Decarbonization strategies that are verifiable are essential for decreasing emissions, scaling up climate solutions, and gaining traction among stakeholders.
• Financial institutions play a critical role in combating climate change, and credible decarbonization strategies are critical to meeting their obligations.
• Companies may establish a decarbonization framework using four critical stages that will help them meet emissions objectives and transform the financial system.
• Science-based pathways provide a method for enterprises to achieve real-world transformation while gaining customer and other key partner buy-in.
The United Nations Conference of the Parties on Climate Change (COP26) in Glasgow, Scotland, in 2021 will be a turning point in the global response to the climate issue. Following the Intergovernmental Panel on Climate Change’s stern warnings, the enormity of the needed change and the urgency of swift action is all too evident.
The involvement of financial service organizations (FSOs) in the global response to the climate catastrophe is critical. Many companies are eager to show leadership by pledging not only to eliminate scope 1 and 2 greenhouse gas emissions associated with their own energy use, but also to reduce scope 3 emissions, which include “financed emissions” associated with client activities they fund, invest in, insure, or facilitate.
It is critical to recognize that the financial sector cannot function in a vacuum from the rest of the economy. Every FSO must develop its own decarbonization plan and work with a variety of stakeholders, including as investors, consumers, regulators, and governments. The importance of collaboration between the public and commercial sectors cannot be overstated.
Whatever strategy FSOs use, the capacity to lay out realistic decarbonization (pdf) plans will be important to lowering financed emissions and fostering a feeling of shared purpose among stakeholders. Three high-level imperatives are required to make this possible:
1. Establishing science-based objectives for reducing emissions from funding activities
2. Establishing goals for increasing climate funding flows
3. Increasing confidence in those goals via transparent planning, disclosure, and reporting
This research looks at how FSOs trying to reduce their overall carbon footprint might react to these pressures. It outlines the present uncertainties that businesses face, as well as the industry’s most pressing concerns. It then goes on to describe a practical four-stage approach that FSOs can use to develop market-leading decarbonization plans that will help them meet stated targets while also delivering the real-world changes needed to keep anthropogenic climate change to 1.5 degrees Celsius above pre-industrial levels.
Companies, financial institutions, communities, and more than 130 nations have pledged to reducing greenhouse gas (GHG) emissions to net zero by the middle of the century, or are intending to do so. Longer-term, net zero is the most important aim, but significant emissions reductions in the 2020s – particularly by the world’s major GHG polluters – are also necessary for controlling global warming and ensuring a livable climate.
Many FSOs are currently making aggressive pledges to decrease their scope 3 funded emissions in response to pressure from investors and consumers, as well as the threat of mandated regulation for some. Approximately half of the main FSOs have set net zero objectives for 2050.
This outpouring of ambition is great, but FSOs now have a major burden ahead of them in making it a reality and playing their part in transforming the financial system. It is critical to mobilize resources for decarbonization on a larger scale and to create innovative financing approaches for the shift. Individual FSOs, on the other hand, must have viable decarbonization strategies as a minimum. The Race to Zero campaign’s efforts, as well as its financial partnerships and initiatives, have made significant progress, but FSOs still face many important implementation questions:
• What are our current circumstances? Companies need a clear baseline of their scope 1, 2, and 3 emissions against which to measure progress. Scope 3 emissions, which include sponsored emissions, are crucial for FSOs. Because the necessary requirements, data, and procedures are continually growing, calculating them is difficult.
• What are our plans for the future? Financial institutions must establish goals based on what the most recent research indicates is necessary to meet the Paris Agreement’s objectives. Ambitious FSOs aspire to help carbon-intensive businesses shift while also supporting climate solutions. This necessitates evaluating the adequacy and trustworthiness of counterparties’ own transition plans.
• How are we going to get there? It is difficult to develop unambiguous decarbonization policies that include both intermediate and long-term objectives, and it need strong governance and controls. Senior management must also be aware of and agree on the levers available to cut emissions while sticking to key values such as promoting a fair and equitable transition.
• To whom do we need to communicate? If FSOs are to generate trust, confidence, and momentum in their aims, they will need clear and regulated communication methods to communicate their intentions to consumers, investors, regulators, and employees.
In terms of pledges and actions, the next 5 to 10 years are essential. If net zero is to be attained by 2050, GHG emissions must be cut in half by 2030. Even while some of the low-hanging fruit has already been picked, time is running out for the industry to assist alter every area of the economy.
Finally, businesses must be aware of the opportunity that fast scaling of low-carbon solutions may bring. Climate action has always been considered as a need for bearing the cost of decarbonization. A new viewpoint is emerging: the global shift provides FSOs with the opportunity to engage in an innovation and technology revolution with extraordinary wealth generating possibilities.
Building emission baselines is a difficult and subjective process.
In determining the present condition of a company’s carbon footprint, establishing limits for emissions ownership is particularly difficult. FSOs may have difficulty determining where the boundaries for emissions that they “own” should be defined, what should be accounted for under certain scopes, and which quantification procedures to apply or that may be necessary.
Unfortunately, present climate data from businesses is often unreliable and, in most instances, incomplete. Where real GHG data cannot be obtained directly from counterparties, proxies like as activity data or industry averages must be used to approximate GHG emissions.
FSOs must additionally assess their customers’ funded emissions profiles related to the activities they fund, invest in, insure, or assist, and retain a detailed record of the calculations used. Calculation approaches, on the other hand, are still in their infancy. The Partnership for Carbon Accounting Financials (PCAF) has recently created a standard for estimating funded emissions spanning six asset classes in response to industry need for an internationally acknowledged standard for GHG accounting. Furthermore, the combined efforts of FSOs via their separate UN-convened net zero financial services alliances have aided in the creation of shared momentum in the development of innovative techniques. However, there are still certain holes that will need to be filled in the future.
Challenge: Climate research must underpin viable decarbonization approaches.
FSOs have access to a variety of climatic reference scenarios and transition paths. However, since they are forward-looking, each is predicated on a set of assumptions about how underlying economic, social, and environmental phenomena will unfold in the next years. FSOs must pick from a variety of industry- and internally-driven strategies. Particular has advantages and disadvantages, and it may be difficult to determine which approach is most relevant to each portfolio or loan book, as well as which would give the most comparable data across counterparties.
To demonstrate leadership, FSOs could consider matching their aims with the Paris Agreement’s goals, based on the most up-to-date climate research. When feasible, apply techniques like the Science Based Targets initiative (SBTi) and encourage the decarbonization of emissions-intensive businesses as well as the spread of climate solutions as best practice. Most techniques, on the other hand, are still in the early stages of development and are often only relevant to a small number of financial institutions, depending on their operations and asset classes. SBTi, for example, is being improved and extended, with version 2.0 due out later this year.
Strategy is important, but it’s also a delicate balancing act.
The essence of an efficient net zero strategy is choosing decarbonization levers – particular modifications to how FSOs pick the businesses, activities, and assets they want to finance, invest in, or insure. Even for the most ambitious companies, finding enough of those levers and putting them in place in a coordinated manner is tough and requires difficult choices. There is no quick way to get net zero emissions.
There are a number of reasons why choosing the appropriate levers is difficult. One is the critical significance of achieving significant, measurable carbon reductions during the next decade. Another is the need to move beyond mere divestment; FSOs will only be able to help counterparties in their transition to reduced emissions if they interact with them. The need to swiftly scale up the flow of finance to customers and activities that deliver climate solutions is a third problem. Finally, FSOs must strike a balance between net zero targets and other sustainable development goals, as well as a broad understanding of social, economic, and political variables. If decarbonization initiatives harm society or wealth, popular and political support will dwindle.
Communication is also a critical component of effective tactics due to the necessity for support and involvement. FSOs must find a clear approach to explain decarbonization initiatives – and the logic behind them – to their own investors, customers, and important partners if they are to gain confidence and buy-in from stakeholders.
The problem is that although transparency is growing quickly, convergence is moving at a far slower pace.
Nonfinancial reporting frameworks are being developed by public and regulatory entities all around the globe. This contains a set of evolving transition plan standards that have become a major component of the Task Force on Climate-related Financial Disclosures’ guidelines (TCFD). Regulators, such as the Financial Conduct Authority in the United Kingdom, are already indicating that they intend to use that guidelines when determining whether a company’s climate-related financial disclosures comply with the TCFD’s recommendations. Meanwhile, the European Union aims to demand transition plans from all big enterprises, including short-term objectives and progress reports, in order to improve its green finance credentials.
Transparency is essential for obtaining net-zero results, thus any endeavor is welcomed. While alignment is developing, full harmonization is still in its early stages. Standards continue to increase; frameworks are continually being developed; interpretations differ; and discrepancies abound. Market forces, rather than legislation, are driving change in certain nations. Many new frameworks are likewise unsuitable for markets that are less developed. These constraints provide significant issues for FSOs, which place a high value on reliable data as a foundation for decision-making.
Furthermore, the value of complete transparency cuts both ways. FSOs must be able to convey their decarbonization progress as openly as possible to investors and other stakeholders. For the time being, however, we are still a long way from climate-related reporting being as dependable or meaningful as financial statement data.
The necessity for FSOs to restructure their own operations while also directing the whole economy onto a new path is daunting. Especially if the task has to begin right away. “Building the automobile while driving it” is what CEOs must do.
Despite the obstacles, there are four very practical actions that businesses may take to develop realistic decarbonization programs. The main objective is to develop a framework that enables FSOs to measure, monitor and decrease their emissions, and to report progress to stakeholders. These four steps must be supported by a set of pragmatic design principles in order to succeed.
This is referred to as a decarbonization framework by the worldwide EY organization: a methodology that links practical initiatives with climate science, enabling FSOs to put together the pieces of credible transition planning. Credible decarbonization plans enable companies to increase stakeholder trust in their net zero goals by providing a clear justification for how they will accomplish them and articulating how they will preserve and create value. They may also assist governments, shareholders, and consumers in identifying present and projected funding deficits, as well as developing effective remedies.
Stage 1: Recognize your present emissions.
FSOs have a strong grasp of their balance sheets and profit and loss accounts. Firms must use their financial understanding to mapping their existing scope 3 funded emissions as they get more acquainted with their other scope 1, 2 and 3 emissions – the first step toward delivering on their net zero pledges.
Because the structures and financial sheets of FSOs are complicated, it’s critical to specify how emissions ownership is divided across various activities and sectors. Stakeholder involvement and buy-in can only be achieved if business units are involved in the process. Once the limits have been established, it’s critical to comprehend the applicability of real, approximated, and proxy approaches, as well as the data needs that go with them. Identifying the principles of carbon accounting ahead of time can aid in determining which data can be obtained from counterparties, which must be approximated, and – if proxies are required – which approach to utilize. These may be derived from PCAF standards and the current development programs of Race to Zero’s financial services net zero alliances.
Documentation and governance are also important and will be scrutinized in the future, particularly if choices result in a significant shift in emissions. FSOs must assess each client’s funded emissions profile and preserve detailed records of the methodology used in the calculations.
Data inputs and availability are still a hot topic of discussion. Over 150 environmental, social, and governance (ESG) data sources were evaluated by EY teams in connection to current reporting standards. Even in the field of carbon accounting’s baselining, FSOs have a number of options. Firms must develop explicit guidelines for evaluating data suppliers, indicating that those chosen are appropriate for the company’s needs and have been carefully vetted.
Stage 2: Define your decarbonization goals and objectives.
Credible transition planning requires the capacity to clearly link net zero aims to board-level aspirations and broader ESG commitments. From a functional (e.g., risk and finance) and business viewpoint, net zero objectives must also flow across the firm and be reflected in all strategic initiatives. The risks being addressed, as well as the possibilities associated with credible transition planning, must be understood by key stakeholders, who should be focused on:
• Incentives for green behavior in new goods and services
• Products that are distinct in terms of offerings and consumer categories
• Increasing investor involvement by exhibiting real-world outcomes
• The generation of more value for all stakeholders has increased.
For all of this to be feasible, clear and transparent governance mechanisms from the CEO on down are required. Those in positions of control must develop measurements and KPIs that drive delivery in order to accomplish actual change in the company. These measures will be linked to pay arrangements at prominent FSOs.
At the same time, FSOs must realize that they are establishing goals over which they have little influence. They may choose where and how to grant funding, but they have little direct control over the actions of governments or customers, or the rate at which innovation occurs. While maintaining focused on their own position as facilitators of clients’ transitions, FSOs should be transparent about their beliefs regarding future changes in policy, technology, and public behavior.
Because of these factors, decarbonization paths must be intimately connected to climate science. FSOs could consider joining the SBTi to demonstrate their leadership. This will enable businesses to concentrate on establishing mid-term (2025 and 2030) and long-term (2050) funded emissions reduction objectives that are linked with the selected transition route, such as:
• Top-down objectives (i.e., at portfolio or loan book level)
• Goals for each sector and subsector
• Targets for asset classes or activity levels
• Goals for green funding or investing
Stage 3: Create and execute a decarbonization plan.
FSOs must first analyze the viability of various decarbonization options for all of the activities in their portfolio before developing an effective decarbonization plan. Companies should create a list of possible levers to pull across multiple business units, industries, or asset classes, which should be divided into three categories:
1. How can the institution become involved? By providing guidance, lobbying, and investment management, as well as prioritizing low-emissions money or insurance over high-emissions activities.
2. Where does the institution have the authority to make exclusionary decisions? Through divestiture, or the removal of funding, advice, or insurance
3. Where can the institution take climate solutions to the next level? By boosting the availability of green finance, green investments, or green insurance, for example.
Following that, the possible measures should be prioritized based on their influence on emissions, risk, costs, and customer relationships. FSOs will be able to develop a viable shortlist of possible levers as a result of this.
After then, the effect of those levers must be measured and compared to the decarbonization plan’s short- and medium-term goals. The FSO’s governance and guidelines must be followed while implementing the levers, monitoring their impacts, and iterating on them. This will eventually lead to the release of a decarbonization strategy that contains each company’s position on involvement and participation options, as well as defined requirements for “green” finance, investments, and insurance.
Stage 4 – Make your performance known.
For FSOs to persuade stakeholders of the validity of their decarbonization policies, effective communication and reporting are essential. When evaluating a company’s emissions management and reporting, the Transition Pathways Initiative (TPI) examines two factors:
• Management quality (processes): This relates to the governance of GHG emissions and the risks and opportunities that come with them, as well as the quality of a company’s goals.
• Emissions performance (outcomes): This refers to an FSO’s exposure to assets that are aligned with national and international objectives, such as the Paris Agreement, in comparison to particular sector paths.
Because research reveals that the link between management quality and emissions performance is not always linear, the two are addressed independently. Given the scarcity of trustworthy data on sponsored emissions, this is especially true in financial services. For FSOs, we anticipate management quality to improve immediately, with subsequent improvements in emissions performance coming more slowly.
The quality and openness of FSOs’ decarbonization reporting, on the other hand, often improves in tandem with management quality. Benchmarking serves an important role in monitoring emissions performance, and it often depends only on publicly available data. EY assisted Climate Action 100+ in developing a first framework for obtaining and organising the data required to assess firms’ climate transition performance in 2020. The framework highlights significant indicators of corporate reporting and is based on the TPI technique for evaluating public disclosures.
FSOs may create trust in their capacity to achieve emissions reductions more widely by including performance reporting into a larger stakeholder communication effort that outlines their decarbonization plan, its underlying logic, and the ensuing real-world effect.
Onward and upward
Despite the rapid rate of decarbonization, many FSOs will not be able to meet their net zero objectives, much alone maintain climate change below safe bounds, if present rates of change continue. Credible science-based routes provide a framework for companies to achieve the decarbonization targets they select, as well as gain stakeholder support for their strategy. FSOs may minimize their emissions by following the four steps outlined above:
• Gain a better understanding of how present emissions are funded.
• Set decarbonization goals and objectives.
• Create a decarbonization plan or strategies and put them into action.
• Disseminate information on decarbonization performance and plan.
FSOs must support their efforts with the correct attitude and mentality in order for this method to function. Building and maintaining momentum requires a strong sense of common purpose, as well as the desire to push forward with decarbonization activities despite the many hurdles they provide. As a result, several pragmatic design concepts must support the foundations of credible transition planning:
• Take action quickly: don’t wait for flawless knowledge or 30-year plans. Set short-term goals and reassess strategies on a regular basis as data and standards change.
• Aim for actual gains: not just a balance sheet improvement, but a real-world decrease in emissions.
• Adhere to the mitigation hierarchy: avoid utilizing emissions offsets to meet emission reduction goals.
• Demonstrate accountability: establish goals that accomplish a fair share of emissions reductions, taking into account the size and history of each FSO.
• Ensure justice: reach net zero in a manner that is fair and inclusive, leaving no one behind.
• Be open and honest about the necessity for a “best efforts” approach to a rapidly changing scenario.
• Build a comprehensive data and technology architecture that allows companies to gather high-quality data throughout time to provide comparability and auditability.
In the battle against climate change, net zero is not the final goal. Nonetheless, it is a significant milestone on the long road to keeping our world habitable — and one to which many FSOs have now committed. Credible decarbonization plans give a road map for FSOs to follow in order to achieve that aim. A map, on the other hand, does not guarantee a successful travel. FSOs must also identify the challenges they will confront, the resources they will need along the route, and new, imaginative methods to construct the roads that will enable them to finish the trip.