Banks shouldn’t drag their feet when it comes to target setting and choosing net-zero pathways. The world is moving too fast

Banks absorbing the rush of announcements coming out of the COP26 summit in Glasgow should understand this: portfolio alignment is going to become much more complex, and much more fraught.

Why? Because in order for many of the policies endorsed by governments and industry-led groups over the last two weeks to be operationalised, it is

imperative that credible, net-zero pathways be established at a highly granular level — pathways that are both science-based and sector-specific. As these are rolled out, climate-focused banks will then come under pressure to graft their net-zero portfolio alignment strategies to these pathways. Going forwards, it won’t be enough for a bank to say its financing portfolio as a whole will achieve net zero by 2050, or set decarbonisation goals that don’t drill down to the sector level. They’ll have to be able to demonstrate how each portfolio segment will get to zero emissions, and identify the sector-specific pathways being followed. All this will have to be done quickly, too, in order to avoid blowback from investors, regulators, and climate activists.

Banks do not appear to be very comfortable swimming in these waters. An incendiary story published by The Bureau of Investigative Journalism earlier this week provides a telling illustration. In short, an email seen by the Bureau from the office of HSBC chief executive and head of the Sustainable Markets Initiative’s Financial Services Taskforce (FSTF), Noel Quinn, exposed the firm’s preference to giving signatories to the Net-Zero Banking Alliance (NZBA) three years in which to set 2030 portfolio decarbonisation targets. It also showed the bank was keen to remove a list of named sectors which this first set of targets would have to cover. The final NZBA commitment suggests that HSBC (and the broader FSTF) got some of what it wanted, but not all. The agreed-on wording requires

members to set their first round of targets within 18 months of signing, with these covering “priority sectors where the bank can have the most significant impact”. Still, the details of HSBC’s maneuvering while the commitment was being negotiated infuriated climate advocacy groups.

On the one hand, this story does little but pull the curtain back on the sort of horse trading one would expect when trying to forge a collective agreement among dozens of large, complex institutions. On the other, it reveals a kind of squeamishness around target setting and net-zero pathways that does banks no favours in the court of public opinion, and a sort of caution that doesn’t make sense when one considers the current context of climate science and policymaking.

What’s also odd is that HSBC, and other large banks both in and out of the NZBA, are fairly advanced when it comes to target setting and net-zero pathways. In common with many of its peers, HSBC has used the Paris Agreement Capital Transition Assessment (PACTA) methodology to run a sector-based analysis of the transition risk in its portfolio, covering carbon-intensive industries including coal, oil and gas, and steel, details of which were included in their last Task Force on Climate-related Financial Disclosures report. In the same report, it pledged to develop metrics and indicators this year for the net zero-alignment of its financing portfolio. So why lobby for a long target-setting period and against a list of sector-specific targets in the NZBA agreement?

The Glasgow Financial Alliance for Net Zero (GFANZ), the umbrella group the NZBA belongs to, also evinces an ambivalent attitude towards net-zero pathways. Last Wednesday, as part of the COP26 ‘Finance Day’, GFANZ released a progress report which showcased its efforts to help define net-zero sectoral pathways. It said that while financial initiatives have drafted pathways for some carbon-intensive sectors, like energy and transport, they’re yet to really get to grips with others, like agriculture, forestry, and land use.

A GFANZ workstream is working on changing that. It’s already developed a draft framework for sectoral net-zero pathways as a high-level guide for institutions. Now it’s working with real economy initiatives to support the

creation of net-zero pathways in priority sectors, before expanding its efforts to embrace less carbon-intensive industries.

What’s interesting, though, is what the GFANZ workstream is not doing. According to the report, GFANZ does not plan to build its own sectoral net-zero pathways, choosing instead to support efforts that are already underway. Nor does it plan to prescribe a list of ‘approved’ sectoral pathways for members to use.

At first blush, these seem odd omissions. After all, GFANZ encompasses over 400 financial institutions. Large industry-led groups have not been shy in the past to draft their own common standards: take the

International Swaps and Derivatives Association’s Master Agreement for over-the-counter derivatives as just one important example. So why not pull together on net-zero pathways?

One obvious answer is that most banks, asset managers, and other firms are not bursting with climate scientists (yet) with the credibility to fashion sector pathways. If they went ahead with their own pathways, they’d be ripe targets for accusations of ‘greenwash’. By effectively contracting out the work of developing these pathways to industry groups, they can thus deflect accusations of ‘greenwash’ away from themselves.

A reason for not endorsing any particular methodologies, meanwhile, may be a shared concern among GFANZ members about tying their reputations to that of any specific initiative. For example, the Science-based Targets Initiative (SBTi), which published a framework for net-zero target setting in the financial sector earlier this month, had a public falling out with PACTA’s developer, The 2 Degrees Investing Initiative, in February last year over portfolio alignment. Earlier this year, SBTi was also accused of conflicts of interest and claims that its methodologies for gauging alignment are “misaligned” with the best climate science.

With this recent history, it’s easy to understand why GFANZ members may be leery of openly backing specific pathways and methodologies. They have enough reputational concerns to deal with as it is.

None of this quite explains, though, why banks like HSBC should want NZBA members to have such a long time to define portfolio targets and not have to develop targets for a set list of sectors. On the former, one possibility is that the longer the ‘grace period’, the more time there is for industry-led initiatives to develop pathways and for them to be ‘stress tested’ by the scientific and activist communities. On the latter, it could be that some banks want to choose the order in which they set targets and pathways in order to minimise the disruption to their business strategies.

After all, once a target and pathway is set, a bank has to start adjusting its portfolio for that sector. The longer a sector is kept out of the target-setting process, the longer a bank can continue with business-as-usual.

A softly-softly approach to target-setting and net-zero pathways, however, is at odds with the reality of climate science and banks’ business imperatives. From the standpoint of operational efficiency, it makes sense that firms would prefer a ‘set it and forget it’ approach to target setting — defining the sectoral pathways once after careful analysis, then following where they lead. This way, the portfolio alignment strategy can be decided on at one point in time and allowed to play out over many years, giving

relationship managers, credit officers, and senior executives a stable roadmap. Initiatives like the NZBA don’t quite allow members to take this approach, as banks are required to review and “if necessary” revise their targets every five years. Of course, determining when a change is “necessary” will likely vary from bank to bank. The most climate-credible approach, though, would see banks review and revise their targets and associated sectoral pathways much more often. After all, sector-specific pathways may have a very short shelf-life, considering the pace at which climate science is evolving, new technologies are being scaled up, and government policies are shifting. For example, a draft of the COP26 text, published Wednesday, contains a

paragraph that would push countries to revise and update their emissions-reduction plans next year, rather than in five years. If an annual cadence is adopted from this year on, businesses will also likely have to update their emissions-reduction pathways more frequently.

It also doesn’t make sense for banks to start with just a few sectors and put off net-zero pathways for others into the future. They should know that no sector operates in isolation. The climate actions banks take in relation to a business in one sector will ripple through its value chain to affect businesses in others. If a sector does not have an industry-led pathway initiative in place, a bank could use a ‘stopgap’ pathway based on that sector’s share of the current carbon budget and the annual reduction

in emissions required to bring it in line with net zero. Initiatives like the Partnership for Carbon Accounting Financials, SBTi, and One Earth Climate Model can help here.

Banks should embrace the fact that they will have to juggle numerous sector-specific pathways, and move quickly to drop outdated assumptions and embrace the freshest scientific insights. Not only would doing so keep them on the cutting-edge of climate science, it would also put them in the best position to capitalise on emerging technologies and new policies. An out-of-date sectoral pathway could, after all, bias a bank toward clients who match its ‘profile’, leading them to neglect others which may have greater ‘green’ potential in the near future.

Shifting between pathways like this should not be completely alien territory to firms, either. Banks are already well accustomed to using multiple forward-looking economic pathways to estimate their loan-loss provisions, and updating these pathways’ underlying assumptions to reflect major shifts. Indeed, the COVID-19 pandemic provided a real-world stress test of this dynamic. The macroeconomic picture shifted sharply negative almost overnight last March, brightened considerably once vaccines became widely available, and darkened again as virus variants spread rapidly in mid-2021. Each time, banks made adjustments to their pathways accordingly. 

Of course, loan-loss forecasting and climate alignment pathfinding are not quite the same thing. However, the implications of changing loan-loss assumptions and net-zero pathways should be similar. When a bank finds a certain portfolio of loans are particularly vulnerable to a particular macroeconomic scenario, they may elect to cut down their exposure or become more discerning when it comes to the type of borrowers they deal with — focusing solely on those with large cash buffers and high credit ratings, for instance. When a bank finds a certain set of clients are particularly out-of-sync with a sector-specific climate pathway, they could similarly choose to shrink the amount of balance sheet earmarked for

them, discriminate more carefully between them, or work with them to improve their climate strategy.

What’s interesting is that banks don’t hide the fact that their macroeconomic assumptions change from reporting period to reporting period. Nor are they shy about disclosing the volatility of loan-loss provisions. On earnings calls, analysts ask plenty of questions about the forward-looking economic pathways used and what they mean for the bank’s strategy. Similarly, banks shouldn’t be afraid of updating their net-zero pathways and being open about how revisions affect their lending and investing going forward — even if the strategy a new pathway

entails represents a significant shift from the one they were pursuing before. 

It’s easy to think how such a scenario could play out in relation to, say, the hydrogen industry, where understanding of the emissions impact of the various manufacturing processes has grown to a point where some projects can be identified as climate-friendly, and others as downright harmful. A bank that started out using a pathway that treats all hydrogen the same, then, and invested in hydrogen projects indiscriminately, may in future have to switch to treating ‘green’, ‘grey’, and ‘blue’ hydrogen very differently.

The hoary stereotype of banks is that they love risk but hate uncertainty. When it comes to net-zero pathways, however, uncertainty cannot be avoided. Scientists’ calculation of the remaining carbon budget will change from year to year, and it’s hard to know in which direction and by what amount. The same is true of the costs and availability of climate-friendly technologies and clients’ adaptability. Instead of taking an overly conservative approach, taking ages to choose net-zero pathways and then being loath to update them, banks should lean into the uncertainty and embrace the rapid rate of change.