Comment: Emily Kreps, CDP’s global director of capital markets, says financial institutions should insist that the companies they finance are prepared for the low-carbon transition
Every company in every sector needs to play a role in the low-carbon transition if the goals of the Paris Agreement are to be achieved. The transition to net zero requires vast amounts of capital to be directed at decarbonising the economy and building resilience; as such, the financial sector must play a leading role.
The world needs financial institutions to step up – not only to fund green finance, but also to make finance become green. Financial institutions must measure and disclose the environmental impact of the activities they enable through their loans, investments and insurance underwriting. A new report from CDP – The Time to Green Finance – reveals that financed emissions are a staggering 700 times larger than financial institutions’ direct operational emissions, highlighting the urgent need for financial institutions to align portfolios with a 1.5C world.
While the report shows that almost all climate-related impacts and risks of global financial institutions come from financing the wider economy, only 25% of the 332 financial institutions disclosing to CDP last year reported their portfolio emissions. Meanwhile, the majority of these 84 organisations included less than 50% of their portfolios in their financed emissions reporting.
With rampant underreporting of portfolio emissions, it should be no surprise that financial institutions are also underestimating climate-related risks
Financial institutions’ alignment of their portfolios with a net-zero economy is also lagging. Fewer than half of banks (45%), asset owners (48%) and asset managers (46%) are taking action to align investments with a well below 2C goal, and only 27% of insurers are doing so for underwriting portfolios.
With rampant underreporting of portfolio emissions across the sector, it should be no surprise that financial institutions are also underestimating climate-related risks. Almost two-thirds (65%) do not report credit risks, such as borrowers’ default on loan repayments, while nearly three-quarters (74%) are not reporting market risks, such as stranded assets and financial asset price devaluation. This neglect could have disastrous economic consequences since these credit and market risks have a reported potential financial impact of over $1tn combined.
A key first step for financial institutions is to report their portfolio emissions. After all, you cannot manage what you do not measure. Financial institutions should consider embracing active ownership and engage with their portfolios, insisting that the companies they finance are prepared for the low-carbon transition.
Fewer than half (46%) of asset owners and 50% of asset managers reported engagement, most commonly as active owners. CDP’s Non-Disclosure Campaign and Science-Based Targets Campaign offer collective engagement initiatives for investors to take a step into active ownership. Currently, only 71 financial institutions have set science-based targets.
It is also imperative that financial institutions do more to improve governance. While most financial institutions reported some board-level oversight of climate-related issues, it is largely focused on their direct operations instead of financing activities. In particular, the insurance industry at large is a laggard, with board-level oversight covering the impact of underwriting on climate change at only 31% of insurers.
On the positive side, financial institutions have been seizing low-carbon transition opportunities, with 76% identifying opportunities in sustainable finance products such as sustainability-linked loans, green and transition bonds, sustainable investment funds and insurance solutions – worth up to $2.9tn.
Making finance flows consistent with a pathway towards low greenhouse gas emissions offers financial institutions an opportunity to future-proof their business
There is some cause for optimism, with net-zero pledges from a number of leading financial institutions around the Climate Leaders’ Summit in April. Especially noteworthy was the announcement of the Glasgow Financial Alliance for Net Zero (GFANZ), which will require signatories to set science-based, interim and long-term goals to reach net zero no later than 2050. Joining GFANZ is the Net Zero Banking Alliance (NZBA), which includes 43 banks from 23 countries that have committed to align operational and attributable emissions from their portfolios, with pathways to net zero by 2050 or sooner.
With so much long-term capital still being directed towards fossil fuels, it is encouraging to see a growing number of commitments beginning to be made by financial institutions to align both operational and financed emissions from their portfolios with pathways to net zero. Making finance flows consistent with a pathway towards low greenhouse gas emissions also offers financial institutions an opportunity to future-proof their business.
Regulators are increasingly moving towards mandatory climate disclosures in line with the Taskforce for Climate-related Financial Disclosures (TCFD), and financial institutions are expected to be among the first market participants to comply. Additionally, over the next two years, the EU Sustainable Finance Disclosure Regulation will be rolled out, which contains reporting obligations at both the company and product level.
There is substantial evidence that disclosure leads to action. Now it is time for financial institutions to make good on their commitments, disclose portfolio emissions and align their portfolios with a 1.5C world. Our time is running out to avert a climate catastrophe.
Emily Kreps is global director of capital markets at CDP.
Paris Agreement energy transition Net Zero green finance GHG emissions fiinance sector GFANZ NZBA