What part can Behavioural Economics play in helping financial services address the climate crisis?
Rightly or wrongly, banks are judged so far to have been slow to wake up to the climate crisis. This article takes a deep dive into understanding what is behind this perception and how banks have started to engage in further decarbonisation. It also looks at how banks can use behavioural economics to pursue their decarbonisation goals by overcoming some of the structural barriers they face.
So what is driving that poor perception?
Banks are big investors in carbon-intensive industries. The exact sums are hard to pin down, but two estimates give a flavour of the scale of their investment:
- Since 2021, 24 of the largest banks have put around $30bn into new oil and gas projects.
- Roughly 4% of the UK’s six largest pension funds are invested in fossil fuels, or more than £1,900 per UK citizen.
By continuing to invest in carbon-intensive industries banks are being seen as part of the climate problem rather than part of the solution. This is risky business for banks, which trade on their reputation as trusted institutions with values consistent with those of their customers.
However, this categorisation does not tell the whole story, as it overlooks several key challenges that banks face in their decarbonisation efforts. Firstly, all businesses, including carbon-intensive ones, require financial services to operate effectively. These industries remain important to the economy and still generate positive financial returns. Simply shunning these businesses is not an option for the financial services sector - or the world for that matter.
So where does the opportunity lie?
Despite the big role banks could play in decarbonising the economy, they frequently face behavioural barriers which limit the actions they are willing and ready to take.
The industry will need to abandon the short-termism of quarterly earnings updates and annual reviews often followed in their existing risk base and responsive approach and adopt a strategic and pro-active approach in order to address decarbonisation over the long run. As part of a shift to such an approach banks will need to focus on four key areas:
- Measuring and reducing their direct emissions (also known as Scope 1).
- Helping major greenhouse gas-emitting clients to lower their emissions.
- Empowering investors (who are also banks’ customers) to take action.
- Working with retail and SME clients to change their consumption and investment behaviour.
The fourth area often attracts the least attention, but it might be the one with the most unexploited potential and where private-public collaboration can move the needle. About half of the UK’s SMEs say they want to do more to tackle climate change but are put off for various reasons. These include time and money, but also a lack of attention and awareness, and the perceived difficulty of taking action. If we want to help these motivated but passive SMEs to fight climate change, we need a deeper understanding of the obstacles they face.
This is also the case with members of the public. A clear gap has been observed between people’s declared preferences to help the environment and how much they actually do. This disconnect might lead banks to make efforts to identify their “green” clients through surveys, and make misguided assumptions about their willingness to purchase a sustainable product. The term green has very different associations for different groups of people. One of the main connotations is that green financial products are expensive. Will environmentally conscious customers reject them because of this perception?
Banks face this and many more uncertainties when thinking about their net-zero strategy – what really prompts a client to renovate their home to improve energy efficiency? How do different types of clients view the riskiness of ESG funds? How does the abundance of green financial products affect their reluctance to take action? To answer such questions, banks need to identify what impels their clients to act – and what holds them back. Behavioural economics (BE) can help with this task. Through its analysis of customers’ motivations, the barriers they face and the psychological traits that explain them, BE can provide banks with valuable insights on how to run their decarbonisation strategies effectively.
As green financial products are new to the market, it is important to test how customers respond to them and how different framings may affect conversion rates. A central part of BE is experimentation. By running various tests and experiments, banks are able to identify how a product is regarded when it is launched. We know from BE that context matters and can influence decision-making. Hence, the choice whether to position a product as the client’s default option or as a premium offering will not be neutral and will certainly affect the product’s marketability.
The success of banks’ net-zero efforts depends crucially on how they are able to convert their back book of existing clients. For that, it will be crucial to reach both retail and SMEs consumers. To do so, banks must let go of preconceived ideas that lead them to segment their client base along socio-demographic lines or according to life events such as marriage, children, and retirement. Instead, new thinking is needed: they must observe their clients’ behaviour, identify what drives it, and experiment with different ways to approach their customers before launching a green financial product. Only in that way will banks unlock the potential inherent in their clients’ willingness to help the environment, do their bit in fighting climate change and overturn the perception that they are part of the problem, not the solution.