How climate change could make or break banks’ bottom lines
“We are close to the tipping point where global warming becomes irreversible”
A growing number of studies are showing that climate change could be disastrous for organisations around the world.
If global temperatures jump 4ºC by 2100 (the path we are currently on), droughts, flooding and ferocious storms may be sparked, with economic models estimating a reduction in value of the world’s financial assets by between $2.5tn and $24tn. Implications for financial services institutions could be monumental.
Enter Sustainable Finance
Sustainable Finance is defined as “the provision of financial services taking into account environmental, social and governance considerations (ESG) for the lasting benefit of clients and society”. The demand for Sustainable Finance has risen in recent years, driven by a renewed international focus, co-operation on climate related issues and a broader sustainability agenda.
While the 2007 Kyoto Protocol set emission cutting targets for a limited number of developed countries, the tide turned in 2015 as the Paris Agreement marked an unprecedented unification of nearly 200 countries to combat climate change through the United Nations Framework Convention.
As a result of this international focus, and the potential impacts to their bottom line, an increasing number of banks are realising that ignoring social and environmental issues could increase their exposure to credit, compliance and reputational risks. Mercer recently found 83% of banks have ESG strategies and several banks have made public commitments to sustainability:
- JP Morgan and Goldman Sachs have pledged to source renewable power for 100% of their global energy needs by 2020
- Citigroup announced in 2015 that they will invest $100bn over the next decade to finance green initiatives and sustainable growth
- HSBC recently pledged to provide $100bn in sustainable financing and investment by 2025.
The figures add up
It makes financial sense for banks to invest in keeping climate change at bay. $315bn could be saved if temperatures rise by less than 2ºC – the “danger limit” agreed as part of the Paris Agreement. To support this aim, banks need to ensure that they increase their exposure to green, climate friendly investments, whilst reducing their exposure to clients and investments with high ESG risks.
The opportunities for investment will be vast. The OECD estimates that $6.9tn of infrastructure investment will be required over the next 15 years to remain below the 2ºC target, whilst, according to estimates, borrowers will need to invest at least $700bn annually in infrastructure, clean energy, resource efficiency, and green construction by 2030. Climate-smart financial solutions, from green bonds issued by governments and international institutions to micro-loans for entrepreneurs, are creating new and innovative opportunities in this space.
A reduction in exposure to ESG risks can be facilitated by conducting client analysis, improving reporting and implementing sustainability targets.
A review of client portfolios can quickly highlight areas of concern for a bank. For example, investors have been warned about investing in new coal and gas fired power stations after 2017. Research shows that, to meet the 2ºC target, no new carbon-emitting power stations can be built unless they are later closed or retrofitted with carbon capture and storage technology. Figures highlight the extent of exposure across banks: between 2014–2016, 37 international banks financed 158 companies with $290bn for extreme fossil fuel activities. When banks review their portfolios, they should build a view of where companies will need to diversify away from fossil fuels (and as a result may still be lucrative in the future), and consider how to reduce their association with others.
Reporting will increase awareness of the risks and opportunities faced by banks, which they can later act on. The Financial Stability Board has set-up a Task Force on Climate-Related Financial Disclosures (TCFD) which has proposed a voluntary framework to disclose comparable and consistent information about the risks and opportunities presented by climate change. The aim is to support more efficient allocation of capital and therefore help the transition to a more sustainable low carbon economy. Many banks have signed the statement of support for TCFD, including Barclays, BNP Paribas, Citi, HSBC, Morgan Stanley and UBS. More will likely follow suit and in the longer term the framework may become mandatory.
The TCFD framework provides a set of recommendations structured around core elements including Governance, Strategy, Risk Management and Metrics and Targets.
The importance of this lies in:
- Improving access to data to enhance how climate-related risks are assessed, priced, and managed
- Enabling companies to effectively measure and evaluate internal, supplier and competitor risks
- Ensuring investors can make informed decisions on where and how to allocate capital
- Enabling lenders, insurers and underwriters to better evaluate risks and exposures across differing time horizons
Crunch time
The mandate for the global financial industry has been set by the international community and banks must now act to develop their Sustainable Finance agenda for the lasting benefit of clients and society.
The future viability of their business model is dependent on taking actions to minimise credit and market risks posed by climate change – whether that be through assessment of their client base, capital allocation, or provision of green products to help finance the future. Enhanced reporting and disclosure will act as an enabler to this transition and taking these steps now will place them in a favourable position with investors, government agencies, employees and the public.
What’s more the world, not just their financial health, may depend on it.