Taking aim at transition planning? Start with strong foundations.

COP27 marked the culmination of a year’s effort for defining transition planning requirements, driven by stakeholder and societal expectations shifting from sustainability targets to action taken to achieve them. The financial sector’s attitude towards climate change has also evolved rapidly in this time, as explored in our survey of financial service executives with the Institute of International Finance. To help organisations translate targets into action the Glasgow Financial Alliance for Net Zero (GFANZ) and the UK Transition Plan Taskforce (TPT) have now created blueprint frameworks for developing and disclosing a credible transition plan.

Breaking down long term targets into meaningful interim targets is a key part of developing a transition plan, and 310 financial institutions have now set interim targets as members of GFANZ. Despite this progress, actual coverage of interim targets remains low when considering the percentage of financing activities included in the target scope. This is because setting interim targets is challenging, particularly for financial institutions.

According to GFANZ’s progress report, of the asset managers that have set interim targets only 39% of their aggregate assets under management are covered. Banks with interim targets have patchy sector coverage beyond oil and gas and power generation, and only 10% of targets apply across lending, investment, and capital market activities. Target setting guidance for the insurance sector has only recently been finalised, discussed in our insurance team’s recent blog.

In the first blog of this series we introduced our approach to transition planning – a five phased approach designed to simplify designing, implementing and disclosing a transition plan by breaking down the required activities into manageable steps. We also set out some key steps leaders could take at the outset of their transition planning journey to help set off in the right direction. This approach is designed to help condense transition planning requirements from GFANZ, TPT, the Taskforce for Climate-related Financial Disclosures (TCFD) and the International Sustainability Standards Board (ISSB), within three phases - Aim, Plan and Report, while introducing two additional phases for operational design and delivery – Structure and Deliver.

In this blog we look to dive deeper into the Aim phase of our approach, setting out three priority challenges. Tackling these will create confidence in the foundations that subsequent transition planning steps will be based on.

1) Expand the scope of your scenario analysis and emissions baselining

To develop achievable interim targets, it is essential that firms complete scenario analysis and greenhouse gas (GHG) emission baselining. Scenario analysis is challenging given uncertainty around the speed and shape of the transition, and physical shocks which are hard to model over the short, medium and long-term. Getting accurate transition and physical risk data is also a significant challenge, and often requires going out directly to third-parties to gather information.

Scenario analysis for financial services firms is used to identify, prioritise and quantify climate risk under different scenarios. The priority areas of transition and physical risk exposure identified in scenario analysis need to inform and align with the prioritisation of interim decarbonisation targets and resilience objectives. Where the TPT goes further than other frameworks is in expecting an explanation for exclusions of any risks from transition plans.

Once priority transition risk exposures have been identified, baselining exercises should determine a reference point in time against which emission reductions in the future are measured. Accurate emissions data is needed to underpin credible targets from the outset and may require direct outreach where market data products are inadequate. The TPT recognise that Scope 3 emissions are particularly difficult to measure, so have conceded firms may need to use credible estimates in some circumstances. For Scope 3 portfolio emissions, organisations should follow guidance from sector-specific net zero alliances as well as leading industry practice such as Partnership for Carbon Accounting Financials (PCAF).

TPT guidance recognises that baselining efforts should focus on material areas of emissions first, to inform target setting that expands in coverage over time. Financial institutions need to clearly delineate what emission categories and portfolio segments are included in their baseline and justify current exclusions.

2) Set interim targets informed by national and sectoral pathways

Once emissions have been baselined, transition planning guidance suggests organisations break down generic, long-term net zero targets into interim milestones more aligned to business planning horizons. GFANZ have highlighted the critical role that sectoral pathways need to play in helping organisations take this step, as well as the role of regional pathways to ensure alignment with national commitments. By aligning with these pathways institutions can ground their interim net zero targets in an understanding of how the pace, timing and mechanism of decarbonisation will vary by sector and how regional policy will shape this.

A key challenge to effective use of reference pathways is understanding their inherent complexity. Different reference pathways provide different scenarios for sectoral decarbonisation, underpinned by different data and assumptions. Where sectoral pathways can reveal what is possible, regional policy and associated pathways show what is practical for a specific country or region. Although 80+ countries have now set net zero policies or legislation providing a direction of travel, relatively few have outlined net zero pathways, and only 7 have provided sector-level detail. Even once sector and regional pathways have been published, they will need to evolve with changes in socio-economic conditions, policy environments and technological development.

Institutions will extract value from pathways if they use them in the right way. Rather than considering one pathway scenario, several should be used to guide and set a nuanced target that is in line with the organisations view on the assumptions driving pathway divergence. Engaging closely with policy makers can help institutions further inform their view of pathway selection and what is likely to materialise in reality.

3) Pursue net zero as a business strategy

Developing practical net zero strategies that are integrated within an organisation is a crucial enabler to allow an organisation to execute against a credible transition plan. However, few have demonstrated how their businesses will change as these strategies are implemented.

The impact of net zero strategies will vary across financial institutions but will likely be significant for all. Organisations need to assess alignment between business strategy and decarbonisation, and then start to identify levers that help drive both, reducing disruption and maximising synergies and opportunities.

Collaboration and engagement with all aspects of the business will be critical in developing strategies that are prioritised and practical. Executive teams will be judged on their implementation of transition plans when progress is disclosed annually as recommended by the TPT. Strong governance and monitoring processes are, therefore, essential. As highlighted in one of our previous blogs.

Conclusion

Financial institutions have an opportunity to pause and reflect on work conducted to date. Emissions baselining, target setting and strategy development are activities which organisations may think they’ve nearly completed. The new guidance for transition planning highlights the gaps that exist in these outputs as they stand and how they relate to subsequent stages of transition planning.

Before organisations can take the next step on their transition planning journey, they need to revisit and fill these gaps to ensure that they have a coordinated strategy to manage net zero and climate risk, and the links between them.

Solid foundations promote the organisational stability and cohesion needed to encourage a culture of innovation and employee engagement that can square decarbonisation actions with broader business goals.

This is the second in a series of blogs that look at practical application challenges around transition planning. We also recently published a blog focusing on the TPT framework.