GFANZ & NZBA: The Financial Industry’s Path to a Net-Zero Economy?

Among the remarkable results of the UN Climate Change Conference in Glasgow (COP26), one promises to be a game changer in the world’s struggle to overcome the climate change threat: the Glasgow Financial Alliance for Net Zero (GFANZ).

GFANZ constitutes an alliance of over 500 firms across 45 countries that control $130 trillion in assets. Its purpose, from a broad perspective, is to ensure a high degree of commitment and coordinated efforts by the financial industry on the transition to a net-zero emissions global economy. To do so, GFANZ focuses its scope of action on four core objectives: i) increasing the number of financial institutions willing to engage in net-zero initiatives; ii) encouraging the designing of ambitious and well-structured transition plans; iii) supporting cooperation between members in technical matters that aim to increase the net-zero oriented lending policies; and iv) coordinating actions between industry actors to lead the world’s economy towards the net zero goal.[1]

GFANZ will not be undertaking its crucial task alone. Instead, GFANZ will gather under its umbrella the different alliances and efforts that were immediately put into motion following COP26 and that aim to achieve the net-zero goal.[2] One such initiative is the Net-Zero Banking Alliance (NZBA), organized by the UN and its Environment Programme Finance Initiative. NZBA recognizes the crucial role that banking institutions play as financial intermediaries in the process of allocating resources within the real economy. NZBA’s members are committed to “transition all operational and attributable GHG emissions from our lending and investment portfolios to align with pathways to net-zero by mid-century, or sooner, including CO2 emissions reaching net-zero at the latest by 2050, consistent with a maximum temperature rise of 1.5°C above pre-industrial levels by 2100.”[3]

Where are we?

As of today, more than 500 financial institutions have joined GFANZ. NZBA has also seen significant growth since April 2021, going from 43 founding members to 122 banks that represent around 40% of the total global banking assets.[4]

GFANZ recently released its “Recommendations and Guidance Financial Institution Net-zero Transition Plans”, which provide committed financial institutions with the tools necessary to develop both credible and ambitious net-zero transition plans which are expected to support the real economy in the process of reducing GHG emissions. In order to successfully do so, the document identifies four main approaches by which financial institutions can support the transition: “i) financing or enabling the development and scaling of climate solutions to replace high-emitting technologies or services; ii) financing or enabling companies already aligned to a 1.5 degrees C pathway; iii) financing or enabling the transition of real-economy firms, according to robust net-zero transition plans; and iv) financing or enabling the accelerated managed phaseout of high-emitting assets.”[5] Further, the document draws the detailed framework that financial institutions should follow in the different stages of their transition plans, setting forth i) the foundations of each plan; ii) its implementation and engagement strategies; iii) the metrics for measuring the progress against the targets; and iv) the internal governance structure that shall oversee and be responsible for the success of the process as a whole.[6]

Latin America Overview

During the last 10 years, Latin America’s financial institutions have been going through a massive expansion in the design and use of financial and capital markets green products, such as green credit facilities, sustainable securities, and green derivatives. However, it was only recently and especially following COP26, that authorities stepped in and began to issue stronger net-zero-aligned regulations, aiming for the financial intermediaries to become key players in the reduction of the real economy’s GHG emissions.

The Central Bank of Brazil, for instance, issued in September 2021 a set of regulations that include an updated list of Environmental, Social, and Governance (ESG) risks that must be incorporated as part of the credit risk analysis conducted prior to disbursing any loan. The new risk assessment requirements are expected to create incentives for borrowing companies to decarbonize their business and receive lower interest rates on their credit lines.

Brazilian banks will also have to consider, among others, two additional sustainability factors in their direct lending operations: i) the portfolios’ capacity and expected reaction upon the occurrence of climate change scenarios, which means performing stress tests[7] on climate change situations; and ii) the level of their exposure, which shall be consistent with the strategies set forth by the bank’s management. The latter means that lenders will have to carry out both portfolio and company assessments, dealing with ESG risks in the same way they do with other traditional financial risks (e.g., market, liquidity, and credit).[8]

In Colombia, the Superintendency of Finance recently launched its “Green Finances and Climate Change Strategy”, whose purpose is to turn the local financial industry into a leading actor in environmental risk mitigation.[9] This strategy seeks to boost the implementation process of the most recent regulation issued by the Superintendency of Finance, (Externa Circular 018, September 22, 2021) which created the new risk management system that financial institutions are required to follow. Under this new regulation, banks are required develop credit policies for properly assessing and mitigating the environmental risks that could potentially affect the borrowers’ payment capacity.

Moreover, the Superintendency developed five main categories that will guide the accomplishment of its goals: i) Colombia’s green taxonomy for proper identification of green and sustainable assets and activities; ii) financial innovation by promoting the creation of new financial products that encourage the transfer of capital towards green and sustainable initiatives; iii) usage of data and metrics following international standards for an improved measurement of the impact of environmental risks within the financial system; iv) inclusion of ESG matters for better risk management; and v) climate change assessment and stronger oversight by the regulatory authority following a risk-based approach.[10]

In Chile, the Ministry of Finance has updated the financial system’s strategy to tackle climate change with the purpose of providing the tools required for a smooth and organized transition of the real economy towards a carbon-neutral stage by 2050. The strategy recognizes the importance of the financial industry in achieving the zero-emissions goal, given its role as a capital distribution channel throughout different economic sectors. Bearing the latter in mind, the Ministry sets forth three core objectives: i) encouraging the production of data and information for a better allocation of resources that meet the country’s climate objectives; ii) stimulating the design of new financial instruments and products that could support the development of the financial markets and support the reduction of GHG emissions; and iii) increasing the financial industry’s resilience and competitiveness by improving the risk management capacity and taking advantage of the opportunities arising from becoming a green finance leading country within the region.[11]

What Should We Expect?

It is clear that the financial industry worldwide has embarked down a path to more climate-aware banking. An all-time high number of banks have joined GFANZ and NZBA in an effort to drive the financial industry to become an active player in the transition towards a net-zero emissions real economy. However, the responsibility for performing such a crucial task cannot be discharged exclusively by the financial entities; it also requires a deep change in policies applicable to emission-intensive industries that demand high leverage levels to conduct their business (e.g. fossil fuels and mining). In other words, the lack of a proper alignment of incentives between the financial industry and the real economy could have a negative impact on the efficient allocation of capital, thus affecting both the system’s stability and the environmental purpose. The latter goal is especially important because the financial system reflects the real economy’s behavior and, in that sense, banks have a supportive (yet not a determining) role in the success of achieving the net-zero target.[12]

The transition toward a net-zero financial industry needs to be as ordered and resilient to climate-related risk as possible to avoid a major impact on the system’s stability. To date, major financial institutions’ lending exposures to emissions-intensive industries reached 60% of the banks’ on-balance sheet accounts.[13] In that vein, the Basel Committee on Banking Supervision (BCBS), recently issued a set of principles that aim for an effective management of climate-related risks by banks engaged in a net-zero transition process and provide guidelines for regulatory authorities.   BCBS recommends, for example, the implementation of capital and liquidity adequacy assessments by regulators and bank boards that take into consideration, based on banks’ business and exposure, the impact that climate-related risks may have on financial institutions’ solvency.[14]

COP 27 Insights

Recently, in the context of the 2022 United Nations Climate Change Conference held in Egypt, the UN High-Level Expert Group on the Net Zero Emissions Commitments of Non-State Entities issued a report that sets forth the roadmap for financial institutions (among others) in designing ambitious net-zero targets.  The report includes a set of 5 core principles and 10 recommendations to help states achieve the emissions goal by 2050. The principles are focused in 5 main areas: i) ambition in the immediate, medium and long-term milestones; ii) coordinated commitment of actions and investments by entities; iii) transparency in the disclosure of information; iv) science-based plans to achieve the proposed targets, as well as third-party accountability; and v) actions driven by equity and justice.[15]

Conclusion

GFANZ and NZBA constitute, to date, the financial industry’s strongest alliances with the clear objective of undertaking an active role in the process of decarbonizing the world’s economy. We have witnessed, within a short time span, in Latin America and elsewhere, the influence that these initiatives have had among major banks and regulators alike, encouraging and reflecting a deep commitment to reaching the ambitious net-zero goal. Nonetheless, the financial system will not be able to achieve the target on its own.  The net-zero milestone requires coordinated action with policymakers to i) articulate the policies required for real economy’s actors to move in the same direction in terms of emissions reduction; and ii) avoid adverse effects to the stability of financial institutions, derived from an inefficient allocation of resources within industries that do not meet environmental risk standards.

[1]GFANZ Abouts,  https://www.gfanzero.com/about/#leadership (last visited Nov. 8, 2022).

[2] Aside from NZBA, GFANZ works alongside other organizations such as the Net Zero Asset Managers initiative (NZAM), the Net-Zero Asset Owner Alliance (NZAOA), the Net Zero Financial Service Providers Alliance (NZFSPA), the Net-Zero Insurance Alliance (NZIA), the Net Zero Investment Consultants Initiative (NZICI), and the Paris Aligned Investment Initiative (PAII).

[3] NZBA Commitment Statement, April 21, 2021.

[4] Net-Zero Banking Alliance Members, https://www.unepfi.org/net-zero-banking/members/ (last visited Nov. 9, 2022).

[5] GFANZ, Recommendations and Guidance: Financial Institution Net-zero Transition Plans, (July 27, 2022), https://assets.bbhub.io/company/sites/63/2022/06/GFANZ_Recommendations-and-Guidance-on-Net-zero-Transition-Plans-for-the-Financial-Sector_June2022.pdf

[6] GFANZ, supra.

[7] Stress tests aim to measure a bank’s capacity to absorb losses derived from a financial crisis. Typically, these tests are focused on counterparty credit risk, following Basel III capital requirements and stress testing guidelines.

[8]Brazil’s banking system braces for new ESG regulation, https://www.latinfinance.com/web-articles/2021/9/brazils-banking-system-braces-for-new-esg-regulation (last visited Nov. 9, 2022).

[9] Colombian Superintendency of Finance, Road to Colombia’s Financial System Greening: Colombian Superintendency of Finance’s Green Finances and Climate Change Strategy, https://bu.com.co/sites/default/files/2022-08/Hacia%20el%20enverdecimiento%20del%20sistema%20financiero%20colombiano.pdf, August 2022.

[10] Colombian Superintendency of Finance, supra, at 21-44.

[11] Ministry of Finance, Financial Strategy in Face of Climate Change, https://greenfinancelac.org/es/recursos/novedades/ministerio-de-hacienda-de-chile-actualiza-la-estrategia-financiera-frente-al-cambio-climatico/ March 2022.

[12] Claudio Borio, Stijn Claessens and Nikola Tarashev, Finance and Climate Change Risk: Managing Expectations, https://www.bis.org/speeches/sp220607.pdf, June 8, 2022.

[13] Pablo Hernández de Cos, a resilient transition to net zero, International Economic Forum of the Americas, https://www.bis.org/speeches/sp220711.htm, 11 July 22.

[14] Basel Committee on Banking Supervision, Principles for the Effective Management and Supervision of Climate-related Financial Risks, https://www.bis.org/bcbs/publ/d532.pdf, June 2022.

[15] UN High-Level Expert Group on the Net Zero Emissions Commitments of Non-State Entities, Integrity Matters: Net Zero Commitments by Businesses, Financial Institutions, Cities and Regions, https://www.un.org/sites/un2.un.org/files/high-level_expert_group_n7b.pdf, Nov 8, 2022.