5 April 2018

Banking on a changing climate?

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

There has been a flurry of announcements from banks that they will stop lending to companies that burn coal to generate power or are involved with other emissions-intensive fossil fuel-related activity.

This is part of a broader awakening by banks to the risks that climate change poses to their business.

Regulators are also increasingly taking an interest in these risks, with the UK's Prudential Regulation Authority (PRA) and the Dutch central bank expected to release reports on the subject in coming months.

Banks are coming under pressure from all quarters to understand and mitigate climate risks.

When the UK's PRA issued a report examining insurers' exposure to climate risk, it was a landmark moment for the sector because it catalysed an increase in efforts to understand the problem. Its report into the banking sector could prove equally transformative.

Meanwhile, the Dutch central bank, De Nederlandsche Bank (DNB), has also been examining climate risks at the country's banks, and has quizzed its three biggest lenders. The German central bank has also been actively warning about climate risks.

Roselyne Renel, group head of enterprise risk management, Standard CharteredShareholders are also increasingly weighing-in, with an engagement initiative convened by Boston Common Asset Management having garnered support from investors with $2 trillion of assets. A recent report summarising the learnings of the initiative concluded that banks' attempts to adapt to the risks and the opportunities presented by climate change are "often skin deep at best".

The Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD) has recommended that all companies disclose their climate risks, and its final report included a chapter on how financial institutions should report their exposure.

In the past, climate change has mainly been a reputational issue for banks but, in recent years, they have started examining the financial ramifications of the risks it poses.

"Climate change, two or three years ago, was a complete corporate social responsibility discussion," says Roselyne Renel, group head of enterprise risk management at Standard Chartered, who has been tasked by its group chief risk officer with overseeing the bank's response to climate change. "Today, it's also a risk management and strategy issue. The pressure is not just coming from regulators but also shareholders and staff too."

The extent to which banks are exposed to climate risk is unknown.

"We don't know how much climate-related risk the banks have on their balance sheets. Nobody really knows what their exposure is to these risks yet – work is only just beginning," comments Paul Fisher, vice chair of the Cambridge Institute for Sustainability Leadership's banking environment initiative, and a former director of the Bank of England.

Standard Chartered's Renel adds: "How do you model climate risk for your counterparties? Do we have an answer today? No – I would be amazed if any bank does.

"Everyone is thinking about it but no one has an answer yet. We are right at the beginning … we perhaps have another 12 to 24 months to go."

She sees banks increasingly focusing on climate risk.

"We have a process where we look at our emerging risks. Climate change is very firmly on our horizon, it's number one. I would be very surprised if climate change doesn't get elevated to a 'principal risk' type within 12 to 24 months."

She explains that examples of principal risk types include operational risk, cyber risk and market risk.

Being elevated to a principal risk would mean having "a risk management framework in place, clarifying what are the models we use, and how it links to our strategy".

"Two or three years ago, cyber risk was where climate is today. For us today, cyber is a principal risk type.

"I am sure the PRA is going to start asking banks to put climate change into their stress test scenarios," she adds.

The tragedy of the horizon

When the UK's PRA announced its review into the banking sector, in June 2017, Bank of England governor Mark Carney said in an interview that the risks in banking, relative to general insurance would be expected to be lower partly because, whereas insurers tend to be long-term investors, the average duration of banks' loan books tends to be shorter.

So, does the shorter-term nature of banks' time horizons mean they are less exposed to climate risk?

"Chief risk officers tend to have a two or three-year time horizon," says CISL's Fisher. "The fact climate change is a long-term risk doesn't mean it won't crystallise for a long time. Under certain scenarios, London could flood now, even though the risk will escalate over time."

Goldman Sachs' head of environmental markets, Kyung-Ah Park, says: "Even though the average duration of investments is relatively shorter, we do take tangible policy into account as part of our investment thesis and we will look at carbon scenarios as well, when applicable.

"If it looks like adequate return for that risk isn't there, then you are not going to make that investment."

Daniel Klier, group head of strategy at HSBCDaniel Klier, group head of strategy at HSBC, insists that banks need to think long-term despite the shorter durations of their loan books. That's because many companies will need to raise loans in order to repay their existing loans, and if banks withdraw credit this could make it challenging to seek reimbursement.

"You need to understand what happens after the payback period," he argues. "We have to think much longer-term. How do you get your money back if no one will refinance the loan?"

Renel at Standard Chartered also believes a long-term view is needed: "We are a corporate bank, so long term relationships are important to us, even though the majority of our exposure may be short-term in nature," she argues. "How this topic will affect us over the long-term is very important."

The PRA's report into the insurance sector identified three key risks:

-          Transition risk - the risk that investments will be devalued amid the shift to a low-carbon economy, by changes in policy, technology or investor sentiment;

-          Physical risks – posed by the impacts of climate change, such as flood risk caused by rising sea levels or extreme weather; and

-          Liability risk – of being sued by parties that have suffered loss or damage.

Of these three risks, most banks consider transition risk as the most immediately threatening.

"Transition risks could start to materialise from as early as 2020, in some scenarios," believes Eric Cochard, head of sustainable development at Crédit Agricole CIB.

Banks have already been actively trying to reduce their exposure to lending to some of the more emissions-intensive activities, such as coal. This is partly on moral grounds, but also because there is a danger that these activities will be adversely impacted by a change in regulation or demand that makes them less lucrative. Examples of action include:

-          French bank BNP Paribas in October said it would stop lending to companies or projects focused on oil and gas from shale and tar sands, or exploiting the Arctic. Two years earlier, it said it would slash its lending to coal mining in developed economies.

-          Societe Generale said it would stop lending to oil sands and Arctic oil projects, in December. In 2015 it said it would stop financing coal-fuelled power plants and mines.

-          Natixis in December said it would walk away from tar sands and Arctic oil, adding that it would promote an internal green incentive to promote considerations of climate and the environment. It stopped financing coal projects in 2015.

-          ING introduced a "sharpened" coal policy in December, which will see the Dutch bank phase out nearly all lending to coal-related businesses by 2025.

-          Crédit Agricole said it retreated from Arctic offshore oil and shale in 2012, and divested in 2015 from miners whose main business is coal and from coal power plants in developed countries. A year later it extended it to all countries.

"We know some sectors and geographies are more exposed than others," adds Crédit Agricole's Cochard. "While it's complex, energy and transport have been identified as particularly at risk. But we can't say that all the actors in one sector will be affected the same way. It's important to differentiate between actors.

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

"Exclusion was quite an obvious decision for coal because it was clear to us that coal was coming to an end."

Stanislas Pottier, global head of sustainable development at Crédit Agricole group, says: "We consider that carbon exposure could have an impact in the near future. Once it starts having an impact, it could move rather fast."

HSBC's Klier argues that the energy transition will be an evolution rather than a revolution, pointing out that it will probably occur over decades rather than years. Nonetheless, HSBC – like many banks – is now examining its loan books trying to assess the risks.

The obvious places to start are companies involved in power generation, oil & gas, metals & mining, automotive, construction, and chemicals, Klier points out.

Dutch central bank, DNB, based on its interviews with its three biggest lenders, sees potential for Dutch banks to look more at the real estate sector.

This is particularly the case for properties in the Netherlands, where legislation means commercial properties will need to have an energy efficiency rating of C by 2023, in order to continue operating.

In a recent speech on climate risk, Klaas Knot, a governor at DNB, said: "Unfortunately, neither we nor our banks know the energy label distribution of the offices used as collateral for loans to regular corporations.

"For loans to commercial real estate companies, banks know for roughly 50% of those loans what the energy label distribution is. Of those loans where we did know the label distribution, we found that 46% of bank loans to commercial real estate companies in relation to offices, have an energy label lower than C.

"This is around €6 billion worth of loans. All these loans, one could say, have elevated credit risks, which banks, one way or the other, will need to manage. Fortunately, we are seeing many banks react swiftly."

Lauren Compere, managing director at Boston Common Asset Management, agrees with this assessment: "More banks have focussed their initial assessments on fossil fuels and not enough on mortgages or commercial real estate."

The second part of this two-part feature explores physical risks and liability risks. Read it here.