Giving banks ‘air cover’ to finance the transition of high carbon emitters

BANKS could soon adopt a framework on reporting potential emissions reductions of their portfolios, raising hopes that doing so will unlock much-needed capital for decarbonising high-emitting sectors.

The Glasgow Financial Alliance for Net Zero (GFanz), a global coalition of financial institutions, is expected to finalise the new methodology by the time the United Nations Climate Change Conference (COP28) starts on Nov 30.

Where’s the need?

Averting disastrous global warming requires more than simply building more solar panels and wind turbines. It also necessitates that current human activities transition towards net-zero emissions.

GFanz highlighted three objectives of transition finance:

• To fund and enable climate solutions and companies that are already aligned with recognised net-zero pathways and mitigation strategies;
• To support companies that are not yet aligned with net-zero pathways but have credible transition plans to do so; and
• To support the managed phase-out of high-emitting activities and assets that cannot achieve net-zero.

But there is a vast gulf between how much it will cost to fund a successful transition and the amount of money available. The scientist-led Intergovernmental Panel on Climate Change recently estimated that transition finance needs to be three to six times their current levels by 2030 to limit global warming to 1.5 degrees Celsius above pre-industrial levels.

Global investment in energy infrastructure alone must rise from 2.5 per cent of the world’s pre-Covid gross domestic product to 4.5 per cent by 2030, according to the International Energy Agency.

What’s the problem?

Banks are under pressure to reduce and disclose their financed emissions, which are the greenhouse gases generated from activities funded by their lending and investment portfolios. In fact, accounting rules issued by the International Sustainability Standards Board in June require financed-emissions disclosures.

But an emphasis on reducing financed emissions can discourage banks from financing transitions in carbon-intensive sectors such as coal-fired power generation, steel, cement, chemicals, paper-making, aviation and construction. That is because doing so might increase the emissions of a bank’s portfolio. For instance, extending funding for the early retirement of a coal-fired power plant will mean that the bank adds the plant’s emissions to its portfolio until the plant is decommissioned.

Simply focusing on emissions reduction without regard for how reduction occurs can also lead to problematic approaches. For example, a bank may reduce its financed emissions by selling high-emitting assets in its portfolio. But if the buyers are not committed to net-zero goals, the reduced financed emissions may not lead to real-world decarbonisation.

What’s the proposed solution?

GFanz’s proposal has been described as “air cover” for the banks as it gives them a robust methodology to project and track future emissions reductions, in the same way that the financial world tries to estimate future returns on capital.

The new methodology introduces a forward-looking metric called the “expected emission reduction” (EER), which measures the bank’s contribution to real-world decarbonisation. It is intended to complement existing financed-emissions metrics.

EER is derived by assessing the future attributable emissions that are reduced or avoided against a “business-as-usual” baseline. How to determine those variables will depend on the nature of the financed entity or project.

For entities that are aligned or aligning with credible net-zero pathways, Gfanz proposes estimating the potential emissions reduction of the entity against a baseline. This should encourage banks to finance entities that are further away from net-zero baselines, and that have more ambitious transition plans, since these factors increase EER value.

For entities that have established climate solutions or managed phase-outs, Gfranz proposes calculating EER as avoided emissions of replacing the current high-emitting source with a lower-emitting alternative. As with the reductions-based methodology, this approach incentivises banks to finance the replacement of higher-emitting assets with cleaner alternatives.

How EER might change things

Beyond the potential to improve the amount of money available for transition financing, the new metric could allow banks to more easily tell how well entities can stick to their goals and projections.

The metric also sets the stage for a new way to compare banks’ climate actions. For instance, it might be possible to compare the ratios of banks’ EER to their portfolio sizes to determine how much a bank is contributing towards decarbonisation.