Climate Change in the Banking Sector: A ‘Tragedy of the Horizon’

Eva Mynott

November 2018

Climate change as a disruption to the banking sector

The Intergovernmental Panel on Climate Change (IPCC) has established that greenhouse gas (GHG) emissions are currently at the highest level in history. This development mainly originates from human activity. If we continue to emit GHGs on this scale, this will have grave, extensive and even irreversible consequences (IPCC, 2014). The United Nations Framework Convention on Climate Change (UNFCCC) has therefore formulated the goal to limit global temperature rise to 2 degrees Celsius. This is manageable if and only if emissions are significantly reduced over the next decades. For example, the European Union aims to have reduced emissions by 40% before 2030. The 2015 Paris Accord contributes to this goal by prompting nations to step away from carbon-intensive industries and related capital. It specifically mentions the role of the financial sector in “making finance flows consistent with a low greenhouse gas emissions and climate-resilient pathway” (Article 2.1.c). The International Energy Agency has estimated that, with the pledges made in the Accord, the carbon budget to maintain the 2 degrees limit will be exhausted as early as in 2040 (figure 1). Therefore, the transition to a carbon-neutral economy will need to be fast (IEA, 2015). As banks have significant assets under management and are critical for capital allocation in the economy, they could perform a leading role in this transition (NGFS, 2017).

Figure 1: Carbon Budget and Energy-Related Emissions, Source: IEA (2015)

Why should banks care? Apart from strategic and moral justifications, the main rationale is that climate change and associated risks can be highly disruptive to the banking industry. Climate change risks are usually divided into two broad categories: physical risks and transition risks. The IPCC predicts that physical effects will emerge as soon as in the next ten to fifteen years. This means that the incidence of natural catastrophes will increase, and the distribution of these physical risks is increasingly fat-tailed (IPCC, 2014). Physical risks for banks mainly materialize through counterparties to which they are exposed, as opposed to insurers who directly experience the adverse effects of climate-related disasters. Physical climate-related effects are disruptive in the sense that they are usually unpredictable both in timing and scale (French Ministry for the Economy and Finance, 2015).

Besides physical risks, the financial sector is also likely to be affected by transition risks. Transition risks are any risks related to the transition to a more sustainable economy. They come in many forms. For instance, the transition can be triggered by sudden shifts in the use of energy resources, particularly due to unprecedented advancement in low-emission technologies (French Ministry for the Economy and Finance, 2015). This transition away from carbon-intensive assets then leads to a revaluation: the assets and reserves will become ‘stranded’. This will not only affect the fossil fuels sector, such as coal, oil and gas. It also impacts sectors that depend upon fossil fuels, such as utilities, heavy industry, and the transportation sector. Banks that are exposed to this will suffer direct financial losses (DNB, 2016). In this sense, a sudden transition can be perceived as a large and persistent macroeconomic shock. If banks are not prepared for the transition, it could destabilize the financial system and even lead to systemic risk by triggering contagion (ESRB, 2016).

“(…) success is failure. That is, too rapid a movement towards a low-carbon economy could materially damage financial stability. (…) [it] could destabilise markets, spark a pro-cyclical crystallisation of losses and lead to a persistent tightening of financial conditions: a climate Minsky moment”
-- Mark Carney, Governor of the Bank of England

Regulation and climate changes policies can also accelerate this transition. Even if some banks may not currently acknowledge the financial risks associated with climate change, they may be forced to do so in the near future due to more stringent regulation. Similar to technological advances, regulation can spur a rapid devaluation of certain heavy-industry asset classes and lead to considerable losses for banks (ESRB, 2016). Finally, ‘climate sentiment’ risks should not be underestimated either. Climate sentiment relates to sudden changes in investors’ perceptions towards climate change risks. Banks that do not keep up with this may therefore have a competitive disadvantage and experience reputational issues. Changing sentiment could also induce economy-wide shocks that spiral and exacerbate losses on banks’ asset portfolio value (CISL, 2015).

Despite these risks associated with climate change, it is not trivial to determine when, and if, they will materialize. Moreover, uncertainty remains with respect to the speed of the actual reduction in carbon exposure and greenhouse gas emissions. The ESRB estimates that in an adverse, but not unlikely scenario, a late and sudden transition could lead to extreme losses in a very short period. This additional layer of uncertainty is what makes climate change and transition risks particularly disruptive (ESRB, 2016).

Expected policies and regulatory developments to consider

The speed and disruptiveness of the transition to a low-carbon economy may be accelerated through climate change policies and regulation. Therefore, a good starting point for banks is to assess short-term predicted changes in the regulatory landscape. Recently, financial sector supervision authorities and regulators from both developed and emerging countries have launched the Network for Greening the Financial System (NGFS). Their aim is not just to increase regulatory oversight on climate change risks in the banking sector - it goes beyond that. They believe that banks should play a fundamental role in making the financial system more climate-friendly, for example by mobilizing capital for green investments (NGFS, 2017). Moreover, in 2016 Michael Bloomberg launched the Task Force on Climate-related Financial Disclosures (TFCFD). The task force aims to provide recommendations on a set of universal climate-related disclosures for companies. These disclosures relate to governance, strategy, risk management, and metrics. In this way, it becomes easier for banks, in their role as investors and lenders, to assess the climate-risk they are exposed to through their counterparties (TFCFD, 2018). Other ideas that have been proposed but have not been implemented so far include a ‘green supporting factor’ or a ‘brown penalizing factor’ for banks. In the first case, a bank is allowed to have lower capital reserves if it to some degree invests in sustainable projects or low-emissions assets. This approach has been criticized as it is not clear whether green investments are generally less risky. If this is not the case, this supporting factor may lead to the undermining of capital buffers. As for the brown penalizing factor, banks will need to keep additional capital reserves if they are exposed to non-sustainable, deemed risky projects or assets (Vander Stichele, 2018; European Commission, 2018a).

Even though some policies are still in their infancy and many comprise voluntary procedures, climate-related legislation for the financial sector is on its way. The European Commission (EC) has recently started drafting policies and regulation related to climate change risks for banks, as well as the financial sector in its entirety. Based on the recommendations of a High-Level Expert Group on Sustainable Finance, the EC established three legislative proposals in May 2018 that have yet to be approved. The first law relates to creating a taxonomy, which means developing a general classification system for financial products and activities, which would make it easier for banks to separate green from climate-unfriendly investments. Secondly, banks, other investors, and anyone selling investment products, will need to disclose how they take climate-related risks into account in their operations. This essentially entails transforming the TFCFD disclosure recommendations into non-voluntary legislation. Thirdly, the EC aims to develop a standard ‘positive carbon’ benchmark, which will make it more accessible for banks to estimate their carbon footprint (European Commission, 2018b). It is uncertain whether the proposed legislation will be implemented anytime soon, particularly in view of the EU elections in May 2019 (Vander Stichele, 2018).

The need for banking sector transformation

A banking sector transformation is needed to make banks less susceptible to the outlined climate-related risks. Banks would do well to prepare for a rapid and disruptive transition to a low-carbon economy. A first step could for instance be to start gaining insight into the climate- and transition-exposure of their investment and lending portfolios. This requires coordination within the banks to develop metrics and gather the right data (UNEP, 2018). This is not only necessary to prevent costly ignorance; it is also important in view of expected disclosure legislation. Moreover, it should become a rule rather than an exception to invest in green assets and divest from carbon-intensive industries or climate-unfriendly projects (NGFS, 2017; European Commission, 2018a). ING for example has recently stated its commitment to decrease its coal investments, to eventually have nearly zero coal exposure in 2025 (ING, 2017). Apart from divesting from specific carbon-intensive industries, it is also a possibility to start making more widespread use of available corporate ratings, such as the environmental and climate (E&C) corporate ratings from Standard & Poor’s Global Ratings (Williams and Wilkins, 2017). Finally, one of the fundamental problems that banks should tackle is their relatively short horizon compared to pension funds and insurers. There is a maturity mismatch between short-term bank interests and longer-term green financing and sustainability risks (IPCC, 2014). Banks need to start conducting short-, medium- and long-term scenario analyses and carbon stress tests to assess the likelihood and scope of climate-related losses, for example in their lending portfolios (UNEP, 2018).

Apart from mitigating negative impacts and managing risks, there are also numerous climate change-related opportunities for banks. For example, in the near future the global energy sector is expected to need about $3.5 trillion per year to facilitate the transition to a low-emissions state of the economy (TFCFD, 2018). Investing in climate-friendly assets in this sector or developing low-emissions services can become highly competitive strategies for banks. In other words, it can be profitable for banks to be at the forefront of this transition (UNEP, 2018). The IPCC has also recognized opportunities for banks to adjust to a more sustainable economy. They suggest the possibility of issuing green bonds, expanding environmentally-screened investment funds, and developing sophisticated weather derivatives to hedge physical risks (IPCC, 2014). Through these opportunities, banks find themselves in an excellent position to lead the way and steer the financial sector towards a more climate-friendly future. Instead of allocating capital to its most productive use, banks of the future will be expected to allocate capital to its least destructive use.


References

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  • Carney (2018, April 6). ‘A transition in Thinking and Action’, speech given at International Climate Risk Conference for Supervisors, De Nederlandsche Bank, Amsterdam. Retrieved from: www.bankofengland.co.uk/speechatransitioninthinkingandaction
  • CISL (2015, November). ‘Unhedgeable risk: How climate change sentiment impacts investment’. University of Cambridge Institute for Sustainability Leadership. Retrieved from: www.cisl.cam.ac.uk/unhedgeablerisk
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Eva Mynott

MSc Finance (DHP in Quantitative Risk Management)