By Angela SP Yap

On 28 October 2022, one of the biggest global finance-led climate-change initiatives, the Glasgow Financial Alliance for Net Zero (GFANZ), made headlines as it has quit the United Nations’ (UN) Race to Zero (RtZ) campaign. In 2021, GFANZ made it a rule that all members “must align with the RtZ criteria”. In less than a year, cracks had formed and its latest 2022 report reads that GFANZ will instead “continue to engage regularly” with RtZ and other global climate groups with a note that any guidance issued is voluntary. 

Led by former Bank of England Governor Mark Carney and backed by billionaire Michael Bloomberg, GFANZ was launched during the UN’s 26th Conference of the Parties (COP26) Summit in April 2021. At the time, GFANZ membership comprised of 160 of the world’s biggest banks and pension funds who cumulatively controlled over USD70 trillion worth of assets (currently it has over 400 members with over USD130 trillion in assets). RtZ is the net-zero standard-setting body tasked with overseeing compliance of member organisations, including GFANZ.

The alliance was historic as members of the finance coalition pledged to responsibly steward financial flows in order to accelerate the transition to net zero by 2050. This meant that the world’s biggest banks would commit themselves to transformative lending patterns and practices to nudge economies on the path to limit global warming to 1.5°C. Even then, climate experts and campaigners were sceptical.

Fallout

The latest criteria issued by RtZ, in June 2022, raises the bar and requires member organisations to phase out the future development, financing, and facilitation of fossil fuel assets, such as coal, and publish transition plans for Scope 3 emissions (indirect greenhouse gas emissions generated as a result of activities undertaken either upstream or downstream). RtZ also warns that members should not be exposed as “trying to find loopholes” to the new guidelines which come into effect from June 2023 onwards.

In response, Australia’s superannuation fund, Cbus, and Austria’s Bundespensionskasse pension fund, withdrew from the Carney-Bloomberg green alliance, stating that the data tracking and reporting requirements under RtZ compliance were too complex and excessively resource-intensive. Other global systemically important banks, including JP Morgan, Morgan Stanley, and Bank of America, said that they would leave the alliance as RtZ policies put them at risk of lawsuits and may be at odds under the existing and upcoming Securities and Exchange Commission rules. Speaking under condition of anonymity, The Globe and Mail quoted a source who said a bloc of Canadian banks also had concerns over the legal implications of RtZ’s requirement to withdraw financing from the fossil fuel industry. Even supervisory authorities have expressed concerns, with the European Central Bank noting that RtZ and similar criteria will put GFANZ member banks at risk of lawsuits if they fail to deliver on their pledges.

As impact investing and environmental, social, and governance (ESG) concerns gain ground in the international financial sector, it seems inevitable that the chasm will widen between the non-profit sector and financial services on what it takes to go green.

According to sources who spoke to FT this September, the heavyweight banks in GFANZ felt blindsided by the tougher UN climate criteria and that its legal implications had not been considered in advance by the standard-setting body.

“I am close to taking us out of these global green commitments — I’m not going to allow third parties to create legal liabilities for us and our shareholders. It is immoral and irresponsible,” said one senior executive at a US bank during internal discussions. “What if we get it wrong, make a mistake or someone lies? Then the bank can be sued, that is an unacceptable risk.” The hour-long discussion also raised how newly proposed SEC rules “could add hundreds of pages to annual reports and require a small army of extra accountants and lawyers to produce and vet the data, which…is not yet reliable or properly codified.”

Meanwhile, civil society organisations (CSOs) and climate activists are chiming ‘I told you so’. Voices such as Johan Frijns, Executive Director of BankTrack, who said: “‘GFANZ cutting ties with the UN-backed Race to Zero campaign is yet another example of how financial institutions always seem more keen on appearing to act on climate change rather than actually doing so. There is a limit to the credibility of ‘voluntary initiatives that leave it to their voluntary members to volunteer what to do’ no matter how many volunteers they have managed to bring ‘into the tent’ with extremely lenient entry requirements. Today’s announcement that GFANZ will go it alone, a week before COP27, leaves its credibility hopelessly shattered. It is high time for governments to finally step in and regulate the financial industry to comply with the Paris climate goals.’’

Such behaviour begs the question, are there adults in the room?

Because I Told You So

BankTrack’s comment that such behaviour is par for the course in banking and bankers is, in this author’s opinion, either naïve or disingenuous. Even in climate policy circles, leading minds such as Dr Peter J May, Distinguished Professor Emeritus of American Politics at the University of Washington opine that “[t]he notion that regulations should be based on achievement of specified results rather than on adherence to particular technologies or prescribed means has been widely accepted as a basis for improving social and environmental regulations. The concept of performance-based regulation has been endorsed by the Bush and Clinton administrations, by a variety of business and environmental groups providing consensus proposals for reform of environmental regulations, and by various groups recommending regulatory reforms in other areas of regulation.”

What CSOs like BankTrack are backing is a prescriptive regulatory regime, a rules-based system where requirements are granular and explicit, right down to minute system settings and reference codes. Research has found that over-regulation not only reduces the possibilities for innovation; it drives more opportunistic behaviour such as regulatory arbitrage, shadow banking, and other opaque market behaviour. It is also the reason why supervisory authorities have in recent times been applying a more goals-based approach in growing sectors such as fintech, cryptocurrency, and climate investing.

Research by Dr Christopher Decker at the University of Oxford, presented in the paper Goals-based and Rules-based Approaches to Regulation, cautions for why it is important to get the right regulatory mix:

“A rules-based approach generally involves rules that are precisely drafted, highly particularistic, and prescriptive; gives regulatees advance notice as to what actions they can and cannot engage in; and provides no or limited exceptions, and limited flexibility in any specific factual context. In contrast, a goals-based approach typically involves the setting of goals, outcomes, principles or standards, usually cast at a high level; a lack of prescription about how regulatees achieve these requirements; and requires regulatees to exercise judgment to predict what actions will achieve the regulatory objective.

“In practice, the choice of approach – goals-based regulation (GBR) or rules-based regulation (RBR) – in specific contexts can have significant consequential effects. Various assessments have associated the adoption of the RBR-type approach in a particular area with the poor performance, or even failure, of the relevant regulatory system. However, the adoption of a GBR-type approach in some areas has also been associated with regulatory problems.”

The evidence, per Dr Decker, is that “the balance of advantages to disadvantages of each approach (GBR or RBR) depends on the context in which it is applied”. Such contextual considerations include:

  • the timing of intervention and costs of each approach;
  • simplicity or complexity of the context;
  • nature of the risks regulated and potential for regulatory error;
  • information conditions;
  • degree of innovation;
  • the attitude and capabilities of regulatees;
  • communication, shared understandings, and predictability;
  • ability of regulator to adapt to an alternative approach;
  • ability to craft rules to capture the actions or activities of interest;
  • identifying and evaluating goals and outcomes; and
  • incentives to comply and the risk profile of regulatees.

The operative words being ‘balance’ and ‘context’ – both of which seem to have gone over the heads of many throughout the GFANZ-RtZ debacle.

Stuck With the Bill

You can’t insist on ordering everything on the menu, then stick someone else with the bill. That’s just bad manners. However, that is what RtZ did.

Its imposition and short phase-in period of climate standards for banks are out of step with the realities of lending – the interconnectedness of structured products, minutiae of legal agreements, system architectures, and accounting rules. Their proposed rules would likely cause a systemic default that would rupture financial stability.

As far back as September 2021, the Bank of International Settlements (BIS) warned of a build-up of green asset bubbles as the global ESG push drives up the price of eco-friendly investments. The European Securities and Markets Authority echoed the same earlier this year, adding that geopolitical tensions and inflation caused lingering concerns about green asset overvaluation and “investors should consider the risk of market corrections”.

Recent numbers also show a dip in ESG flows since global economies began reopening. The UK’s largest investment platform, Hargreaves Lansdown, said that these funds were 115% lower year-on-year this January and others such as Aviva Investors’ Chief Executive, Mark Versey, told FT that some green stocks are “frankly overpriced” and that “buying brown and helping it to become green will deliver better investment returns, and it doesn’t matter what asset class you’re talking about”.

Green is Not Risk-free

Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision and Governor of the Bank of Spain, said it best in his speech, A Resilient Transition to Net Zero, at the Conference of Montreal last July:

“The primary role of prudential regulation is to mitigate risks to banks. A resilient and healthy banking system is one that can best support households and businesses through the provision of key financial services, also during the transition to net zero. As such, prudential regulation forms part of a much broader set of tools and measures – including fiscal, technological, or legislative – when it comes to responding to climate change and the transition to net zero.

“We already have a goal and instrument when it comes to the resilience of banks, and should therefore refrain from using prudential regulation to meet other climate-related objectives (such as promoting ‘green-type’ investments). We should be setting capital requirements based on the inherent risk profile of each asset class.

“In transitioning towards net zero, the risks to banks are two-sided. While much of the focus has rightly been on exposures to ‘brown’ assets that risk becoming stranded over time, we should also remain vigilant to the risks from ‘green bubbles’.”

Remembering the Tsunami

Perhaps what will work is to reframe the narrative for banks – that climate change is not another cost to absorb, but a key factor in banks’ crisis preparedness measures.

After all, a climate-induced financial crisis is nothing new. Just ask ex-Bank of Japan (BoJ) Governor Masaaki Shirakawa, the man who battled a ‘green swan’ – extreme financially disruptive events resulting from climate-related risks – before the term was even coined by the BIS in 2020.

On 11 March 2011, a magnitude 9.1 earthquake struck off the northeast coast of Honshu, Japan, which triggered a six-minute tsunami that decimated entire towns and caused a nuclear disaster. With waves as high as 40 metres, the defensive sea walls of the Fukushima Daiichi nuclear power plant, located along the coast, collapsed. Emergency generators were knocked out by the force of the tsunami, resulting in the meltdown of its core reactors and emission of dangerous radiation. As the death toll rose in the thousands and losses in the billions, the ensuing sell-off in Japanese stocks sent the yen to an all-time high. Japan was battling a climate-triggered financial crisis.

Working with other central banks, Governor Shirakawa and his team sold as much yen as required on the foreign exchange market to stabilise the currency. On the first business day after the disaster, the BoJ provided JPY21.8 trillion in liquidity, four times larger than its largest daily liquidity provision since the Lehman Brothers crisis, ensuring that banks could keep on lending. It instructed financial institutions to accommodate the withdrawal of deposits even when depositors had lost passbooks or certificates of deposit, providing three times the usual amounts of cash to people in affected areas. The BoJ also doubled government bond purchases under its asset purchase programme to JPY10 trillion. These raced measures reassured financial markets and prevented a spill over to other global markets.

Recounting the experience just 30 days after the deadly tsunami, Shirakawa said: “In the week following the earthquake, rumours spread mainly among some foreign financial institutions that Tokyo financial markets would close. While hard to believe, there was also a groundless rumour that the Bank of Japan would move its computer centre to Osaka. Extreme anxiety can in itself induce self-propagating market reactions. Fortunately, such rumours gradually dissipated.

“If the financial and settlement systems as a whole had ceased to function normally, the adverse effects on people’s lives and economic activity probably would have been even greater. The robustness of the financial system that we have seen this time was attributable to the hard work and solidarity of the people involved after the earthquake struck. I would also like to point out that the steady efforts of those involved in normal times, such as in developing business continuity plans and carrying out street-wide disaster exercises, greatly contributed to this robustness.”

Solidarity – is it present in the global push for climate finance?

Meeting in the Middle

The word ‘adulting’ – nominated as one of the most creative words of 2016 – is a humorous way of describing the act of doing basic, grown-up stuff. Things like showing up on time, owning a problem, or taking responsibility.

Being a grown-up also means being the voice of reason. It entails asking questions such as: What signal does it send to others when the biggest among us walk away from RtZ or GFANZ? Can we hold diverse opinions and still negotiate at the table? Can we meet in the middle?

This is a crucial adulting moment for banks. Although there are no prescriptive answers, there is however, a better way forward.

Will the adults in the room please stand up.

Angela SP Yap is a multi-award-winning social entrepreneur, author, and financial columnist. She is Director and Founder of Akasaa, a boutique content development and consulting firm. An ex-strategist with Deloitte and former corporate banker, she has also worked in international development with the UNDP and as an elected governor for Amnesty International Malaysia. Angela holds a BSc (Hons) Economics.