This blog was published on 25 November 2021.
At a glance:
- Firms have made net zero and other low-carbon commitments in order to meet their own ambitions and the expectations of their investors, employees and customers.
- In the run-up to, and over the course of COP26, there has been a marked shift in regulatory expectations in relation to net zero. Policymakers will increasingly expect firms to support the net zero transition, and the credibility of firms’ transition plans is set to come firmly within the supervisory purview.
- Risk and Compliance functions can play an essential role in supporting their firm on the journey to net zero, including by leveraging steps already being taken to meet regulatory expectations set on other aspects of sustainable finance. Moreover, having a credible net zero plan will help firms accelerate their efforts on climate risk management.
- For example, the firm’s risk management framework can be deployed to help ensure its balance sheet is managed in accordance with the net zero strategy. Risk and Compliance functions can also consider how changes being made to embed climate risk in governance, remuneration and incentives can be further enhanced to align with net zero plans and help to drive change throughout the firm.
- Similarly, steps being taken to ensure that non-financial risks, such as reputational and liability risks, are integrated into risk management frameworks will support the net zero transition – as well as reduce the firm’s liability risk and help to combat greenwashing. Risk and Compliance functions can adapt existing control frameworks to ensure that there are processes, policies and controls in place to monitor products promoted as green or sustainable across the product lifecycle.
- Furthermore, banks, insurers and investment managers have a pivotal role to play in supporting their customers, clients and counterparties on their climate ambitions and ensuring that they are brought along on the net zero journey. Risk and Compliance can help to identify conduct risks, as well as consider how transition scenarios will affect different groups in society and the implications for the firm’s social risks.
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Firms have made net zero and other low-carbon commitments on a voluntary basis in order to meet their own ambitions and the expectations of their investors, employees and customers. In the run-up to, and over the course of COP26, there has been a marked shift in policymaker and supervisory expectations in relation to the transition to net zero. Policymakers will increasingly expect firms to support the net zero transition, and the credibility of firms’ transition plans is set to come firmly within the supervisory purview.
This makes it essential that Risk and Compliance functions work closely with corporate strategy teams, business units and Finance, to ensure that there is alignment between net zero plans, climate risk management frameworks, and climate and ESG disclosures. Doing so will enhance the ability of firms to harness the opportunities of the transition to a more sustainable economy, meet their own goals, and meet the expectations of their stakeholders.
This blog looks at how Risk and Compliance functions can support the journey to net zero, including by leveraging capabilities that are already being developed to meet regulatory requirements and supervisory expectations. See our previous blog for an overview of the regulatory developments around the disclosure of transition plans.
Credible net zero plans
Under the Glasgow Financial Alliance for Net-Zero (GFANZ) [i], firms have sought to underscore the credibility of their net zero plans by committing to measure their emissions, prioritise the most greenhouse gas (GHG)-intensive sectors, and develop a decarbonisation pathway based on science-based targets. Other key areas of focus are scenario analysis, the use of carbon offsets, and performance against transition targets. Emerging standards can assist firms in these tasks, such as the SBTi, the NZBA Target Setting Protocol, the PCAF Global GHG Accounting and Reporting Standard, and the PACTA Methodology [ii].
Firms also need to have in place a credible approach to implementing the plans. Firms will need a Board-reviewed transition strategy and aligned roadmap, and a detailed and resourced plan of actions. Firms will need to be clear on what ‘net zero’ means in the context of their business, as net zero can be achieved in different ways. The transition plan will need to describe any alignment to a global temperature goal, relevant regulatory mandates, and/or sectoral decarbonisation strategies. Firms will need to be clear on any plan assumptions and uncertainties.
The credibility – and business implications – of transition plans will increasingly face supervisory and stakeholder scrutiny. There are also growing expectations that transition plans should be subject to independent review or third-party assurance. For example, this was a TCFD recommendation [iii] and the CSRD proposals include a requirement for the assurance of reported information.
See our paper on Tackling the Challenges of the Net-zero Transition for further detail on measuring financed emissions.
Actions for Risk and / or Compliance:
Financial climate risk management
Having a credible net zero plan will help firms accelerate their work on climate risk management as reducing exposures to high GHG-emitting sectors helps to reduce both climate transition risks and liability risks. It will also assist firms in reporting taxonomy-aligned investments and assets.
Once firms have made a net zero commitment and developed their transition strategy, they should then ensure that their overall business strategy and risk management framework is aligned to their transition strategy and that they manage their balance sheet accordingly. They should look at multiple time horizons to understand how their business and the wider environment will evolve and set a risk appetite consistent with their transition strategy.
The TCFD recommends that transition plans describe how the organisation intends to maximise its prioritised climate opportunities. They should also describe the supporting financial plans, budgets, and related financial targets (e.g. the amount of capital and other expenditures supporting the decarbonisation strategy), as well as the risks that the organisation faces from the transition and the assumptions, uncertainties and challenges in its execution [iv].
Scenario analysis is an important tool for banks and insurers to understand the scale of exposures to climate risk and to support them in strategic planning and meeting climate-related targets. According to TCFD guidance, firms should use scenario analysis to test the achievability of their transition plan and associated targets using multiple climate-related scenarios [v]. As corporates and financial services firms publish increased detail about their net zero transition plans, banks and insurers should ensure that they factor this information into their scenario analysis. This might also have implications for the timelines around which assets may become stranded.
Actions for Risk and / or Compliance:
Governance, culture and incentives
Firms can help to drive change by ensuring that their remuneration and other incentives are aligned with their net zero plans. For example, if firms have specific targets in relation to reducing investment, lending or underwriting with high GHG-emitting sectors, incentives for sales staff must be aligned. We are increasingly seeing firms incorporate targets aligned to climate ambitions in executive scorecards. In doing so, firms should manage the measurement and reporting accuracy of those targets closely, as they could be a source of poor behaviour.
Actions for Risk and / or Compliance:
Liability risk and greenwashing
In addition to regulators expecting firms to disclose increasing detail in relation to their net zero plans and emissions, regulators are also seeking to support the development of green products, for example, through regulatory requirements on green product disclosures, such as those under the UK’s planned SDR and the EU Sustainable Finance Disclosure Regulation.
Ensuring accurate and complete disclosures on net zero plans, emissions and green products will support the net zero transition, as well as reduce the firm’s liability risk and help to combat greenwashing.
Treatment of customers
Banks, insurers and investment managers have a pivotal role in supporting their customers, clients and counterparties on their climate ambitions. Firms can differentiate themselves in the market by bringing their customers and clients along with them on their net zero journey, for example, through products such as sustainability-linked loans.
This will involve communicating clearly with their customers on transition plans, in particular, where there may be changes to product prices or availability, such as for high GHG-emitting sectors or activities. Firms must also be clear on the risks attached to green products and the activities green financing should be used to fund.
Where firms are able to make decisions on behalf of their clients or customers, for example in relation to investment products or pensions, they will need to find a balance between taking action and ensuring consent.
Actions for Risk and / or Compliance:
Thinking about ESG holistically
Supervisors require firms to think about broader ESG risks and firms face ESG disclosure requirements. As Governments, corporates and financial services firms deliver on their net zero plans, there will be implications for different groups in society, raising social risks.
Actions for Risk:
While firms’ net zero commitments have been made on a voluntary basis, policymakers will increasingly expect firms to support the net zero transition, and the credibility of firms’ transition plans is set to come firmly within the supervisory purview. Risk and Compliance functions will be able to advise the wider firm on regulatory and supervisory expectations and guidance on net zero plans to support the transition.
Having a credible net zero plan will help firms accelerate their work on climate risk management. Risk and Compliance can work closely with corporate strategy, Finance and business teams to leverage their firm’s risk management framework in support of their firm’s net zero strategy.
The delivery of net zero plans also raises regulatory considerations for firms in terms of disclosures, the treatment of customers, and thinking about ESG holistically. Risk and Compliance can help their firm to differentiate itself in the market by supporting the development of a robust ESG data strategy and target operating model, as well as considering the wider implications on customers of the transition to a sustainable economy.
[i] The Glasgow Financial Alliance for Net-Zero is a forum which brings together the leading net-zero initiatives across the financial sector. GFANZ includes the Net-Zero Banking Alliance (NZBA), the Net-Zero Asset Owner Alliance (NZAOA), the Net-Zero Asset Manager Initiative (NZAMI), and the Net-Zero Insurance Alliance (NZIA).
[ii] The Science Based Targets Initiative, the Net Zero Banking Alliance Target Setting Protocol, the Partnership for Carbon Accounting Financials Global GHG Accounting and Reporting Standard, and the Paris Agreement Capital Transition Assessment Methodology.
[vii] The clock is ticking for banks to manage climate and environmental risk, ECB, October 2021.