How lenders can help mitigate GHG emissions to reduce climate risks

How lenders can help mitigate GHG emissions to reduce climate risks

FinTech companies are redesigning our current economic systems to make them more accessible to marginalised populations and make them more responsive to unforeseen negative events. Climate FinTechs are a subset of these companies; they ensure that the environment is a key stakeholder and that it gets a seat at the table. But there are still a lot of obstacles preventing ambitious climate FinTechs from reaching their goals.

How money is designed can affect how sustainable an economy is.

Given some of these obstacles are removed in the future, this post provides a high-level overview for how banks and lenders can create systems that mitigate greenhouse gas emissions at their investment portfolio level, and encourage their borrowers to decrease their carbon footprint by rewarding purchase of low-carbon products and services. Who is responsible for removing these obstacles, so lenders can start saving the world? Citizens, governments. You, me, us. Everyone. We are responsible for where our money goes, after it leaves our bank accounts. Consider this post as complementary reading material for your next brainstorming session where your team and you discuss how to heal the world.

Traditional finance ignores negative externalities. Carbon pricing is an attempt to internalise them.

Finance is a field that is defined in terms of risks. People specialise in identifying, analysing, and managing these risks. Different types of risks — credit risk, liquidity risk, operational risk, interest rate risk, etc. — boil down to one question. What is the probability that a change in X will cause a decrease in a company’s cash inflow? But mainstream finance often forgets about negative externalities and fails to account for climate risks. Climate risks can be divided into two categories: physical risks and transition risks.

There are two types of climate risks: physical and transition risks.

Physical risks refer to questions like these: when a climate-related extreme event occurs, how will a company’s assets (physical or otherwise) be affected, and what will this mean for the company’s future cash flows? Transition risks, on the other hand, explore the following type of questions: if governments set a carbon tax or implement a carbon market, how will this policy affect the company’s future cash flows? Physical and transition risks have an inverse relationship; reducing one will increase the other. You can learn more about climate risks here.

Future Scenario #1: Lenders save the world
Future Scenario #2: Lenders don’t save the world

Carbon accounting is the first step in analysing climate risks.

One of the main obstacles that prevent ambitious climate FinTechs from reaching their goals is that products and services don’t come with kgCO2e (carbon dioxide equivalent units) labels. Companies would have to calculate these values using carbon accounting methods. There are two types of methods: attributional and consequential. In the former, boundaries are drawn around a company or a product/service. Then greenhouse gas emissions inside this boundary are calculated. In the latter, no such boundaries are drawn. As a result, system-wide changes are captured in the latter but not the former.

Understanding the nuances involved in carbon accounting is important.

For example, company X might decide to outsource manufacturing and reduce emissions within its borders but emissions will go up in company Y that manufactures for company X. Drawing boundaries in an interconnected economy is often a subjective process. Although there are standards like GHG Protocol’s Corporate Standard, different companies can implement the same standard differently. This creates ambiguities and makes comparing products/services harder. You can learn more about carbon accounting here.

Carbon markets can be one solution to our problems and they come in different flavours.

If this key obstacle is overcome, greenhouse gas emissions will decrease but how much they will decrease is uncertain. Lenders can participate in pricing the carbon, but this kind of carbon price is equivalent to a carbon tax. If we want to put a cap on greenhouse gas emissions and ensure that we don’t pass this threshold quantity, then we need a carbon market (also known as an emissions trading scheme). Carbon markets can be regulated by the Government (compliance markets) or they can be started by the private sector (voluntary markets). You can learn more about carbon markets here. Current carbon markets operate at company level. But theoretically, it is possible to create one at person level.

A carbon credit card can be thought of as a carbon market at person level.

Imagine a carbon credit card. Every person gets X amount of carbon credits or allowances (the right to emit X amount of kgCO2e) every month or year. Purchasing a product/service is equivalent to emitting the g or kg CO2e associated with that product/service. If a person buys within this limit (X), they do not have to pay extra. But if they go beyond this limit, they have to purchase extra credits. They purchase these credits from someone else who has used less credits than what they received initially. The person who saves carbon credits earns money and the person who does not save the credits spends money. Building something like this is possible because of innovations like blockchain technology where transparency and immutability are its core characteristics.

We want to leverage the power of markets to solve important socioeconomic problems.

The market is responsible for matching these buyers and sellers. Although there are no bans on any actions, carbon-intensive actions (buying carbon-intensive products/services) are costlier compared to low-carbon actions. It is also possible that in future, a carbon credit card like this will become one of the key data sources for setting interest rates on loans. This post gives an overly simplified account for a very complex problem. There are many stakeholders, each with different priorities. And there are no clear solutions.

This post was originally published on Medium by Drasti Shah.