The perspective of Financial Institutions

Drivers of change for Financial Institutions (FI): The “Big Picture”

Climate change will affect the whole economy and is a systemic risk to the financial system. What is happening is that the World is warming. The estimated increase in global average temperatures above pre-industrial levels by 2100 will vary, depending on future actions:

• If we take no action, global surface temperatures will rise to 4°C by as early as 2060
• Current policy does not achieve what needs to be done to reduce greenhouse gases enough to keep such warming to below 2°C
• The Paris Agreement aims at “limiting global warming to well below 2°C”

Physical and Transition Risk

The associated risks from global temperate rising are in two categories:

1. Physical Risks: with each degree of warming there is an increase in events such as flooding, wildfires and droughts as well as chronic patterns like rising sea levels, droughts, and failing crops; and
2. Transition Risks: transitioning to a lower-carbon economy will entail extensive policy, legal, technology and market changes to address mitigation and adaptation requirements related to climate change.

Impacts on the economy from these risks will include business disruption, asset destruction, funding challenges, reconstruction / replacement of assets, lower values of stranded assets and increased volatility in energy prices.

Impacts on companies could include production facilities going offline, supply chain disruption & liabilities, increased long-term operating challenges and increased costs, increasing product demand uncertainty, increased risk of stranded assets, and opportunities from climate technology & green products.

Regulatory and investor pressures

Despite the challenge of the “Tragedy of the Horizon” highlighted by Mark Carney, banks and investors are rapidly incorporating climate change into their lending and investment decisions in response to regulatory and investor pressures. There is a recognition by groups such as the NGFS, ECB and BoE of climate change being a source of major systemic risk and increasing regulatory requirements on firms to manage those risks. The speed of this transition was reinforced at the COP26 held in Glasgow, UK where the time between updates to the Nationally Determined Contributions (NDCs) was reduced from the five years agreed in Paris to just one year – with all countries requested to present NDCs with increased ambition at COP27 to be held in Sharm El-Sheikh, Egypt in 2022.

Investor pressure is mounting too from groups such as the UNEP Finance Initiative, TCFD and Share Action. There is a recognition that climate change is a source of major financial risk and that investor mandates are reflecting an appetite for sustainability and a need to manage climate risk. 

Banks’ and investors’ response

Banks and investors have started to respond to these regulatory and investor pressures by making both external commitments and developing their internal capabilities. Typical external commitments may include:

• Developing and publishing climate change risk management capability
• Aligning lending / assets under management to Paris / a below 2°C outcome
• Having net zero emissions by 2050
• Halving financed emissions by 2030
• Publishing 2025 targets aligned with these commitments

Typical internal capabilities under development may include:

• Climate change scenario analysis capability – for both transition and physical risk
• Client-level measurement of financed emissions
• Client-level measurement of temperature alignment
• Incorporation into credit sanctioning and pricing
• Incorporation into strategy and opportunity identification

How FIs measure their climate risk exposure

FIs measure their climate risk exposure by modelling decarbonisation pathways and estimating Counterparty Probability of Default (PD). Lacking the skills and expertise needed to develop these pathways in-house, FIs frequently use external providers such as the Climate Change Scenario Model, created by Baringa and developed in partnership with BlackRock. These models can help FIs answer the fundamental questions that every Financial Services organisation has to answer, and gives them the data to be able to respond.

Typical questions include:

• What is my climate change risk, and the value that will be lost from my balance sheet ?
  • How will the value of my assets, and my clients' assets, change over the next 30+ years due to climate change? 
  • How does this differ under different scenarios?
  • How do I respond to the regulators’ scenario analysis requirements?
• How are the investments we have made impacting the climate, and how does this compare with my peers?
  • Is this congruent with my values, and the values of my clients and investors?
• Now that we understand our position, what opportunities exist to reallocate capital to improve our impact on the climate at the same time as making commercial returns?
  • What is my strategy going forward?
  • What opportunities are there to change what we invest in and fund? 
  • How will I engage with the market and demonstrate that I am taking this seriously and having a positive impact on society as well as protecting my investors' capital and making commercial returns?

The outputs of these models are used to assess the climate risk of companies which is then used in the lending decisions of FIs through metrics such as Probability of Default. FIs can manage their climate risk exposure by understanding the impacts and opportunities across the board and optimising the portfolio of individual asset levels. The impact on the market value capitalisations of individual companies in the future, e.g. 203, can be modelled for a given temperature alignment. Aggregating these positive or negative impacts on value across all of the companies in a portfolio provides a view as to whether each company increases or decreases the portfolio’s climate risk exposure.

Finally, FIs are assessing companies ‘Credible Transition Plans' (CTPs) to help mitigate their risk exposure. In order to understand a customer’s transition strategy, FIs ask questions such as:

1. What targets have they set, and how are these defined?
2. What are the specific, implementable elements of the strategy, what is the timeframe and to what extent will it deliver targets?
3. Model their emissions and temperature alignment
4. Financial starting point – i.e. cash flow creating ability to change strategic direction
5. The specific policy / regulatory environments in which they operate given their geographical footprint
6. Operations / investments to date
7. Management’s track record on strategy delivery
8. How are management / Exec incentives aligned to the strategy?
9. How have they evaluated the strategy (e.g. under what scenarios have they assessed it)?
10. What tangible evidence (e.g. investments, shifting capex, etc.) is there of the new strategy being implemented?
11. Do they demonstrate how their financial performance will evolve under the strategy?

Building a repeatable assessment framework and toolkit to enable FIs to assess CTPs requires four key steps:

1. Create a Paris Agreement-aligned scenario and translate into transition pathways
2. Define building blocks of a credible transition plan and required data set
3. Create a CTP assessment framework: customer questionnaire, scorecard and checklist for frontline staff
4. Pilot the approach to upskill and engage coverage teams

In conclusion, FIs are now incentivised and engaged in understanding the climate risks of their clients. The momentum building from COP26 for faster climate action is driving the need for the acceleration of the skills and capabilities needed to do so. In future, we are expecting further engagement between banks and investors and their clients, and increasing importance assigned to the plans for the decarbonisation of each company’s operations.