Green challenges for providers of financial services 

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SG can mean quite different things to different institutions, depending on their starting points, in terms of loan portfolios, employee diversity, product-set, and size.

The amount of business model change required by a big incumbent versus a new digital bank, for example, could be dramatic. Doubly so because large firms face obstacles smaller firms do not, such as less flexibility to make changes quickly, gaining board and stakeholder approval, and the challenge of changing employee cultures within huge organisations.

As such, each bank must decide how it wants to engage with ESG and when. This decision will depend on various factors, such as a business's specific customer base (age bracket, wealth bracket), geographies (different cultural concerns), and product set. Much like when prioritising aspects of digital transformation, providers should first go after the intersection of what is easiest for them to deliver, what promises to have the most customer impact, and what is considered most important by stakeholders.

This matters because there is insufficient evidence that consumers will actually pay more for ESG or that banks doing best in ESG earn more. The data is different in wealth management but in day-to-day retail banking, the evidence suggests that broadly construed ESG considerations influence choice but do not necessarily mean consumers will pay more.

Not surprisingly, those consumers with more choice – wealthier consumers, who are often more digitally mature – are typically more likely to be influenced by ESG factors more of the time, as illustrated below.

The challenge in this context is delivering on ESG in a meaningful way in day-to-day banking interactions. Many of the most impactful initiatives, certainly from an environmental perspective, are determined by global governance institutions, heads of state, and C-suite executives, then pushed out into lending policies through sectors that will or won’t receive funding and the rates attached to that funding. That creates a brand halo, but there’s insufficient evidence that consumers will choose a bank offering inconvenient service even if it is environmentally market leading.

Questions then become which initiatives banks should focus on first and which promise to add the most value? Should a bank focus on trying to be a “good” bank within its core service provision (primarily ‘S’ and ‘G’)? Or should it prioritise minimising environmental impact? The less aligned a specific ESG strategy is with a bank’s core mission, the more likely it is to represent an additional cost that does not support existing business policies.

For example, a bank that delivers market-leading ‘S’ and ‘G’ within its financial advice can build a competitive advantage around that. However, a bank that carries on with current practice but plants a tree each time a customer saves X amount of money is likely creating extra cost and trivialising the potential of ESG.

Progress requires a grown-up, pragmatic conversation around incremental change under real-world business conditions. In a banking context, there is arguably more real-world positive impact from the largest, most unethical bank in the world becoming 5 per cent more green than launching a new bank with only 100,000 customers that’s 100 per cent green.

Leading economists of various political stripes have called climate change the greatest market failure in human history. Unchecked, it threatens to drive an economic loss equal to between 5 per cent and 20 per cent of global GDP each year.

The UN maintains that without a step-change in the activities of the world’s largest banks, it will be impossible to meet Paris Agreement goals. Banks do not have a physical supply chain, but they do exert massive environmental impact through four main activities:

• Lending and saving
• Investing
• Distribution (offices, branches, channels), and
• Advice

However, even if a given institution decides it is fully committed to minimising environmental impact, there are various prudential and conduct risks that could arise, both in terms of the direct risks (i.e., the physical impact of climate change on assets) and the transition risks (i.e., the challenges inherent in a wholesale move towards a low-carbon economy).

Most banks have significant books of business wrapped up in loans and instruments to ‘brown’ assets. As long as those brown assets continue to generate profits for the bank, bank executives will need to balance their duty to finance the ESG transition against their fiduciary duties to shareholders.

There are also various unintended social consequences to environmental moves. Declining to renew loans on existing coal mines, for example, may improve a bank’s carbon disclosures, but it could lead to significant social implications as mines close and unemployment grows (which, in turn, would have a massive impact on that market’s retail lending and potential impairments). Having the experience, insight, and data to map all those potential consequences is proving to be a challenge.

Meanwhile, there are various types of transition risks in the shift to new technologies. Technological breakthroughs might decrease the price of renewable energy, leading in turn to a steep drop in the demand for fossil fuels and a radical change in the energy mix. Businesses or countries that mine, process, or sell fossil fuels may need to write down assets or ultimately default.

Banks, insurers, and pension funds that have outstanding loans or corporate stocks in the fossil fuel industries will see the value of their investments decrease in the long term. The speed, scale, and success rate of adopting climate-resilient solutions, as well as investor preparedness, will determine the actual impacts on the financial services industry.

Some of the largest global financial services institutions, such as HSBC and Santander, have pledged net zero emissions by 2050. They will measure emissions not only from their own operations and supply chains but, even more important, from their financed emissions. Often referred to in their lending and investment books as scope 3, these can be up to 1,000 times greater than their own emissions. In the US, the Big Six investment firms have promptly followed suit.

Banks are key decision-makers that influence the entire economy with their funding decisions. If banks choose to cut off financing to a particular company or industry, they will struggle immensely. This makes banks responsible for ensuring that their investments promote positive values.

Oil and gas companies have high capital and operational expenses. To meet these financial demands, they turn to banks for financing, which banks are happy to do as they can provide very large loans with very little risk.

The financing of these oil, gas, and in some cases, mining firms has a two-fold negative impact on the environment. First, it contributes to the depletion of natural resources as finite fossil fuels are excavating from the earth with little regard for their preservation, as this is driven purely by profit. Secondly, and more worryingly, the greenhouse gas (GHG) emissions from burning these natural resources massively contribute to pollution and climate change.

Between 1990 and 2010, total global net emissions of GHGs increased by 35 per cent, according to the US’s Environmental Protection Agency (EPA). Between 1990 and 2015, the EPA also reported that the total warming effect from GHGs emitted by humans increased by 37 per cent.

There are two ways in which banks can effect change in this space. Banks can look to divest out of their holdings in companies that engage in the excavation and production of fossil fuels and no longer offer financing to such firms. The second measure that banks can take is to invest in and fund renewable energy projects. This second point is so important as we will always rely on access to energy, so unless there is a viable alternative to fossil fuels, it is not feasible to divest from them as another entity will make up the lost capital as demand will remain.

By helping to develop alternatives to fossil fuels, banks can ensure that they are doing all they can to aid the global energy transition. In the long term, renewables will become our primary energy source and will become a massive market, meaning that these investments will also be attractive from a profit perspective in the long term.

Banks are facilitating deforestation and the depletion of greenfield sites through the funding of infrastructure projects and farming. This is relevant nowhere more than in the palm oil market, where vast swathes of rainforest are destroyed to facilitate production. The European Commission estimates that 2.3 per cent of global deforestation is due to palm oil production.

BlackRock had been critical of Procter & Gamble for their sourcing of palm oil from Indonesian firm Astra Agro Lastari. It, however, turned out that BlackRock was the third-largest shareholder in Astra International, the parent company of Astra Agro Lestari.

Consequently, BlackRock was a bigger culprit than P&G in this instance of harmful palm oil production. As a customer, P&G was responsible for increasing demand. However, without financiers such as BlackRock, there would be no supply, cutting the problem off at its source.

Banks can look to aid biodiversity by initially pulling out of harmful projects that contribute to deforestation or the depletion of greenfield sites, such as divesting from palm oil production. Furthermore, banks can consolidate this effort by investing in underutilised brownfield sites and planting trees to offset the ecological devastation caused by deforestation.

Fossil fuel financing continues to be the primary bone of contention here. Despite various pledges and commitments by banks to reduce financing, according to the Rainforest Action Network, total fossil fuel financing by the world’s largest 33 lenders steadily increased between 2016 and 2018 to $1,900bn – a figure nearly double the issuance of green bonds since 2007 ($1,000bn).

The world’s biggest fossil fuel financier is JPMorgan, at $317bn between 2016 and 2020 according to BankTrack, followed by Citigroup ($238bn), Wells Fargo ($223bn), and Bank of America ($199bn). These banks risk being on the wrong side of history.

Having financed $148bn between 2016 and 2020, Barclays came under pressure last year to stop financing fossil fuel companies. In January 2020, a group of shareholders filed a landmark climate change resolution for the bank’s annual investor meeting, thrusting the European financial industry to the centre of the debate on climate change.

Some 11 institutional investors (which collectively manage £130bn and include big UK public pension funds Brunel Pension Partnership and LGPS Central), as well as 100 individual shareholders, co-filed the proposal.

The resolution called on Barclays to publish a plan to phase out financing companies in the energy sector and gas and electric utilities not aligned with the Paris Agreement.

According to ShareAction, Barclays has provided more than $85bn of finance to fossil fuel companies and high-carbon projects since the Paris Agreement was signed. This makes it the world’s sixth-largest backer of fossil fuels and constitutes the highest level of fossil fuel financing of any European bank, exceeding its peers by $27bn.