How Banks and Green Finance are Helping Address Climate Change

Finance is crucial to efforts to tackle climate change, with an estimated USD200 trillion-odd of investment needed for the world to reach net zero emissions by 2050. The banking industry is especially well positioned to influence the transition to a low-carbon economy, as its direct financing of companies means it has control over who does and doesn’t receive capital.

There are signs that the global focus on decarbonization is having an impact on the way banks do business. We’re seeing a tightening of criteria around lending to energy companies and other high-carbon industries, banks advising on transition initiatives, growth in funding for renewables and other green technology, and more banks entering into climate finance partnerships with governments, development institutions and other investors. Lenders have also reportedly been busy recruiting talent from environmental non-profit groups.

Let’s take a detailed look at the areas where banks are focusing their efforts.

Funding the construction of renewable energy projects is arguably the most obvious and direct method for banks to help drive the low-carbon transition.

Many banks offer green loans to support projects with a clear environmental benefit. Competition for clean energy assets is high, so these instruments may come with preferential terms for borrowers – especially if the lenders are working towards their own targets. 

Because bank lending is largely a private market, these instruments are typically self-certified based on the intended use of proceeds. Global industry bodies – notably the International Capital Market Association, the Loan Syndications and Trading Association in the US, the UK-based Loan Market Association and the Asia Pacific Loan Market Association – have aligned on a framework of Green Loan Principles to promote standardization around disclosure and the need for external verification, among other things.

The transition finance market is certainly growing. Green, social, sustainability, sustainability-linked and transition bonds (GSS+) outstanding reached a combined USD4.2 trillion as of the end of June 2023, with green bonds making up for the lion’s share, according to Climate Bonds Initiative data (see chart below).

But there is still debate around whether projects are “green” enough to qualify for green finance. Some countries exclude nuclear power, while until 2020 China’s green financing guidelines allowed funding for some coal-fired power projects. 

As a 2021 CFA Institute paper on green bonds says: “Green bonds are one instrument that helps achieve the goal of a low-carbon world, not a silver bullet for ensuring sustainability.”

Certainly, non-profit groups argue that banks are falling short of what’s needed. Of the USD2.5 trillion in loans and bond underwriting for energy activities that 60 major banks provided to 377 leading energy companies, just USD178 billion, or 7%, went into clean energy activities, found a study published in January 2023.

This being said, there is evidence that the tide is starting to turn. The five banking giants in the FTSE 100 lent USD35.7 billion to fossil fuel companies in 2022, down from USD51.6 billion in 2021, according to non-profit the Rainforest Action Network.

Numerous lenders have committed to phasing out financing coal projects, while some are going further. HSBC said in December 2022 it would no longer directly finance new oil and gas fields, while BNP Paribas made a similar pledge in May this year.

While green finance – including loans, bonds, convertible bonds, letters of credit, derivatives and other instruments – aims to provide capital for climate-aligned projects, banks have also recognized the need to help carbon-intensive companies on their transition. 

Sustainability-linked loans and bonds have become a popular way of incentivizing companies to make their operations more sustainable, including through emissions reduction. These instruments are not tied to a specific use of proceeds, so can be used by borrowers who do not already have green assets. In a typical structure, a lender may offer a lower interest margin if the borrower hits certain key performance indicators (KPIs), such as a reduction in energy usage. 

Again, voluntary frameworks call for these KPIs to be robust and ambitious, with external verifications where possible.

Critics say these instruments allow banks to continue lending to carbon-intensive companies instead of divesting, and regulators including the UK’s Financial Conduct Authority have voiced concerns over the potential for conflicts of interest.

However, it is clear that lenders are stepping up their engagement with corporate and institutional clients and encouraging them to commit to credible transition plans, if they haven’t already. ING, for example, has devised pathways to net zero emissions for the nine sectors in its loan book most responsible for climate change and reports on its progress and targets on climate alignment. Others, such as BNP Paribas and Deutsche Bank, are making similar moves.

While traditional lending activity, via standard bonds and loans, is banks’ key method of driving decarbonization, more niche areas are also gaining importance. The likes of leveraged finance, trade finance and treasury management have been later to the ESG game, but that is changing, as banks and borrowers recognize the need for action.

Leveraged finance – whereby companies, typically private equity firms, take on debt to finance expansion or acquisitions – had been slow to integrate ESG standards. That changed in 2021, when the volume of European ESG-linked leverage finance deals shot up and sustainability features started increasingly being incorporated into leveraged loan agreements.

Banks are seeing an opportunity for a market that was typically very opaque to be more transparent. Consequently companies that don’t report or integrate ESG into their financing arrangements may find funding options drying up.

Bankers in trade finance, meanwhile, are prioritizing ESG and some are focusing on offering favorable rates based on ESG scoring criteria to drive ESG in transactions, found a survey published in March by supply chain finance platform Demica. But it’s still early days: some three-quarters of respondents said they did not use ESG rating services when evaluating or structuring transactions.

The impact of sustainability on treasury management is perhaps even more nascent. Some banks feel that the treasury department can contribute to a company’s ESG goals by aligning its strategy with them. For instance, treasurers could set minimum ESG standards for doing business with counterparties, including banks, vendors and others. They could also automate more processes, consider digital tokens for more efficient transactions and audit internal processes to see where waste and costs can be reduced.

But banks’ corporate clients may need further convincing. According to the PwC 2023 Global Treasury Survey, 83% of respondents said they considered sustainability in their treasury decision-making, but only 16% had a defined policy in place to address it. What’s more, only 3% indicated it was an important selection data point when selecting cash management banks.

Blended finance – the use of public sources of capital to attract private investment in developing countries – is a small but growing area of climate finance. It has long been touted as a suitable tool for helping with the energy transition, and more initiatives are emerging with the backing of large banks. 

Late last year, for example, various governments, including the EU and US, launched Just Energy Transition Partnerships to mobilize up to USD15.5 billion in Vietnam and USD20 billion in Indonesia. The aim is for the private sector to mobilize half the capital, and various major banks are involved through the Glasgow Financial Alliance for Net Zero (GFANZ), including Bank of America, Citi, Deutsche Bank, HSBC, Macquarie, MUFG and Standard Chartered.

Banks and other finance providers are in a position to support companies seeking to tackle climate change, both through financing decarbonization projects and influencing corporate behavior. 

As policymakers, regulators and consumers push for more action on climate, the role of banks in allocating capital for the transition will come into ever-sharper focus. 

 

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