Decarbonization: What role do banks play?

Banks play a central role in the global economy, channeling trillions of dollars in capital to businesses and industries. Historically, this has included substantial financing for carbon-intensive sectors like energy, mining, and heavy industry, which are key drivers of greenhouse gas emissions.

Today, banks face the dual challenge of meeting traditional client demands while committing to global decarbonization. They can promote decarbonization by financing low-carbon initiatives, reallocating capital to low-carbon projects, and developing sustainable products such as green bonds. But the task ahead is immense.

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Financing the transition

Achieving global decarbonization will require an unprecedented reallocation of capital. Experts estimate that meeting global net-zero targets by 2050 will demand between USD 4 and 6 trillion annually. To put that in perspective, annual sustainable debt issuance in recent years has been around USD 800 billion—less than half of one percent of total global debt.

Closing this gap requires a monumental, coordinated effort from governments, investors, and banks. The transition to a low-carbon economy will be enabled by policy and regulation, investor pressure, and strategies deployed by banks themselves.

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Banks’ strategies and tools

Banks have adopted various strategies to drive decarbonization. These include green bonds, sustainability-linked bonds, and transition bonds. Banks also use ESG data and ratings to measure the sustainability credentials of their clients and are working toward greater consistency and standardization to reduce greenwashing.

Conditional financing is another tool. It allows phased divestment from high-emission clients by making continued financing conditional on credible decarbonization plans.

Managing risks and challenges

Despite progress, considerable risks remain. Banks face physical risks from climate change and transition risks from the move away from fossil fuels. This requires banks to rebalance lending portfolios, manage stranded assets, and navigate the uncertainty of emerging green technologies.

Additionally, banks must contend with capital misallocation during periods of excessive enthusiasm for ESG assets. Between 2020 and 2021, such misallocation led to an ESG asset bubble, significant losses, and a setback for the decarbonization initiative.

Looking ahead

While challenges persist, sustainable finance has shown signs of recovery, supported by improved transparency, increasingly effective tools and products, and greater regulatory clarity. Banks remain committed to providing and developing the strategies, tools, and products needed to keep decarbonization efforts on track.

Intuition Know-How, a premier digital learning solution for finance professionals, offers a series of comprehensive content on sustainable finance, covering topics such as decarbonization, ESG investing, climate risk, and much more.