10 August 2020

Fossil fuel lending is a financial stability issue

The decline of fossil fuels systems is not only a threat to investor returns but also to financial stability. The NGO Finance Watch argues that this should have implications for the way banks are regulated, and urges regulators to use their powers to intervene without delay

NGOs and others have been calling for banks to reduce their oil and gas lending for years, often using well-evidenced moral or scientific arguments, and pointing out that the global carbon budget will be exhausted within 10-15 years.

But the rapid progress in the renewable energy sector and switch away from fossil fuels could have financial consequences as well, reaching beyond the oil and gas sector and possibly endangering financial stability.

Financial regulators have a legal obligation to protect the prudential safety of banks and other financial firms. Finance Watch's head of research and advocacy, Thierry Philipponnat, argues in a recent report, Breaking the Climate Finance Doom Loop, that the prudential risks of fossil fuel lending are intensifying and regulators should lose no time in intervening.

"This is a prudential issue, pure and simple. Fossil fuel lending is getting riskier, and regulators have a legal duty to ensure that banks are capitalised to withstand losses on their fossil fuel assets. The measures are all there in the regulation – regulators just have to apply them," he says.

The risks of not acting came into focus in June when Shell and BP wrote down nearly $40 billion from the value of their oil and gas assets. The oil majors had each seen their market values halve over the last 12 months, wiping out more than €160 billion of investor equity.

For financial stability, however, equity is only the tip of the iceberg. Syndicated bank loans account for an increasingly large share of oil and gas financing; altogether, banks provided $2.7 trillion to the oil and gas industry in the four years after the Paris Agreement. If worsening conditions in the oil and gas sector cause some of these loans to become impaired, the losses will hit the banking sector and, if not absorbed there, cascade further into the financial system.

Philipponnat, who is also a board member at the French Financial Markets Authority (AMF) and chair of its Climate and Sustainable Finance Commission, argues that regulators have a duty to break what he calls the "climate-finance doom loop", in which investments in fossil fuels enable climate change, and climate change acts as a threat to financial stability.

"Lending for fossil fuel activity creates two risks: it creates a financial asset that might become stranded, and it feeds wider macro-prudential risks by contributing to climate change," he says.

The main response of financial regulators so far has been to improve transparency so that investors can more easily disinvest; and to conduct climate stress tests, which look at how financial institutions might fare in different climate change scenarios.

However, stress tests look only at the direct risks that climate change could bring, mainly transition risk and physical risk. The indirect risks from the disruption to economies in general could be much larger and are almost impossible to model, as the Covid-19 crisis has shown.

Financial regulators' efforts to intervene directly have become bogged down in legal and mathematical discussions that could take years to resolve, by when the planet's carbon budget will be nearly exhausted.

This delay is grounded in a paradox: policymakers recognise the near-impossibility of modelling climate-related risks, but say that they need such modelling to be done before intervening. Unfortunately, given the short time available, late action is equivalent to doing nothing.

Central bankers are waking up to this and some have called already for less modelling and more action.

According to Finance Watch, the EU already has a general legal basis to take action, from the Treaty on the Functioning of the European Union, which establishes the precautionary principle as a governing principle.

There is also a specific legal basis for action in the EU's Capital Requirements Regulation (CRR). The CRR is designed to prevent financial instability and provides, among other things, for higher risk weightings in situations where the risk of loss cannot be measured precisely even if its occurrence is highly likely.

Risk weighting is part of the Basel model of bank regulation in which equity capital requirements are applied to banks' assets after each asset has been adjusted to reflect its risk. An asset deemed to be "safe", from the bank's point of view, such as a mortgage or a sovereign exposure, could have a risk weight of 20% or zero, for example. A capital requirement of, say 8%, is applied only to the risk-adjusted value meaning that the bank can fund the asset almost entirely with debt, which makes the asset more profitable for the bank, if there is no default.

An asset deemed to be more risky, such as an unsecured loan to a start-up business, might have a risk-weight of 100%, meaning that the bank must apply the 8% capital requirement to the full amount, so the bank can only fund 92% of the loan with debt. The rest is provided as equity, which can absorb losses.

Fossil fuels loans are subject to the risks of becoming 'stranded' and contributing to macro-prudential risks by enabling climate change. These are risks that are highly likely to materialise but are difficult to model in advance, given the lack of historical data.

Philipponnat argues that the CRR provides a basis to require banks to have more capital for assets with these characteristics. Article 128 of CRR applies 150% risk weights to exposures associated with risks that are particularly high or difficult to assess, such as private equity or speculative property loans. Loans for existing fossil fuel assets could be added to this category, he says.

Lending to fund exploration for new fossil fuel reserves is riskier, with a near certainty that new reserves being explored today will become stranded before the end of their normal exploitation cycle. Article 501 of the CRR provides for risk weights to be applied qualitatively in certain categories, for example allowing lower risk weights for loans to SMEs.

Philipponnat argues that this article could be adapted to apply a risk weight of 1250% to new fossil fuel exposures. When multiplied by an 8% capital requirement, this would require new fossil fuel exposures to be funded entirely with equity, which is appropriate for the level of risk involved.

These measures would need some legislative work to become permanent but, with the risks intensifying, they could already be implemented as temporary measures under Article 459 of CRR, which allows the European Commission "to impose, for a period of one year, stricter prudential requirements for exposures where this is necessary to address changes in the intensity of micro-prudential and macro-prudential risks".

Given the global nature of the problem, Finance Watch is recommending that this risk-based approach be presented for use in other jurisdictions via the Basel Committee for Banking Supervision and the Financial Stability Board.

Tackling the impact of climate change on financial stability is a realistic and increasingly urgent objective; the last thing that a warming planet needs is another financial crisis.

Given the enormous impact on human societies, the cost of measures to break the climate finance doom loop is rather moderate. This is not to say that those measures will not hurt some private interests in the short term but, with all the understanding that one can have for private actors defending their profitability, there is no doubt that the public interest calls for action and that it is the duty of policy-makers to take it, especially when they have the possibility and the tools to do so.

Greg Ford is senior advisor at Finance Watch.




Finance Watch
Greg Ford