Banks’ role in financing the energy transition

Regulatory, reputational and risk management considerations are leading banks to play a central role in the decarbonisation of the global economy. EU legislation on emissions disclosure for both the financial sectors and other companies is a driver for institutions to help clients identify and implement the changes they need to embrace a sustainable business model.

Banks have a number of compelling reasons for addressing the climate impact of the companies they do business with – starting with the fact that it is an essential pillar of risk management. Companies that fail to address adequately the risks arising from their carbon emissions face operational and regulatory threats to their business model.

Many banks also see themselves as an important facilitator of change: it is clear that governments do not have the resources on their own to manage the huge challenges that decarbonisation entails. The financial industry is needed to play a crucial role in implementing the transition.

Institutions also must consider reputational and regulatory considerations. Increasingly, the carbon emissions and sustainability practices of clients for which banks provide financing or underwrite capital market issues reflect on the institutions themselves.

Banks are increasingly coming under pressure from legislative and regulatory requirements to disclose so-called scope 3 emissions, defined by the 1990 Greenhouse Gas Protocol as those that are generated in a business’s value chain or through the use of its products and services by customers. For banks, this includes any direct investments they make as well as their lending and underwriting – and it is likely to be the lion’s share of the emissions they report.

Risk management and beyond

The risk management factor is becoming more critical as regulators increasingly focus on sustainability-related issues as part of their prudential supervision. Financial institutions will need an understanding of not just the emissions generated by their own business but throughout their value chains.

The longer companies delay assessment of their environment- and climate-related risks, the more complexity and expense they will potentially face in the decarbonisation transition, and the greater the operational risks they potentially run.

The longer companies delay assessment of their environment- and climate-related risks, the more complexity and expense they will potentially face in the decarbonisation transition, and the greater the operational risks they potentially run. Banks that provide financing and other services are exposed to the knock-on impact of those risks.

Another factor to consider is the possibility that customer behaviour will change. Consumers are becoming increasingly aware of, and more discerning about, the environmental impact of the products and services they use. Says Alessandra Simonelli, Head of sustainable development at Banque Internationale à Luxembourg: “It’s a major risk for businesses not to be aligned to this move to a low-carbon world, plus there are operational reasons such as reducing costs including energy. It’s a question of making sure that the business model today fits within the world of tomorrow.”

The other important role banks play is that of transition facilitator. Moving to a low-carbon economy will necessitate huge investment that governments cannot finance alone. By supporting sustainable business practices, banks can help their clients implement the necessary changes. “We believe we are part of the equation to make the transition happen,” Simonelli says.

Some companies face fundamental changes, including in some cases deciding whether their existing business model is still viable.

Monitoring companies’ business model assessment

Banks are making efforts to ensure that all their clients assess how their business model fits within the evolving environment, the risks they face and the action they need to take, which will vary hugely from company to company. Some businesses just need to work on their energy efficiency – perhaps by swapping fossil fuel-powered heating and ventilation for renewable energy. But others face much more fundamental changes, including in some cases deciding whether their existing business model is still viable.

It is obvious that a significant percentage of companies will not be able to survive, at least in their existing form. Take the example of a paper manufacturer, which may need to make a huge investment to fund its transition, which can only pay for itself through the production of more paper. But the company may find it doesn’t have the natural resources available to create sufficient paper, while – more importantly – demand is falling for the single-use paper it provides. For such companies, decarbonisation will entail a radical change of business practices and processes.

Companies need to be aware of the risks throughout their value chain. A great deal of the direct climate impact, in the form of extreme weather, rising sea levels, drought and rising temperatures, may affect Asia and Africa more than Europe, but many companies source raw materials and manufacturing in these regions. The Covid-19 pandemic demonstrated how quickly disrupted supply chains can have a profound business impact, and it is a risk companies need to manage.

Pathways to decarbonisation

Banks are looking to be working with each of their clients to assess their exposure to environment and climate risks, and the actions they are taking in response. In common with other stakeholders, such as shareholders, banks need to understand companies’ trajectory and targets in order to be able to assess their progress along the way.

In many cases banks do not possess all the expertise they need in-house, so they will collaborate with energy experts. BIL, for example, partners with Luxembourg consultancy energieagence, with which it brings clients together to help them devise pathways to decarbonisation. BIL has also organised joint conferences to help set clients on their pathway, explaining the first steps and what they can do to improve their energy efficiency.

The pathway will be different for every sector. Each must determine its carbon budget, indicating how it will stay within the maximum level of emissions that would meet the Paris Agreement goal of ensuring that global warming remains within 1.5ºC of average pre-industrial temperatures. The speed of decarbonisation is not the same for each sector, and will be linked to any specific rules that apply to it, as well as the availability of appropriate technology.

What about non-compliance?

Most companies are currently at the outset of their transition journey; banks are assessing their readiness to embrace change and helping them put plans in place. Right now, any consideration of the consequences of failure or non-compliance remains some way off. However, this will be a factor in the longer term, and financial institutions will need to decide how they deal with it. If clients’ risks are particularly large, this may be reflected in the cost of lending, for example, or even whether they will be able to borrow at all in the future.

In any case, banks must first seek to understand the difficulties companies face – is it lack of expertise, inadequate resources or poor understanding? Ultimately, decarbonisation should be in a company’s own interests and those of its shareholders, so banks will need to look at any barriers that may be preventing them from taking action.

The pathway is likely to become clearer as disclosure and reporting scope under the EU’s Corporate Sustainability Reporting Directive expands over the course of this decade. The legislation will eventually require around 50,000 European (and some foreign) companies that meet at least two criteria out of the following – having at least €50 million in turnover, €25 million in assets and 250 employees – to disclose quantitative and qualitative information about their sustainability impact, opportunities and risks, including scope 3 emissions. This will help build a perspective on businesses’ entire value chains.

Banks have a vital role in supporting companies in their efforts to decarbonise, but it is also vital for their own risk management and regulatory obligations, and they have a crucial role to play in advancing the decarbonisation transition as a whole.

Moving to a low-carbon economy will necessitate huge investment that governments cannot finance alone, and banks can help their clients implement the necessary changes.