(Bloomberg) -- Judson Berkey didn’t hold back.

It was early February and the UBS Group AG banker had WebEx-dialed into a meeting held on the 17th floor of the Japanese Financial Services Agency’s building in the Kasumigaseki district of central Tokyo. The closed-door gathering with representatives of the Federal Reserve, the European Central Bank and public officials from around the world was billed as a “check-in” for regulators to ask key market participants how they were dealing with the growing tapestry of rules and guidelines around transitioning the economy away from high-carbon assets.

What might otherwise have been a staid conference took an unexpected turn as Berkey, group head of engagement and regulatory strategy at UBS, interjected. The finance industry was being asked to align loans, investments and capital-markets portfolios with a global warming trajectory of 1.5C, while the planet may in fact be hurtling toward a 2.8C increase from pre-industrial times, he noted.

The upshot: The world’s biggest banks can’t live up to the green regulatory ideal unless they start dumping huge numbers of clients worldwide at a reckless pace and also roil economies in large swathes of the globe that primarily rely on dirty fuels. Faced with that dilemma, many lenders are quietly reeling in their climate ambitions.

“Banks are living and lending on planet earth, not planet NGFS,” Berkey told the group in an impassioned speech, alluding to the Network for Greening the Financial System, a collection of central bankers that creates model scenarios for how the energy transition may evolve. Details of what transpired at the meeting hosted by the Financial Stability Board — a coordinator of global regulations — came from people who were in the room but asked not to be named discussing private talks. Berkey confirmed his participation, declining to say more.

The UBS banker’s outburst, which got little pushback from those present, exposes the cracks emerging in a multitrillion-dollar transition finance project, and taps into what’s rapidly becoming one of the most contentious issues in the global banking industry. In private, senior bankers in sustainable finance divisions in London, New York, Toronto and Paris grumble about unrealistic expectations from regulators, civil society and climate activists around the industry’s role in getting the planet to net zero.

The standoff that’s brewing is setting the stage for a showdown at the heart of the ESG movement, where environmental, social and governance considerations are being pitted against old-fashioned capitalism. 

As the gatekeepers of capital, banks can play a central role as catalysts for cutting greenhouse gas emissions. Private capital will need to cough up the lion’s share of the $5 trillion to $10 trillion in annual commitments needed to pay for the green transition, and according to hedge fund billionaire Bridgewater Associates founder Ray Dalio, that will only happen if there’s “a return on the money.” 

“You have to make it profitable,” he told delegates at the COP28 climate summit in Dubai in December.

Climate change is “an economic externality, and you can’t expect a free market to deal with it voluntarily,” Adair Turner, who ran Britain’s financial regulator during the subprime and euro-zone debt crises and is now chair of the Energy Transitions Commission, said in an interview. Most of the transition away from high-carbon activities toward greener business models “will be financed by private institutions making, broadly speaking, profit-maximizing decisions,” he said.  

Banks that had enthusiastically committed to align their entire operations with net zero goals are having second thoughts as the real-world ramifications of acting on those pledges become painfully apparent.  

For instance, doing business in the energy sectors of coal-dependent countries like South Africa, Poland and Indonesia would be off limits. 

Not only do the commitments make it harder for banks to serve commodities clients like Glencore Plc, but even companies not always associated with heavy carbon footprints are ending up in the crosshairs. Nvidia Corp., the wildly successful tech colossus, has an implied temperature rise of 4C and cosmetics giant L'Oreal SA is at an eye-popping 6C, meaning their business models are currently aligned with a trajectory of devastating global warming, according to data compiled by Morningstar Inc.

“Our net zero commitments are about being our clients’ lead partner and are consciously taken around the idea that we need to be there with our clients and our clients need to succeed, not that we need to hyper select clients in order to get to net zero somehow faster or better,” Jonathan Hackett, head of sustainable finance at Bank of Montreal, said in an interview.

Some of the world’s biggest lenders, including Deutsche Bank AG, HSBC Holdings Plc and Bank of America Corp., are adding caveats to their restrictions on financing coal, the planet’s most-polluting energy source.

BlackRock Inc. Chief Executive Officer Larry Fink says he has stopped using the term ESG and emphasized the world’s largest asset manager's work with energy firms in a letter to investors this week. The firm has scaled back its participation in international climate investing alliances.

In its sustainability report published on Thursday, UBS referred to a “notable shift in emphasis'” in discussions around climate change. After years spent on net zero pledges, there’s now a greater recognition of the need for a transition phase, and going forward high inflation and input costs will be “key considerations” for clients developing strategies to decarbonize, the Swiss bank said.

In February, a string of financial heavyweights, including JPMorgan Asset Management, Pacific Investment Management Co. and State Street Global Advisors, withdrew from Climate Action 100+, the world’s largest investor group formed to fight global warming.  Lenders, including HSBC, decided to withdraw applications to get their climate goals certified by the United Nations-backed Science Based Targets initiative. Other such voluntary climate alliances have been shaken by similar walkouts of late. 

Spokespeople for the firms said the moves didn’t reflect a reduced commitment to climate finance. Behind the scenes, people close to the decisions to exit point to the inconvenience of continued membership, spanning everything from the risk of being sued by anti-ESG agitators in the US — especially in the event former President Donald Trump returns to the White House — to the growing mountain of paperwork associated with upholding climate targets. There’s also lost revenue.

“For banks with substantial capital markets businesses, like those competing with the JPMorgans of the world, it’s fee income that’s on the line here,” said James Vaccaro, Chief Catalyst at Climate Safe Lending Network, a group that helps the finance industry figure out how to cut its carbon footprint. “Ditching clients off track from 1.5C means losing major lines of revenue.” 

When climate consciousness erupted onto the financial stage in 2021 at the so-called COP26 summit in Glasgow, major western banks clamorously committed to reduce their carbon footprints. Financed emissions — those that arise from lending and investing — would fall in line with a pathway to achieve net zero by 2050, they pledged. In tandem, most of them promised to pour a big chunk of money — anywhere between $750 billion and $2.5 trillion per bank — into green and sustainable deals by the end of this decade. 

But all that was before they had rolled up their sleeves and done the math. Declarations of intent on slashing greenhouse gas emissions “over projected” what the industry could do, said Adam Matthews, chief responsible investment officer for the Church of England Pensions Board. There’s now a “gradual peeling away of flaky members as the penny has dropped that this is much harder than a photo call and press release,” he said.

Inside the finance industry, irritation hit a new level after the publication of an ECB paper in January stating that 90% of the euro-zone banks it analyzed are “misaligned” with the goal of limiting global warming to 1.5C. The central bank called this a “staggering” outcome.

The ECB noted that many banks depend largely on clients in energy-intensive sectors for revenue. It looked at six industries — power, automotive, oil and gas, steel, coal and cement. On average, these exposures amount to 15% of their highest-quality capital, although the ECB cited “significant variation among banks.” In other words, widespread losses on loans to high-carbon sectors would probably wipe out a large chunk of banks’ financial reserves.

Defining what can go under the rubric of the green transition remains a work-in-progress, even as lenders including Barclays Plc, BNP Paribas SA and Citigroup Inc. create new investment and corporate banking teams for it. 

In some cases, banks are even placing the financing of coal plants under an ESG banner. Lenders are looking for ways to hold on to clients in an array of high-emitting industries spanning cement to shipping and aviation. HSBC has made clear that many clients within these industries will only reach net zero if nascent carbon-reduction technologies can be sufficiently scaled up. 

Coal has tended to face the tightest financing restrictions of all fossil fuels, and international packages to help developing countries transition away from coal have struggled to attract western bankers concerned their involvement would breach their climate policies.

Now, some banks are testing the waters.

A January request for proposals from banks to help finance a coal deal linked to one of the so-called Just Energy Transition Partnerships in Indonesia received a “strong response,” a spokesperson for the Asian Development Bank told Bloomberg. HSBC, Standard Chartered Plc and Bank of America are among lenders that have pitched for the deal that would finance the early closure of the Cirebon-1 coal-fired power station in West Java, Bloomberg has reported. The only way the banks can do that is by expanding their exposure to coal in the medium term.

Cirebon is one of hundreds of coal-fired plants that power homes and industry across Asia. Unlike in the US or Europe, many coal plants in Asia are still just a few years into an estimated lifespan of roughly four decades. They’re also locked into long-term power agreements and have investors who expect the returns they were promised when they allocated funds to the plants. So shutting them early comes at a significant financial cost.

“Getting to net zero in time won't be possible unless we all work together to find ways to finance the credible early retirement of Asia's relatively young coal power assets, even if it looks like our coal-related emissions go up in the short term,” said Celine Herweijer, HSBC's chief sustainability officer. “This is about avoided real world emissions.”

The bank published an updated coal policy in January, which shows it now applies a “risk-based approach” to coal projects that might otherwise have been excluded. Herweijer said there's work under way in the industry to separately account for coal-related emissions if they’re the result of financing credible early-coal retirement initiatives.

But some global banks and investors say continued ties with coal just isn’t worth the risk.

“It’s a bit of a slippery slope,” said Thibaud Clisson, climate lead at BNP Paribas Asset Management. The world needs to “get rid of coal as soon as possible, so at this stage, we don’t want to take this opportunity to be less strict,” he said.

Alice Carr, executive director of public policy at the world’s biggest climate finance coalition, the Glasgow Financial Alliance for Net Zero, or GFANZ, says “financial institutions are considering how to do these kinds of [early coal retirement] transactions presently, and we need the right guardrails because there’s a lot of reputational risk if you don’t get them right.” GFANZ is co-chaired by Mark Carney, who is the chair of Bloomberg Inc.’s board and a former Bank of England governor, and Michael R. Bloomberg, the founder of Bloomberg News parent Bloomberg LP.

For Climate Safe Lending’s Vaccaro, it’s how banks go about it that’s important. The opportunity to pivot to green financing is “big enough” to offset some of the lost revenue of dirty clients, but banks are unlikely to seize it if they continue with their “doublespeak” on both embracing sustainability and maintaining business as usual, he said.

Climate activists are worried. Experience suggests that banks and investors “love nothing better than a good policy loophole,” said Paddy McCully, senior energy transition analyst at French climate nonprofit Reclaim Finance. “If one exists, the chances are high they will pour some money through it.”

Meanwhile, investors sticking with carbon-heavy assets say those staying away risk ignoring the real issues in the wider economy.

Many current policies restricting investment in such companies “create a bias” that hurts emerging markets, according to Diana Guzman, chief sustainability officer at Prudential Plc. “Divestment isn’t going to be the solution,” said Fumitaka Nakahama, group head of global corporate and investment banking at Mitsubishi UFJ Financial Group Inc.As they balance the needs of their clients against their green commitments, veterans of global finance say they want regulators to be honest and acknowledge that progress on climate is slow, and that without the right incentives, bankers won’t play the role expected of them. 

“It was always convenient for finance to be projected as the savior on climate, when in reality, finance can only go so far if the enabling policy environment isn’t there,” according to the Church of England Pensions Board’s Matthews.

That was the point UBS’s Berkey made during the Tokyo meeting, and according to those who were in the room, when he had finished speaking, everyone could see “the wheels turning” in the regulators’ heads.

--With assistance from Nicholas Comfort.

(Adds details from UBS’s sustainability report published Thursday and updates comment by GFANZ’s Carr. An earlier version corrected the spelling of UBS in the web search-engine optimization (SEO) headline.)

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