VIEWPOINT

2024

LENDING FOR AS U S TA I N A B L E F U T U R E
3 strategies to enable carbon& impact-driven lending decisions
AUTHORSIn today’s rapidly evolving financial landscape, there
is an undeniable imperative for financial institutions
to take a leading role in advancing a low-carbon

Joseph Huang
Becky Choueconomy. In this Viewpoint, we delve into the pivotal

Darwin Hsiao

role of financial institutions, from realigning lending

Wilson Liu

policies to integrating climate risk assessments. We
explore the challenges and strategies essential forbanks to reduce carbon emissions and ensure theirresilience and prosperity in this transformative era.

ARTHUR D. LITTLE

VIEWPOINTNAVIGATING THE
CHALLENGES OF
CARBON REDUC TION

This shift in the banking industry marks aFinancial institutions are under mounting

sustainable future while maintaining financialpressure to take a proactive role in decarbonizing

stability. As banks navigate these uncharted

their portfolios and actively facilitating thewaters, a combination of innovative strategies

broader carbon transition within the economy.

and risk assessment methodologies will be key toIn response to the objectives outlined in thefulfilling the dual objectives of reducing financed

Paris Agreement, numerous banks have madeemissions and maintaining business profitability.

significant moment, highlighting both thegrowing awareness of climate-related risks
and the industry’s dedication to fostering apublic commitments in recent years to reduce
their financed emissions, which are generated
when they do business with carbon-emitting
companies. However, the practical steps to3 S TR ATEGIES FOR CARBON DRIVEN LENDING DECISIONSrealize these carbon-reduction targets represent

A bank’s lending operations can apply a dual-

a common and intricate challenge, particularly

dimension matrix approach to integratefrom a lending perspective.

climate risk assessment into the existing risk
management framework during the lending

One noteworthy aspect of this challenge

process (see Figure 1). The approach essentiallyis the need to expand upon traditional risk
assessment practices. Banks are increasingly
required to broaden their assessment criteria toinclude a thorough evaluation of their clients’climate-related risks and sustainability. This

incorporates a modicum of climate risk intobanks’ existing lending evaluation metrics andallows banks to further segment clients to makemore informed lending decisions.

comprehensive evaluation framework is vital for

Various carbon-related evaluation metrics

banks to not only achieve their carbon-reduction

come into relevance when reviewing clients orgoals but also to support the broader aim of acases, including the client’s industry and carbon

sustainable, low-carbon economy.

emissions. In our view, banks navigating thesemetrics
consider threerisk
key strategies
ure 1. The dual-dimension matrix approach
tomustclimateto make a sound climate and sustainability
essment
assessment:

Figure 1. The dual-dimension matrix approach to climate risk assessment
Low

Carbon-related
metricsLow

High
ILLUSTRATIVEIIIIIIHighI

Client segment I — Low risk

II

Client segment II — Medium risk

III

Client segment III — High risk

Existing lending metrics
Source: Arthur D. Little

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ARTHUR D. LITTLE

VIEWPOINT

1. Develop financed emissions-based
evaluations by quantifying and utilizing
financed emissions data in evaluation
processes
2. Leverage internal carbon pricing by
integrating it within the bank’s internal risk
models and decision-making processes.
3. Play an active role in the client’s transition
process by collaborating to facilitate their

ABSOLUTE EMISSIONSSERVE AS THE
F O U N D AT I O N A L
BASELINE FOR
C L I M AT E - A C T I O N
ALIGNMENT WITH
THE OBJECTIVES OFT H E PA R I S A G R E E M E N T

transition toward a more sustainable path.
1. Develop financed emission-based

During the lending-evaluation process, clients’evaluations

carbon emissions become a vital metric within

For financial institutions, the practice ofconducting Scope 3 financed emission
accounting serves as a foundational pillar forevaluating climate risk within lending processes.
At its core, measuring the financed emissionsof a portfolio has a pivotal role, providing thefoundation upon which financial institutions
can conduct scenario analyses, establish clear
targets, inform strategic decision-making,and transparently report their progress. These
interconnected elements collectively assume
a central position in aligning portfolios withdecarbonization objectives.

the dual-dimension matrix approach. Uponthe completion of carbon accounting, banks
can utilize the financed emission data, in bothabsolute and normalized terms, together
with existing lending metrics to drive lending
decisions. In practice, absolute emissions serveas the foundational baseline for climate-actionalignment with the objectives of the Paris
Agreement. If a client’s absolute carbon emissions
significantly exceed industry benchmarks,
the result may trigger comprehensive reviews
or necessitate adjustments to their lending
conditions. Normalized data, on the otherhand, translates absolute financed emissions

The Partnership for Carbon Accounting

into emission-intensity metrics. Other metrics

Financials (PCAF) offers a robust standard forsuch as economic emission intensity, physicalbanks. A financial industry–led initiative, PCAF

emissions intensity, and weighted average carbon

helps financial institutions assess and disclose

intensity (WACI) may also be applied to provide agreenhouse gas (GHG) emissions resulting frommultifaceted evaluation.

loans and investments. It provides detailed
guidance for each asset class, enabling financial
institutions to calculate the financed emissions
resulting from activities in the real economy
that are funded through lending and investment
portfolios. Notably, over 430 banks managing
assets exceeding US $93 trillion have embraced
PCAF’s methodology to calculate financedemissions.

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ARTHUR D. LITTLE

VIEWPOINT

Additionally, leveraging accumulated carbon
emission data over time empowers financial
institutions to evaluate a client’s historicalcarbon-reduction performance. Even whenclients exhibit carbon emissions that arehigher than industry average at a single pointT H E T R U E VA L U E
OF ICP LIES IN ITSABILIT Y TO MANAGE
RISKS AND PINPOINTOPPORTUNITIES

in time, the stability of emissions reductions
over previous years can be viewed favorably
and reflected in lending condition adjustments.
Assessing a client’s carbon-reduction efforts
can be benchmarked against internationallyrecognized scenarios, such as those outlinedby the International Energy Agency (IEA) andthe Network for Greening the Financial System(NGFS). Alternatively, financial institutions
can craft their own exploratory scenarios andcarbon-reduction pathways for a comprehensive
comparative analysis.

Financial institutions primarily employ two
types of ICPs: shadow price and internal fees.
The shadow price represents a theoretical costthat is not directly imposed but serves as a toolfor evaluating the economic impacts and tradeoffs related to various aspects, including risk
assessments, new investments, net present value
calculations, and cost-benefit analyses. Internal
fees are concrete carbon charges applied to
specific business activities, product lines, or units

Systematically integrating financed emissions intobased on their GHG emissions. Currently, mostclimate risk assessment and lending procedures

institutions adopt the shadow price approach inempowers financial institutions to achieve aimplementing internal carbon prices.

thorough grasp of their carbon footprint. A

The true value of ICP lies in its ability to manage

methodical approach aligns portfolios with thebroader goal of a sustainable future. Ultimately, thisinformation equips financial institutions to address
climate change and promote the transition to asustainable, low-carbon economy.
2. Leverage internal carbon pricing
The financial services industry is increasingly
embracing the use of internal carbon prices (ICPs)
as a proactive approach to manage climaterelated risks and prepare for the transition toward
climate neutrality. ICP is essentially a pricing

risks and pinpoint opportunities. It provides
financial institutions with a valuable tool todevelop resilient strategies and implementation
approaches that facilitate the transition towarda low-carbon economy. ICP acts as a valuable
instrument enabling banks to include a “carbon”
perspective into their existing investment andfinancing decision-making processes. During
the lending process, considering individualcarbon costs can lead to varying client and caseprioritization, allowing banks to adjust lending
decisions accordingly.

mechanism employed by organizations to assess
the financial implications of potential changes
in investment, production, and consumption
patterns and the costs associated withemissions-reduction efforts and technologicaladvancements.

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4ARTHUR D. LITTLE

VIEWPOINT

AS THE GLOBALECONOMY CONTINUESTO S H I F T TOWA R DS U S TA I N A B I L I T Y,THE USE OF INTERNALCARBON PRICINGWILL BECOME AN
I N C R E A S I N G LY
V I TA L T O O L

3. Play an active role in the transition process
The financial services sector undeniably has
a crucial responsibility in driving the global
shift toward a net-zero economy. This taskholds paramount importance as the world
collectively strives to mitigate the impacts ofclimate change. Financial institutions serve adual purpose, in terms of efficiently allocating
capital and delivering essential financial services.
Simultaneously, they contribute to ensuring
an equitable, orderly, and just transition. The
multifaceted characteristic empowers theIn the context of the dual-dimension matrix
approach, ICP can be integrated with a bank’s
existing risk models and indicators, such asprobability of default (PD) or risk-adjusted

financial sector to not only play a vital role
throughout the transition process but tocooperate with various stakeholders toachieve a sustainable future.

return on capital (RAROC), to provide a holistic

As the world embarks on the journey toward aevaluation of a client’s credit risk that considers

low-carbon economy, banks find themselves

its climate and sustainability risk and return. For

compelled to modify their lending policies

example, if a bank employs a quantitative PD risk

to better connect to their decarbonization

model, it can incorporate the results of carbon

objectives and public commitments. One

accounting for individual clients and cases, alongcommon modification to their approach involveswith the bank’s internal carbon price, into thediscontinuing financing for specific categories

financial variables of the quantitative model. This(e.g., thermal coal) or entire industries (e.g., oilallows the calculation of adjusted default rates

and gas). These adjustments are primarily driventhat account for carbon costs, thereby serving as

by the need to mitigate the potential exposure

an indicator to inform lending decisions. Similarly,

to high-emission assets and to curtail thebanks can factor carbon costs into indicators

associated climate and financial risks. And yet,such as RAROC, offering a comprehensive

the complexity of the transition transcends mere

assessment that considers both the carbon andindustry categorizations. Many carbon-intensive

profitability aspects of lending.

sectors encompass high-emission assets likeAs the global economy continues to shift towardsustainability, the use of internal carbon pricing
will become an increasingly vital tool in thefinancial industry’s toolkit. Integrating ICP into
decision-making processes is a strategic movethat allows financial institutions to gain a deeper
understanding of the climate-related risks they
face. By quantifying these risks and aligning them

power plants, airplanes, and ships, which poseclimate-related risks and present the financial
risk of becoming stranded amid the shift toward
a net-zero economy. This requires financial
institutions to undertake a holistic evaluation ofa client’s long-term climate risk while proactively
guiding and assisting clients throughout theirtransition process.

with their existing risk models, banks can makemore informed investment and lending decisions.
Furthermore, ICP assists banks in identifying
areas where carbon-reduction efforts can yieldfinancial benefits, serving as a valuable guidefor directing investments toward sustainable,
low-carbon opportunities.

LENDING FOR A SUSTAINABLE FUTURE

5ARTHUR D. LITTLE

VIEWPOINTWith the dual-dimension approach, banks canassist clients in achieving their transition goals byapplying different client engagement approaches
to different client segments, based on theircarbon and non-carbon risk characteristics(see Figure 2).
For example, for the low-risk segment, banks
can initiate discussions with clients on thelatest sustainability issues or regulations,
thereby fostering greater awareness of thesubject. For the medium-risk segment, banks
may collaborate directly with them to develop a

A C O L L A B O R AT I V E
A P P R O A C H N O T O N LY
STRENGTHENS THE
R E L AT I O N S H I P B E T W E E N
THE BANK AND THE
C L I E N T, I T A L S O H A S
THE POTENTIALTO REDUCE
CARBON EMISSIONSS I G N I F I C A N T LY

detailed transition plan. The plan may outline theclient’s transition goals, the specific actions theyintend to take, and the degree of accountability

Banks should evolve into partners on theirrequired. Moreover, for the high-risk segment,clients’ journey toward sustainability. By offering

lending terms can be structured to align withsupport, guidance, and tailored financial

the client’s progress toward the attainment ofsolutions, they can advance the shared objectives

transition goals. Such a collaborative approachof a low-carbon economy while safeguarding

not only strengthens the relationship between

their interests in a rapidly changing financial

the bank and the client, it also has the potential

landscape. This cooperative synergy between

to reduce carbon emissions significantly. Mostbanks and clients is conducive to sustainable

importantly, it equips clients with the necessarytransitions and serves as the bedrock uponfinancial resources to realize their transition

which financial institutions can contribute toefforts effectively.

the realization of a net-zero future.

2. Different engagement approaches for different
egments

ittle

Figure 2. Different engagement approaches for different client segments
ILLUSTRATIVE

Client segment

I

Low-risk clients

IIMedium-risk clients

IIIHigh-risk clients

Engagement approach•

Proactively initiate discussions
on latest sustainability issues
or regulations•Collaborate directly to develop
detailed transition plan•

Structure lending terms to alignwith progress toward climate &transition goals

Source: Arthur D. Little

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6ARTHUR D. LITTLE

VIEWPOINT

CONCLUSIONA D VA N C I N G A
N E T- Z E R O E C O N O M Y

F I N A N C I A L S E R V I C E S I S AT T H E
FOREFRONT OF STEERING THE WORLDT O W A R D A N E T- Z E R O E C O N O M Y

The financial services industry is at the forefrontof steering the world toward a net-zero economy.
Addressing the three strategies outlined in thisViewpoint could guide the way to a sustainable future:1

The integration of climate risk into risk
management frameworks should be standardpractice, ensuring thorough evaluations during
the lending process.

2

Financial institutions should adopt internalcarbon-pricing mechanisms, thus enabling themto make informed decisions that align with climate
objectives.

3Banks should actively engage clients in thetransition process to foster awareness, set
decarbonization targets, and collaborate on
detailed transition plans.

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