Banks must start considering their long term future as they scale.
With the threat of climate change creeping closer amongst financial markets, the effects of its carbon emissions are imminent. With increasing demand from investors, employees, and customers to take action, it’s time for financial institutions to onboard eco-strategies and think sustainably.
In this article, we will explore how banks can evaluate and reduce climate risks to transition finance into a low carbon economy.
Integrate Climate Risk into Risk Management Frameworks
Climate change is one of the greatest risks we have seen in the last decade, with an astonishing 74% of people worried about its impact.
It is increasingly being on banks radars, making it more important than ever before to integrate a climate policy into risk management frameworks in a timely manner.
What is a Climate Risk?
A climate risk refers to the potential negative impacts climate change may have on economies, societies, and businesses.
Banking related environmental risks are typically broken down into two categories:
- Physical Risks – These risks impact bank facilities, operations and customers. This can further split into acute physical risks like extreme weather events that could destroy infrastructure or disrupt supply chains and chronic physical risks such as long term shifts in weather patterns. Both types can present financial risks including debilitating effect on financial markets and could potentially lead to the closure of physical branches.
- Transition Risks – Risks associated with shift to a low carbon economy. These are connected with changes in policies and laws to making operations more sustainable while aligning with changing stakeholder expectations for sustainable products. All of this can add additional costs especially for banks that have investments in fossil fuels.
Asset managers may find it challenging to assess climate related risks. Their role is to assess the extent to which staff, customers, and a bank’s physical infrastructure is in danger from potential risks, including nature risks such as extreme weather events and changing weather patterns.
Transition risks present an ever bigger challenge, as they require extensive assessments of each industry the bank serves. Risk assessors must outline how they need to evolve by evaluating how varying industry verticals release greenhouse gases and the energy efficiency of supply chains. To efficiently conduct this evaluation, it must be viewed from a long term perspective.
Climate stress testing must be integrated into risk management frameworks. Scenario analysis allows managers to assess how a banks financial and operational health may be affected in a climate crisis. Banks can use the results of scenario analysis to outline their strategy in reducing carbon emissions.
Divestment from Fossil Fuels
Many players in the banking sector have large investments into fossil fuel companies, influencing the continuation of their utilisation.
As significant financial backers, one of the most impactful ways banks can tackle climate change is by reducing or removing corporate bonds and investments in fossil fuel companies and high-carbon industries. Shifting capital towards energy saving measures such as solar, wind, and hydroelectric renewable energy sources can pave the way to a sustainable infrastructure that supports net zero emissions.
Divestment from fossil fuels aligns with global goals such as those set in the Paris Agreement. Taking actions like these shows banks are turning away from areas that are fuelling climate change. In turn, boosting their reputation as a sustainable option to attract environmentally friendly investors and clients.
If banks begin to partake in fossil fuels divestment it sends a strong signal to the financial sector. This encourages businesses to engage in sustainable practices and companies receiving financial backing are then motivated to look into cleaner areas, accelerating the dissociation with fossil fuel use.
Sustainable Lending & Investment
Sustainable lending and investment are key components of sustainable finance. Incorporating ESG considerations into lending and decision making process can help banks align with sustainability goals and reduce environmental risks.
Banks hold the power to allocate where capital flows. They can issue loans to businesses that are pursuing climate related projects or being proactive to meet sustainability targets. Banks can provide various loans to promote sustainable lending, including the following:
- Green Loans – Exclusively used to finance specific environmentally-friendly projects.
- Sustainably-Linked Loans – Broader loans issued with pre-agreed sustainability performance targets that determine lower interest rates or longer repayment terms if met. A focus tends to be on overall sustainability of the borrowing body and not exactly how a loan is spent.
Sustainable finance focuses on investing in organisations and assets that have strong ESG performance or a positive environmental impact. Banks can use investment vehicles, such as green bonds and impact investing, helping to balance long term financial returns for companies focusing on climate mitigation and adaption.
In turn, this reduces transition risks for the bank itself and nature related risks on a wider scale through funding green projects and providing financial incentives to businesses with good sustainable practices.
Green Bonds & Climate Finance
Climate finance is when financial tools are used to assist efforts that combat climate change. It involves making sure money flows from financial institutions to sustainability projects.
It can involve various avenues such as climate adaption financing, low carbon projects to mitigate both physical risks and transition risks, and reducing financial risks associated with climate change. As financial regulators tighten standards on carbon emissions, high carbon investments become riskier – incentivising the financial system to shift to sustainable finance like green bonds.
Green bonds are a brilliant example of climate finance. They play a significant part in tackling climate change and their usage continues to growing, 2024 saw record sales of green bonds with $356 billion. They act as debt instruments, their proceeds are used exclusively to fund projects that address climate change.
Banks can issue green bonds to promote projects that align with global climate goals and through the strict reporting associated with green bonds, transparency is increased. This shows a bank’s commitment to sustainability and reducing climate risks. Banks benefit because they receive a stable return and attract ESG investors to help the transition to a lower carbon economy and combat climate change.
Reducing the Company’s Carbon Footprint
A company’s carbon footprint entails their total output of greenhouse gases. By reducing a carbon footprint banks can reduce climate risks and limit global warming.
Measuring carbon footprint can be more straightforward for smaller businesses, but for larger financial institutions it can be more complicated and time-consuming.
There are three scopes of greenhouse gas emissions under the Greenhouse Gas Protocol. Scopes 1 and 2 are relatively easy to measure. However, Scope 3 can be more complex to measure because it accounts for all indirect emissions that result from activities of assets, not controlled by the reporting body but are in its chain.
If banks can work out a way to report their carbon footprint, they can set defined targets to reduce greenhouse gases in all three scopes. This will mitigate transition risks, building resilience against the change to a low carbon economy. Banks are at the top of the financial food chain, if they set a positive example and reduce their carbon footprint, others will follow.
Banks who show strong sustainability efforts are likely t attract green investors, giving more green opportunities to a bank, making the transition from high carbon investments to greener ones easier.
Using More Sustainable Resources
Using sustainable resources will help banks shift to a low carbon output. This ranges from physical buildings and products, waste management, and energy usage.
Banks can invest in energy-efficient technologies and practices within their operations. For example, banks can upgrade to LED lighting or implement additional building insulation. Additionally, banks can monitor energy consumption through smart meters. Increasing energy efficiency lowers greenhouse gas emissions and operational costs, contributing to a smaller carbon footprint.
Switching to renewable energy sources such as such as solar, wind, or hydropower will massively decrease their carbon emissions and reliance on fossil fuels and drives growth in the renewable energy sector.
Banks can adopt environmentally friendly suppliers use eco-friendly materials. This type of procurement reduces the environmental impact of the supply chain. Banks can also work on reducing single-use plastics and encouraging the use of recyclable materials.
Reducing paper usage by switching to digital platforms is a good way to use more sustainable resources. Decreasing paper consumption reduces deforestation, waste, and energy use, contributing to overall environmental conservation.
TIMBERCARD by Copecto is an innovative example of how banks can use sustainable resources. It is the world’s first plastic-free wooden payment card body that financial services can adopt as a centre piece of sustainability to combat the large quantities of plastic cards wasted every year.
Developing Green Financial Products
Green financial products are designed to support projects and businesses that place focus on protecting the environment. Banks can develop these products to address climate change in a day to day fashion.
Banks can issue green bonds to raise capital for eco-friendly projects, helping to reduce global carbon emissions. Green loans offer favourable terms to companies and individuals investing in sustainable initiatives.
Sustainability-linked loans and ESG funds are other green financial products. ESG funds are investment funds that focus on businesses with strong ESG performances. These funds attract investors looking to align their financial goals with sustainability objectives.
Green trade finance is another product banks can develop into their financial system. By offering trade finance products, that incentivise sustainable supply chains, banks can promote environmentally friendly practices across global industries, helping to reduce the carbon footprint of trade activities.
Helping Consumers Adopt Existing Green Financial Products
Banks can educate consumers through campaigns to inform them about the benefits of green financial products. This includes providing information on how the products work and the positive impacts they have on the environment.
Utilising data analytics, banks can offer personalised recommendations to customers based on their financial goals and sustainability preferences. Banks can also offer incentives based off these personalisations to encourage the adoption of green financial products. For example, they might offer rewards for investing in ESG funds.
Consumers engage readily with products that are easily accessible, so it is crucial to making green financial products so.
Banks can create partnerships with environmental organisations which can enhance the credibility of green financial products. Banks can leverage these partnerships to promote products through joint marketing efforts and initiatives.
Providing transparent reporting on the impact of green financial products helps build trust and credibility. Banks should regularly update consumers on how their investments or loans are contributing to environmental initiatives.
Promoting Environmental, Social, and Governance (ESG) Criteria
Banks can promote ESG criteria by implementing it throughout their decision making processes. This lays the foundation for sustainable finance at the forefront of financial activities. Each lens of ESG offers a new perspective for banks to identify the non-financial impact of financial decisions which in some way will impact the financial system anyway.
Promoting ESG criteria lays down the path to other avenues discussed within this blog. These include sustainable lending and investment, reduction of physical and transition risks, and driving the development of green financial products.
ESG metrics are a guide for banks to foster environmental responsibility, internally and externally, to begin aligning the economy with climate related financial disclosures – steering banks away from high risk investments and into sustainable ones.
Raising Awareness with Clients and Stakeholders
Many major clients and stakeholders (such as governments, large businesses, and other financial institutions) are the ones funding sustainability efforts within banking organisations. This gives banks the ability to shift the financial activities of their stakeholders to address climate change and environmental risks.
One effective way to do this is collaborating with regulators and industry leaders to innovate climate friendly policies. Making industry coalitions, not only raises awareness, but encourages clients to follow suit in aligning their operations with overarching climate goals.
Banks can engage with stakeholders by offering green incentives to empower them to make meaningful decisions. Transparent ESG reporting and consistent sustainability reporting to detail their achievements and green financial products will inspire key stakeholders to do the same.
Opening communication channels through forums, conferences, and social media to educate people on financial stability implications from climate change like physical risks, from extreme weather events or rising sea levels.
Challenges For Banks Taking Climate Action
Balancing Profitability with Sustainability
Banks are profit driven, prioritising short term financial risks in risk management. This can cause conflict when transitioning to sustainable finance. The question is, how can banks balance the two?
As sustainable finance focuses on long term outcomes, banks may not see immediate financial returns, meaning reduced profitability. If a series of central banks began shifting towards sustainable finance this could mean reduced profits on a larger scale which could have implications for the financial system.
Balancing between profitability and sustainability can be difficult for banks, especially in the current financial environment. Banks will need to redefine the financial landscape to find balance between sustainability and profitability.
Banks must innovate new revenue streams and educate stakeholders on new ways of financing, all whilst assessing progress and pitfalls through careful climate risk management to identify the best outcome.
Navigating Regulatory Complexity
Climate regulations are complex and ever-changing.
They can vary drastically between countries and regions. Many countries have stringent climate laws and policies such as carbon pricing and mandatory ESG reporting, while others may have no regulations in place at all. Global inconsistencies may it difficult for international organisations to formulate a cohesive climate strategy across all regions they operate in.
With environmental regulations constantly evolving, banks struggle to anticipate the correct long term strategies for addressing climate change, causing delays in implementation.
Measuring and Reporting Impact
Measuring and reporting the impact of a banks sustainability efforts can present difficulties for a number of reasons.
One reason being, the lack of standardised metrics. Currently, there are no universal standards for how to measure the environmental impact of businesses, as different regions operate under different frameworks. Examples include the Global Reporting Initiative (GPI) or Greenhouse Gas Protocol (GGP), each demanding different metrics, making it harder for banks to compare environmental impacts against other businesses.
Limited data availability and reduced data quality, especially on scope 3 emissions (indirect emissions from investments and loans portfolios) provides an issue for banks. Gathering data across a supply chain or from borrowers and investors is difficult and then identifying their individual environmental impact due to lack of transparency and inconsistencies.
Reduced data availability and quality creates an even greater threat for banks. Incomplete data makes it difficult for banks to assess their environmental impact, meaning they could potentially underestimate climate related financial risks.
Conclusion
Banks have a pivotal role to play in the fight against climate change, with their actions going far beyond their immediate operations.
By integrating climate initiatives into risk management frameworks, divesting from fossil fuels, and adopting sustainable practices, banks can significantly influence the shift toward a low-carbon economy. Their financial power enables them to promote green projects, offer eco-friendly products, and encourage clients and stakeholders to follow suit.
Though challenges like balancing profitability with sustainability and navigating regulatory complexities persist, proactive steps and transparent reporting can drive meaningful change.
Embracing these strategies not only aligns banks with global climate goals, but enhance their long-term viability and reputation in an increasingly eco-conscious market.
Take a proactive step toward sustainability with TIMBERCARD by Copecto. Empower your financial choices to support climate action, be part of the change driving a greener future.