We explored in Part 1 of this 2-part blog post series, what are the fundamental changes in order to achieve a sustainable financial transformation, and how the banking sector must focus on shifting towards a climate-resilient banking system.
In this Part 2, we will dive into how applying a transversal change in the bank’s activity and strategy will allow a successful reinvention.
This transformation must start at an operational level, becoming part of corporate management and include:
- Integrating ESG-aligned criteria in the admission process ensures the banking portfolio is enhanced and aligned with industry-oriented environmental transition paths.
- Monitoring the inherited risks and presenting a cross-sectoral view.
- Embracing the inclusion of sustainability as a strategic axis in the entity.
A remuneration policy linked to sustainable profitability will ensure that the directive board is involved in environmental matters.
Two goals must be considered; the first is embedding an ESG vision into an organization’s operations which underlines the need to measure environmental risks, and the second is to align the portfolio towards decarbonization paths, including developing the capabilities to achieve it.
To reach the first goal, banks should study how environmental risks spread to traditional financial risks (especially credit risk). The risk of the transition is staying updated with the newest sectoral regulation and new technologies (which may impact the client’s balance sheets). Regarding the physical risk, the important thing is to correctly project risks and map exposures, using tools such as scenario analysis and climate stress testing, which focus on supporting decarbonization.
Creating a portfolio aligned with a science-based decarbonization path involves studying the financed emissions from different business sectors and understanding the relative weight of the different counterparties in each portfolio. This results in comprehending which companies have a competitive advantage with a sustainability plan and which are lagging. Therefore, this would allow the bank to define different strategies with each client to ensure the greening of the portfolio.
According to the UN, this decade is called the “Decade of Action” and “calls for accelerating sustainable solutions to all the world’s biggest challenges – ranging from poverty and gender to climate change, inequality and closing the finance gap.” Now is the time to start investing in analysis and operations that can lead us to implement fundamental, measurable changes.
Economic modeling [3] has shown that physical risks in the long term are a much more significant threat than transition risks. Although transition risks are more critical in the first decade, there is a need for action from an environmental and economic standpoint.
Finally, banks should report how financial Sustainability is part of the banking processes to illustrate results and milestones. Published information must offer reliable, accurate details regarding the potential impact of physical and transitional risks and strategic plans that display, in sustainability terms, the balance sheet and the effort deployed. KPIs included should be related to the portfolio. This transparency reinforces shareholders’ trust in the banking strategy and financial project, which is crucial for many institutional investors.
Where can banks start the sustainable transition of their portfolios?
There are five steps banks should focus on:
- Define top-management responsibilities regarding climate risk and sustainability governance. Banks, in a more advanced stage, have established a Sustainability Department, with an executive reporting directly to the CEO or a member of the Management Board, responsible for the organization’s strategic shift.
- Measure the portfolio’s alignment with the main decarbonization milestones and develop models for estimating climate-related risks. In this aspect, data is vital to understanding and propelling change. Analyzing the portfolio and applying social and climate expected paths to forward-looking modeling towards strategic decision-making would directly impact commercial and financial planning and the Risk Appetite Framework. Disclosing strategic goals is necessary, as banks must make their climate pledge public and the details of their commitments to society and the environment.
- Understand that data availability and management make developing and deploying climate scenario analysis challenging. It is a cross-organizational exercise. Hence, banks must cover the needs of all internal stakeholders when planning their data-warehouse capabilities.
Hence, banks must cover the needs of all internal stakeholders when planning their data-warehouse capabilities.
- In addition to providing analytical capabilities, banks should develop portfolio management tools to control the evolution of their balance sheet proactively. Understanding the implications, even in the long run, is crucial to making the right decisions from a climate-risk standpoint and assuring profitability and stability for the financial entity.
- Lastly, banks should adopt their underwriting and commercial processes, representing the most impactful action to drive transformation, including climate-risk considerations in underwriting policies and processes and adding the correct climate-risk premium to prices offered to clients. This might present a dilemma between seizing commercial opportunities, growing the bank’s market share, and shifting towards a more climate-resilient balance sheet, which should entail less long-term risk. For this reason, banks must strive to find a balance between short-term financial results and climate-friendly decisions.
In summary, every change will bring a new challenge, and the abrupt and quick transition will depend on regulatory decisions, market pressure, and consumer behavior. However, banks have a crucial role in how the story of reinvention of sustainable financing unfolds.
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