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Even banks that are seeking to drive carbon out of their loan and investment portfolios face an array of risks from the transition to net zero, says Moody’s Investors Service.

In a new report, the rating agency said that banks have a long away to go in curbing financed emissions and bringing their portfolios in alignment with a low-carbon economy.

Many of the world’s largest banks have begun setting out more detailed plans for reaching net zero financed greenhouse gas (GHG) emissions by 2050 — a key commitment under the Net Zero Banking Alliance (NZBA), which includes Canada’s large banks.

Yet, while the setting of targets represents progress, and banks have improved their ability to track their financed emissions, they still face a number of challenges in meeting these commitments, Moody’s said.

“Carbon transition, a key environmental risk, will require banks to actively manage their loan and investment exposures to preserve their credit quality,” the report said. “Even banks with ambitious climate targets could face negative credit implications as they balance financial, regulatory and reputational risks with new business opportunities.”

Moody’s added the banks’ net zero plans “face obstacles from a lack of well-established methodologies and undeveloped implementation strategies.”

For many banks, engaging with clients to encourage them to reduce emissions will be key to meeting their own targets. “However, detail is scarce on how banks have begun or plan to engage,” it said.

And, it’s not clear how banks will decide when they have to move beyond engagement to scrapping relationships with clients that aren’t willing, or able, to curb their emissions, the report noted.

Moreover, the ability of banks to meet their targets will rely on government and regulatory policy, it suggested — and there’s wide variation in these efforts to date.

“Authorities in the EU have thus far been more proactive, enabling EU banks to move ahead more confidently. Other regions have been slower to enact specific rules, raising the risks that leaders in those regions will be misaligned with future policy decisions and laggards unable to manage emerging transition risks,” Moody’s said.

In the meantime, faced with growing pressure from investors and other stakeholders, the largest banks will likely pursue emissions reductions ahead of government action, in pursuit of a competitive advantage, the report said.

“As the industry evolves, stakeholder pressure will likely filter down to smaller banks,” it said.

The report also noted that, despite the challenges facing banks that have made net zero pledges, the credit issues will be “far greater” for those that haven’t.

“As the economy decarbonizes, declining asset quality and asset prices for portfolios concentrated in carbon-heavy sectors could result in loan losses, lower profitability and, in severe cases, weaker capitalization,” the report said. “The credit implications could be substantial for banks that do not actively manage their exposures through the transition.”