(by www.ethicalcorp.com) - Barclays, Credit Suisse, Goldman Sachs, and Swiss Re have all committed themselves to it. Not to mention Leonardo DiCaprio, Dido and Pearl Jam. Carbon neutrality is the latest game in town, and carbon offsets are becoming the “it” commodity.

In December 2004, HSBC, Europe’s largest bank by market value, made a commitment to become ‘carbon neutral’. The first bank and the second major financial institution (behind Swiss Re) to make the pledge, HSBC led a growing list of ‘carbon neutral’ financial institutions that are implementing corporate emissions reduction schemes.

“At the stage we are now, carbon neutrality can be considered best practice in the financial sector,” says Nick Robins, Head of SRI Funds at Henderson Global Investors. “Such commitments are important for building climate change literacy in the business world.”

HSBC’s strategy of becoming ‘carbon neutral’ involved measuring the carbon emissions associated with its buildings and the business travel of staff, leaving out those caused by its clients. Subsequently, it implemented a variety of award-winning energy efficiency and green power purchasing schemes to reduce its emissions as much as possible. The bank then offset the rest by purchasing emissions reduction credits in the voluntary carbon market.

Stepping Stones

In the summer of 2005, HSBC announced a 5 percent carbon reduction target by 2007. It also initiated a tendering process to identify emissions reduction projects for offsetting its emissions in the fourth quarter of 2005, estimated to be170,000 tons. By October, four projects had been selected, among them the Te Apiti wind farm in New Zealand, the largest in the Southern hemisphere and capable of generating enough electricity for 45,000 average-size homes.

“We deliberately chose a range of different technologies from different countries that we could learn from,” says Francis Sullivan, HSBC’s Adviser on the Environment. “And it was important for us to ensure the robustness of the process by having the credits independently verified.”

As part of the selection process, DNV was engaged as an independent auditor, and validated the wind farm project against the Gold Standard. And HSBC required suppliers to take on the delivery risk of the credits and provide certificates that guaranteed their value.

But ultimately, offsetting rests on the notion that current emissions in one place can be compensated by facilitating reductions in future emissions elsewhere. For critics, this logic is deeply flawed.

“Carbon offsets are based on fictitious carbon accounting, and can by themselves not make a company carbon neutral,” argues Larry Lohmann of The Corner House, the U.K based NGO. “The practice of offsetting is slowing down innovation at home and abroad and diverting attention away from the root causes of climate change.”

For Lohmann, it is critical that banks more directly address the realities facing a fossil-fuel dependent global economy. HSBC’s new carbon finance strategy does signal an intention to address carbon reduction measures more actively in its engagement with clients. And it is currently exploring the option of achieving carbon neutrality in the future through emissions reductions in its client base. A carbon management task force, chaired by Group Chairman Stephen Green and advised by The Climate Group and ICF Consulting, is expected to present concrete proposals to senior management by the end of the year.

But for now, offset projects will constitute the main element of its Carbon Management Plan. According to Mark Kenber of the Climate Group, in the absence of a carbon regime that provides a long-term price guarantee for carbon, offset projects will not be sector-transforming projects. Nevertheless, he argues they still serve an important purpose.

“Carbon neutrality is a way for HSBC to gain a better understanding of how carbon accounting, carbon project financing and the growing carbon market work,” says Kenber “So I see this as a stepping stone for HSBC, and the new carbon finance strategy demonstrates that HSBC does too.”

De-Carbonizing Investments

While currently focused on its direct emissions, HSBC has admitted that its most significant climate impact is embedded in its financing decisions. This is borne out in rough calculations released by Dutch Sustainability Research, which estimated that the global carbon footprint of the four biggest Dutch banks, derived from their combined investment portfolios, is three times the total emissions of the Netherlands.

To better understand the distribution of carbon risk across companies, Henderson Global Investors recently commissioned Trucost to profile the direct and indirect carbon emissions of the top 100 listed companies in the UK, the FTSE 100. The report, The Carbon 100, revealed that 86 percent of emissions were associated with five industrial sectors, with the extractives industry alone accounting for half. Not surprisingly, the financial services sector represented a tiny sliver in the pie chart.

But according to Nick Robins of Henderson, a failure on the part of banks to take responsibility could be devastating.

“For us, the results of the Carbon 100 pointed to three critical questions for the future”, he says. “Who owns carbon, who insures carbon, and increasingly, who banks carbon. With the decline in pollution-intensive manufacturing in Western Europe and North America, public pressure on banks that finance such industries in developing countries is likely to rise.”

Perhaps heeding the call, HSBC’s new carbon finance strategy and energy sector risk policy reveal its plans to raise awareness among clients of emerging climate-related risks and opportunities. And project finance clients of HSBC in emission-intensive sectors are now also required to disclose their greenhouse gas emissions and promote reductions.

“HSBC will work with our clients and help them become more energy efficient and to deploy new lower carbon technologies,” says Jon Williams, head of group sustainable development, commenting on the new strategy. “We will simultaneously support clients who are developing and growing low carbon, clean technology, and non-fossil fuel energy solutions, such as renewable energy technologies.”

For Lohmann and others urging banks do more, it is critical that HSBC consider ways to reduce the carbon emissions embedded in its investment portfolio. Addressing indirect emissions may not be very far off for HSBC, but according to Sullivan, banks should not bear responsibilities that ultimately lie with clients.

“Over time, we will start looking at this from a carbon book perspective,” he says. “But we have to be clear on ownership. We can work with clients to manage their carbon emissions, but these will remain indirect and therefore not attributable to us.”

Setting a Standard

HSBC’s commitment to carbon neutrality has received critical acclaim by observers inside and outside the industry. Most recently, it was named the first overall winner of the annual FT Sustainable Banking Award, based on the recommendations of a panel of sustainable finance experts in the banking industry. Banktrack, the NGO network, has also referred to HSBC’s commitment to carbon neutrality as an example of leadership in the market. However, earlier this year, it produced a scathing report on the environmental and social policies of 39 banks across 13 categories, with failing grades scattered across the board. In this company, HSBC and ABN AMRO came out on top, both earning an overall D+.

Among hundreds of individual rankings, only the policies of two banks received the highest possible grade; Rabobank’s adoption of the UN Draft Norms on Human Rights and HSBC’s adoption of the World Commission on Dams standards, as part of its Freshwater Infrastructure Policy. Alongside its sector guidelines for forestland and forest products, chemicals, and most recently, energy, this policy shows how HSBC is among the leaders in adopting well-recognized policies and standards in the banking sector.

In implementing these policies, HSBC, along with other banks, favors a strategy of engagement, in which its sustainability expertise is brought to bear in cases where clients are not complying with its policies, but are showing credible progress towards doing so.

“Rather than walk away from clients in high-risk sectors, we believe the responsible way forward is to try and work with them,” explains Sullivan. “This would allow us to share our own growing expertise and the positive experiences of our most committed clients within our global client base. We want to try and make difficult transactions doable.”

In making the case for constructive engagement, Sullivan refers to cases where clients are based in countries that are in the process of upgrading their policies and regulations, such as the new E.U. member states in Eastern Europe. But for critics, leadership in sustainable finance is most effective when driven by the courage to take a stance.

“Withdrawing financing on grounds that the client is in breach of environmental and social standards delays the project and exerts a chilling effect in the market by making other investors nervous,” says Lohmann. “It sends an important message.”

He has met with villagers adversely affected by the Trans Thai-Malaysia Gas Pipeline, a joint enterprise between Petronas of Malaysia and the Petroleum Authority of Thailand (PTT), financed by a Barclays-led syndicate that includes HSBC. Lohmann, alongside other civil society groups, accuses the project of violating the rights of project-affected communities in Songkhla province of Thailand.

“HSBC’s involvement in this project demonstrates that the argument of constructive engagement does not hold water,” he says.

Citing client confidentiality, HSBC would not confirm or deny its involvement in the project or any other, but claimed it ensures that every project it finances complies with the Equator Principles and its own environmental and social policies.

Moving Beyond Neutrality

In relation to perhaps the most daunting challenge of all, banks can become major drivers of change. The World Business Council on Sustainable Development (WBCSD) has estimated that stabilizing current greenhouse gas concentrations by 2050 would require doubling energy efficiency and halving carbon intensity in the next half century.

By all accounts, financial markets are critical to realizing this structural transformation in energy use.

Paradoxically, the reliance on carbon markets to facilitate the transition to a low-carbon economy has made compliance-driven regulatory structures all the more important. But even though government-backed constraints on carbon do not exist in many markets, Kenber argues banks should not sit back and wait.

“For longer term investments in emissions-intensive industries, the incentive to manage carbon risk is still not very strong,” he concedes. “But if you are considering financing power plants expected to operate for 20-30 years or more, you do need to know that carbon will play a role in your pricing and your cost for the duration of the project.”

In principle, Sullivan agrees. “Now that carbon increasingly has a value, you can either capture it or face risk,” he says. “And we have an advantage in the marketplace because of our global reach, which would allow us to facilitate carbon trades by connecting clients in different parts of the world with each other. ”

Meanwhile, Lohmann hopes banks soon begin to consider their broader role in addressing the root causes of climate change.

“The Carbon 100 is an excellent first step in increasing our understanding of how different companies and industries contribute to climate change,” says Lohmann. “These kind of inventories can help banks recognize how their financing in particular industries may contribute to shoring up the current fossil-fuel economy.”

In response, Sullivan contends that the evolution of HSBC’s carbon finance strategy will necessarily depend on the level of government support for different clean technologies, the rate of change in client demand, and the general development of carbon markets.

“HSBC is quite a cautious organization, and we would not want to risk our own money or our clients money,” he explains. “It is important that the industry moves forward on a broad front.”

For Robins, the serious consequences of climate change should provide more room for policies that reaffirm business values, build reputation, and may eventually increase business. As an example, Robins suggests that HSBC and other banks could make the financing of coal-fired power plants contingent on the use of carbon capture and storage (CCS) technology.

“HSBC has already decided against financing defense equipment sales, even though it is entirely legal do so,” he says. “In relation to climate change, insurance companies have started to decline insurance to clients that do not have carbon management plans in place. So there is a precedent for this in the financial sector.”