The ability for financial services firms to distinguish true climate action from greenwashing (when a business purports to be environmentally conscious for PR purposes) is a key driver in overall sustainability strategy and ESG risk management. In order to turn ambition into impact, substantive action is required - companies’ net zero strategies must be applied, transparent and easily understood by all stakeholders. For financial services firms, a significant aspect of their own success in converting ambition to impact lies in their ability to transition the portfolios they finance. Effective decision making and risk management in this respect means they must be able to distinguish between green and net zero transition activities which are real, applied, impactful and holistically sustainable, as opposed to statements of intent and ambition which are not backed up by action, or actions which fall short of the necessary standards.
Banks are under fire for making trade-offs between sustainable and unsustainable investments and companies in all sectors are increasingly facing greater scrutiny over their own public statements. A recent report by the New Climate Institute and Carbon Market Watch examined the transparency and integrity of 25 multinational company pledges to reduce emissions. It found that headline emissions reduction targets were often ambiguous. Half of the companies analysed did not go far enough in their explanations of how targets would be met. A significant proportion of the remaining companies made pledges with no specific emission reduction commitment. In their position as "aggregator-reporters" - meaning that the reporting position of banks and other financial services firms derives significantly from the aggregation of multiple client and portfolio positions underlying their business - it is clear that banks cannot rely on these corporate targets and statements at face-value.
Stakeholders, including environmentally-conscious, active investors, are calling for financial services firms to direct capital away from companies who make net-zero claims that are detached from concrete plans to execute. The reputation penalties for apparent greenwashing are significant.
However, the majority of banks believe greater climate-related financial disclosure forms only part of the solution according to our research. In our new European report ‘Raising the standard: How banks can improve the quality of climate-risk financial reporting’ DLA Piper asked banks which strategies were most likely to minimise the challenges of greenwashing and the two most popular answers were improvements in technical skills and improvements in data quality. This suggests that banks have faith in their ability to select the right course of action once technical skills and data are in place - this is no surprise if analogies as to assessment of net zero credentials are drawn with the rigorous credit process - however, there is clearly rather less confidence that the tools required for this purpose are currently in place.
This is not a bank or financial institutional issue alone and there are calls for governments to temper the amount of expectation placed on financial services firms to be able to use levers available to them to make a positive impact on net zero goals. Government and regulator-led centralised action is also necessary because banks are currently hindered by unavailability of clear, comparable data and lack of consistent frameworks against which to measure intentions, statements, actions and outcomes. Global initiatives like ISSB and GFANZ, alongside national initiatives like the UK's Transition Planning Taskforce are working to fill some of the gaps but this is ongoing - in the meantime, greenwashing remains a high risk issue.
How should banks manage the dilemma of dealing with clients who either don’t respond to calls to transition to sustainable practices, or who fail to keep their promises? In the survey, 92% of respondents said that the best way to deal with clients whose climate risk profile causes the bank exposure is to use financial penalties. This approach is already being reflected in some financial instruments and products, however, the efficacy of such penalties may be enhanced in the future. The application of the proceeds obtained, for example, needs to be more carefully considered especially as such penalties may become larger in the future. Having institutions profit from net zero failures in their client and investment portfolios is clearly not the right answer, and causing corporates who may be struggling to achieve relevant targets (as opposed to intentional or avoidable failures) to suffer additional financial distress at that moment may actually drive worse net zero outcomes.
In a similar vein, outside the financial sector, the pressure to divest completely from polluting companies is growing. Activist shareholders, pressure groups, NGOs and even employees are joining a growing chorus of net-zero sceptics, in general unmoved by banks’ and their clients’ statements of intent. Perhaps that’s why 88% of senior decision-makers in banks told us that diverting capital away from environmental polluters is a good way to tackle climate change.
But in practice, the arguments are more nuanced than that. Divestment frequently transfers emissions to companies that may be more thinly capitalised, less affected by pressure from activists and less motivated or less able to take the actions required for positive real world emissions impact. This may ultimately make it harder to induce the lower-polluting behaviour that benefits us all. Institutions that divest such holdings are sometimes rewarded with higher ESG ratings, despite the fact that the underlying behaviours (and real world emissions) remain unchallenged. There are medium and long term factors here and whilst the short term apparent “gains” may be attractive, decisions have to be assessed with the “hindsight filter” of impacts by 2030 or by 2050. We already have a number of global examples of long term negative environmental and fiscally burdensome outcomes from similar short term decision making (because the public purse is ultimately the bottom line in a stranded asset and dislocated community scenario) and sustainable net zero financing means acting in a manner which avoids this in the future.
Banks and financial institutions are clearly faced with a number of challenges in this area. Key aspects to improving outcomes and lowering risk are the ability to identify greenwashing in client and investment portfolios, to react appropriately and implement consequences which ultimately lead to lower emissions and sustainable real world outcomes, and to measure, report and perform against internationally comparable frameworks which provide appropriate transparency and accountability. Whilst finance is a strong lever in bringing about net zero, financial institutions cannot operate this in a standalone manner, the world is working on catching up standards, metrics and frameworks (including the essential transition finance framework that is urgently required) but in the meantime, greenwashing risks will continue to rise.
DLA Piper’s Financial Services sector group has recently launched a new report: ‘Raising the standard: How banks can improve the quality of climate-risk financial reporting’.
The report looks into the key issues relating to climate-related financial disclosure and ESG investing, revealing that nine in ten senior bankers agree that improving related reporting practices would have a substantive impact on global efforts to reduce climate change. We polled 700 senior decision makers within banks across the UK, France, Germany, Italy and the Netherlands about their plans for improving disclosures in 2022 and beyond, the challenges they face in getting to where they need to be, and whether or not climate-related issues hold priority within their businesses. In light of our findings, we also identify the key priorities for financial institutions to consider when looking to take transformational action.
The full report is now available to read here.