Climate change risk

The pivotal role of banks in the transition to a sustainable economy

Climate change risk

Amidst the aftermath of the corona pandemic and the unfolding tragedy in Ukraine, the Intergovernmental Panel on Climate Change (IPCC) published its latest report1 on climate change on 28 February 2022, containing a more alarming message than ever before.

The Working Group II contribution to the IPCC’s Sixth Assessment Report states that “climate change is a grave and mounting threat to our wellbeing and a healthy planet”. It is a formidable, global challenge to transition to a sustainable economy before time is running out. Banks have an important role to play in this transition. By stepping up to this role now, banks will be better prepared for the future, and reap the benefits along the way.

In the Paris Agreement (or COP21), adopted in December 2015, 196 parties agreed to limit global warming to well below 2.0°C, and preferably to no more than 1.5°C. To prevent irreversible impacts to our climate, the IPCC stresses that the increase in global temperature (relative to the pre-industrial era) needs to remain below 1.5°C. To achieve this target, a rapid and unprecedented decrease in the emission of greenhouse gasses (GHG) is required. With CO2 emissions still on the rise, as depicted in Figure 1, the challenge at hand has increased considerably in the past decade.

Climate change risk fig 1

Figure 1 – Annual CO2 emissions from fossil fuels.

To further illustrate this, Figure 2 depicts for several starting years a possible pathway in CO2 reductions to ensure global warming does not exceed 2.0°C. Even under the assumption that CO2 emissions have already peaked, it becomes clear that the required speed of CO2 reductions is rapidly increasing with every year of inaction. We are a long way from limiting global warming to 2.0°C. This even holds under the assumption that all countries’ pledges to reduce GHG emissions will be achieved, as can be observed in Figure 3.

To quote the IPCC Working Group II co-chair Hans-Otto Pörtner: “Any further delay in concerted anticipatory global action on adaptation and mitigation will miss a brief and rapidly closing window of opportunity to secure a livable and sustainable future for all.”

Climate change risk fig 2

Figure 2 – CO2 reduction need to limit global warmin.

Climate change risk fig 3

Figure 3 – Global GHG emissions and warming scenario’s.

The role of banks in the transition – and the opportunities it offers

Historically, banks have been instrumental to the proper functioning of the economy. In their role as financial intermediaries, they bring together savers and borrowers, support investment, and play an important role in facilitating payments and transactions. Now, banks have the opportunity to become instrumental to the proper functioning of the planet. By allocating their available capital to ‘green’ loans and investments at the expense of their ‘brown’ counterparts, banks can play a pivotal role in the transition to a sustainable economy. Banks are in the extraordinary position to make a fundamentally positive contribution to society. And even better, it comes with new opportunities.

The transition to a sustainable economy requires huge investments. It ranges from investments in climate change adaption to investments in GHG emission reductions: this covers for example investments in flood risk warning systems and financing a radical change in our energy mix from fossil-fuel based sources (like coal and natural gas) to clean energy sources (like solar and wind power). According to the Net Zero by 2050 Report from the International Energy Agency (IEA)2, the annual investments in the energy sector alone will increase from the current USD 2.3 trillion to USD 5.0 trillion by 2030. Hence, across sectors, the increase in annual investments could easily be USD 3.0 to 4.0 trillion. As much as 70% of this investment may need to be financed by the private sector (including banks and other financial institutions)3. To put this in perspective, the total outstanding credit to non-financial corporates currently stands at USD 86.3 trillion4. Assuming an average loan maturity of 5 years, this would translate to a 12-16% increase in loans and investments by banks on a global level. Hence, the transition to a sustainable economy will open up a large market for banks through direct investments and financing provided to corporates and households.

The transition to a sustainable economy is also triggering product development. The Climate Bonds Initiative (CBI) for example reports that the combined issuance of Environmental, Social, and Governance (ESG) bonds, sustainability-linked bonds and transition debt reached almost USD 500 billion in 2021H1, representing a 59% year-on-year growth rate. Other initiatives include the introduction of ‘green’ exchange-traded funds (ETFs) and sustainability-linked derivatives. The latter first appeared in 2019 and they provide an incentive for companies to achieve sustainable performance targets. If targets are met, a company is for example eligible for a more attractive interest coupon. Again, this is creating an interesting market for banks.

By embracing the transition, with all the opportunities that it offers, banks are also bracing themselves for the future. Banks that adopt climate change-resilient business models and integrate climate risk management into their risk frameworks will be much better positioned than banks that do not. They will be less exposed to climate-related risks, ranging from physical and transition risks to risks stemming from a reputational perspective or litigation, also justifying lower capital requirements. The early adaptors of today will be the leaders of tomorrow.

A roadmap supporting the transition

How should a bank approach this transition? As depicted in Figure 4, we identify four important steps: target setting, measurement and reporting, strategy and risk framework, and engaging with clients.

Climate change risk fig 4

Figure 4 – The roadmap supporting the transition to a sustainable economy.

Target setting

The starting point for each transition is to set GHG emission targets in alignment with emission pathways that have been established by climate science. One important initiative that can support banks in setting these targets is the Science Based Targets initiative (SBTi). This organization supports companies to set targets in line with the goals of the Paris Agreement. Unlike many other companies, the majority of a bank’s GHG emissions are outside their direct control. They can influence, however, their so-called financed emissions, which are the GHG emissions coming from their lending and investment portfolios. The SBTi has developed a framework for banks that reflects this. It encourages banks to use the Absolute Contraction approach that requires a 2.5% (for a well-below 2.0°C target) or 4.2% (for a 1.5°C target) annual reduction in GHG emissions. A clear emission pathway guides banks in the subsequent steps of the transition process.

Measurement and reporting

With targets in place, the next important step for a bank is to determine their level of GHG emissions: both for scope 1 and 2 (the GHG emissions they control) and for scope 3 (the financed emissions). Important initiatives for the quantification of the financed emissions are the Paris Agreement Capital Transition Assessment (PACTA) and the Platform Carbon Accounting Financials (PCAF). PCAF is a Dutch initiative to deliver a global, standardized GHG accounting and reporting approach for financial institutions (building on the GHG Protocol). PACTA enables banks to measure the alignment of financial portfolios with climate scenarios.

By keeping track of the level of GHG emissions on an annual basis, banks can assess whether they are following their selected emission pathway. Reporting, in line with the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), will contribute to a greater understanding of climate risks with their investors and other stakeholders.

Strategy and risk framework

Setting targets and measuring the current level of GHG emissions are necessary but not sufficient conditions to achieve a successful transition. Climate change risk needs to be fully integrated into a bank’s strategy and its risk framework. To assess the climate change-resilience of a bank’s strategy, a logical first step is to understand which climate change risks are material to the organization (e.g., by composing a materiality matrix). Subsequently, studying the transmission channels of these risks using scenario analysis and/or stress testing creates an understanding of what parts of the business model and lending portfolio are most exposed. This could lead to general changes in a bank’s positioning, but these risks should also be factored into the bank’s existing risk framework. Examples are the loan origination process, capital calculations, and risk reporting.

Engaging with clients

A fourth step in the game plan to successfully support the transition is for a bank to actively engage with its clients. A dialogue is required to align the bank’s GHG emission targets with those of its clients. This extends to discussing changes in the operations and/or business model of a client to align with a sustainable economy. This also may include timely announcing that certain economic activities will no longer be financed, and by financing client’s initiatives to mitigate or adapt to climate change: e.g., financing wind turbines for clients with energy- or carbon-intensive production processes (like cement or aluminium) or financing the move of production locations to less flood-prone areas.

Conclusion

Banks are uniquely positioned to play a pivotal role in the transition to a sustainable economy. The transition is already providing a wide range of opportunities for banks, from large financing needs to the introduction of green bonds and sustainability-linked derivatives. At the same time, it is of paramount importance for banks to adopt a climate change-resilient strategy and to integrate climate change risk into their risk frameworks. With our extensive track record in financial and non-financial risk management at financial institutions, Zanders stands ready to support you with this ambitious, yet rewarding challenge.

ESG risk management and Zanders

Zanders is currently supporting several clients with the identification, measurement, and management of ESG risks. For a start, we are supporting a large Dutch bank with the identification of ESG risk factors that have a material impact on the credit risk profile of its portfolio of corporate loans. The material risk factors are then integrated in the bank’s existing credit risk framework to ensure a proper management of this new risk type.

We are supporting other banking clients with the quantification of climate change risk. In one case, we are determining climate change risk-adjusted Probabilities of Default (PDs). Using expected future emissions and carbon prices based on the climate change scenarios of the Network for Greening the Financial System (NGFS), company specific shocks based on carbon prices and country specific shocks on GDP level are determined. These shocked levels are then used to determine the impact on the forecasted PDs. In another case, we are investigating the potential impact of floods and droughts on the collateral value of a portfolio of residential mortgage loans.

We also gained experience with the data challenges involved in the typical ESG project: e.g., we are supporting an asset manager with integrating and harmonizing ESG data from a range of vendors, which is underlying their internally developed ESG scores. We also support them with embedding these scores in the investment process.

With our extensive track record in financial and non-financial risk management at financial institutions in general, and our more recent ESG experience, Zanders stands ready to support you with the ambitious, yet rewarding challenge to adopt a climate change-resilient strategy and to integrate climate change risk in your existing risk frameworks.

Foot notes:

1 The IPCC Working Group II contribution: Climate Change 2022: Impacts, Adaptation and Vulnerability.
2 The IEA report, Net Zero by 2050.
3 See the Net Zero Financing roadmaps from the UN, ‘Race to Zero’ and the ‘Glasgow Financial Alliance for Net Zero’ (GFANZ).
4 Based on the statistics of the Bank for International Settlements (BIS) per 2021-Q3.
5 The Climate Bonds Initiative’s Sustainable Debt Highlights H1 2021.