The Next Step for Financial Institutions: Aligning the entire Financial Chain
A core goal of the Paris Agreement is “make finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.” Since 2015, financial institutions of all types – from development banks to asset owners and pension funds – have committed to making their portfolios ‘consistent’ with the Paris Agreement. In practice, Financial Institutions are at times approaching alignment from different points of entry: either focusing on one hand “what” or on the other hand “who” is financed. In the run-up to COP26 the Climate Action in Financial Institutions Initiative and UNEP FI have convened a group of Financial Institutions to take a step further to look at the alignment of the entire financial chain.
Understanding of the Alignment of the Entire Financial Chain
After committing to align their portfolios with the Paris Agreement, financial institutions have started by developing approaches to assess the alignment of their own portfolios. However, understanding the alignment of a portfolio requires that they look at the alignment of different “parts” of the financial chain.
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As presented in Figure 1, some institutions started with the ‘what’ or a ‘use of proceeds’ approach, focusing on the activities directly financed through project finance and other asset classes with known use of proceeds, i.e. the individual projects or business activities. This has often been the case for development banks and lenders to activities where direct use of proceeds is relatively easy to trace.
Other Financial Institutions, have focused on the “who”, or the recipient counterparties or clients to which they are extending debt or purchasing an equity share. In this case, alignment involves ascertaining whether the company or entity as a whole is aligned. This has particularly been the case of corporate lenders, institutional investors and asset owners those involved in corporate and retail lending and finance, non ‘pure player’ equity.
Finally, in some cases Financial Institution may also be assessing the alignment of its partners – such as banks they are doing syndicated lending with or involved in intermediated finance or credit lines; or whether the entities that buying their ‘green’ bonds or from whom they are securing financing from themselves are aligned.
Moving forward, many financial institutions recognize that to align they will need to look at both the “what” and “who” and connecting the dots between these approaches.
Different entry points, but many shared questions
While financial institutions may start the alignment process with different areas of focus, they are often encountering similar questions as the discover that looking at one part of the financial chain can quickly lead to other parts of the chain. Furthermore, financial institutions are often facing similar strategic and technical questions their peer financial institutions, as well as financial institutions in other parts of the financial system.
- Strategically, how can financial institutions determine when it is sufficient to look at use of proceeds level only, or also at recipients; whether this can support clients, counterparts and companies to align themselves support both improved risk management and positive climate impact; and how can Financial Institutions make engagement, avoidance, divestment, etc. successful strategies to align the financial chain. Finally, Financial Institutions are asking what can be expected from regulators on the alignment of financial chains.
- At a technical level, all Financial Institutions are asking how they can overcome technical challenges such as asset/client/counterparty level data, scenarios and ‘methodological’ questions of direct transactions? And for many, how do you address the additional layer of complexity around the alignment of intermediated transaction (onlending, equity funds, etc.) ? This often touches on the complex question of whether it is necessary to go beyond a binary ‘yes/no’ assessment of alignment? And, in turn, how to interpret a counterparty’s target, progress, etc.?
Addressing these questions through interdisciplinary and cross-sector exchanges Can accelerate the development of comprehensive approaches consistent across the financial chain.
A Group to Help Financial Institutions Go Further, Faster – Together
In the final six months in the run-up to COP26, the UNEP FI and the Climate Action in Financial Institutions Initiative, of which I4CE is the secretariat, have co-convened an “FI Group” of like-minded institutions from across the financial sector to look at how they can assess – and support – the climate-consistency or ‘alignment’ of financial chains. By partnering and enjoying the support of the Finance in Common Summit, the two initiatives and stakeholders can leverage the growing collective knowledge and emerging practice to move forward together – both further and faster.
This Financial Institution Group on the Alignment of Financial Chains aims to serve as part of the needed ‘connective tissue’ between initiatives. It will complement the conversations happening under the umbrella of the Glasgow Financial Alliance for Net Zero (GFANZ) with those occurring among the public development banks. It will connect in a voluntary manner the different parts of the financial community to:
- Facilitate cross-capitalization and knowledge sharing between leading financial institutions across the financial community on approaches for the alignment of clients and counterparts, and the critical conditions for success;
- Foster collective emulation and convergence to help overcome internal and external challenges;
- Send signals to the rest of the financial community about possible next steps on the alignment journey.
The group will look at the common question around three areas where there is a strong potential for financial institutions to learn from each other:
- WHY and WHEN should financial institutions focus on the alignment of the different parts of the financial chain (ie. who and what is financed)?
- HOW can Financial Institutions assess the alignment of different parts of financial chains (ie. overcoming challenges around assessing both what and who)?
- WHAT should Financial Institutions do with the results of alignment assessments (ie. avoidance, engagement, awareness at strategic and operational)?
With the support of the Finance in Common Summit, the informal Financial Institution group was launched during an inaugural webinar on Thursday July 1. The webinar was on opportunity to hear from leading Financial Institutions such as AFD, CDC Group, BBVA and Standard Charter Bank on why this is a key issue for Financial Institutions seeking to align – and that more work is needed moving forward. Two more webinars are planned later in the year prior to the COP in Glasgow. To move forward at pace and scale, this group will help to both raise ambition across all Financial Institutions – as well as ensure they have access to the knowledge they need to move forward.”