The world is facing its largest international challenge in the history of mankind – climate change. Scientists have sounded dire warnings for the future of life on earth should temperatures continue to climb at its current trajectory – increased frequency and severity of droughts, floods, storms, heat waves and fires, with dramatic knock-on effects.
The response to this challenge has been multifaceted. Governments have sought to raise public awareness, accelerate energy transitions, incentivize green alternatives, such as electric vehicles, and introduced progressive carbon taxes to alter the economic calculus.
Public awareness has grown, with a small but increasing part of the global population actively choosing green options and paying a premium to do so. Meanwhile the corporate world is prioritizing transitionary initiatives, both out of a sense of its own self-interest — choosing to follow the trend rather than get disrupted — and a genuine sense of social responsibility.
But one of the most dramatic responses in recent years has been from the financial services sector.
What is driving the green transition in finance?
It is a mix of climate risk, investor pressure, industry action and customer demand.
Firstly, the environmental impact of climate change and the policies introduced to address it have created new risks for financial institutions. The physical effects of climate change can cause direct and indirect damage to clients’ activities, while transitionary policies — carbon taxes, technological changes and behavioral changes — risk creating stranded assets.
Financial institutions are increasingly measuring and re-evaluating those risks, and making consequent changes to their risk management practices. In many countries, banks in particular are now required to carry out stress tests at the behest of their national regulators, and to demonstrate how they are setting up or changing their processes and governance structures to manage climate risks.
Secondly, institutional investors in particular have increasingly become activist investors, redeploying funds away from high-emitting sectors and exerting their influence on the world’s largest corporations to commit to progressive changes of their own.
Thirdly, we have begun to see industry-wide action towards funding climate transition – perhaps the biggest achievement of COP26. This culminated in the creation of the Glasgow Financial Alliance for Net Zero (GFANZ), which brings together over 450 banks, asset managers, asset owners, financial service providers and insurers that collectively represent more than $130 trillion in assets under management and advice, with commitments to align their financing towards achieving global Net Zero emissions by 2050. This has risen pressure on financial institutions to make similar commitments.
Lastly, more and more companies and retail consumers are looking for ways to green their activities. For example, some have introduced green branding to existing activities, such as green auto loans to retails. Others are looking to design new products to finance new technologies that have non-traditional risk profiles, such as installation of rooftop solar arrays. This creates opportunities for financial institutions but also requires new understanding of clients’ demand and reimagining of how the bank approaches clients.
South East Asian banks slow to respond? Not from a lack of will
Others in the region – notably UOB and Maybank – have announced intentions to make portfolio alignment commitments but have yet to join the international groups. While the majority of banks in the region have created Environmental, Social, and Governance (ESG) policies and excluded certain non-green activity. They have, however, stopped short of making wholesale Net Zero commitments for their lending and investment portfolios. Additionally, regulatory stress testing and guidelines designed to increase banks’ management of climate risk is being introduced in Singapore and Malaysia, with other countries yet to follow.
The response from banks in South East Asia has undoubtedly been slower than their Western counterparts, but it is important to note that climate action in the region is complicated.
The very industries that are contributing most to climate change – Oil & Gas, Coal, Mining, Palm Oil, Agriculture, Heavy Industry and Transportation – represent the cornerstones of the regional economy. Failure to recognize and take appropriate action leaves local financial institutions at danger of holding stranded assets long after international investors have exited. However, taking action locally is complicated by the need to balance responses to climate risk with other critical development goals.
Given the tensions between the various developmental goals, there is broad acceptance that asking emerging markets to make the same cost and development sacrifices in the interests of climate transition as developed markets would be unjust. Aligning to Net Zero in Indonesia does not and should not mean the same thing as aligning to Net Zero in Western Europe.
Nonetheless, recognizing the fact has not yet led to action, and global debates are still raging as to who should bear the cost of climate transition. What is the share between public versus private finance? How much should richer developed countries that are historically responsible for many greenhouse gas emissions contribute to climate transition in the nations in which assets are located?
While these debates continue, South East Asian governments are increasing their understanding of the need to transition. Many have made aggressive national commitments to tackle climate change. Indonesia for instance has pledged to achieve net-zero emissions by 2060 or sooner. This entails peaking emissions in 2030, reducing emissions further at an annual average of 30.7 metric tons of carbon dioxide equivalent (Mton CO2e), and achieving a net sink of emissions in the forest and land use sector.
Resisting a global megatrend is after all a losing battle, especially with the introduction of international policy, such as the European Union’s carbon border tax, that can affect all exporting industries. But there are other reasons why the region should take advantage of the transition – it is rich in solar energy, has reserves of transition metals, and can domestically thrive from moving away from fossil fuels.
To put it simply, climate alignment is a business opportunity for banks. The estimated global investment needed to limit warming to 1.5C above pre-industrial levels run into the trillions annually. That will create a wealth of financing opportunities.
The winners will be financial institutions that understand the opportunities and risks, have created products and services to support their clients in the transition, and have shown a commitment level aligned to their leading clients. Since there are limited financeable climate transition opportunities at present, there is also a first mover advantage.
How can banks capture this opportunity?
As a start, there are four steps that banks should take:
- Assess the risks and manage them. Whether dictated by the regulator or not, banks should review their credit portfolios for exposure to climate risk. This involves understanding where assets are exposed to heightened physical risk; and where companies and assets are at risk of becoming stranded or distressed as a result of transition policies. Next, they should set up appropriate risk management policies, embedding them into the bank’s processes and governance structures, and price for these risks.
- Map the opportunities. Banks should work collaboratively with clients to support their climate transitions with financing and advisory services. This needs careful mapping – we recommend that corporate banks in the region consider the implications for sector strategies, as well as the products, services and client engagement models needed. Some opportunities for transition finance may also require partnerships with multilateral development banks and other sources of public funds. Setting up such partnerships early will be beneficial to banks in the region.
- Take control of the agenda by setting your own targets. The need for a just transition in emerging markets is clear, and it is now up to banks in the region to define what that means. Taking a sector-by-sector approach, and considering the economic and viability of transition, can help banks to define a viable and just transition path for their economies.
- Organize around the issues that matter. Collectively, banks in the region can help to better define a just transition for the region. This is the role that local and international banks and financial institutions should be playing, and the right collaboration model for development and private finance. That also means tackling some controversial issues, such as Palm Oil land-use change and its use as a feedstock in biodiesel. This has a far higher chance of success when organized across institutions. ASEAN level coordination is urgently needed.
The time for banks in the region to act is now. Those that do so decisively will both avoid the risks of transition and position themselves to seize the opportunities. While failure to do so could leave the region behind in a global transition.