Walking the same path at different speeds: the challenges for banks in the transition to a sustainable economy

Banks across the globe are facing increasing pressure to act as facilitators of the green transition. As a result, they are facing increasing pressures to set sufficiently ambitious emission-reduction targets and support post-covid economic recovery. All against the backdrop of high inflation and rising interest rates, while dealing with persistent low valuation and increasing competition from non-bank financial institutions.

In supporting the transition to a sustainable economy, banks face both information and coordination challenges. The lack of sufficiently granular and comparable data on environmental and social impacts makes ‘green’ labelling of investment products a risky endeavour. Banks will eventually need to make massive investments in controls and data systems to be able to perform the due diligence needed to make green investments trustworthy, quantify impact, and push back against accusations of greenwashing.

Such an information deficit only aggravates the difficulties in achieving the level of coordination that the green transition requires. This has been evidenced by the internal struggles faced by the Net-Zero Banking Alliance, as well as other sectorial arms of the Glasgow Financial Alliance for Net Zero (GFANZ). As pressure to commit to more ambitious cuts on fossil fuels financing grows without a clear roadmap on how they are to be achieved, significant legal and reputational risks emerge for banks. Institutions are then inclined to leave those international initiatives in an effort to shield themselves from those risks and pursue their own decarbonisation path. Yet, in doing so, they risk further undermining the industry’s coordination efforts. If the industry does not deliver in the near term, it risks facing a steeper path to transition down the line, as the consequences of climate change become more evident.  

As important as the financial system’s role is, it still needs governments to lead the way by supporting the sectors and technologies that can make the transition possible and setting out clear expectations for the transition to a sustainable economy. Global coordination is again, in this case, the key to avoiding regulatory fragmentation and an environmental ‘race to the bottom’ among jurisdictions. The fact that ESG industry alliances like GFANZ are almost totally inundated with Western banks, lacking any real presence of institutions from some of the world’s largest polluters, is a reminder of the need to develop solutions that can be adapted to the realities of all the world’s regions.

The difficulties of combining ambition and pragmatism to achieve a sufficient level of coordinated global effort appear in many different aspects of the response to climate change. One example is provided by the efforts to develop a global baseline of sustainability reporting standards, where more ambitious approaches, such as those based on the ‘double materiality’ principle, need to be made compatible with those based on the traditional approach of business impact. Furthermore, in a world of global financial flows, the need to develop common reporting standards is also tied with the need to agree on a basic understanding of which activities to consider sustainable and under which conditions. This is, in turn, connected with the role multilateral financial institutions, development banks and national central banks play in the transition. Central banks, in particular, have thus far adopted a range of different approaches to the ‘greening’ of their portfolios, due, in party, to the various economic environments and mandates within which they operate.

Climate stress testing is also becoming increasingly more common, but, at least as of yet, there are no broadly accepted methodologies for it. Some jurisdictions are even considering the feasibility of adopting dedicated prudential regulatory treatment of climate risks and sustainable investments, while the links between climate and financial risks are still being studied.

This fragmentation creates significant challenges for banks, especially global banks, not only to comply with the plethora of different requirements, but also to establish transition plans that are adapted to each jurisdiction while, at the same time, combining to form a coherent global effort. The task of global coordination is titanic, but it is more necessary than ever to have the whole world walking the same path together, even if it is at different paces.