RFI Foundation: Financial institutions need to identify what impact they want to have on climate, nature & Just Transition
Financial institutions looking to make progress on their climate, nature and ESG priorities have seen expectations rise from investors, regulators, customers, and other stakeholders. No longer can they just release a sustainability report with glossy photos that highlight their community involvement. Financial institutions are now expected to lay out a clear strategy and show progress on implementing it, with a Just Transition plan to mitigate any adverse social impacts that could result.
The new expectations can represent the legs of a three-legged stool which needs to be strong enough for financial institutions to stand on going forward. The legs are all linked together. The increasing strain of economic growth on planetary boundaries is forcing action on climate change and reversing nature loss. As actions scale up and the social impacts of different approaches become clearer, there is greater recognition that the transition to a more sustainable relationship with climate and nature carries with it significant social impacts along the way.
The situation has been widely described, including in three input papers for the G-20 sustainable finance working group by UNEP. This explores how voluntary frameworks for reporting nature dependency risks operate, scaling up finance for nature-based solutions, and how Just Transition considerations impact financial institution transition planning.
A major change is coming whether we like it or not; nature will dictate a new road if the current unsustainable path continues from both climate change and natural capital loss. The acute stresses that will result from reacting to the changes, rather than proactively addressing the issues, will build over time. Unlike past economic crises, where the initial shock gradually dissipated, the systemic risks will look more like a series of escalating crises, and a response that is directed in hindsight will leave a residual chronic legacy that makes it harder to address each successive crisis.
These changes will affect not only economic and financial stakeholders, but many others. They will be unprecedented. History will not be a guide in the same way that has been possible in recent decades. It will be important to set out a set of adaptable principles to support decision-making. It will not be enough to have decisions guided only by data; they will also have to be guided by a positive objective that takes into consideration a much wider range of impacts besides just financial impacts on companies, investors and financial institutions.
During a recent MIFC Leadership Council event in London, Sultan of Perak Nazrin Muizzuddin Shah highlighted that improving transparency through disclosure can be a catalyst for change, but Islamic finance should go beyond this. He specifically called out “the fulfilment of the higher social and humane objectives captured by the concept of Maqasid al-Shariah” and the need “to avert harm and to promote benefit”.
Disclosure and data are a useful part – critical in many cases – of good decision-making. However, in an uncharted future where climate and nature are driving new realities, and social impacts continue to reverberate, data will always be backward-looking. Many types of ESG, climate and nature also originate from or are impacted by complex systems, so they are difficult to gather, validate and incorporate with traditional data sources.
As they apply the new data sources, financial institutions will need to balance two key constraints inherent in the data. On the one hand, they will face mandatory requirements that stipulate specific methods for calculating the data they disclose. They will have to invest in technology to help collect, manage, analyze and report on mandated climate disclosures, which will result in single-point estimates of data such as Scope 1, 2 and 3 emissions for customer activities or similar metrics for nature loss.
These reporting requirements may not be the most relevant data points for every financial institution’s decision-making process. They are designed for consistency across reporting entities, which is important for investors who must aggregate data across a wide variety of investments. The standardized approach, especially for data about value chain emissions will largely become a compliance exercise for financial institutions to ensure they follow the standard to which they are subject, regardless of its relevance for their decision-making.
Diving into financial institutions in particular, the standardization of metrics for financed emissions will hide a lot of detail that will impact the way financial institutions respond to their asset-level financed emissions. One important type of omission is the additional information that a bank has about how its customers are responding to the transition risk related to their value-chain emissions. For reporting purposes, 1 ton of greenhouse gases (GHGs) is 1 ton of GHGs – full stop.
Three types of information will be lost if a bank limits its focus to its mandatory emissions reporting: the degree of control that a financial institution and its customers have to reduce the reported emissions; the connection between the emissions and other sources of (not reportable) risks such as through nature loss; and indirect costs associated with reducing one source of GHG emissions compared with another.
If you measure only what you can manage, this often creates a mindset that what you cannot measure will not be important to your future financial returns, which was the initial impetus for ESG in the first place! There is also an important concept involved in decision-making that goes beyond purely quantitative or immediate financial returns. Every choice will have a mixture of positive and negative implications for climate, nature or society, and reporting frameworks cannot offer guidance on this aspect of decision-making. It will be imbued with ethical consequences of choosing one way or another, or taking action versus delay.
Islamic financial institutions will start to approach the decision-making process in terms of what is permissible or not. However, this only weighs on those activities that should always be avoided. In the case of dealing with climate, nature and ESG issues, within the scope of permissible decisions, the Maqasid is used to set the objectives as a guide to what direction decisions should move in. Sultan Nazrin used the words “social and humane” to describe the key characteristics of these objectives.
Within the view of a financial institution, the objectives can be reflected through a greater understanding about how the financing a bank offers, or which is available in the market in which it operates, exists in relation to climate, nature and social or Just Transition objectives. It will be extremely rare to find anything that is completely aligned with every objective.
There will be some cases where the financial sector is working towards climate change objectives, but where there are negative social impacts. Or where social benefits are being advanced this year or next that are not sustainable because they depend on unsustainable impacts on climate and nature. Islamic finance should be able to rely on the Maqasid to help make the judgment call about what activities to undertake by pairing together the available data, the finance it can access, and an ethical perspective on the purpose of the activities in which it engages.
The wider financial sector will have undertake a similar process of putting together data, finance and an ethical perspective as it determines its own contribution to responsible finance. The pitfall facing the financial sector as a whole, apart from specifically ethically oriented institutions, is to judge the ethical impacts of their decisions without defaulting to the view that financial returns or regulatory requirements provide an equal guide.
This will not always be easy. Regulations like the European Union’s Climate Transition and Paris-Aligned Benchmarks specify benchmark index portfolio emissions reductions in quantitative terms, even though optimizing a portfolio based on past emissions can direct finance to the wrong place. This can have significant implications such as directing finance away from regions or activities that require substantial transition finance, which has hardly a chance of supporting an outcome that fairly addresses climate, nature and social objectives.
The over-reliance on data can lead financial flows astray, especially if these quantitative requirements are hard-coded into regulation. Financial institutions will always have some regulations they must follow, regardless of the outcomes they produce. In most cases, however, the regulation will not be as black-and-white and will allow for business judgment by financial institutions. The Institutional Investor Group on Climate Change (IIGCC) released guidance for investors to use asset-level Scope 3 emissions data that can illustrate the balance that financial institutions will have to strike.
The guidance provided by the IIGCC is based on market approaches to measuring the emissions footprint of companies, and through the process, aggregating asset-level (i.e., portfolio company) data into portfolio-wide estimates of “financed emissions”. This may involve using some of the same techniques employed for reporting frameworks, with all the limitations involved.
However, the IIGCC does not conclude that this data provides a source of truth to inform decision-making mechanically. By contrast, it acknowledges that “without qualitative context, in the current data landscape, taking a blanket approach to Scope 3 across an investment portfolio could risk incentivising decision-making that is not necessarily aligned with mitigation of climate change and its associated financial risks.”
What this demonstrates is that even as the climate data world has advanced by leaps and bounds in terms of coverage and standards for reporting, there is a difference between measuring the emissions in the past and mitigating them in the future. The emissions that are being measured have a cost to climate, nature, and society. The mitigation necessary to reach global climate goals will also have impacts on nature and society. Climate change mitigation is not just about reducing emissions, it is about doing so in a way that syncs with commitments to reverse nature loss and produce a Just Transition. The decision-making process of banks and investors needs to address all three objectives (climate mitigation, reversing nature loss, and a Just Transition) using information about the qualitative context behind the climate data they use, and more importantly within a decision-making process that places value on the outcomes.
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