Interview - Engaging with Banks and Fund Managers for Climate
What are banks and institutional fund managers really doing about climate change? What are their priorities? What are their limitations and challenges? Could they do more? In this interview, hear from Gabe Malek from the Environmental Defense Fund about their experiences working with major banks and fund managers on climate change.
SC: Please tell me generally what your work at the EDF involves as a starting point.
GM: So my work involves collaborating with finance sector partners on the energy transition and net zero planning and strategy, the motivation being if we can get banks and asset managers to set rigorous climate standards, then we can push a variety of companies across industries to cut emissions more ambitiously.
SC: So that's both commercial banks in their lending side and asset managers as equity investors in the companies, right?
GM: That's right.
SC: Do you find those two to be similar or very different when you work with them?
GM: They have different interests and incentive structures. I think the asset managers we're talking about are really big and passive asset management firms, and their key tool in the toolkit is engagement. They're not going to divest from particular sectors. That's just not within their strategy. So our focus in speaking to them is more about what questions should you raise with management teams when you go about that engagement. When should you vote against a board member at an annual meeting? What does "good" look like for a net zero plan, and how can you communicate that through your investment stewardship?
For the banking side there are probably more tools available to directly influence the ways companies behave, but the incentive structure is different because these companies are their clients rather than their portfolio companies. So they're cautious about how they interact with those companies, because they want to retain that business. So it means that the pace from the banks is maybe not always as fast as it is from some of these investor coalitions, but there are a wider array of tools banks can use, whether that's adjusting cost of capital, integrating certain climate standards, and their advisory services for mergers and acquisitions. So we're trying to explore basically all aspects of what a bank does and connect those to climate.
SC: So it's all aspects of the bank's business, including lines of credit financings, project financings, and M&A. Do you see any particular aspects of those being more responsive to climate concerns? Is there some pattern in it at all?
GM: Yes. So the US banks have taken a similar path so far on addressing climate. The six largest US banks are members of the Net Zero Banking Alliance, and that alliance has some general ideas about steps banks can take to move towards net zero. So it makes sense that a lot of these firms are working in parallel. What we've seen so far is banks prioritizing their direct financing and underwriting. I think it's just easier for them to quantify, control, and attribute those emissions to themselves. It's harder to say we helped advise this oil and gas merger and acquisition, and this project has x amount of CO2 emissions, and because we played this role, we now attribute the fraction of that to us. It's hard to make that calculation, whereas for financing and lending, the Partnership for Carbon Accounting Financials (PCAF) has already developed a methodology that's become widely accepted for banks to calculate financed emissions. So they're using that as a starting point to say we're going to reduce financed emissions by X percent for these sectors by 2030.
Those are their concrete objectives that they've stated. JP Morgan was the first bank to make a commitment and release these 2030 targets, and then Morgan Stanley, Goldman Sachs, and then recently Citi followed. So we now have four US banks that have released 2030 finance emissions targets. They've all started with the energy sector and the power sector. Then three of the four banks have also included targets for transportation. They're not saying if we fail to meet these targets, we will exit our financing for these companies. They're not going that far. They are just saying "these are the benchmarks we hope to hit and here's how we're going to work with our clients to ensure that we meet those targets"
SC: Are they setting higher cost of capital, like credit spreads in those sectors because of the emissions cost or credit costs? Or are they still doing it as before?
GM: I think it's a safe assumption. In their public disclosures, they don't mention explicitly the extent to which they're adjusting cost of capital in those sectors, but in many conversations I've heard just with industry, there seems to be a growing recognition that cost of capital will be changed to account for the physical and transition risks that those sectors are facing.
SC: So for people in the industry, as these large banks exit the sector or reduce their financed emissions, what do you think would be their options?
GM: It's the golden question, because worst case scenario is that now they go to less ambitious banks that are just willing to do these deals anyway. It's this prisoner's dilemma that we're facing across the energy transition, but I think in actuality there's a human element to this. The banks and companies have long-standing relationships, and there's a reason that the six major banks in the US are so dramatically bigger than some of their competitors. It's because they have top talent in their firms, and they attract companies looking to do deals with really strong advisory services. So I think it's very possible that companies will respond to this pressure from banks because they might not want to exit that relationship and find a new banking partner. But I think the short answer is that it's unclear at this point. We're still kind of early days.
SC: What is the impact of a bank saying "we want to reduce our financed emissions"? Are they looking for the companies to then reduce their emissions, so that they could continue to lend the same amount, but then the companies have to do the work to reduce their emissions?
GM: From EDF's perspective that's the ideal path, because as we're discussing you could take two paths. The first is "I'm just gonna provide less financing to this sector and as a result reduce my financed emissions." Or you're really going to depend on those companies to use the financing you provide to cut their own emissions. The latter path has real climate impact, and the former is just moving money around. It's just moving the emissions around too, so hopefully banks will not only raise cost of capital for continued exploration and production in oil and gas or continued development of diesel trucks, but lower cost of capital for innovative green technologies that are necessary for these companies to transition.
SC: How are the banks monitoring the total emissions? Are they relying on the things like the CDP disclosures or the TCFD disclosures of emissions from the companies?
GM: It's a very convoluted calculus. You have to get the emissions data from the companies. Step one, it's probably coming from CDP disclosures, TCFD reports now. The companies are sometimes including emissions data in their sustainability reports directly. I think TCFD has done a strong job as a first step to get companies reporting more, and then hopefully the SEC will release new rules this year mandating climate risk disclosure. Once they have that emissions data from companies, most of these banks are using a similar methodology. They're basically saying, okay what's the total financing this company receives, where does our bank fit into that total financing (what percentage), and then we can essentially weight the percentage of emissions that we're responsible for.
SC: Do you work with the European banks as well or just the American-based banks?
GM: We haven't done much work with the European banks. So far it's mostly been American.
SC: So is there some kind of line that these banks are drawing in terms of saying "We're going to engage, but if we don't see the progress, then we're going to reduce our financing to these companies to meet our goals?"
GM: Nothing that explicit. They've said in abstract terms that if companies are not moving forward with a responsible and orderly transition, then they might withdraw some financing. But there's no minimum standard, for example if the company doesn't reach X percent methane emissions reduction by 2025, you're going to stop financing. There's nothing that explicit.
SC: So when they say they've set a goal to reduce their financed admissions by 2030, how are they releasing data that the rest of us could monitor how they're doing and whether they're on track to meet those goals?
GM: The ones that have made these 2030 targets have committed to publicly report on their progress towards the target.
SC: Is that something that you participate in when you monitor what they're doing? Is monitoring a part of what you do?
GM: Certainly. When any bank releases a net zero report, we look into it and review it and try to understand the strengths and weaknesses. Once we start seeing these incremental updates we plan on doing the same.
SC: So how do you envision this working with the commercial banks to scale up? By finding more banks to commit to this, or by increasing their targets, or following up on their targets? What is your plan with this process?
GM: I think there are a number of ways to scale up, and we're trying to decide how best to prioritize. The first would be extending climate to additional aspects of what the bank does. Right now we're looking mostly at direct financing and underwriting. So can we get banks to integrate climate standards into their M&A advisory services? Can we get banks to integrate climate into their legislative affairs teams and start advocating for public policy that's needed to support the transition? Can we get some of those minimum standards in place for financing so that there's just more meat on the bone, that we can say you need to reach this level of methane intensity in the oil and gas sector if you want to continue to receive financing, or you need to have this type of electric vehicle transition plan if you're a major shipper? So that's work to be done with the US banks that have already taken a step in the right direction. Then I think another opportunity to scale up, and we haven't explored this in depth thus far, is trying to engage more banks internationally on the transition. Many of the world’s largest banks are in China, and they're providing a lot of financing to projects that have serious climate implications, and we're just not plugged into that yet. So maybe down the road seeing how we could shape the dialogue there would be productive.
SC: What about going to the smaller or more regional banks in the United States?
GM: I think smaller regional banks have important exposure to climate risk. Climate risk for them is more acute than it is for a large multinational like JPMorgan, because their assets are more geographically concentrated, and they might look at fewer sectors. So others in EDF have started talking to major agriculture banks, which face extreme risks from climate change. The difference there is that, in many instances, these regional banks aren't the ones financing new carbon intensive projects, so they're less important from a mitigation standpoint. But from an adaptation and resilience standpoint they're essential to address. There's work to be done. We just haven't embarked on that yet.
I'll just add that the agriculture team at EDF just did work with finance sector partners to release a new type of bond for farmers that essentially incentivizes farmers to use sustainable practices in their farming. And they did work with agriculture banks to make that happen, so there is some of that going on. It sits at a different part of the organization.
SC: So what are the biggest challenges when you work with banks that you found?
GM: I think the biggest challenge has been getting banks to support climate-aligned public policy. Banks don’t want to jeopardize their relationships with clients. Though we’ve seen larger asset managers write investor letters to congress and to other elected officials on key policy topics like the EPA's methane regulations, we haven't seen banks take a similar step. I think the feedback we've gotten is that "If an investor writes a letter, that doesn't change much for them, because they don't have to manage this relationship with a portfolio company. For us if we write a letter supporting methane regulation perhaps we're going to lose business from some of our oil and gas clients." So they're more cautious on that front, and it can impede the pace of progress.
SC: How do you think you could get past this conservatism that you're seeing in terms of banks relationships?
GM: I think when some of the effects of climate change start manifesting in the performance of these companies and their ability to pay back loans, banks will be forced to acknowledge the risks posed by climate change and will naturally want to accelerate the work they're doing on the energy transition. You start to see some of that in small doses already, with extreme weather that we've witnessed in recent years, but even still for banks like the top five in the US that are so diversified, those events haven't yet made the same impact, but undoubtedly they will. The report a few years ago from the CFTC really made the point that climate change poses a systemic risk to the finance sector, both banks and asset managers. So in my opinion it's just a matter of time, and luckily banks are starting to move. They're doing way more now than they were a few years ago, dramatically so.
SC: You've raised a lot of good points, which is at what point does it affect the bottom line of the banks? Is it going to take regulators' changes in capital requirements, risk scenario analysis? A lot of that has been done, but not necessarily implemented to a point where it will become a real thing. Do you think the banks realize that that is all or believe that that could be coming in their way?
GM: I think they definitely do. They look across the pond and see Europe taking steps towards stronger regulation of the finance sector on climate change, whether it's the EU sustainable finance taxonomy or stress testing from the European central bank. I think they know that that's on the horizon here in the US, at least with the current administration, and I think it's probably too high of a risk for them to try to wait it out and bet on a new administration in 2024. So they're starting to prepare. It'll be crucial for an organization like EDF to really monitor how the banks weigh in on those topics, because they're they're putting forward these net zero plans now, and they're joining coalitions on climate, but it's very possible that their regulatory teams could be working to undermine enhanced regulation around stress testing. I think it's a safe assumption that these companies prefer as minimal red tape as possible, but when that regulation is actually in the long term going to help them manage climate risk, EDF would certainly hope that we see support from the banking community on that.
SC: That's great to hear about that. Now let's switch a little bit to the asset manager side. There you're working with the asset managers, not the pension fund plan sponsors at the companies, but actually the companies that manage the assets. Is that the focus of your work?
GM: That's right.
SC: OK. So you're saying passive managers--so basically people who manage index funds like Vanguard and Fidelity with their huge passive S&P 500 and similar types of indices. So obviously being an index fund, like you said they cannot just divest, because then they are then no longer an index fund.
SC: So when they engage does that mean basically to vote on proxies? Does it mean more than that to actually have conversations with the company and their management in terms of what they're doing? Do index funds do that?
GM: It does involve a lot of conversations. Actually I think certainly in the news it culminates with the proxy vote, but throughout the year these stewardship teams are having semi-regular conversations with companies of interest. What's typical is that a stewardship team will say "These companies are on our watch list because they fail to align with these stewardship principles that we've established as a firm, and for those companies on the watch list, there will be more frequent check-ins between the team and management than there would otherwise be." I think just by nature of the number of companies that any of these firms invest in, they just can't possibly meet with all of their management teams, so they're essentially just prioritizing: "These are the ones that are at risk. We think that esg issues are resulting in underperformance financially, and we want to intervene."
SC: So again, what are they relying on to make those decisions for this? The disclosures from the company such as the CDP and TCFD?
GM: Yes, so that's an area we're trying to address. So a lot of the information they're getting now is from ESG data providers--Sustainalytics, MSCI, Refinitiv basically--around greenhouse gas emissions, and any sort of plan that the company is released related to net zero. A lot of these databases will just aggregate the company's disclosures, and these stewardship teams are using those data subscriptions to determine which companies to watch. What EDF is trying to do, and we launched this new platform--it's free publicly--is ESG by EDF. The motivation was that investors have all of this data through ESG platforms, they don't quite know what to do with it and they don't know which metrics matter. What we're trying to say as an environmental organization based on climate science policy and economics is that these are the metrics that you should focus on for carbon intensive sectors, and all of the other data that you're swimming in is largely noise. So let's make this a much more simple process and prioritize along these these key areas. So for oil and gas, as an example, we released a report in October on flaring in the oil and gas sector. It's a key climate risk. It's a big driver of methane emissions. You won't find flaring data in a refinitiv data set, so it's up to us as EDF to alert investors to other sources they can use to monitor flaring and raise it with companies as a priority ESG issue.
SC: So this is a publicly available data information set that you're providing, ESG by EDF?
GM: Yes, so it looks quite different from a data platform. It's not going company by company and saying here's how they're performing. It's a website that's more of an insights research platform where we have reports. We have shorter form analyses, so the flaring report was about 35 pages long, where it started off explaining flaring to investors, outlining why flaring presents financial risks for companies, and then highlighted about 20 companies that are oil majors, some independents, some national oil companies, and then rated them on flaring. So we couldn't cover every single company, but we just said these 20 are probably most important for you as an investor, and here's how they're performing.
SC: So this is the data that you're providing to the asset managers, and then what's the response when they see an additional ESG or a climate data set like this in their decision-making process?
GM: People have been quite receptive and enthusiastic. So far we've had a variety of conversations with investors helping them make best use of that report. One thing that was important to us and that will remain important is in the report providing about five questions already written that investment stewardship teams could pose to companies in that sector. That's, in our opinion, taking this whole process a step further and making it even more simple for these teams. So you're not just presented with the raw data, you're then translating that data into questions that stewardship teams can then use to monitor future progress. So really we found that when we hand our report over to investors and say "Oh, you're interested in this company. Here's how they're performing, and if you want to follow up maybe consider posing these questions." They're quite enthusiastic, because it just makes the process a lot more straightforward for them.
SC: OK, so they present these questions to the companies, but the companies are part of the index. So ultimately they can't divest from the companies, so what is the company's response? Or what range of responses do you see from the companies?
GM: It gets back to one of the big questions about whether and how this type of engagement can actually make meaningful change, because like you're saying companies that are part of an index are going to remain part of that index. So where's the leverage? I think the main point of leverage is in the ways that management teams essentially are influenced by share price. They don't want to see their share price go down. Their compensation is heavily tied to the performance of the stock, and if the stock underperforms, then they might not stay on as CEO. In the case of Board members, if you have enough investor pressure, then perhaps the Board member is going to get voted out by the investors. So they're trying to protect against that risk. So even though they feel confident that they'll remain part of the index for the foreseeable future, they still listen to investors, especially the big ones, quite closely. Back in 2017, no company was putting out a TCFD report because the TCFD was just being launched. Then in a matter of five years, hundreds of companies released TCFD reports. And why did they do that? Blackrock and others said explicitly we're going to vote against management teams that do not disclose to the TCFD, and we're going to keep engaging companies that don't disclose to TCFD. So all of a sudden you see the industry respond.
SC: So what do you think of the whole Exxon proxy and how their additional directors? Do you think that's a positive trend, and is it in fact making a difference in what the company is doing?
GM: It was an exciting inflection point to really understand the extent to which investors care about climate risk. I think it's too early to fully grasp what impact it's made, if any. Changing a company like EXXON is trying to make a U-turn with a massive cargo ship. It's just going to take a ton of time, and early results aren't stellar. Exxon just put out its net zero commitment, and that commitment did not include scope 3 emissions, it didn't include their non-operated assets, so they're still behind some of their european peers. But can we say that the Board vote was a complete failure? I just don't know yet. I think we need to give it a bit more time, because change at any organization of that size is just going to be slow.
SC: Sure. So as they put out the net zero targets and goals, is that something that you're also monitoring and putting out your analysis on them?
GM: Definitely. So my team hasn't put out a formal analysis of their commitment because they haven't yet released a plan. It was just a high level commitment, but the director of EDF's energy team was quoted in The New York Times analyzing the commitment, and EDF monitors those types of developments quite closely.
SC: OK, and when these stewardship teams engage, are they one stewardship team that covers all the different funds at say a Blackrock, so it covers their index funds and their actively managed portfolios?
GM: Yes, they're often breaking up these stewardship teams by sector similar to how you would have an analyst on a trading desk for example. So they'll have their oil and gas stewardship analysts and so on and so forth.
SC: OK, so when that person meets with the company, he or she also represents the funds that could sell the shares and divest, so it's not always a "This is a nice meeting to have but you are always going to keep us around in your portfolio and everything"
SC: What is your general feeling about the ESG funds and the ESG indices that have become very popular in the first place, and the ESG indices that are following along like some of the MSCI or S&P PACTA index that are coming up?
GM: It's a whole wild west right now. ESG means very different things for many financial products, and again there's the potential for regulation this year from the SEC. They've alluded to it. It's unclear when and if it will happen, but there needs to be more transparency around what ESG means as a label. I think that's less important for impact - you could call these funds whatever you want. What really matters is their underlying holdings. I think transparency is important for consumers, because ultimately a lot of the ETFs are being purchased by retail investors. If I'm just the average person trying to invest my 401k, I don't want to be misled by a product that I think is doing more than it is. That's where i think the labeling matters, and in that labeling process I don't think there's actually one specific way to do ESG. You could have an ESG fund that includes companies like BP and Shell because they're leaders in their sector relatively, and I think that's a valid argument to make. You have other funds like Engine No. 1's Vote ETF, which is looking at a wide range of companies, basically the S&P 500, and just saying we're going to engage actively with all of these companies on ESG issues, and I think that's ESG. Then option three you have a portfolio that's all clean energy companies or all electric vehicle companies and that too is ESG. I think we don't need one concrete label that applies to every single thing. We just need to be more transparent about what we mean in those specific instances when we're claiming that something is ESG.
SC: Have you at some point work with companies or the fund sponsors to switch to more ESG or climate aligned investing funds? Was that over something that you were doing?
GM: So we have been and are still working with companies to encourage them to add more ESG or climate aligned products to their 401k retirement plans, and we ran into a regulatory barrier early on. We ended up focusing a lot of attention on regulatory change because the Trump administration introduced a rule that put a major chilling effect on companies. Nobody really wanted to go near ESG when it came to the 401k market. So we worked all of the Fall basically trying to encourage the Biden DOL to introduce new rules that thawed that chilling effect and made it clear that fiduciaries could consider ESG. Now the Biden administration already released their proposed rule. They're moving towards the final rule that will have a major effect, more of an effect than any direct engagement with companies could have, but we're still talking to them. We're still trying to just educate people about the space, because they are the bottleneck here. Employees want it, fund managers want to sell it, they just need to be added to the plans.
SC: So what do you see as the biggest challenges for this route of going through the asset managers to get the companies to change or improve their climate performance?
GM: I think it's just one tool in the toolkit, and so my team takes that route. If EDF as a whole were just looking at that strategy, our approach would be incomplete. But luckily EDF is working in parallel along a variety of tracks, so while my team's looking at asset manager engagement, there's a whole other branch of EDF that's doing policy advocacy, and there's a whole other set of teams at EDF that's engaging directly with companies on these issues. If we are just trying to rely on asset managers to drive this transition, we're not gonna get to where we need to be. I think we can use asset managers as a catalyst to encourage and accelerate corporate action in the absence of more ambitious climate policy, but I do think ultimately climate policy and regulation is the linchpin. We just don't have that right now, and in the meantime we need to make sure that asset managers are using the influence that they have on companies effectively.
SC: There's been a debate: There are some people, even former people from the asset management field, have said that you absolutely need governments to step in, but others have said no it's better that the asset managers take the the lead. So i'm curious what makes you feel that ultimately asset managers cannot get this done?
GM: I think that we're seeing in many instances, already, that absent effective policy, clean technology is not cost competitive with the carbon intensive alternative. They're not going to take the option that delivers lower returns, and in many instances they have a fiduciary obligation to take the path that delivers higher returns, so they're pigeon holed. That's why i think policy is essential. If you had a price on carbon, then all of a sudden, you would have a completely changed perspective in the asset management and investor community about what's valuable and what isn't, and what's risky and what isn't, because you would finally integrate the externalities of emissions into the valuation of these carbon intensive assets. That's just one example. There are others that are more sector specific. If we're actually trying to transition truck fleets across the US to electric trucks as opposed to diesel trucks, the total cost of ownership right now for long-haul trucking really depends on enhanced incentives from federal and state government in the intermediate term to balance out the cost of ownership. In the long term we'll see that electric trucks are the superior choice to diesel. But for now when we need to transition we need that policy catalyst, and asset managers can't input that, because of the incentives that are needed, and that's just not what they're designed to do. Investors are equipped to react to market trends and invest where they see strong risk adjusted returns, but what shapes those risk adjusted returns is the policy landscape to a large degree, and that's out of the investor's control.
SC: So what are your key hot button or priorities as you move forward here? Are you focusing more on banks or more on asset managers? What are you trying to do in each of those fields to scale up?
GM: There's work to be done on both fronts. One of our key projects this year that unites the two is this question of asset divestiture in the oil and gas sector. So BP sets a net zero target. To work towards that target, they start to sell off some of their carbon intensive assets, and ultimately those assets go to either other public companies with worse track records on climate or private companies with worse track records and worse disclosure, or national oil companies that have the same problem. So we're starting to see this transfer of emissions to other financial players that are going to be less effective environmental stewards than public companies like BP that have made ambitious commitments. Again this is a prime example where regulation could play a really strong role, is just a classic externality problem that governments are theoretically designed to address. But absent that we're trying to work with companies, asset managers, and banks to address this issue, so can we get a company like BP to commit to integrating methane standards and flaring standards into the contracts that it uses to structure transactions with prospective buyers, essentially requiring buyers to maintain certain levels of stewardship in order to take on the asset. And then where do investors and banks play a role? The banks are the ones advising these M&A deals, and they can actually integrate some of these standards into the deals. They hold the key there to a large degree. Then asset managers are well positioned to drive disclosure around this. I think disclosure is what comes easiest for a lot of asset managers because they're just trying to collect more data, so they can say BP when you put out that annual report on your progress towards net zero, disclose not only the emissions you've reduced, but segment what percentage of that emissions reduction came from asset divestiture, because that's functionally different from lowering emissions through stewardship.
SC: Yes. I think this is a real problem, because basically people are going to kick the emissions ball around and eventually it will find its way into a sovereign wealth fund or private equity-owned entity that will not respond to any public concerns or outside interests. I can see this is a very interesting problem because then the question is what is the role of these public markets and public investors? If we're all just here to trade the assets around without really acting like owners in some collective sense, then everybody will just say "Fine it's off my books, it's your problem." I've been reading a pretty interesting book about the whole private equity industry, about how they function and the roles of each of of the public markets. I'll send you some links--I've been putting together some stuff about the whole divestiture issue I'd like to get your feedback on. I'm seeing the similar issue with the multiples of these oil companies are just lower, and they're getting to a point, where especially I would imagine BP is selling off these assets, they're probably selling them a very attractive prices for a private equity buyer to pick them up and leverage with a bank that doesn't care and will do the business.
GM: Yes, absolutely that's exactly the combination you want to avoid.
SC: And is methane flaring something that you're actively working on, and is that something that you have a lot of conversations with investors about or with different companies?
GM: Yes, that's probably the biggest focus for our team because we see that near-term emissions reduction opportunities in oil and gas. There are other questions that the sector needs to address around decommissioning and capital allocation towards renewables, but the near-term immediate opportunity is methane flaring, so that's where we're having a lot of conversations.
SC: Great. Well this has been great. You're giving me a lot. I think I might want to follow up with you on some of these points and schedule another call, but you're giving me a lot of material. So let me get that organized first and send it to you.
GM: Thanks so much.