Opinion – Rodrigo Zeidan: Financial system plays an important role in the allocation of resources for climate transition

“I don’t believe in any measure taken by the market; only regulation by the state is capable of reducing carbon emissions.” That was the message of a senior German professor in response to a sustainability rating model I helped develop for a Brazilian multinational bank. My answer was to smile and ask if he thinks we should trust the Brazilian government to design environmental regulations.

The COP26 Climate Summit ended yesterday and among several signs of progress, the United States and China agreed to work together to limit global warming. But we cannot rely on government actions alone. For example, the financial system plays a very important role in allocating resources for the climate transition.

Today, much of the global discussion is on the use of ESG indicators to guide portfolios. The idea is that it is possible to divide business risks into environmental, social and governance (and therefore these risks are known as ESG, in English terms). Investors should sell stocks and bonds of companies with bad ESG indicators and put the money in low-risk companies.

But such an important area is the use of credit scores combined with sustainability information in lending decisions. Banks cannot rely solely on ESG indicators, due to the lack of standardization. Several companies report their estimates of ESG risks, but there are more than 300 accounting standards for these indicators. It is impossible to compare many of the scores, even if we assume that companies report non-operational risks correctly.

Another problem is the focus only on non-operational risks. This focus means that investors can use ESG indicators to create discount factors for company values, but banks have no incentive to use them. After all, there are lending goals to be met: a system that just throws scores down doesn’t work if the goal is also to increase credit for better businesses.

But banks have inside information to create scores for their customers. They already do this with common credit scores to know what interest rate to charge. There are practical and elegant ways, although with a high initial development cost, to create sustainability scores, through models that use hierarchical analysis processes, for example.

A company could have a BBB+ credit score and another for sustainability, which could be lower or higher. A bad socio-environmental score would make the cost of credit higher, as the bank’s risk would also be higher, but the opposite would also happen: companies that accelerated the climate transition would get more credit, with lower interest rates.

But if there are models and banks that advertise goals to be sustainable, what is missing? There is a mix of greenwashing (a form of green lie – saying there is action when there is only speech) and organizational inertia.

“But our institution already takes into account environmental and social risks,” a bank executive said at a meeting. “But how?” “We make clients sign a document stating that they do not use slave labor, do not deforest the forest, etc.” Unfortunately, this is a common attitude, although there are many interesting initiatives in the industry. What matters is that the financial sector moves, because otherwise it will not be its shareholders who will pay the bill, but all of us.