Banking and plans to reduce the carbon footprint

A new legislative package is expected to be approved in 2023, the sixth sequel, to modify the banking prudential legislation (CRDVI). Undoubtedly, one of its key pieces will be the so-called carbon transition plans. The legislative proposal requires banks to prepare it and banking supervisors to review it periodically, and provides for the European Banking Authority (EBA) to develop the configuration of this new requirement through guides. Consequently, if this legislative proposal is finally adopted —something that seems probable at the current juncture—, it would be convenient to start asking ourselves certain basic questions in relation to its configuration.

Perhaps the first thing we should clarify is what is meant by carbon transition plans. Although its final definition is still not entirely clear, and this will ultimately depend on the EBA, they are being configured as annual programs or plans, approved by the boards of directors, in which the banks will assume specific objectives to reduce their footprint. short, medium and long term, with a minimum objective of achieving the alignment of the activity of the credit institution with the net neutrality of carbon that arises from the commitments of the Paris Agreement of 2015. These plans must cover the emissions derived of the direct activity of the bank (scope 1), of your electricity consumption (scope 2) and also —and more importantly— those derived from their investments and loans (scope 3). In other words, the plans must not only contemplate the activity of the bank itself, but also that of its clients. The plans must specify the measures that the bank is adopting, or will adopt in the future, to reduce that carbon footprint (changes in credit policies, in its investment criteria…). They must also include different scenarios (for example, accelerated decarbonization needs in the face of worse-than-expected climate trajectories) and the tools that would allow the bank to achieve the objectives set in the plan.

The obligatory nature of these plans will simultaneously serve two purposes. On the one hand, the plans should contribute to reducing banks’ exposure to the transition risks that climate change entails. And, on the other hand, to the banks, through the function of financial intermediation, influencing their clients (stewardship function) so that they also reduce their emissions. If banks’ decarbonization goals are contingent on those of their borrowers, banks will have powerful incentives to shift their portfolios toward lower carbon-intensive businesses and economic activities, or to pressure their clients to transition to more carbon-intensive activities. lower emissions.

Although the rationale is clear, these plans raise, in my view, a long list of unresolved questions. To mention a few: what role should banks play in decarbonization? How should decarbonization targets be set? How to ensure that they are comparable between entities?

The first dilemma is perhaps the most basic: should banks become watchdogs of the consistency of their clients’ activities with national or international decarbonization objectives? Should that be their role? In reality, this outsourcing in banking is not that different from the role that banks play with the prevention of money laundering and with surveillance in compliance with international sanctions, where in a way banks are the first line of surveillance. before the activities of its clients.

The second: how ambitious should the goals be? Given that each country has defined its own decarbonization targets (so-called nationally determined contributions or NDC), can banks simply follow the targets set by the States or should they venture further? Be careful, this is not trivial, since if a bank seeks to decarbonize faster than its own country, it could be improving its contribution to climate change mitigation, but —at the same time— it could be intensifying the transition risk for the whole of its economy, by effectively reducing the time that its customers have to adapt to the new rules of the game of a decarbonised economy. And what about banks with a presence in several countries? We all know that not all countries have been equally ambitious in their commitments.

Perhaps the elephant in the room is the third and last of the issues that we are raising today, the well-known and disputed credibility and comparability of information on emissions. There is no doubt that great efforts are being made at all levels in order to improve the quality of the information, but there are still major limitations —for example, and in particular, in the information of the scope 3 on the emissions of the clients themselves. As a result of these improvements, it is foreseeable that the new techniques will make it possible to move towards a customer emissions estimation approach based on their physical activities (and not on financial information, as is currently generally measured), and there is no evidence that these two approaches will reach the same conclusions. Paradoxically, and despite all the efforts that a bank may have made to reduce the carbon footprint of its portfolios, the intensity of its footprint could be increased simply because the way of measuring it has changed (base effect). In short, improvements in emission measurement techniques may result in a lack of comparability not only between entities, but also between the emissions of the same entity at different times.

In short, there are still many questions and few answers. But time is running out.