CitiGroup’s CEO Michael Corbat wrote last month of the “courage to walk away” from clients unwilling to tackle their carbon emissions – before going on to reaffirm his support for the fossil fuel industry, which CitiGroup has reportedly financed to the tune of $187bn since 2015.
This threat to walk away from companies not making the low-carbon transition is a powerful, but often overlooked, tool at the disposal of banks, and one that could affect real change, says Samu Slotte, Head of Sustainable Finance at Danske Bank.
The dynamics of banking make divestment far more potent for companies than if an investor exits, he argues. “If an equity investor sells, it's their problem to find a new investor to replace them; but if there's a risk that one of your banks will divest, it is the company that needs to replace that gap in their financing.”
And that might not be as easy as efficient market theory suggests, says Slotte, who describes the banking market as “fragmented”. In practice, he tells RI, “smaller and mid-sized companies do not have an abundance of banks that they can turn to for financing”. It is, instead, a more localised market, which makes divestment a “very powerful tool”. Companies with limited access to capital are more likely to be responsive to the expectations of their financiers, including those on emissions reductions.
“We don’t necessarily need thousands of banks to commit to setting Paris-aligned targets,” he tells RI. “It could be enough that the key banks in a region do it, and affect the supply curve of companies”.
Ultimately, companies are looking for predictability from their banks, Slotte continues. “Corporates hate banks that are on and off; it’s a partnership, so it's important that banks can clearly communicate their policies on climate change and say, ‘according to our assessment we would expect you to move along this trajectory, this pathway and unless that happens we might not be able to refinance you next time, we might need to exit’.”
He confesses his “surprise” that divestment in a banking context hasn’t been discussed more, but suggests it is because banks are relative newcomers to sustainable finance when compared to investors – particularly those on the equity side.
Danske Bank, he says, has increasingly started to have conversations with clients on their emissions, but admits it is still early days.
Earlier this year, the Nordic banking group committed to setting a climate target for its corporate lending portfolio in line with the goals of the Paris Agreement by 2023 as part of a raft of sustainability pledges. Once in place, Slotte tells RI that these will aid dialogue with clients around emissions – but setting them is no mean feat.
“We don’t necessarily need thousands of banks to commit to setting Paris-aligned targets,” he tells RI. “It could be enough that the key banks in a region do it, and affect the supply curve of companies”.
Danske Bank committed to the targets “without a full insight of what it will mean for its operations”, he admits, but did so because it is the “right thing to do from a long-term financial perspective and also from a climate perspective”.
In May, a few months after making the commitment, it became the first Nordic bank to sign up to the Partnership for Carbon Accounting Financials (PCAF), which Slotte said will enable it to map the emissions tied to its lending book, ahead of setting targets. He stresses the importance of globally comparability of banks’ disclosures, and believes that PCAF will become “the international standard” for carbon.
Danske Bank will map its corporate lending portfolio sector-by-sector and hopes that two large sectors will be mapped by the end of the year. Its plan is to map all sectors before setting targets, although this might change, Slotte admits, with targets potentially being set for certain sectors before others are mapped. The deadline the bank has set itself to create the targets is 2023.
Keen on taxonomies, cooler on capital requirements – thoughts on the EU’s sustainable finance work
On the EU’s work around sustainable finance, Slotte praises the creation of the green taxonomy, which passed into law earlier this year, describing it as an important step in “supervising the language used in the market”.
He echoes recent calls made by Europe’s financial regulators and many others to increase the scope of the taxonomy beyond green, though, and is especially in favour of a taxonomy of unsustainable business activities.
“I know there are critics who say it will stigmatise some sectors”, he says, “but it is clear that there are industries that need to transform, and having jointly-agreed definitions – in the same way we now have green definitions – on what they should transform away from would be a helpful thing.”
On the controversial question of whether capital requirements should be eased for ‘green’ loans – a question the European Banking Authority is currently tasked with answering – Slotte is cooler, telling RI that there needs to be strong evidence of lower risk for such assets first.
“If there is evidence that there is that there is a different risk, then that would justify different risk parameters”, he says, “but if you can't prove that then capital risk weights shouldn't be the one that we move”.
Besides, he says, access to capital isn’t currently a limiting factor for green investment and – given low interest rates – he wonders whether such changes to margins for unsustainable projects would really shift capital. “If the pricing went up 20 basis points, would that kill the project? Probably not.”
Such a move might have a “signalling effect”, he notes, but “would not be in any way a decisive factor on how capital is allocated”.
Sustainability linked loans, the importance of keeping incentives aligned
The recent ramp up of the sustainability-linked loan market is something that Slotte has mixed thoughts on. He tells RI he sees the positives of socialising the idea of “building ESG into the credit pricing”, but worries about the unintended consequences of incentives between banks and corporates being misaligned.
Sustainability-linked loans are constructed in such a way that companies are rewarded, usually with reduced interest rates, for meeting what are meant to be financially material sustainability targets.
Slotte stresses that it is “extremely important that the market develops in a direction where the sustainability KPIs [key performance indicators] are set in the correct way”.
“If we don't have financially material KPIs, you create the incentive mechanism the wrong way round. The bank would, at least theoretically, hope the company fails to meet their targets because then they get a higher margin.”
Banks have a responsibility to maintain “the same economic logic as loan pricing in general”, he says. “i.e., you get a lower margin, if you're a better credit”.
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