Understanding How the Financial System Impacts Climate Change

Note: This article is Part 2 in a series of two articles. It draws upon the Green Templeton Lecture on this topic delivered by Jo Paisley on 8 February 2024. Part 1 can be found here.

Measuring Firms’ Impacts on the Climate

How do you measure the impact that a company has on the climate? The most direct impact is via a company’s emissions of greenhouse gases (GHGs), or its impact on the availability and quality of carbon sequestration (e.g. through deforestation or soil degradation). Emissions occur at different points in the company’s activities and value chain, across scope 1, 2 and 3, as summarized in the table below.

Adapted from the Greenhouse Gas Protocol Initiative’s Corporate Accounting and Reporting Standard (2001).

Financial firms do not have large direct impacts on the climate, as the greenhouse gas emissions from their own operations are relatively small (that is, their scope 1, 2 and upstream scope 3 emissions are small). Rather, it is their financed emissions which matter (that is, their downstream scope 3 emissions). These are related to their financing activities, such as lending, investing or insurance underwriting.

The importance of this perspective was recognized in the Paris Agreement, adopted by 196 Parties at the UN Climate Change Conference (COP21) in December 2015, which has three overarching goals:

1. Mitigate: Hold “the increase in the global average temperature to well below 2°C above pre-industrial levels” and pursue efforts “to limit the temperature increase to 1.5°C above pre-industrial levels.”
2. Adapt: Increase the ability to adapt to the adverse impact of climate change and foster climate resilience and low greenhouse gas emissions development.
3. Finance: Make finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.

For the finance sector, this third point is key. But how do we make financial flows consistent with a pathway of limiting global warming (that is, to below 2°C or the more ambitious target of 1.5°C above pre-industrial levels)? To try and achieve these flows there has been an increased focus on the concept of ‘alignment’, where financial firms examine their portfolios and establish how much emissions (and therefore warming) are associated with those financial flows.

Net-Zero Targets Underpin Alignment

The first step for a firm to establish alignment is for it to make a commitment to reach net-zero emissions. For a financial institution, the target is for their portfolios to reach net-zero emissions by a specific date, that is aligned with the Paris Agreement targets. This is commonly done by committing to a ‘science-based target’, developed by the Science Based Targets Initiative (SBTi). This maps out GHG emissions reductions targets needed to ensure that they are in line with what science indicates is needed to keep global warming below 1.5°C. Once a firm has made a commitment, it is then validated by the SBTi.

The SBTi has developed specific methodologies to underpin the setting of targets for some sectors including cement, power, and steel (and is developing it for other sectors). But it is more complicated for financial firms, since they deal with a range of different sectors and geographies, which are following different decarbonization pathways. The SBTi also notes how dependent financial institutions are on information from their counterparties to be able to inform their own net-zero strategies.

Portfolio Alignment Metrics Are Not Standardized

Once targets have been set, there are a variety of approaches to measure alignment — and correspondingly a variety of portfolio alignment metrics. The Guidance by the Glasgow Financial Alliance on Net Zero (GFANZ) breaks the problem down into three key steps (Figure 1). Underpinning these steps are nine key judgements, on which there isn’t yet a consensus. For example, different providers of alignment metrics use a range of different scenarios, use intensity and/or absolute emissions measures, use different time horizons for measurement, cover different asset classes, and present the metrics in different ways (see Appendix Q in the guidance for a very handy summary).

Source: Measuring Portfolio Alignment: Driving Enhancement, Convergence and Adoption, GFANZ

Over time, it is likely that best practice standards will emerge, hopefully underpinned by a common methodology. But for now, alignment metrics at different financial institutions are not necessarily comparable and so care is needed when trying to compare institutions’ degree of alignment with the Paris Agreement. It’s also not possible to add them all up and come up with some sort of aggregate measure of the impact of the financial system on the climate.

If we can’t use alignment metrics reliably as a measure of impact, what else can we look at to understand more about the financial sector’s effect on the climate?

Effectiveness of Divestment and Engagement Strategies

Financial firms can lower their impact on the climate in two main ways — divestment or engagement. Divestment means that capital is reallocated from high-emitting firms toward those with lower emissions. Engagement means that the financial institution continues its lending/investing/insurance underwriting, but it encourages companies to reduce their emissions (e.g. by demanding that the polluting companies set climate targets and/or invest in greener technologies).

Divestment may, however, have unintended consequences. Consider an asset owner that sells a stake in a high-emitting counterparty, such as a coal-fired power station. Although it may make the portfolio look greener, this will not have any impact on real-world emissions (and might even make things worse if the purchaser plans to increase the output of the power station). This phenomenon is recognized by the SBTi in its Financial Institutions Net Zero Standard, as well as new disclosure frameworks such as that published by the Transition Plan Taskforce.

Measuring the impact of engagement on the climate is very hard. But recent research has looked at the effectiveness of both divestment and engagement strategies at banks that have made net-zero commitments relative to those that have not. Overall, they found no evidence that these commitments led to increased divestment from high-emitting sectors relative to banks without a net-zero commitment. Nor was there evidence that the net-zero commitments led to increased financing for renewables projects. Just as worrying was the finding that the process of engagement between banks and their counterparties did not seem to be leading to higher levels of ambition in these counterparties (e.g. via more stringent decarbonization targets or reductions in their verified emissions.)

So overall, there is no evidence that voluntary net-zero targets are leading to a more climate-friendly impacts for banks, although the banks making commitments do seem to benefit from improved ESG ratings themselves.

Can Finance Have Real-World Systemic Impacts?

But what about more specialist forms of investment that focus on impact? In a recent blog, Gosling and Walkate examine sustainable investing, which is defined as: “Using investing activity to influence companies and assets so as to generate financial returns while achieving positive outcomes for people and the planet, and avoiding negative ones.” They look at what it would take for sustainable investing to have real-world systemic impacts, finding that three conditions are needed, which they refer to as the three stages of a rocket:

• First, the investor’s activity must have some effect on the companies/managers of companies in which they invest, which can trigger a change in what the company does (e.g. divestment leads to an increase in the cost of capital).
• Second, managers at the company must actually respond to that effect and change their actions. This creates an impact in the real world that would not have happened in the absence of the investor activity (e.g. a company invests more in green technology because of a lower cost of capital).
• Third, the impact in the real world must persist even after second-order impacts; also, it must not be completely unwound by the response of competitors and consumers to the company’s actions (e.g. adding up the impacts across the system leads to a system/industry level decline in emissions).

The authors review the academic literature to judge the systemic effectiveness of sustainable investing. Overall, they found that the first stage works least well, and when it does have impacts, they tend to be relatively small. But there’s also little evidence that sustainable investing is meeting conditions 2 or 3, leading to any firm-specific or measurable-systemic impacts. Of the strategies — divestment or engagement — they believe that engagement appears to be more effective. But there is limited evidence of economically significant real-world impacts. And the changes that a company makes tend to be where the actions required are in the company’s long-term best interests and are not too costly.

Summing Up: Climate Change and the Financial System

So far, we’ve looked at two perspectives on the relationship between climate change and the financial system. Part 1 of this article examined the impact of climate financial risks on financial firms and the potential for financial instability — the classic risk management perspective. In contrast, this article looked at how the financial system impacts on the climate — the alignment perspective.

These perspectives are likely to clash, at least in the short term (as discussed in a recent podcast). Take a bank that has an established relationship with an oil and gas company, with an excellent track record of repayments. From a credit risk perspective, there is a strong business rationale for continuing to lend to them, at least in the short term. But the company has a high carbon footprint, which is going to be difficult to align with the bank’s commitment to lowering the carbon footprint of its lending.

Over the longer term, if the economy transitions to a low carbon one, oil and gas companies naturally become less attractive lending propositions as they face increasingly stringent transition policies, and demand for their products decline. But if the real economy doesn’t transition in line with the Paris Agreement, then we face a world in which physical risks are rising, but transition risks are lower. In such a scenario, is it realistic to think that the financial system will be aligned to as 1.5°C pathway?

This highlights the fundamental truth that at a global level, the financial system can only be as ‘aligned’ with the Paris Agreement as the real economy. Some portfolios will be greener than others, but it is not possible for the financial sector to run ahead of the real economy in aggregate. As Gosling and Walkate note, firms do what is profitable; engagement can lead to impacts, but investors need to be realistic about the limited potential for systemic change.

Finance has an important and powerful role in supporting the transition, committing to net zero and engaging with companies to encourage decarbonization in the real economy. And this makes sense from both perspectives. Given the inevitability of reaching net zero from a climate science perspective, fossil fuel usage will be phased down. Continuing to invest in this sector both increases the risks of stranded assets and adds to systemic risks. Overall, however, policy will be critical to drive the transition in the real economy; it won’t be delivered by relying on voluntary commitments in the private sector.

Jo Paisley, President, GARP Risk Institute, has worked on a variety of risk areas at GARP Risk Institute, including stress testing, operational resilience, model risk management, and climate and environmental risk. Her career prior to joining GARP spanned public and private sectors, including working as the Director of the Supervisory Risk Specialist Division within the Prudential Regulation Authority and as Global Head of Stress Testing at HSBC.