Insight

Zeroing in: Making the transition to net zero

Written by James Thomas on Wednesday February 9, 2022

Where does the financial sector lie on the path to net zero, and what are the next steps ahead? James Thomas reports

As the urgency of the climate crisis grows increasingly clear, achieving ‘net zero’ emissions has become a priority.

Zeroing in: Making the transition to net zero

To coincide with COP26, plans were announced to make the UK “the world’s first net zero-aligned financial centre”. Key to this is the requirement for financial institutions and public listed companies to produce “net zero transition plans”. At the EU level, the ECB has made similar noises.

This is a serious challenge. Indeed, the ECB recently found that “banks themselves deem 90% of their practices to be only partially or not at all compliant” with its expectations regarding climate-related and environmental risks.

How, then, should firms plot a path towards net zero?

The state of play

The specific requirements of transition plans remain to be fleshed out and regulated entities are taking a diversity of approaches towards the issue. As Jeremy Irving, Head of Financial Services at Browne Jacobson, suggests: “Looking at the annual reports of the big financial firms there is a spectrum between those that haven’t said anything yet on climate change – who will have a significant jump to make this year – and those that have given it considerable thought.”

For some, the strategic significance of climate change has been demonstrated by the appointment of senior individuals with responsibility for climate risk. “We’ve seen many organisations appointing a Chief Sustainability Officer (CSO) either reporting to, or sitting as a peer to, the Chief Risk Officer,” Irving continues. “For a lot of firms, the strategy is geared around the CSO being effectively the in-house adviser on climate change, acting as an interface with the regulator, monitoring the issues and explaining their ramifications across the business.”

Achieving clarity

One major obstacle to developing transition plans is the issue of ‘Scope 3 emissions’; the “emissions associated, not with the company itself, but that the organisation is indirectly responsible for, up and down its value chain”.

“Banks are struggling to gain visibility when it comes to their investment and lending portfolios,” explains Jessica Camus, Chief Corporate Affairs Officer at Diginex, an impact technology company that creates ESG reporting tools. “They currently have no visibility of the footprints of the companies they are financing or investing in.” This is particularly concerning, she continues, because the CO2 impact within a bank’s supply chain can be more than 80% of the bank’s total carbon footprint.

Getting a handle on Scope 3 has been stymied by a lack of understanding amongst partners within the supply chain. Moreover, the complexity of supply chains (in particular for global organisations) can introduce additional challenges including, for example, the risk of double-counting or the improper recording, circulation and tracing of carbon offsetting certificates.

Some organisations and sectors are performing considerably better than others in getting to grips with this. “Organisations focused on the consumer industries generally have a clearer picture of their emissions,” says Camus. “Many sectors – such as extractives, agriculture and forestry – are only now catching up, although the challenge here is significant given the complexity of these supply chains.”

As ever, smaller businesses are often lagging behind. Indeed, recent research found that 1 in 5 SMEs reported that “no one in-house … fully understands the meaning of net zero”, while only 11% were currently measuring their emissions. “Banks are trying to understand the disclosures, metrics, tools and approaches that they should be using when engaging their SME banking clients in the conversation around setting emissions reductions targets,” continues Camus. “But even having that dialogue is difficult because the SMEs often don’t understand what they are supposed to do in order to take responsibility for their own carbon footprints.”

Many banks are therefore viewing their role as one of engagement in the first instance. “Some are taking steps to educate their SME partners around what carbon footprinting is, organising workshops, or offering an extended range of services and tools to them,” Camus explains. “Others are tying their lending or investment terms to certain performance levels when it comes to CO2, making it a requirement for SMEs to report, and outlining the tools that they will use to collect that data as part of their due diligence process”.

Although obtaining a clear picture of the climate impact of their investment and lending portfolios represents a considerable challenge for banks, some already view it as an opportunity. “For financial services to play a role in a more sustainable future, we need to ensure that financial institutions are accountable for the impact of their portfolios, and transparency is key to this,” suggests Neil Sellers, Head of Credit Risk, Triodos Bank UK. “We welcome the focus on transparency within the FCA’s recently-published ESG strategy. One way we demonstrate transparency is to represent every customer we lend to via our interactive online map, which we’ve recently updated to also include the companies within our investment funds. In addition, we’ve supported the development of the Platform for Carbon Accounting Financials – a globally-recognised methodology that enables banks and others to measure and report on the carbon emissions associated with their portfolios.”

Evolving expectations

With the abundance of sustainability metrics and reporting standards, consistency is essential if regulated firms are to act with confidence in developing their net zero plans.

Camus feels that standard setters must be swifter and more decisive, in particular because the global footprint of many large financial institutions creates the potential for regulatory arbitrage. “The biggest challenge for the financial sector has been the lack of harmonisation across the various reporting standards,” she suggests.

However, from the alphabet soup of standards, frontrunners are beginning to appear. “Companies wanting to appeal to investors have been using the Sustainability Accounting Standards Board (SASB) in preference to the Global Reporting Initiative (GRI) reporting framework,” explains Camus. “With regard to climate reporting specifically, the Task Force on Climate Related Disclosures (TCFD) standard is emerging as the leader. It is an interesting standard because it has both quantitative and qualitative elements, with organisations having to explain their governance structures and how they account for climate risks and opportunities.”

Irving agrees. The regulators have been operating with a broad brush thus far, he suggests, but further detail will follow swiftly, and it seems likely that TCFD – with its 11 questions across the four areas of Governance, Strategy, Risk Management, and Metrics and Targets – will serve as the model for that.

“Currently, the regulators are not prescribing precisely what the building blocks of a firm’s approach should be, but they are telling firms to start thinking about it; to start asking questions of themselves, and particularly to make reference to the TCFD framework. Looking at the FCA’s recent ‘Dear CEO’ letters, it’s reasonable to expect increasingly intensive dialogue between regulators and industry and it is clear that the regulator would like to see firms going further and faster.”

For those working in risk and compliance, Irving recommends careful study of the publications being produced by the regulators, notably materials produced by the FCA/PRA Climate Financial Risk Forum. These offer considerable detailed insight into current best practice thinking regarding climate disclosures and climate risk management in particular.

Industry-led initiatives have also emerged – including the Glasgow Financial Alliance for Net Zero and the Climate Safe Lending Network’s Good Transition Plan – which provide a useful source of information and ideas for those feeling their way in the realm of net zero.

Part of a bigger picture

Looking forward, regulators will be focusing on how firms embed climate change concerns within their broader approach to ESG. As Irving continues: “It appears that the UK Taxonomy will be similar to the EU Taxonomy. And although the EU has pushed the message around climate sustainability, when you delve into the EU Taxonomy it actually uses concepts such as ‘cultural heritage’, as well as other social factors. Regulators have clearly started to think about how environmental and social factors are related.”

The FCA’s ESG Strategy provides further evidence of this. “The recognition that ESG is about more than just climate is important,” says Sellers. “The FCA’s strategy notes the significance of nature and biodiversity, of promoting diversity and inclusion, and of ensuring the transition to a net zero economy is a just one. Within our own net zero strategy, we acknowledge that financial institutions must consider holistic solutions to the challenges posed by the climate crisis. We cannot simply decarbonise our portfolios at the expense of wider societal impact, for example.”

For Sellers, the path to net zero appears to represent nothing less than a reassessment of the purpose of the financial sector itself. “The FCA highlights the role that a financial institution’s own governance and culture has on its environmental and social contribution – and for us it’s this investor intention that is important,” he suggests. “To be truly sustainable, we need financial institutions to focus on their impact – moving away from a pure risk and return model – and to acknowledge their ability to drive positive change, whilst also taking responsibility for where their activities have caused harm.”

Interested in learning more about ESG? At the ICA we have a new and exciting short course covering all things ESG due out later in 2022 so keep an eye out for that launching by checking the website and our different media channels.

Find out about our Demystifying ESG short course ►