Over the past several years, environmental sustainability has emerged as a key strategic objective for financial institutions in advanced economies. Net-zero pledges, global alliances, and commitments to accelerate the energy transition are proliferating across Europe, North America, and parts of Asia–Pacific. In parallel, financial regulators in these regions are examining climate risks more closely and requiring institutions to assess their exposures through climate stress tests and scenario analyses.
Latin American financial institutions have generally been slower to integrate sustainability into their strategic agendas. However, four converging trends are rapidly reshaping the regional financial sector’s approach to environmental protection and climate change. These trends have potential to make 2023 a significant year for sustainable finance in Latin America.
Across the region, sustainability-oriented capital flows are surging
At the end of 2022, about 80 percent of Latin American countries had updated their nationally determined contributions (NDCs)—their commitments to cutting greenhouse gas (GHG) emissions under the Paris Climate Agreement—with major regional economies adopting substantially more ambitious objectives. For example, Mexico originally aimed to reduce emissions by 22 percent relative to the baseline by 2030, but in November 2022, it updated its NDC to set a more aggressive target of 35 percent. Brazil updated its NDC in March 2022 and now aims to reduce its GHG emissions by 37 percent from 2005 levels in 2025 and by 50 percent in 2030 before achieving climate neutrality in 2050. Broadening their commitment beyond climate, multiple Latin American countries have joined the High Ambition Coalition’s 30×30 initiative, which is working to protect at least 30 percent of the world’s terrestrial and marine areas by 2030.
The transition to a more sustainable economy is presenting opportunities for financial institutions to benefit society’s broader well-being by enabling a complex array of new capital flows and financing options. Research from the McKinsey Global Institute (MGI) points to several areas where investments would need to increase to reduce greenhouse gas (GHG) emissions (e.g., building low-emissions assets and infrastructure, decarbonizing emissions-intensive industries), implement climate change adaptation and mitigation measures, and protect natural capital and biodiversity. Energy security and decarbonization can be complementary objectives, as investing in self-sufficient low-carbon solutions can accelerate the regional energy transition.
According to our research, achieving net zero by 2050 will push Latin America’s total spending on physical transition-related assets to 9.4 percent of regional GDP, or about $20 trillion, with annual spending on physical assets rising by about $700 billion over the baseline (Exhibit 1). Brazil—with its vast and diverse geography, large economy, and abundance of critical environmental capital, including the Amazon rainforest, one of the world’s three largest carbon sinks—accounts for over one-third of regional climate-finance opportunities (Exhibit 2). Other countries in the region have extensive biodiversity and large industrial bases that offer considerable decarbonization potential, as well as extractive sectors (e.g., copper, lithium) that could play a key role in the global transition to net zero.
Beyond the transformation of their domestic economies, Latin American countries have rich natural endowments and resources that will be critical to the global energy transition (Exhibit 3):
- Mineral resources. Latin America is a major source of lithium and other key mineral resources required for the energy transition. Argentina, Bolivia, Brazil, and Chile have especially large proven reserves.
- Renewable energy. Latin America’s vast potential to generate multiple forms of renewable energy may exceed future regional demand, presenting export opportunities for energy and related products.
- Liquid biofuel. Expanding liquid biofuel production in Argentina, Brazil, Colombia, and Guatemala could support the decarbonization of regional and global transportation systems.
- Forests. Latin America has an enormous capacity to offset carbon emissions through reforestation and afforestation, including an estimated 34 percent of the world’s total mitigation potential from reforestation. Voluntary carbon credits can incentivize investments in ecosystem protection and restoration, including the use of climate-smart agricultural and forestry techniques to strengthen carbon capture and storage. Brazil’s voluntary carbon-credit market alone is projected to reach $15 billion in 2030 and $35 billion in 2040.
- Agriculture, livestock, and fisheries. Latin America’s large primary sector offers extensive opportunities to invest in sustainable agriculture, livestock, and fisheries. Transforming coastal fishing and aquaculture clusters in countries such as Chile, Ecuador, and Mexico can create a strong blue-economy value proposition that presents significant business opportunities in biodiversity-dependent sectors such as tourism and biomedical research.
Latin America’s vulnerability to climate change will likely increase financial institutions’ physical and transition risks
As Latin America becomes increasingly vulnerable to the effects of climate change, physical and transition risks will probably have a greater impact on financial institutions. Latin America’s exposure to climate risk is rapidly intensifying. The region is home to 13 of the 50 countries most susceptible to climate-related shocks, and the climate crises could push 2.4 million to 5.8 million people into extreme poverty in Latin America and the Caribbean by 2030. A McKinsey Global Institute analysis of Latin America’s risk profile under a high-emissions scenario (RCP 8.5) found that the region is most acutely exposed to heat waves, humidity, droughts, and ecosystem degradation.
In addition to physical and transition risks from climate change, many of the region’s key economic sectors are under direct threat from other forms of environmental damage. For example, the loss of biodiversity poses an immediate danger to agriculture, forestry, and fisheries. These sectors are critical to economic output, food security, and livelihoods, so protecting them will likely be a top priority for Latin American policy makers, international aid agencies, and multilateral development institutions within and outside the region.
As public investment in conservation and climate resilience contributes to an expanding range of opportunities for complementary private investment, financial institutions can help meet the demand by building their capacity to identify, measure, and manage the impacts of climate-related risks. Institutions that position themselves to facilitate private capital flows supporting climate adaptation, resilience, and conservation may enjoy a significant competitive edge.
Financial and market regulators in Latin America are shifting attention to environmental risks and opportunities
Other regions’ regulators became active first, but their Latin American counterparts are now beginning to address climate risk and other aspects of environmental sustainability. Central banks, securities-market regulators, and financial authorities in Asia, Europe, and North America continue to expand and refine regulatory frameworks around climate risk. In 2022, the use of climate stress-testing and scenario analysis became increasingly widespread. Prudential requirements for identifying and managing climate risks were strengthened, and in some jurisdictions, additional capital requirements were imposed on banks that fail to address climate and environmental risks. In Latin America, several central banks and supervisors have joined the Network for Greening the Financial System (NGFS) global initiative, which enables the sharing of international best practices for systematic management of climate risk and prevention of greenwashing (i.e., promising to take, or claiming to have taken, environmentally friendly actions, without actually delivering on the promises).
Though Latin American authorities have been slower to implement sustainability-focused financial regulations, Brazil, Chile, Colombia, and Mexico have recently taken concrete steps to strengthen regulatory requirements around corporate disclosure, sustainable banking, and climate-risk management:
- The Central Bank of Brazil and the National Monetary Council issued new disclosure requirements (GRSAC reports) and established rules governing how banks incorporate environmental, social, and governance (ESG) policy considerations (PRSAC guidance) and climate-risk analyses. Brazil’s Securities and Exchange Commission is working to align domestic sustainability disclosures with international standards.
- Chile’s Financial Market Commission issued a sustainable-finance disclosure agreement that tightens standards for sustainability reporting among supervised entities.
- Colombia’s financial regulator adopted a “green taxonomy” that provides a set of standard classifications of sustainable activities. By clearly defining key terms and concepts, the green taxonomy aims to foster the development of a more expansive and sophisticated market for sustainable finance products.
- In Mexico, the Ministry of Finance and Public Credit has recently launched a “sustainable finance taxonomy.” Meanwhile, the Bank of Mexico is promoting ESG risk measurement methodologies and capital mobilization opportunities, and the National Securities and Exchange Commission is establishing ESG-related adoption and disclosure requirements.
Early movers are making commitments to the net-zero transition and other sustainable-finance objectives
Following the example of their peers in Asia, Europe, and North America, Latin American financial institutions have started launching sustainability programs and establishing or strengthening environmental commitments. Many of these commitments focus on reducing emissions, including those generated by the institution itself and those resulting from its lending activities or investment books. About 50 percent of Latin American banking assets belong to institutions that have joined the Net-Zero Banking Alliance (NZBA) (Exhibit 4). These institutions have declared a net-zero commitment for 2050 and set sizeable decarbonization targets for 2030, with emissions cuts typically ranging from 20 to 40 percent across most portfolio sectors.
The bulk of the banking sector’s net-zero assets typically belong to branches or subsidiaries of foreign banks. Our conversations with banking leaders indicate that many other institutions are considering or planning to make similar commitments in the near term. To accelerate this trend and help signatories implement their commitments, the Glasgow Financial Alliance for Net Zero has expressed its intention to open a Latin America hub in 2023.
Sustainable-finance flows are increasing, with a growing number of regional institutions publishing external commitments to mobilize billions of dollars in sustainable financing. Meanwhile, the number of sustainable products and transactions is steadily rising. According to the Climate Bonds Initiative, issuance of green bonds more than doubled in less than two years, rising from $13.6 billion in September 2019 to $30.2 billion in June 2021. Sustainability-linked debt instruments tied to key performance indicators (KPIs) are being discussed with increasing frequency, in the context of new issuances and debt restructuring. In February 2022, Chile published a national sustainability-linked bond framework. Later in the same year, Uruguay issued a $1.5 billion sustainability-linked bond, which may prove to be a major milestone on the path to a sustainable-finance sector capable of providing scalability for private investors and multilateral lenders.
Designing a comprehensive, programmatic approach for Latin America’s aspiring leaders in sustainable finance
Sustainability is rapidly becoming a CEO-level topic for financial institutions in Latin America, as it already has become in Asia, Europe, and North America. The international experience shows that integrating sustainability into business and functional processes is associated with reaping the greatest rewards in terms of business growth, climate-risk mitigation, and strategic positioning. Because sustainability affects many different business and functional teams across the institution, and because implementing systemic change requires sustained managerial attention, efforts to embed sustainability concerns in routine operations could follow a holistic approach built on five key pillars (Exhibit 5).
The first three pillars are strategic. They focus on defining objectives, designing a business strategy to capture opportunities, and revising the risk framework to identify and manage environmental risks. The final two pillars are supportive. They encompass the necessary conditions for delivery, as well as the unique stakeholder-management and reporting requirements associated with sustainable finance.
Environmental strategy, ambition, and commitments
In advanced economies, environmental strategies tend to focus on mitigating climate change and supporting the energy transition. Overarching institutional targets often concentrate on decarbonization, including the goal of achieving net-zero emissions, typically by 2050.
Several financial institutions in Latin America are starting to embrace this approach, with some net-zero commitments announced in 2022. Achieving these objectives will require building the capabilities and expertise necessary to measure emissions and establish scientifically credible reduction targets for direct emissions by the institution and indirect emissions generated by its lending and investment portfolios.
Beyond following the example of financial institutions in advanced economies and focusing on carbon emissions, Latin American leaders have the option to craft a strategy tailored to the environmental priorities of the countries where they operate. Latin America faces a variety of environmental challenges beyond climate change, including declining biodiversity, ongoing deforestation, and increasing water stress. In addition to the process of assessing and reducing GHG emissions, financial institutions in the region can measure and manage other environmental impacts.
Tackling these challenges could make Latin American financial institutions global leaders in environmental-impact management beyond climate change, helping establish best practices that could be applied by their peers in other regions of the world that face similar challenges. Financial institutions in Latin America that aim to reach their potential as leaders in sustainability can do so by defining their strategic priorities, overarching ambitions, and internal and external commitments to environmental and climate action.
Opportunities for growth in environmental finance
Latin American financial institutions could play a crucial role in mobilizing the investments required for the energy transition, climate-change mitigation and adaptation, and the broader preservation of environmental quality. Typically, organizations that achieve the goals for a transformation of this magnitude employ a structured approach: they estimate the business potential of sustainable finance opportunities and define the value propositions and go-to-market strategies to capture them. Such an approach includes four key components, all of which could apply to sustainability initiatives:
- identifying and sizing financing value pools based on country-level and subregional economic analyses that include both a current-policies baseline and a net-zero scenario, as well as other scenarios related to nature conservation
- assessing revenue potential based on the size of the value pool and essential, “right to win” criteria such as market position, client relationships, and brand strength
- developing value propositions, including adaptations of core products and services (e.g., green bonds, sustainability-linked loans, green factoring and leasing), transition-finance advisory services, and new green business offerings (e.g., voluntary carbon offset market making and advisory, supply chain finance ecosystems, one-stop shops for home efficiency and green mortgages)
- building a sustainable-finance team and defining an operating model for existing sales and product teams to fulfill their new strategic objectives
Latin American institutions can learn from successful value propositions developed in other regions, tailor them to the local context, and build robust sustainable-finance offerings and go-to-market strategies for priority customer segments.
Climate and other environmental risks
Latin American financial institutions are exposed to geographies that face high physical risks (e.g., extreme weather events, environmental degradation) and to sectors that face high transition risks (e.g., oil and gas, mining, agriculture). Managing these risks will require developing new tools to identify and measure the risks, combined with initiatives to embed climate risk into processes for risk assessment, underwriting, portfolio monitoring, and decisions about risk appetite.
Accomplishing this involves gathering new data from clients and external providers and employing new methodologies for scenario analysis and stress testing. Embedding the results of qualitative and quantitative climate risk assessments into risk appetite statements, credit underwriting and investment scorecards, pricing models, and portfolio monitoring metrics will help companies reap practical benefits such as improved decision making, lowered exposure to high-risk counterparties and geographies, and further growth in low-risk, high-return opportunities.
Implementing an effective sustainability strategy requires close coordination between the client-facing teams in the front office and those involved in product development, sustainability, risk management, regulatory compliance, and external relations. Financial institutions are likelier to achieve this level of coordination if they design fit-for-purpose routines for governance, team accountability, and program management. In parallel, they can consolidate the necessary institutional capabilities by launching new programs to build sustainability-related knowledge and expertise at levels ranging from the board and senior management to the sales teams interacting directly with clients. Targeted recruitment and consulting support can be used to acquire talent with additional specialized skills in areas such as climate science and emissions calculation.
Financial institutions also should consider acquiring and integrating new climate data from a broad range of internal, client, and vendor sources for a variety of use cases, including setting net-zero targets, assessing physical and transition risk, and identifying business advisory opportunities. Designing appropriate data governance mechanisms and a strong data architecture early in the process can help institutions avoid problems such as siloed data tables and redundant versions of the same data element in different use cases.
Reporting and stakeholder management
The fifth pillar of a successful sustainability strategy is external communications and stakeholder management. Institutions should identify which external parties to apprise of progress toward net-zero goals and other commitments, as well as opportunities to mobilize sustainable-finance flows and the evolution of climate and environmental risks. Institutions typically present this information in annual reports drafted according to international standards such as the Task Force on Climate-Related Financial Disclosures (TCFD) framework. While TCFD is a voluntary standard for climate disclosures, securities-market regulators in Latin America and elsewhere are starting to issue specific disclosure requirements based on its approach. Similar standards for impact reporting are being developed for other topics, including biodiversity and ecosystem services. As financial institutions report on their net-zero goals and related performance, they should ensure that their reporting does not constitute greenwashing. This will require closely aligning their disclosure objectives and external communications with their strategic plans and institutional capacity-building efforts.
Sectoral alliances are an increasingly prominent feature of sustainable finance. Senior executives can pursue this approach by developing a clear vision for engagement with global initiatives—for example, the Glasgow Financial Alliance for Net Zero (GFANZ) and the UN Environment Programme Finance Initiative (UNEP-FI)—and with local public- and private-sector entities. Each alliance imposes specific conditions and commitments on its signatories, and each offers unique opportunities. Determining which alliances are most consistent with achievement of the institution’s sustainability strategy will inform the timeline for developing the required capabilities.
Finally, regulatory compliance is not merely a legal requirement but also a significant topic for sustainability strategy and implementation planning. While most Latin American countries are still in the early stages of developing sustainability requirements, policy makers in Brazil, Chile, Colombia, and Mexico are elaborating their regulatory frameworks to incorporate sustainability criteria. Financial institutions across the region can stay ahead of regulatory requirements and maintain a competitive edge in the global market for sustainable finance by proactively building the capabilities currently required in other jurisdictions.
Though Latin American financial institutions have been slower to integrate sustainability into their strategic agendas than institutions elsewhere, they are beginning to accelerate their efforts. The four converging trends now reshaping the regional financial sector’s approach to environmental protection and climate change may make 2023 a significant year for sustainable finance in Latin America. Given the complexity of this topic and the number of different teams and areas involved within each institution, the advantage may go to players that adopt a strategic and comprehensive approach.