Because of the central role that banks play in our society and economy, reputational risk arguably weighs heavier in the banking sector than in other industries. Data breaches, fraud scandals, lawsuits—these can all greatly damage a bank’s reputation. But with the rise of environmental awareness, we believe investors should also closely monitor financed greenhouse gas (GHG) emissions when assessing reputational risk.

What’s clear is that a bank’s carbon footprint goes beyond its operations and extends to its loans and investments. Many initiatives have been launched to accelerate banks’ efforts to reduce global financed GHG emissions, with the Net-Zero Banking Alliance (NZBA) being the most influential. However, while commitments abound—with more than 100 banks having joined the NZBA in just over a year—only a few banks are actually on a path to meet their commitments. For investors, commitments, pledges, and grandiose statements don’t really matter if banks aren’t taking concrete actions. In other words, we believe that what’s important from a reputational risk standpoint is to analyze whether banks are progressing toward their net-zero commitments.

Banks should be ready to take action by now

Achieving net zero is widely considered critical to combating climate change and limiting the temperature rise of our planet to less than 2˚C, but the reality is that fossil fuels and other carbon-intensive industries are still vital to the world’s economy; for example, fossil fuels still generate more than 60% of global electricity production, while petroleum products account for about 90% of the total U.S. transportation sector energy use.

So although renewable energy is growing relatively quickly, and electric vehicle sales are gaining momentum, the damage to the world’s economy would be too great should banks just stop financing and supporting fossil fuel companies and their projects today. Moreover, recent geopolitical events in Europe and high inflation further stress the importance of the existing trade-offs between energy affordability, security, and sustainability—and a radical shift away from fossil fuels by current lenders could result in other financial institutions with much lower sustainability standards filling the void to help keep energy sources available and affordable.

Shareholders are well aware of the potential impact of immediate fossil fuel divestment: During the 2022 proxy season, nearly 90% of the shareholders at three major U.S. banks voted against proposals that would have required the banks to stop investments in new fossil fuel projects by the end of the year. That doesn’t change the fact that environmental concerns are important for shareholders, but we believe that what investors want to see in the current transition toward reaching net zero is constant progress more than drastic changes in banks’ financing activities; that is, a soft landing for banks, carbon-intensive borrowers, and, ultimately, for the world’s economy.

“In keeping with its perspective on client engagement, the Net-Zero Banking Alliance does not advocate for immediate divestment of existing [fossil fuel] positions.”

—The Net-Zero Bank Alliance

In any case, decarbonizing, or cleaning, a loan book can’t be done overnight; developing and implementing a sustainable strategy that will effectively contribute to net-zero targets without complete divestment requires significant resources and time. We therefore wouldn’t necessarily expect a decrease in fossil fuel financing since the Paris Agreement entered into force in 2016. Indeed, the dollar amount of fossil fuel financing from the world’s 60 largest banks in 2021 was essentially flat compared against five years ago—and without the COVID-19 pandemic, which caused a drop in oil and gas demand and investments, fossil fuel financing likely would have increased even more relative to 2016.

In our opinion, over the last few years, even the banks that are putting increased efforts toward their environmental practices have concentrated more on collecting and analyzing data, setting targets, and allocating resources than on taking concrete actions. However, we also believe that their grace period is coming to an end, and banks’ actions—or inaction—will be judged more harshly going forward, making financed GHG emissions an increasingly large reputational risk.

Monitoring financed GHG emissions is key

Reputational risk is a complex element to factor into a company’s fundamental analysis, as it’s broad, can be subjective, and can be affected in different ways. For financed GHG emissions, we believe there are two metrics that are crucial to monitor from that perspective.

1 Total financed GHG emissions—Both the total amount of financed GHG emissions and pathways toward meeting net-zero targets are important to track. We believe banks with carbon-heavy loan books will face additional pressure to act more swiftly, while constant and meaningful progress will most likely be rewarded.

2 Quality of data disclosed—PCAF developed a methodology that defines different levels of data quality. In a perfect world, we wouldn’t need quality scores and borrowers would have their GHG emissions audited and sent directly to their lender. However, there’s no regulation requiring them to do so, and it’s extremely difficult for banks to collect GHG emissions data from all the companies and projects they finance.

Therefore, PCAF quality scores of 1 or 2 (GHG emissions calculated by the company directly) are extremely rare, and banks have to use sector- and region-specific averages and other assumptions and proxy data to fill the gaps, muddying the data. A score of 5 suggests that disclosed data isn’t reliable, while omitting to disclose quality scores points to a lack of transparency.

While PCAF plays an integral role in improving banks’ disclosure practices, we believe that disclosure inconsistency is still the main challenge investors face when monitoring financed GHG emissions. Although we expect the situation to improve in the coming years, the fact that there are many discrepancies in how banks disclose their financed GHG emissions makes comparisons between them virtually impossible. 

Case in point, we analyzed 2021 disclosures from thirteen PCAF signatories that are among the largest banks in the world, and only four of them disclosed total GHG emissions. Moreover, some banks included committed credit lines (vs. drawn amounts only), some used units of production as denominators (vs. dollar amounts of the loans), and some included scope 3 emissions (vs. scope 1 and scope 2 only). Sector definitions can also differ significantly from one bank to another.

Out of the thirteen banks we analyzed, only seven—which we named Bank A through Bank G—provided numbers for the key energy sector, and even among these seven banks, hardly any conclusions can be drawn due to many gaps and no uniformity in the data provided. Bank A and Bank G, for example, both disclosed their scope 1, scope 2, and scope 3 emission intensity based on drawn amounts and units produced. However, even though 68gCO₂/MJ is twice the number disclosed by Bank A, we can’t conclude that Bank G’s energy loan book is more carbon intensive than Bank A’s, as they don’t use the same definition of the energy sector.

The fact that there’s currently a lack of uniformity in the financed GHG emissions disclosed by banks means that the impact of financed GHG emissions on banks’ reputational risk is still limited, as it’s difficult for investors to separate the environmental leaders from the laggards.

However, while some banks may get away with inferior sustainable lending practices for the moment, we believe that, eventually, disclosed data will become more standardized, allowing investors to make better-informed decisions with regard to financed GHG emissions and reputational risk.

Investors have a role to play

PCAF is an industry-led initiative, which means that its signatories already work together to develop a more harmonized accounting approach to financed GHG emissions, and improvements should naturally be made by banks over the short term. Regulators are also requiring more comprehensive disclosures: The SEC recently proposed that U.S. financial institutions’ climate disclosures include financed GHG emissions and the methodology used, while recommending the use of the PCAF Standard in its statement.

However, to reach disclosure standardization that will ultimately help investors in their decisions, we believe that active ownership has a crucial role to play as well. Shareholders joining the conversation sooner than later and using their unique position to engage with and positively influence banks in their disclosure practices can be a major boon. For example, in April 2020, we engaged with one of the banks in our portfolio and asked them to seek ways to quantify the bank’s financed GHG emissions and to become a leader in this area. Later that year, the bank became the first in its region to publish a climate action plan and to join PCAF and the NZBA.

For financed GHG emissions, active ownership can touch on various disclosure aspects, as each investor’s situation is different, but we believe there are potential disclosure improvements that investors would benefit from. These include:

• Sector definitions—Sector definitions should be standardized and more detailed. Currently, some banks combine power generation with utilities, while others present only power generation. Similarly, pipelines and refining aren’t always included in the energy sector, making comparisons difficult.
• Scope—Banks should report both scope 1 and scope 2, as well as scope 3 when possible. For example, in the power sector, some banks only disclose scope 1, while others disclose scope 1 and scope 2 combined, making it impossible to compare one with the other. For the energy sector, scope 3 should be reported.
• Geography—Some banks report their financed GHG emissions for their overall loan book, while others focus on a specific geographic location. Banks should cover their entire loan book and provide a geographic breakdown of the emissions, when relevant.
• Type of loan—Some banks report financed GHG emissions on outstanding loans, while others also include committed credit lines. Best practice would be to disclose both numbers, which is what some of them already do.
• Units—Some banks report financed GHG emissions on a per kWh basis or TJ basis, while others report on a dollar-of-loan basis. While the best practice would be to present both, reporting on a dollar-of-loan basis is crucial to making comparisons across industries possible.

Active ownership requires research and diligence from investors, but we believe it will result in better financed emissions disclosure over the long term, allowing investors to clearly separate climate-focused leaders from laggers. Active ownership is also considered one of the most effective approaches to reduce risks, especially reputational risk, as high-quality dialogues with holding companies can help drive corporate practices to new heights.

Banks better start delivering

While banks, as a group, have yet to show significant progress toward their net-zero targets, the financial impact has been limited so far. In our opinion, investors haven’t penalized banks with carbon-intensive loan books mainly because they can’t—current disclosed data isn’t consistent and reliable enough to make investment decisions. However, we believe that pressure will continue to mount for banks to reduce financed GHG emissions, and as investors get access to better data, scrutiny and the impact on reputational risk will increase.

Disclosing financed GHG emissions is complex, and we’ll continue to engage with them and promote initiatives such as PCAF to help improve disclosures and transparency—while avoiding investments in stubborn banks with inferior sustainable lending practices. Therefore, when we ultimately reach a level of disclosure standardization sufficient for investors to factor financed GHG emissions into their reputational risk analysis and their investment decisions, we’re hopeful that our bank holdings will be rewarded thanks to the behind-the-scenes collaborative work that’s being done today.