Banks as Drivers Towards a Green Economy

In this section there is a change in tack. While in the prior three sections lessons in governance for the knowledge economy were extracted from some well-defined past experiences, this section will focus on current developments that are also likely to condition banking governance in years to come. It is generally accepted that one of the characteristics of the advent of the knowledge economy is that wealth has migrated from tangible to intangible assets; from material things to immaterial data as the building blocks of intellectual capital. With this comes the opportunity for organisations to relieve pressure on physical resources and pursue sustainability. This section will focus on the environmental dimension of sustainability: How do organisations integrate into their physical context? What is the role that banks can play to support society in its quest for environmental sustainability?

The UN-promoted Principles for Responsible Banking (PRBs) were launched by 132 banks from 49 countries, representing more than $47 trillion in assets (or a third of the global industry) in New York City, during the annual United Nations General Assembly, on 22 and 23 September 2019. These PRBs, oriented at combating the climate crisis mainly by banks shifting their loan books away from fossil fuels as sources of energy, were drawn out by UN officials and the representatives of 30 banks.

UN Banking Principles

It took over 18 months by the task force headed by Simone Dettling of the Geneva-based United Nations Environment Protection – Finance Initiatives (UNEP FI) to arrive at a final proposal. Illustrative of the difficulties met are that the principles have been defined as voluntary and non-binding, and that the signatories are given four years to flesh out their implementation plans.

The signatory banks commit through six principles to:

• Align their credit origination criteria with the 2015 Paris Agreement (COP-21) targets to contain and eventually reduce anthropogenic global warming.
• Set targets to increase 'positive impacts' and reduce 'negative impacts' on people and the environment.
• Work with their customers to encourage sustainable practices.
• Consult, engage and partner with relevant stakeholders to achieve society's goals.
• Implement their commitment to the Principles through developing effective governance and a corporate culture of responsible banking.
• Be transparent on how they report their progress and be accountable for outcomes.

Indeed, the agreement requires banks to consider the impact of their loans not only on their financial portfolio and loan book but also on society. These six principles have internal and external objectives. The first four focus on the external front and work towards using banks to entice their customers to adopt sustainable practices aligned with the COP-21 emissions reduction goals. On the internal front, the final two principles are about target setting and seeking to promote effective corporate governance and a culture of responsible banking (i.e., sensitivity towards stakeholders and greater transparency and accountability).

We contend that as they stand now, the PRB are a toothless tiger. They are voluntary and non-binding. What is more important, by demanding the immediate and complete banning of finance to projects that are not green, it can be inferred that they disincentivise those banks that have a large client base in extractive, fossil fuels and other high emissions industries from becoming signatories. If this is confirmed, the PRBs will be adopted by those banks with least impact on curbing of greenhouse gas (GHG) emissions.

The PRBs are specifically about banks assessing the effect of their loans on GHG emissions. The signatory banks commit to not lending money to projects that are environmentally compromising through high GHG emissions and for which the bank needs to perform an environmental impact assessment and estimation of its carbon footprint; this is not trivial. The Greenhouse Gas Protocol establishes three components of carbon footprint.

What the Protocol calls Scope One refers to direct emissions by the recipient of the loan (i.e., the company's own operation and processes).

Scope Two refers to the emissions of the utility company that supplies them with electric power (i.e., if they are based on coal generation that has a huge impact; if it is based on renewables then emissions are lower; and if it is on nuclear, lower still).

And Scope Three refers to the whole value chain, that is the chain from suppliers down to extraction of raw materials, and the emissions of consumers when they use the corporation's products. So, for example, if the recipient of the loan is a car manufacturer, it must account for emissions from the iron ore and coal miners and steel smelters, through to the emissions of the consumers when they use their cars. As can be imagined, the company requesting the loan will commit to carrying out mitigation activities throughout the whole life cycle of the project (eg, some of the relevant mitigation activities will be at the decommissioning stage of the project) and the bank is responsible that this is complied with. How does the bank keep track that those mitigation activities are executed and maintained throughout the life cycle of the project? This is not a minor issue either.

There are also difficulties in measurement and reporting. It is undeniable that corporate reporting on sustainability has increased dramatically over the last few years as shown in figure 1 however, many studies confirm that corporate reporting on sustainability is based on highly idiosyncratic ESG indicators calculated by external consultants in a relatively non-standard and often opaque way. This is corroborated by the European Banking Authority (EBA) when it calls for 'promoting internationally consistent disclosures of key metrics Green Asset Ratios to support the identification, assessment and measurement of sustainability financial risks'.

This means that sustainability reporting is unreliable for bankers and portfolio managers comparing initiatives across companies, and so is not a trustworthy tool for managing loan books or fund portfolios. There are however some promising efforts to develop standardised and transparent tools for this purpose, such as TPI that was awarded the 2020 ESG Assessment Tool of the Year at the Sustainable Investment Awards, hosted by Environmental Finance. (The Transition Pathway Initiative (TPI) is a global, asset-owner led intiative which asseses companies' preparedness for the transition to a low carbon economy.) The EBA is also looking in this direction and claims to have a 'robust, evidence-based regulatory framework'. It argues for a single EU data platform of ESG-related information to support evidence-based decision making.

Companies have relative control over Scope One emissions by changing their internal processes or by outsourcing them. They have also some control over Scope Two by changing their energy suppliers to cleaner-based ones. But they have little control over Scope Three. They need to work with their suppliers to reduce supply chain emissions and change their products (which is arguably even more difficult) to reduce consumer emissions. Very few publicly traded companies report their Scope Three emission, but the good news is that these are highly concentrated. This is corroborated by Climate Action 100+ that monitors 100 systemically important emitters that it claims account for two-thirds of annual industrial emissions plus another 60 that have leverage to drive the energy transition. ( Climate Action 100+ is an investor initiative to ensure the largest emitters of corporate GHGs take action in respect to the climate crisis.)

So, adoption of PRB has significant operational challenges that banks must overcome in order to take their role in greening the economy seriously. They must change their internal processes of credit origination to include the environmental impact assessment and GHG emissions measurement, and they must create the tools to be able to monitor emissions mitigations activities on the part of their clients, for the whole life cycle of the project.

From the analysis of six large banks (i.e., Citigroup, JP Morgan-Chase, Mitsubishi UFJ Financial Group, Industrial & Commercial Bank of China, HSBC and Wells Fargo) of which three are signatories and three are not, it is interesting that (at least up to recently, before the current Trump administration took office) there are no big differences between signatory and non-signatory banks on how they incorporate environmental awareness into their corporate narrative. All behave in a way that incorporates environmental sustainability into their strategy formulation. So, the decision to enrol or not on the PRB programme appears to be based on their loan book and how they expect it to evolve. There is little visibility of this from the outside, and the fact that the signatory banks are given four years from the time of signing to flesh out their programmes means that external effects of strategy implementation are not yet visible.

From the stakeholder management perspective, adopting the PRB creates an evident conflict of interest with the shareholders as this will have a double impact on returns on investment. On the one hand there will be a revenue loss on low-risk financing of conventional coal mining and coal-burning powerplants, and an operational cost increase due to all the organisational changes that need to be put in place to cope with environmental impact assessments and monitoring the environmental performance of the projects they finance. Only Citigroup appears to acknowledge this, but even it does not give any indication of how it is managing this conflict of interest.

Supposing all the difficulties to reduce GHG emissions can be overcome, what will be the real impact on the taking control of the climate crisis? Just to put things into perspective, anthropogenic GHG emissions amount, in total, to 55 billion CO2 equivalent tonnes per year; of these, 37 billion tonnes can be traced to fossil-fuel emissions and industrial processes (The Economist, 2020). Thus, the remaining 18 billion tonnes, or one-third of the emissions, are simply to keep 7.5 billion humans alive (i.e., breathing and eating) and therefore cannot be significantly acted upon without making ethically unpalatable decisions. So, when scientists and policymakers talk about the need to reduce emissions by whatever target is set, it must be remembered that that must be achieved from the lower base of 37 billion. Thus, for the PRB to have some tangible effects, they will need to achieve the broadest possible adhesion.

Despite the impressive number of signatory banks and the volume of assets they represent, it is notable that only three of the top ten global banks by market capitalisation have signed on. Why are the others not in? It is because they have a significant client base in the high-emissions sectors, and withdrawal from lending to them would have a large short-term impact on their financial results. However, from the figures given in the previous paragraph, the PRB initiative will only make a real contribution to the attainment of the COP-21 goals if a great majority of banks sign on, and especially those that serve the highest-emitting industrial sectors.

If the threat of abruptly losing revenue is overcome through adopting this loan portfolio management approach, banks will have to work on the cost side of adopting PRB. Their operations will be significantly more complex both in the origination of loans and in the monitoring the environmental performance of their clients' projects throughout their life cycle. They will have to count on bleeding-edge technologies to achieve this without overburdening their operational cost. There is already research into novel applications of machine learning and distributed ledger technology (e.g., blockchain) to device effective solutions for these challenges. A highly promising outcome of the analysis of the three American banks (Citigroup. JP Morgan Chase and Wells Fargo) is that up to last year they were all aligned with the COP-21 goals, even at the time that the first Trump administration had walked away from the Paris agreement. Citigroup and Wells Fargo were explicit about this, and JP Morgan Chase was aligned de facto due to the policies it had adopted. If this happened in the US, it can logically be expected that this commitment is observed in banks headquartered in countries that have adhered to the COP-21 goals. These developments notwithstanding, governments cannot rely only on using PRB as a driver for the green economy through their banks. For this initiative to have any clout, it must be supported by other factors. One is to have a robust carbon tax scheme that would make GHG overly expensive for the polluter, and thus create the incentives for companies to internalise the cost of this externality. Having this in place would contribute to improving measurement and valuation thus overcoming many of the limitations stated previously. In this way, widespread carbon taxes would unlock the power of finance and motivate financiers to steer their loan books and fund portfolios away from fossil fuels towards more environmentally friendly ones and from dirty industries towards clean ones.

Topic for Reflection: Is your bank a signatory or a non-signatory of the PRB? What has been the driver for your bank to adhere, or not, to the PRB? How involved is your bank in financing GHG emitting industries (by comparison to the six short cases described in chapter 6 of the book)? Research what are the characteristics of the main carbon-tax schemes, and give a well-founded opinion on whether it would work in your market.