Banking on a changing climate? Part 2

Channels: Debt, Stranded Assets

Companies: HSBC, Latham & Watkins, Client Earth, Commonwealth Bank of Australia, TCFD, Crédit Agricole, Goldman Sachs, Standard Chartered, Dong Energy

People: Paul Davies, Aaron Franklin, Kyung-Ah Park, Daniel Klier, Roselyne Renel, Eric Cochard, Stanislas Pottier, Paul Fisher

Climate change poses a significant threat to banks. How big is their exposure to climate risks, and what are they doing to mitigate them, asks Peter Cripps. The second part of this two-part feature explores physical risks and liability risks

The first part of this feature set the scene, and explored transition risks.

Physical risks

The physical risks of climate change are often considered by banks to be less immediate, and are also harder to model.

"Transition is easier to understand and more asset specific," concedes HSBC's Klier.

The current impacts tend to be localised. Crédit Agricole's Cochard says that, despite the series of damaging hurricanes in 2017, it will be a while before the physical impacts are felt broadly across the portfolio.

In the meantime, the key is having a diversified portfolio to help spread the risks, across geographies and sectors, he says.

There is an argument to say that collateral may help shield banks against the physical impacts of climate change. For example, a flood may damage a house but may not impair the collateral to the mortgage lender. However, in more severe cases, for example when a home is destroyed by a hurricane, this may not be the case.

Renel at Standard Chartered points out that obtaining high quality data can be a problem. She says banks may need to turn to the insurance sector for assistance. For example, banks may not have kept data on properties that have been hit by floods. This data is more likely to have been retained by insurers, she explains.

She adds that insurers may also have a larger role to play in risk transfer as the physical impacts of climate change bite.

When it comes to both physical and transition risks, HSBC's Klier points out that, ultimately, climate factors need to be integrated into mainstream credit assessments.

"For the most exposed sectors and countries, we will start to embed it into our credit risk assessments," he says. "It starts with questions like: is the board aware, does it use scenarios? It's really important to make it part of our normal credit process."

CISL's Fisher points out that this will entail a vast amount of retraining for banks.

Liability risks

Banks do not face the same kind of liability risks as insurers. They do not sell directors and officers cover, which accounts for most of the exposure of insurers.

Law firm Latham & Watkins partner Paul Davies said that in jurisdictions like the US or Europe, lenders were unlikely at present to be held directly liable for the activities of the companies they lend to.  However, the position could change over time, "particularly if one considers other jurisdictions like China".

Another Latham & Watkins lawyer, Aaron Franklin, cautioned that banks acting as underwriters of bonds should assess the materiality of climate risks to an issuer's business when drafting the risk factors in the offering documents.

Client Earth, an activist law firm that specialises in environmental issues, argues that banks could be sued for failing to adequately disclose their climate risks.

While there is a risk of being sued for not disclosing, some directors fear they could be sued for making forward-looking statements about climate change that prove to be incorrect.

However, a recent report produced by the Commonwealth Climate and Law Initiative (CCLI), finds that companies and directors are actually likely to face greater liability exposure if they fail to report climate-related financial risk altogether.

A shareholder filing against the Commonwealth Bank of Australia criticised the bank for failing to adequately disclose climate risk as a good example of this. The case was dropped after the bank released new reporting that recognised climate change as a financial risk.

Client Earth has argued that complying with the TCFD recommendations is currently the best insurance policy against climate-related legal action.

"I think banks have a major role to play in forcing behavioural change in some of their clients" - Roselyne Renel, Standard Chartered

HSBC is an example of a bank that has pledged to report in line with the TCFD's recommendations.

"TCFD is one of the biggest game changers," argues HSBC's Klier. "It has already changed behaviour in financial institutions.

"TCFD suggests a five-year time horizon, and says the stress testing will come in the second half, once the data is good and consistent," he says. "We are starting with carbon data through CDP. "We are also starting to look at machine learning to capture data in the public domain.

"This is clearly work in progress and it's clearly not an easy task but CDP is a good starting point."

The United Nations Environment Finance Initiative has set up a pilot programme supported by 14 banks to try to improve banks' understanding of climate risk and establish 'best practice'. (See box)

When it comes to reporting climate risks, French banks have a head start. A recent report by NGO ShareAction found that French banks were leading their European peers when it comes to managing climate risks. This is mainly due to "innovative policies" such as France's Energy Transition law, Article 173, which was introduced in 2015 and requires financial institutions to report on their carbon risks, among other factors.

Crédit Agricole's Pottier asserts: "Article 173 is already going further than the TCFD."

Solutions

For Goldman Sachs, the risks are less about the exposures of their balance sheet and more about whether they are giving the right advice to clients.

"How to help clients think about climate as a risk is a new opportunity for us," argues Goldman's Kyung-Ah Park. "We can help make the market more efficient. We take our role as an intermediary seriously."

Banks may have a more sophisticated understanding of climate risks than their clients. They can therefore help them understand these risks and encourage them to adopt strategies that are in line with the low-carbon transition.

Standard Chartered's Renel explains: "If we were lending to a company whose only activities were dependent on petrol or diesel, you would have to have the view that they were not going to survive in the long-term. I think banks have a major role to play in forcing behavioural change in some of their clients.

"We are here for good. We want to make positive change. If we can see they are not going to move, we are not going to work with them."

This sentiment is echoed by HSBC's Klier. "In most cases, we want to work with clients rather than walk away," he explains. "We want to work with companies that are transitioning and will help reduce our exposure to climate risk – that's why it's so important that it is part of the annual credit risk assessments."

Banks will also increasingly press their clients to disclose better data on their climate risks, as this will help with their credit assessments.

"To progress in terms of assessing these risks, we still need some more information from the companies we cover," admits Crédit Agricole's Pottier. "The carbon reporting we see today is not what we need in order to have a meaningful risk assessment. We need more information about companies' assessment of their own exposure to climate risks and how they are dealing with them strategically, in order for us to be able to assess whether they are on the right track."

HSBC's Klier adds: "We need to find ways for different parties to work together to show what good disclosure looks like. I don't feel it's happening at the moment.

"We need to break down sector barriers and get oil & gas companies, and banks and investors in a room, talking."

Opportunities

Ultimately, climate factors need to be integrated into mainstream credit assessments - HSBC's Daniel Klier

There are also opportunities for backing winners. "There are big opportunities in infrastructure, smart grids and [energy] storage" says Goldman Sachs' Park. "If you look at where we were in 2005 compared to where we are today it has become a lot more low-carbon oriented. We are one of the biggest investors in clean energy - for example, while we were an investor in Dong Energy it transitioned from oil and gas and went very long into offshore wind."

Crédit Agricole's Cochard points to the green bond market as being another area of growth and opportunity. Crédit Agricole was the biggest underwriter of green bonds in 2017, according to Environmental Finance's green bond database. "It's not just about risks, the opportunities are huge," he adds.

Climate change presents both risks and opportunities, but it needs to be better understood.

"Boards increasingly need to be climate literate," summarises HSBC's Klier. His comment is just as true for banks as it is for the companies they lend to. EF 

Reporting in line with the TCFD

16 banks have joined a UN Environment Finance Initiative (UNEP FI) pilot project to help them report in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).

The pilot aims to develop scenarios and analytical tools to strengthen their assessment and disclosure of climate-related risks and opportunities.

The pilot banks will share their learnings and the results will be made public to encourage banks worldwide to adopt the scenarios, models and approaches developed.

They are focusing on five sectors: energy, transport, metals and mining, real estate and agriculture.

A report into how to assess transition risks and opportunities is expected in coming weeks, to be followed by a report into physical risks.