in addition to many other banks around the world.
However, despite the urgency of the climate crisis and a growing number of sustainable finance and net-zero commitments, a fundamental shift towards Paris alignment within large banks has not yet happened.
The current approach to incorporating Paris alignment in a bank’s business model is erratic. Almost all banks still have fossil fuel-related assets on their balance sheets, and major banks have actually expanded their fossil business since the Paris Climate Agreement was signed in 2015, offering $750 billion to fossil fuels in 2020 alone.
Some banks have made more progress than others. Values-based banks — banks that have a sustainable mandate while offering core banking products similar to those of conventional banks — demonstrate how Paris alignment can be profitable.
For example, Amalgamated Bank in the U.S. and ASN Bank in the Netherlands are largely more advanced in their Paris alignment and emissions-reduction targets than other banks, accounting for their financed emissions, engaging with their clients on Paris alignment, and offering Paris-aligned products and services.
How Can Banks Accelerate the Transition Toward Net-zero Financing?
We set out to answer that question in Banking Beyond Climate Commitments, where we investigated 31 banks around the world, speaking with staff to understand exactly what needs to happen on two key fronts to kick Paris-alignment into gear: client engagement and product and service innovation.
Our number one conclusion is that banks have yet to define how Paris-alignment commitments will require their businesses to change — including the speed of change and how they will measure progress.
While every component of a bank’s business will need to change, the core is its relationship with clients and the products and services catered to them. Addressing these two elements are key to ensuring Paris alignment and achieving net-zero emissions commitments.
5 Ways Banks Can Achieve Net-zero Emissions through Client Engagement
While most banks put client engagement central in their stated plans for Paris alignment, most haven’t yet put in place policies that are ambitious enough to align their client engagements with the Paris Agreement.
The current Paris-aligned client engagement strategies are structured around “supporting clients in their climate transition.” None of the banks we spoke to — except for values-based banks — wanted to exclude clients, even polluting ones. So far, mainstream banks have only put forward limited restrictions for coal finance.
While banks might hope that they are able to convince all clients to transition their business models away from Paris-unaligned activities, hope isn’t enough. Banks need to be clear about their expectations for clients. In cases where the client’s Paris alignment will be impossible, the bank must consider excluding the client.
We recommend banks take five actions to achieve net-zero emissions through client engagement:
- Collect and manage emissions data on clients’ activities By transparently accounting for portfolio-wide emissions, banks have a strong data basis upon which to build their client engagement strategies.
- Set emissions-reduction targets. Based on their own overall net-zero commitments, banks should set client-level emissions-reduction targets using GHG emissions data and tested methodologies such as the Science Based Targets initiative.
- Introduce client benchmarking. Banks should use data and conversations with clients to benchmark clients’ Paris-alignment performance against their peers, and share best practices.
- Formulate clear client-engagement policies. Each bank should design and implement clear client-engagement policies to ensure clients transition to low-carbon activities, including a defined timeframe for the transition and a declaration of what conditions will lead to dismissal. Prudence is also required when accepting new clients and engaging in new transactions.
- Ensure that relationship managers are knowledgeable. Bank staff need to be trained on Paris-alignment requirements and opportunities. In addition, banks’ human resources policies should design the right incentives for training and rewards for non-financial performance.
Financial Institutions Can Drive Net-zero Commitments Through Products & Services
What if, instead of just dropping polluting clients, banks could be partners in helping them transition to low-carbon activities?
This is the goal.
Building on the success of green bonds — which raise capital for specific green projects — banks are starting to offer “sustainability-linked loans.” These are marketed as meeting a demand for “transition finance”— finance designed to help companies shift to low-carbon activities. Green bonds usually involve an interest rate that fluctuates based on sustainability key performance indicators, which could be related to emissions-reduction goals or supply chain sustainability metrics. In other words, a bank provides a loan to a company to finance transition activities, and the loan becomes cheaper to pay back the more successful the company is in its sustainability efforts.
These innovations are important. However, their rigor has so far proven uneven — and, because transition finance inherently involves working with higher-polluting clients, concern for greenwashing is high.
As in the case of client engagement, banks need to clearly describe their approach. The data and methodologies they use to introduce new products and services should be robust and transparent. Whereas industry standards have evolved for green bonds, no such third-party oversees transition finance.
High-quality sustainability data can be hard to come by, but it’s necessary if loan rates and other fees depend on sustainability performance. These areas can improve if banks create greater demand for this information both directly with their clients and with sustainability data providers and ESG ratings agencies.
Banks Must Move the Financial Sector Toward Net-zero Finance
Banks work with clients ranging from individuals to large multinational corporations in every sector. The diversity of these clients underscores the influence banks can have on the economy. Banks — like investors — can and must collaborate to encourage companies towards a Paris-aligned future through innovative and sustainable financing solutions.
The shift to Paris-aligned banking will be most effective when all private sector banks act. The Glasgow Financial Alliance for Net Zero and the Net-Zero Banking Alliance can play a vital role in steering banks into a sustainable direction by setting ambitious standards.
While we’ve focused here on what banks can do alone and together, regulatory authorities like the Federal Reserve, FDIC and others (in the U.S.) also have a crucial role to play in encouraging banks to align their business with the Paris Agreement. We’ll need action from all stakeholders to meet the challenge of financing a net-zero emissions, climate-resilient world.
