The Economics of Net Zero Banking

In recent years, the banking sector has witnessed a significant shift, with banks representing 41% of global banking assets voluntarily committing to aligning their portfolios with a decarbonizing, net zero economy. Even banks without net zero commitments are pursuing investments in low emissions transitions. This trend raises important questions about the economics behind these commitments and their implications for the banking industry and capital allocation in the real economy.

Understanding Net Zero Banking

Net zero banking refers to the over-time evolution of a bank’s lending portfolio to align with a decarbonizing global emissions trajectory, via the reduction of financed emissions and the augmentation of investments in clean energy and other decarbonized economy technologies.

At first glance, net zero commitments seem counterintuitive for bank economics. Traditional carbon-producing sectors often offer attractive lending opportunities due to their stable cash flows and fixed assets. In contrast, emerging decarbonizing industries might appear riskier in the short-term. Moreover, banks have long-standing relationships with clients in carbon-intensive sectors, making a shift towards net zero lending potentially disruptive.

In our review paper, we consider the various reasons why banks may find it profitable to decarbonize their lending portfolio, and survey the evidence from the literature that supports or negates these ideas. This blog post outlines our framework for organizing the literature, and we refer interested readers to the full paper for specific references.

The Economics Behind Net Zero Banking

We frame the question by considering that net zero lending may create differential value through the channels of risk and returns, where in turn spans both profit margins and lending book growth arguments. We begin with what net zero is not. Recent research suggests that net zero commitments are not primarily driven by lender divestment. Instead, we uncover roles (i) for risk arguments influencing the optimal green-versus-brown lending portfolio, (ii) for decarbonization and green investment leading to enhanced profitability through bank lending growth, and (iii) for lending portfolios adapting in a regulatory preparedness.

1. Default Risk

Banks may view net zero lending as a strategy to manage long-term default risks. As the global economy transitions towards net zero, carbon-intensive industries could face increased regulatory pressures and market challenges—often called transition risk. On the other hand, in the short-term, lower carbon technologies tend to be newer and more innovative, which may introduce risks associated with investing in more emerging technologies. As literature develops, more work on dynamics may be important. For example, the dynamics of profitability and innovation may play out in a way that makes risk properties change over time.

2. Profitability and Growth Opportunities

Decarbonization and green investment may separately be tied to enhanced profitability, even conditioning on a given level of risk. The transition to a low-carbon economy presents significant financing needs, especially if firms face financial constraints. This financing need likely creates new business lines and profit avenues for banks. Financial institutions that develop expertise in financing green technologies and sustainable projects may gain a competitive edge in this growing market. This “competitive edge” may appear in the data as differential price margins for a given risk or through growth in lending volumes.

3. Regulatory Preparedness

Banks may be positioning themselves for anticipated policy changes or regulatory requirements related to climate risk. By proactively adjusting their portfolios towards net zero, they may reduce compliance costs and reputational risks in the future.

Heterogeneity in Banking Strategies

The research highlights that the economics of net zero banking are not likely to be uniform across all banks. Factors such as bank specialization, relationship banking, scale, and market power play crucial roles in determining how individual banks approach net zero lending.

Challenges in Assessing Net Zero Lending

A significant challenge in evaluating banks’ net zero efforts is the potential for greenwashing and opaqueness in lender balance sheets. A number of existing studies suggest a disconnect between banks’ public statements on environmental issues and their actual lending practices. However, this discrepancy may also reflect the complexities of financing long-term transition investments that do not immediately result in emissions reductions over the short-term. New administrative data and innovations in our analysis and measurement of net zero lending will likely help researchers better address these competing interpretations.

Looking ahead: the Need for Further Research

While the literature on green and brown bank finance is growing rapidly, many aspects of the risk and returns of net zero loans remain understudied. We highlight a number of areas for future research:

1. Borrower-bank level interactions and heterogeneity
2. The role of specialization and relationship banking in net zero lending
3. The impact of scale and market power on banks’ ability to finance the energy transition

Conclusion

The economics of net zero banking represents a complex and evolving field. As banks navigate the transition to a low-carbon economy, their strategies will likely continue to evolve, balancing risk management, profitability, and regulatory considerations. Improved data on both short-term emissions reductions and long-term decarbonizing investments will be crucial for researchers and stakeholders to accurately assess the impact and effectiveness of banks’ net zero portfolios. As the global economy continues its shift towards net zero, understanding the economics of net zero banking will become increasingly important for policymakers, investors, and the banking industry itself. This evolving landscape presents both challenges and opportunities, reshaping the future of finance in the face of climate change.