ESG Matters: Linking real economy and financial institutions’ transition plans

Update
13.05.2024
In the May edition of ESG Matters, we discuss NGFS's report on the interaction between real economy and financial institutions’ transition plans and its relevance for both financial institutions and corporates. Our monthly Spotlight section brings you up to date with the latest developments in ESG governance, disclosure, financial regulation and litigation.

Highlight:

  • Linking real economy and financial institutions’ transition plans

    Climate transition plans are seen as a key tool for an orderly economy-wide transition and are receiving increasing attention from international standard-setters and voluntary market-led initiatives. They not only reflect where companies stand in terms of ESG impact and development, but also enable the financial system to mobilise capital and manage climate-related financial risks. In this respect, the information contained in non-financial companies’ transition plans is crucial for financial institutions.

    The Network for Greening the Financial System (NGFS) discussed the significance of the link between real economy and financial institutions’ transition plans in a report published in May 2023. The NGFS further explored this relationship in a follow-up study, resulting in the report 'Connecting Transition Plans: Financial and Non-Financial Firms' released in April 2024. The report highlights the importance for financial institutions to understand and use the information provided by non-financials in their transition plans. By analysing and using this information effectively, financial institutions can better assess climate-related risks, respond to sustainability developments and optimise the allocation of capital.

    Five challenges
    The NGFS has gathered information from financial institutions through various roundtables and questionnaires. The NGFS recognises that financial institutions face significant challenges that prevent them from making full use of the information that is or may become available. Five challenges were identified.

    • #1. Lack of standardisation - Information from non-financial companies’ transition plans is currently difficult to apply to financial institutions’ own operations due to limited data availability and issues of comparability and consistency. Many companies do not provide data because their transition plans are either non-existent or still under development. Furthermore, information from non-financial companies’ transition plans is often not comparable due to a lack of standardisation. This even applies to the carbon accounting methodology used within the same industry.
    • #2. Focus on strategy rather than stress scenarios - Non-financial companies' plans may focus primarily on business strategy and decarbonisation goals. Financial institutions would want to focus on how the company would cope with extreme stress scenarios such as floods or droughts.
    • #3. Uncertainty of execution - Forward-looking information in transition plans has a high degree of uncertainty from internal and external factors. This means that ongoing assessment of transition plans is required, leading to assessment burdens and requirements for flexible data sets and data infrastructure.
    • #4. Heterogeneity of portfolios - Information in non-financial companies’ transition plans may be difficult to aggregate and compare due to heterogeneity of financial institutions’ portfolios.
    • #5. Translation into risk assessment processes not yet fully developed - Financial institutions may not be ready to use information in non-financial companies’ transition plans for credit risk evaluation processes at this stage, because methodologies for translating climate-related factors into credit risk assessment processes are not yet fully developed.

    NGFS recommendations
    The NGFS highlights that financial institutions currently use information from their clients’ transition plans mainly to account for their own decarbonisation pathways, and only to a limited extent for risk management or portfolio management purposes. The NGFS recommends a much more extensive use of transition plans from the real economy. It has compiled a list of recommendations aimed at promoting both the development and the quality of non-financial companies' transition plans. These are addressed to financial institutions, but also to other key stakeholders.

    Financial institutions could derive more value from the transition plans of their clients and the entities in which they invest. They could increase their engagement and focus on specific elements of non-financial companies' transition plans. Not only for their own decarbonisation objectives, but also for risk management purposes. Due diligence and stress testing of these transition plans could provide valuable data to improve the robustness of risk management processes. It is also recommended that they look closely at the governance and soundness of their clients’ transition plans. Robust governance increases the likelihood that non-financial companies will follow through on their transition plans and enhances their ability to respond to stress scenarios.

    Governments, policymakers and standard-setters are also strongly encouraged to play their part. The NGFS believes that they should facilitate the alignment of transition plans by developing standardised templates for such plans. They can encourage non-financial companies to include different aspects of climate change in their transition plans, such as adaptation and biodiversity. Importantly, they should also provide clarity on the way forward for the real economy. Governments should aim to ensure policy consistence and coherence so that corporates and SMEs can allocate resources to tailored and effective transition plans. Governments could also set sectoral decarbonisation pathways. Each of these would contribute to the usefulness of transition plans for the financial sector, enabling the financial sector to allocate capital to these transition pathways and to engage with the real economy.

    Regulatory authorities are recommended to contribute to consistency and clarity on where they stand and where the financial institutions are expected to go. This could be done by providing guidance on best practices (while allowing for flexibility and individualisation - one size does not fit all). Regulators are also recommended to coordinate standards and timelines globally and across the real economy to avoid fragmentation and duplication and to reduce compliance burdens. It is important for regulators to recognise that while financial institutions may be expected to engage with their key clients and partners, their influence over the actions and operations of non-financial firms is limited. Regulatory action against financial institutions should not impede with the role of financial institutions as capital mobilisers.

    What this means for you:

    • Financial institutions need to consider whether they can make greater use of the transition plans of non-financial companies. Can they be used more extensively for risk management purposes? Are the plans mature? Is governance up to standard? Can stress scenarios be managed? Can engagement lead to stronger transition plans, more useful data and better execution? Which sectors are heavily invested in and what are the expected transition plans for these sectors? How does this translate into the prudential approach of the financial sector?
    • For corporates, it can be expected that the attention of funders to corporate transition plans will continue to increase. How well developed is the transition plan? How mature is the governance around it? Is the transition plan and the data produced useful to funders? Can engagement with financial partners lead to better planning and execution?
    • The NGFS seems to recognise that financial institutions cannot be expected to implement all recommendations immediately. Not only the heterogeneity of portfolios and the availability of data, but also the number of clients and transition plans to be digested are challenges. In addition, financial institutions and corporates cannot effectuate all recommendations without a good framework. Let’s hope with the NGFS that governments, policy makers and regulators will also do their part.

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