In the past few years, hundreds of financial institutions have made big announcements about becoming net zero or carbon neutral by 2050. They’ve been setting targets to cut their greenhouse gas emissions as close to zero as possible and offset the remainder, usually by mid-century.

It’s an important step, because financial institutions’ exposure to the wider economy through lending, investing or underwriting across industries means that they could be more exposed to the economic impacts of climate change. They also can play a key role in financing the transition and facilitating the flow of trillions of dollars in capital needed to mitigate and adapt to climate change.

The creation of organizations such as the Glasgow Financial Alliance for Net Zero, or GFANZ — a global coalition of more than 550 financial institutions with more than $150 trillion in managed or owned assets committed to net zero by 2050 — has put the financial sector’s progress in achieving net zero goals under the spotlight. In addition, regulators are increasingly looking under the hood at financial institutions to assess their preparedness for climate-related risks.

While announcements on net zero targets have grabbed headlines, the reality is more complicated. Data collected in the 2022 S&P Global Corporate Sustainability Assessment, or CSA, indicates that while financial institutions are committing to net zero or to reducing emissions, less than a quarter of them are currently aiming to reduce emissions across their whole value chain.

The data shows that 42% of banks, financial services firms and insurers have publicly committed to reduce emissions or achieve net zero associated with Scope 1 emissions and Scope 2 emissions, out of the 785 financial institutions assessed in the CSA. Scope 1 emissions are emissions from direct operations, while Scope 2 emissions are indirect emissions primarily derived from purchased energy. However, just over 20% have pledged intermediate emission reductions or net zero targets related to their Scope 3 financed emissions, which come from the investments they make or the loans they finance.

Financial institutions have relatively low Scope 1 and Scope 2 emissions. In general they have much higher Scope 3 indirect emissions, which include the greenhouse gases emitted by businesses or projects they finance, invest in or underwrite — representing their most significant climate impact. The environmental disclosure nonprofit CDP has estimated that financial institutions’ Scope 3 emissions are 700x greater than their direct emissions.

Addressing Scope 3 is challenging for financial firms because the clients they lend to or the companies they invest in would need to measure their emissions and implement their own transition plans. And that Scope 3 calculation for financial firms’ clients is difficult to calculate, partly because it depends on accurate emissions information from suppliers. Some of those suppliers operate in countries without disclosure requirements. The lack of transparency and accountability for emissions created in corporate supply chains is a significant concern when assessing the achievability of net zero commitments and completeness of reporting against these targets. Disclosure rates for many industries are quite low, which could help explain why a small number of financial institutions are measuring Scope 3 emissions.

Why short-term targets are important

Taking on the task of measuring Scope 3 financed emissions and setting intermediate goals are fundamental steps for financial institutions to assess climate-related risks across their portfolios. Short-term targets can provide a roadmap to net zero and allow financial institutions to benchmark themselves along the way, especially if they are exposed to the most carbon-intensive sectors such as power generation, steel or aviation and transport. However, the CSA data shows that they are far from doing that. While about 20% of financial companies have set net zero targets, only 17% have set intermediate targets to help them achieve their long-term targets for financed emissions.

The urgency of reducing emissions is clear, especially in hard-to-abate sectors. Scientists say the world needs to achieve net zero emissions by 2050 to limit global warming to 1.5 degrees C, relative to preindustrial levels. But immediate progress is also needed: Scientists have projected that the path to net zero requires cutting global emissions by about 45% by the end of this decade, which means companies across all sectors need to make measurable progress on curbing emissions within the next few years.

To play a key role in reducing emissions, financial institutions need to work with their clients by identifying where the climate risks are and gathering related data. According to the European Central Bank, banks’ financed emissions often come from a small number of large counterparties, increasing their exposure to climate-related risks. Banks often use proxies to estimate exposure to carbon-heavy industries, it said. While that may help close data gaps, banks need to work more closely with clients to obtain more accurate data and information about their clients’ transition plans in order to measure their climate risk exposure going forward, the ECB said.

However, the CSA data shows that financial institutions are not yet drilling down into their balance sheets and locating the potential risks from their clients. Of the companies that report on Scope 3 financed emissions, about half are able to provide a breakdown of the data by asset class, country or sector. Most of these firms are analyzing emissions in their loan books or portfolios on a sector or industry basis. Often, financial institutions are reporting on sectors according to guidelines established by sector-specific alliances or frameworks, such as the UN-backed Principles for Responsible Banking. The UN Financial Programme Finance Initiative’s guidelines encourage banks to eventually set sector-level targets for carbon-intensive sectors.

Of the companies able to report on their Scope 3 emissions, only half of financial institutions analyze  these emissions by sector or industry, while just over 40% break them down by asset class. Just over 10% do it by geography, despite the fact that doing so can guide them in determining how to reduce their Scope 3 emissions, manage climate-related transition risks or develop climate-friendly financial products.

A changing regulatory landscape

Financial institutions are set to come under increasing pressure to assess and measure their Scope 3 financed emissions. The EU is rolling out several sustainability disclosure rules including the Sustainable Finance Disclosure Regulation, which will require investment funds to measure companies’ Scope 3 emissions, as of Jan. 1, 2023. The U.S. Securities and Exchange Commission’s proposed climate disclosure standards would require companies to report Scope 3 emissions up and down their value chains if they deem Scope 3 to be material.

Concerns over the significant risks posed by climate change to financial institutions are also prompting financial regulators and supervisors to conduct climate stress tests on their national financial systems and economies.

Since the 2008 financial crisis, regulators have used stress tests to assess how well banks can withstand hypothetical adverse scenarios, such as a sharp market downturn or an economic shock. Regulators can then better determine whether banks need to shore up capital to weather losses. Regulators are now tailoring these tests to climate change to amass key data on financial institutions’ exposure to potentially stranded assets and examine their resilience to climate risk. What makes them different from existing stress tests is that they force banks and insurers to think beyond their usual three-to-five-year business cycle and look at a 30-year horizon, considering various transition and physical risk scenarios.

Transition risk scenario analysis takes a forward-looking approach to how future policy, regulatory and technological changes as well as legal, market and reputational risks would impact a business. Physical risk scenarios look at the future impact on companies of rising sea levels or an increase in extreme weather events like hurricanes, flooding and wildfires.

Regulators are largely using scenario analysis created by the Network for Greening the Financial System, or NGFS, a group of central banks collaborating on how to tackle climate change, which has asked companies and financial institutions to report on climate risks using the disclosure recommendations of the influential Taskforce on Climate-Related Financial Disclosures. The NGFS framework includes several potential outcomes for financial firms to consider, such as a disorderly scenario in which a delayed or sudden implementation of transition policies creates high costs, and an orderly transition, in which transition policies are enacted quickly around the world with limited costs. The most severe "hot house world" scenario assumes limited action to reduce emissions, leading to significant global warming.

The European Central Bank’s first climate stress test, published in July 2022, found that around 60% of the 104 lenders that participated in the ECB exercise do not have a climate risk stress-testing framework. Most banks do not include climate risk in their credit risk models, and just 20% consider climate risk in their lending decisions, it said.

The climate stress test showed that banks suffer lower losses under an orderly transition than in a disorderly scenario. But the ECB noted that banks are not differentiating between the different long-term scenarios because they do not have adequate strategies in place, other than reducing exposure to heavily polluting industries and supporting low-carbon business. As a result, banks need to incorporate climate-related financial risks into their long-term strategies, the central bank said.

The CSA data echoes the finding of the ECB. It demonstrates that more than half of financial institutions assessed do not conduct any form of scenario analysis on their climate-related physical and transition risks. To prepare for long-term targets and incorporate potential climate impacts into long-term planning, financial institutions need to understand the potential effects of climate change on their business, particularly when exposed to carbon-intensive sectors. Climate scenario analysis can demonstrate where risks lie and set out a pathway to manage them. Data from the CSA shows that on average just over a quarter of companies conduct a climate risk assessment on their downstream financing, investing and underwriting activities.

Insurers, which are directly exposed to underwriting the financial cost of physical damage from extreme weather, have the highest rate of downstream assessment. Reinsurer Swiss Re estimated in August 2022 that global insured losses from natural catastrophes in first half of 2022 stood at $35 billion, 22% higher than the average of the last ten years. In its report, it noted that climate change was “evident in increasingly extreme weather events” such as floods in Australia and South Africa.

Financial institutions that do not act on climate risks could face supervisory action. The ECB said in November 2022 that banks were still not taking climate risks sufficiently into account and have until the end of 2024 to meet the central bank’s supervisory expectations on climate and environmental risks. It also said it had imposed “binding qualitative requirements” on more than 30 lenders in its annual supervisory review. A small number of banks have had their capital requirements raised over their inability to manage climate and environmental risks, the ECB said.

Near-term accountability in the face of long-term climate goals

While it is encouraging to see an increasing number of financial institutions committing to net zero targets, there is more work to be done on setting targets, conducting more portfolio and loan book scenario analysis and measuring their clients’ carbon emissions as a way of reducing their own carbon footprint.

To do this, financial institutions will need to address data gaps and engage with clients on transition plans. That will help them amass key data on climate change risks at counterparties and answer regulators’ questions about their risk assessment strategies. Net zero goals will remain elusive without interim targets, and banks, insurers and investment firms must demonstrate what steps they are taking to ensure near-term accountability in meeting long-term climate goals.