Alex Todorovic
CEO
The Need for Data-Powered Tools in Sustainable Finance
As the global focus on sustainability intensifies, financial institutions are increasingly recognizing the importance of sustainable lending and climate risk management. The financial sector plays a pivotal role in the shift towards a low-carbon economy. By integrating carbon considerations into lending decisions, banks not only contribute to a sustainable future but also protect themselves from emerging climate risks.
Trends and Statistics in Sustainable Lending
Sustainable lending is gaining momentum, with significant capital being directed towards environmentally friendly projects. In 2023, global sustainable bond issuance reached nearly $1 trillion, with the expectation to grow past $1 trillion this year. This reflects a growing commitment from the financial sector to support green initiatives. Global trends indicate a significant shift towards funding for green initiatives, driven by the issuance of sustainability-linked bonds. Key developments include:
- Asia: The Asian Development Bank (ADB) has committed to $100 billion in climate finance by 2030 through green bonds. (1)
- China: China’s green bond issuance totaled $110.33 billion in 2023. (2)
- European Union: The EU issued €12 billion in green bonds under its NextGenerationEU fund. (3)
- Germany: Germany issued $37 billion in green bonds in 2023. (4)
- Canada: In 2022, Canada launched its Green Bond Framework and issued a $5 billion, 7.5-year green bond to help meet its 2030 emissions reduction targets and achieve net-zero emissions by 2050. (5)
Overview of Current Practices in Canada
In Canada, banks are integrating sustainability metrics into their lending criteria, yet adoption varies across institutions. The top Canadian banks have introduced green loan products and sustainability-linked loans, incentivizing borrowers to achieve specific environmental goals. However, smaller institutions and regional banks are lagging to adopt these practices, indicating room for growth and standardization. The Office of the Superintendent of Financial Institutions (OSFI) recently introduced a new guideline – Guideline B15 – to support Federally Regulated Financial Institutions (FRFIs) in developing greater resilience to climate risks. Guideline B15 announced phased requirements for risk disclosures, including measuring and reporting Scope 3 greenhouse gas (GHG) emissions starting in 2025.
Explanation of Climate Risk Factors
Climate risk encompasses two different types of risk. Physical risks include the loss of physical property and assets due to climate change and transition risks related to policy changes and market shifts. Physical risks include damage to property and infrastructure from floods, hurricanes, and wildfires, while transition risks arise from the shift to a low-carbon economy, such as changes in regulations, market preferences, and technological advancements.
How Climate Risk Affects Financial Institutions and Their Portfolios
Unmanaged climate risks can lead to asset devaluation, increased default rates, and higher insurance costs, impacting financial stability. For instance, properties in flood-prone areas may lose value, and companies failing to transition to low-carbon operations may face regulatory penalties and market exclusion. Studies have also shown that assets with higher climate impact are more susceptible to default. (6)
These risks necessitate proactive measures in financial risk management.
Measuring Portfolio Emissions to Derisk Lending Activities
- Importance of Carbon Data in Financial Portfolios
Accurate carbon data is crucial for assessing and managing the climate impact of lending portfolios. Banks need to understand the carbon footprint of their loans and investments to make informed decisions and mitigate potential risks. This data helps identify high-risk areas and opportunities for improvement.
- Methods for Accurate Carbon Footprint Calculation
Advanced analytics and verification processes ensure precise measurement of portfolio emissions. There are two methods for analyzing climate risks within a portfolio. FRFIs can measure baseline emissions with a “top-down” approach, or they can accurately measure their unique portfolio emissions with a “bottom-up” approach. A top down approach begins at a broad, general level and progresses toward more specific details, whereas a bottom-up approach starts at a detailed, specific level and aggregates upward to provide insights or inform strategies on a broader scale.
- A top-down approach to carbon emissions measurement
When an FRFI uses a top-down approach to measure emissions, they look at using industry averages and proxy data combined with minimal primary data to come up with a baseline estimate for their overall portfolio emissions. This approach does not take into account the company’s unique project, product, or material-level emissions. A top-down approach has its benefits, such as time and cost savings; however, it should only be used as a baseline measurement, as there is up to a 50% margin of error on these methods of measurement.
- A bottom-up approach to carbon emissions measurement
FRFIs can implement a bottom-up approach to emissions measurement by analyzing the project, product and material level emissions of the companies, assets or projects in their portfolio. This approach should be utilized whenever decisions are being made on the end measurement. The bottom-up approach traditionally takes more time and effort than a top-down approach, but the importance of good data in decision-making highlights the need for FRFIs to use a data-driven tool. Using a bottom-up approach can provide FRFIs with the ability to assess climate risks for loan issuance, obtain market differentiation, increase stakeholder trust and position themselves as a leader within a rapidly evolving regulatory landscape. This, altogether, will lead to increased capitalization on unique commercial opportunities.
The integration of data-powered tools in sustainable finance is not just a strategic advantage but a necessity for financial institutions navigating the complexities of climate risk. As regulations tighten and investor expectations rise, the ability to accurately measure and manage portfolio emissions becomes critical. While top-down approaches provide a useful baseline, the precision and actionable insights offered by bottom-up approaches are indispensable for informed decision-making. By leveraging advanced analytics and comprehensive carbon data, FRFIs can not only mitigate risks but also unlock new commercial opportunities, enhance stakeholder trust, and position themselves at the forefront of the transition to a low-carbon economy. The financial sector’s commitment to sustainability, supported by robust data and data-powered tools, promises a resilient, forward-thinking approach that benefits both the environment and the bottom line.
“For firms to effectively manage and reduce their emissions, they need accurate, granular, and decision-useful data. Tools and models like those Arbor is developing are key to providing firms with that information.” – David Carlin, Head of Risk, United Nations Environment Programme Finance Initiative (UNEP FI)
References:
- Asian Development Bank. (2023). Green and blue bonds newsletter 2023. Retrieved from https://www.adb.org/sites/default/files/publication/297141/adb-green-blue-bonds-newsletter-2023.pdf
- S&P Global. (2024, June 20). China’s green bond market poised for further growth as green policies ramp up. S&P Global Market Intelligence. Retrieved from https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/china-s-green-bond-market-poised-for-further-growth-as-green-policies-ramp-up-80149981
- European Commission. (n.d.). NextGenerationEU green bonds. European Commission. Retrieved from https://commission.europa.eu/strategy-and-policy/eu-budget/eu-borrower-investor-relations/nextgenerationeu-green-bonds_en
- ICE. (2023, Quarter 2). Impact bond report. ICE Insights. Retrieved from https://www.ice.com/insights/impact-bond-report-q2-2023#:~:text=Global%20issuance%20of%20green%20bonds,and%20US%2437%20billion%20respectively
- Government of Canada. (n.d.). Canada’s green bond program. Department of Finance Canada. Retrieved from https://www.canada.ca/en/department-finance/programs/financial-sector-policy/securities/debt-program/canadas-green-bond-program.html
- Lamichhane, S. (2023). Default risk and transition dynamics with carbon shocks. IMF Working Paper No. 23/174. International Monetary Fund.