Climate change is happening faster than previously thought. Temperatures and sea levels are rising, oceans are warming, and the Jet Stream is meandering and slowing. This triggers more frequent and increasingly severe extreme weather events that cost billions of insured and uninsured losses, posing a real threat to financial institutions’ risk profiles and financial performance.
Climate change is no longer an esoteric theory that exists only to push political agendas, punish carbon-heavy industries, or create interesting debates in executive suites and boardrooms. Climate change and its impact is now a decisive business risk that requires the immediate and focused attention of the financial sector.
Climate-related risks are on the rise
Climate-related disaster costs are on an upward trajectory. Indeed, the U.S. has sustained 323 weather and climate disasters since 1980 where overall damages/costs reached or exceeded $1 billion (including CPI adjustment to 2022). The total cost of these 323 events exceeds $2.195 trillion.
- In 2021 alone, there were 20 such weather/climate disaster events, including 1 drought event, 2 flooding events, 11 severe storm events, 4 tropical cyclone events, 1 wildfire event, and 1 winter storm event.
Overall, these events had significant economic effects on the population in the impacted areas, impacting banks across the U.S. Climate risk ripples through all economic sectors and across all regions, impacting banks of all sizes across the U.S. Banks sit squarely on the frontline as they make loans for clients in virtually every industry, all over the world. As such, this climate-risk exposure is potentially enormous.
Impacts on banks and financial institutions
As financial intermediaries, banks and financing providers stand in the eye of the storm. Climate costs and the accelerating policy changes in response to the crisis will induce a widespread repricing of assets.
Direct and Indirect Exposure to climate risks
Unprepared financial institutions will suffer reduced valuations across a wide range of assets such as carbon-intensive energy and transportation, commercial and residential real-estate exposed to extreme weather events, agriculture at risk of decreasing yields, and increasing weather variability.
No region or geographic area is safe from the devastating effects of climate change. In the Southeast, coastal property damages are already costing insurers billions, and in the Midwest, agricultural yields will face increasingly steep declines.
Changing demand for products based on carbon footprint will lower collateral coverage, increase the probability of default, and ultimately lead to credit and valuation write-offs. The reduced asset valuations can have a contagion effect as banks attempt to decrease their exposure by offering these ‘stranded assets’ at fire-sale prices. Previous events, such as the 2008 subprime mortgage meltdown have catalyzed financial collapses and those are on a much smaller scale than climate change.
Indirect exposure to climate risk matters. Banks may not have direct exposure to climate risks, such as the oil and gas industry, but their clients may generate income from carbon-intensive industries or be real estate located in flood-prone areas. Indirect exposure increases the credit risk of banks, unsecured and secured bank-issued bonds and even issuers in the municipal bond market.
Increasing Threats of Credit Risk
For banks, one of the biggest threats is credit risk. For example, in residential mortgage lending, a bank’s loan book can be impacted by climate risk in two ways – either through “chronic” changes in the environment such as rising seas or through specific “acute” events such as more intense storms, flooding, and mudslides. Expectations of an increase in such events can hurt property values and, ultimately, increase the risk of defaults. However, home lending is only a small slice of the banking industry’s credit risk.
The shift to a lower-carbon economy means entire industries, such as coal mining, power generation, and oil and gas, are susceptible to stricter regulation, disruptive technologies, and changes in customer behavior. These potential shifts are categorized as “transition risk,” and for both lenders and borrowers, they may be substantial.
In addition to increased credit losses and asset repricing risk, climate change induces a multitude of risks for banks, such as asset-liability management, capital, liquidity, operational, reputational, legal, and regulatory risks, all of which require heightened management attention.
These challenges are compounded by rising expectations of employees, customers, investors, and regulators, who demand or mandate detailed disclosures and a proactive commitment toward greening the financial system.
Climate Opportunities in the Financial Sector
In addition to the many risks, the transition to low-carbon economies also presents an enormous opportunity for the financial sector.
- There is increasing demand for capital to finance long-term projects as sustainability and performance are becoming more intertwined.
- As the U.S. moves to reduce carbon emissions in alignment with the Paris Agreement, financing is needed to fulfill commitments in renewable energy, green building construction, building retrofitting, energy efficiency, electric vehicle financing, sustainable forest management, and climate-smart agriculture will intensify.
- ESG-focused lending will allow banks to diversify funding by adding well-priced green bonds, green securitizations, and other sustainability targeted funding to the mix.
What should banks do?
To perform their essential function, climate risks must become part of the firm’s enterprise risk management framework and culture. To remain competitive and relevant, banks need to embrace disruption and strategically build a more sustainable business.
Lead by example, by incorporating ESG and climate topics into its culture, lending and investment policies, and business decisions; seize on the opportunities associated with the transition to a net-zero economy and develop new offerings for its clients.
How Ankura Can Help
Ankura’s multi-disciplinary ESG team has developed an effective approach to optimize climate risks and opportunities and drive value for our clients.
- Our teams can help a bank's boards and leadership teams to understand the nature and potential scale of climate, ESG risks, and opportunities, including the level of risk exposure, the value of loans and investment books, the strength of the firms’ financial position, its ability to absorb losses, and its credibility with stakeholders.
- Once the risks have been identified, our team helps establish the protocols to mitigate risks, including developing a vision statement based on measurable, achievable goals, a well-articulated risk-appetite statement, and establishing processes to consider climate risks in business strategy and operations, human capital and climate corporate intelligence capabilities.
- Once the right governance is put in place and the business plan is complete, our team assists management to develop the policies, methodologies, and tools required to implement. This includes developing appropriate lending methodologies, and proper risk-based pricing; designing a green funding strategy; implementing strategies to reduce the on-balance-sheet exposure to climate and carbon-related risks through decarbonization, divestment, and green investing; communicating with all stakeholders through mandatory and/or voluntary disclosures.
Greening the financial sector is an integral part of greening the U.S. and global economies. While the assessment and inclusion of climate risks in financial decisions have become more prevalent, especially in the larger banks, financial institutions of all sizes can prepare now to avoid the need for costly amends in the future.
Proactive financial institutions can position themselves at the forefront of the green finance movement by making informed decisions to protect their business, reduce their high-carbon liabilities, and facilitate the low-carbon, resilient transformation process. The sustainable journey is not always straightforward, but with a clear strategy, institutions will be well-positioned to navigate the road ahead.
National Oceanic and Atmospheric Administration, Billion-Dollar Weather and Climate Disasters: Overview; https://www.ncdc.noaa.gov/billions/
[1]
© Copyright 2022. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.
