As extreme climate events become more frequent and governments ramp up their commitment to transitioning to lower carbon economies, are financial institutions prepared, or will their unaccounted-for climate risk lead to the next financial crisis? Silvia Pavoni reports.

Meltdown cover image

If the world’s latest financial crisis was sparked by something highly intangible – that is mortgage-backed securities – the cause for the next one could be very physical. Melting glaciers, rising temperatures and earthquakes are new types of threats the financial system still struggles to measure and account for. As with the previous crisis, the occurrence of unlikely scenarios could lead to financial chaos. 

Warnings of such risks are now coming from the highest echelons of the financial community. One of the first came from Bank of England governor and chairman of the Financial Stability Board (FSB) Mark Carney in a speech to insurers at Lloyd’s of London in late September 2015. 

Following this others have tried to quantify the risks. Howard Covington, for example, development board chair of think tank ClientEarth and director of New Star Asset Management, set out to measure such threats across scenarios where rising temperatures affect economic growth.

Mr Covington looked at a “probable worst-case scenario” of the economic damage caused by temperatures rises of between 4 degrees Celsius and 7 degrees Celsius this century, and concluded that the value at risk for global stocks would be $7000bn. Other studies go as high as $43,000bn for the value at risk of global manageable assets, as mentioned in an FSB report.

A gloomy picture 

“Do we think it’s probable? It’s a possible scenario. Some scenarios based on current trajectories have us go out to between 4 degrees Celsius and 6 degrees Celsius even if we begin to reduce emissions now because emissions have kept on accelerating over the past 30 to 40 years. We’ve locked up so much carbon dioxide [in the atmosphere],” says Mark Campanale, executive director of think tank Carbon Tracker Initiative. “At that point, we’ll have a financial crisis because assets will be worth nothing. [Imagine if] London or New York become uninhabitable because of storm damage. It’s kind of unthinkable, which is why we don’t talk about it that much, but it’s a scenario.”

Other experts paint an equally gloomy picture. The US National Wildlife Federation, for example, forecasts that Greater Miami in the US, including Miami Beach’s luxury properties, stands to lose $3500bn in assets by 2070 unless damage from rising tides is mitigated.

“[We need to challenge] the way in which we understand physical risk,” says Nick Robins, co-director of the UN Environment Programme Inquiry into the Design of a Sustainable Financial System, and a former head of the climate change centre for excellence at HSBC. “Physical risk is a small part of risk management. Natural hazards [have existed] all through history but at the margin of finance. From the insurance sector we know that the protection gap between economic losses from natural hazards and insured coverage is widening: more and more people are unprotected,” he adds.

A deep impact

Perversely, some of the very measures designed to prevent such catastrophes may also affect financial and economic wellbeing. In December 2015, at the end of the  21st Conference of the Parties of the UN Framework Convention on Climate Change in Paris, 195 state leaders committed to act to limit global warming to 2 degrees Celsius compared with pre-industrial levels. Experts say to reach the goals of the Paris Agreement, the world needs to decarbonise very rapidly over next 20 years, which involves huge structural changes to transportation, power generation, cement manufacturing and anything that is carbon intensive, from the iron and steel industry to the chemical industry.

Switching off the use of fossil fuels would also entail making the infrastructure supporting that production redundant – everything from train trucks to ships and oil tankers. Lenders and investors in those sectors risk seeing loans unpaid and assets’ value plummet.

It is a very real concern for investors. Earlier this year, ExxonMobil’s management was defeated by a shareholder rebellion over climate change, as a large group of investors voted to instruct the oil giant to report on the impact on the company’s business of global measures to contain rising temperatures.

“What we have to do, together with other investors, is to put pressure on oil companies to look at their business and find what is going to happen if we’re going to live up to, on a global scale, the 2 degrees Celsius goal,” says Peter Damgaard, CEO of Danish pension fund manager PKA and chair for Europe and Canada at the Institutional Investors Group on Climate Change.

A new force

Working with different or extreme scenarios and gathering relevant data is the challenge. To understand clients’ carbon exposure, banks and other financial institutions must first understand their business in greater depth. In June, the FSB task force established after Mr Carney’s speech released recommendations for financial and non-financial companies on climate-related disclosures.

Chaired by Michael Bloomberg, the Task Force on Climate-related Financial Disclosures (TCFD) attracted more than 100 signatories supporting the recommendations, including CEOs of some of the world’s biggest banks, from Morgan Stanley and HSBC to ICBC. While the response to the initiative is widely considered to be encouraging, some people would like it to go further. For example, there are still concerns around the voluntary nature of disclosure and scenario analysis, as well as around banks’ still-significant direct exposure to carbon markets. 

“We’ve been disclosing our own carbon footprint, but we struggle to get a grasp of the carbon footprint of our clients,” says Arnaud Cohen Stuart, head of business ethics at ING, also a signatory to the TCFD recommendations. (After the UK and the US, Dutch companies are the third largest group to support the task force’s report.)

“Data availability is poor and there’s no globally agreed methodology to calculate risk in financial institutions, in banks,” says Mr Cohen Stuart. “It’s a challenge as we have lots of loans not only to stock listed companies that may disclose their carbon footprint but also to unlisted companies that do not disclose it. This is why we supported the TCFD in its call for disclosure. We wouldn’t mind it if that voluntary call got tightened a bit more.”

The Carbon Tracker Initiative’s Mr Campanale adds: “What I’m concerned about is common disclosure standards and scenario analysis. If companies can pick their own scenario analysis, that allows for any company to say ‘yes, we’ve done our scenario analysis and, by the way, we’re fine’.”

But these are recommendations by the market for the market, which do not need to be made mandatory, says Mary Schapiro, former chair of the US Securities and Exchange Commission (SEC) and special adviser to the chair of the TCFD. “Material risks are already required to be disclosed,” she says. “In the US, in 2010, we [at the SEC] provided companies with a climate disclosures guidance: not a separate set of rules at the SEC, but a set of guidance notes around disclosure of climate-related risk to help companies in how they think in this area.”

Legal moves possible

Others have taken a more prescriptive approach. Article 173 of France’s Energy Transition for Green Growth law is one such example, as it forces a wide range of investors, including insurance companies and pension funds, to report on how they integrate environmental and climate change factors in their investment and risk management practices. The EU has taken notice and may turn proposals by its High-Level Group on Sustainable Finance, which released its first recommendations in July, into law.

“At the EU, we look at Article 173 as one of the building blocks, but we need more,” says Christian Thimann, chair of the High-Level Group and group head of regulation, sustainability and insurance foresight at insurer Axa.

“We encourage banks to discuss the risk of sudden value losses and encourage the European Banking Authority to take this into account when considering the sustainability of the financial system,” adds Mr Thimann, who is also a vice-chair at the TCFD. He raises another key concern: because of the short-term nature of corporate reporting and strategy, risks that are not perceived as imminent but as likely to happen far in the future – such as climate risks – do not find an easy way into decisions made today.

“We favour liquid assets over illiquid assets but things that are liquid usually have no social value,” says Mr Thimann. “If you’re a bank, you can have a great relationship with your supervisor if you only have three-month Treasury bills on your balance sheet: liquid, short-term – no problem. But you cannot solve any of our economic and social challenges with three-month Treasury bills.”

Ms Shapiro says: “We need to be really clear that the potential impacts of climate change are not only physical and do not only manifest in the long term. We can have rapidly declining costs and increased deployment of clean technology that can have a very significant near-term implications for extractive industries or other industries.”

Renewable progress

Even without government intervention, there are other threats to oil producers. Experts are celebrating (as well as warning about) the expected growth in and falling costs of the production of wind and solar energy, as well as improvements in batteries that will bring the capital cost of electric vehicles below those of petrol vehicles in the early 2020s.

“These simple projections suggest that on a timescale of a decade or so, fossil fuel assets are vulnerable to being stranded by competition from renewables and electric vehicles,” says Mr Covington in his paper. Even an oil giant such as Brazil’s state-owned producer Petrobras, which had to dispose of its renewable sources to cut its heavy levels of debt, will likely revisit the decision once its balance sheet is in order, according to the company’s CEO, Pedro Parente.

Mr Parente looks at scenarios where oil prices could drop to below $40 a barrel because of a global coordination to fight climate change, as well as better options becoming available via renewable sources, which would threaten the oil sector’s profitability. “Companies such as ours need to take this time to prepare for a new environment, because it will come. The discussion is not on ‘if’, the discussion is on ‘when’. This could be after 2040 but it could be before, at the beginning of 2030,” he says.

Polarised approaches

But some consider the assumption of global coordination to be overly optimistic. While many governments have committed to containing climate change, their support could still be withdrawn. And there is little clarity over what form their commitment will take in terms of policies.

For example, France has passed laws and, earlier in 2017, issued a €7.5bn green finance bond from which proceeds will fund green initiatives (the largest ever such bond and the second sovereign to engage with this growing market), done with the intention of taking a global lead on the matter. Finance minister Bruno Le Maire tells The Banker: “We are determined to build on these first initiatives and bolster the status of Paris as a world-class centre for green finance.” Conversely, in pulling out of the Paris Agreements only few months ago, US president Donald Trump’s administration has sent the opposite signal.

Support for renewable energy has not always been constant either – a lack of consistency that translates into policy risk. “Governments have promised to do things to [fight] global warming, but we don’t know exactly what they’re going to do,” says Paul Fisher, former deputy head of the UK’s Prudential Regulatory Authority, a former member of the Bank of England’s Monetary Policy Committee and a senior associate at the Cambridge University Institute for Sustainability Leadership.

“Governments can be quite capricious. They can take you by surprise; they take several steps forward and one step back; they can withdraw subsidies at short notice,” he says, pointing to the withdrawal of subsidies from UK onshore wind farms in 2016, which led to the cancellation of 2500 planned turbines.

Meanwhile, while banks have begun reducing direct lending to coal and oil companies, their efforts have not convinced everyone.

At the coal face

Globally, there has been a 22% reduction in banks’ loans to highly polluting energy sources, such as coal mining, coal power, extreme oil and liquified natural gas exports, between 2015 and 2016, after a peak the previous year, according to Jason Opeña Disterhoft, senior campaigner at the Rainforest Action Network (RAN), a think tank that monitors lenders’ activity.

However, the overall figure is still worryingly high at a total of $290bn lent to these companies between 2014 and 2016, according to research by RAN, which classifies extreme oil as tar sands oil, Arctic oil and ultra-deepwater oil. Disentangling some of the biggest lenders from these sectors might be tough, simply due the sheer size of their exposures. According to the think tank, the five largest lenders (three Chinese and two North American) that lead the extreme fossil fuels ranking have a combined financing of more than $100bn, over one-third of the total of all 37 banks.

“I wouldn’t be surprised if Chinese banks were still highly involved in coal – but at the same time, the Chinese government is taking a very serious stance on renewables and those [projects] will need to be financed,” says one professional. “Chinese banks will likely follow in the steps of the government, while corporate [action] in the US might differ from government policy.”

China’s government has promised to spend $360bn on clean energy by 2020, making it the world’s largest clean energy investor. At the other end of the spectrum, the US has just dissolved the federal advisory committee leading its National Climate Assessment. The group summarises the impact of climate change to help both policy-makers and the private sector with long-term planning.

A win-win?

Greater focus on renewable energy sources and improvements in green technology is good news for all. Such a focus would help mitigate both the effects of climate change and the risks related to banks’ carbon exposure.

The expected transition to a lower carbon economy could be disruptive but it is also estimated to require about $1000bn of investments a year for the foreseeable future, according to the TCFD.

Opportunities abound, believes Val Smith, Citi’s head of corporate sustainability, who says nearly half of the bank’s goal to finance $100bn-worth of environmentally friendly projects was reached in the first three years of its 10-year plan. Banking products could also be adapted to new environmental concerns to encourage change as well as benefit from it. For example, mortgage valuations could favour energy-efficient houses based on the assumption that buyers will incur lower running costs (such as utility bills) and therefore be less likely to default on payments.

Corporate loans could offer lower interest rates if the issuer improves its sustainability score, as this would improve the company’s overall risk profile – for example, the €1bn revolving credit facility for health technology firm Philips, created by ING, syndicated across 16 other banks and scored by consultancy Sustainalytics. And innovation could also help share insurance pressures across different areas.

The World Bank has created new insurance mechanisms against extreme climate events, shifting risks away from governments and insurers and into the capital markets, such as the $360m catastrophe bond it issued in August for Mexico. Investors buy World Bank notes and take a bet on the chances of the country suffering losses because of earthquakes and tropical cyclones, says Michael Bennett, head of derivatives and structured finance at the World Bank’s treasury division. Should such events occur, Mexico would have access to immediate funds.

New financial solutions

Meanwhile, academic research could help with data and new solutions. Imperial College London, for example, has seen growing numbers of asset managers contacting its Grantham Institute. Set up a decade ago to study the science of climate, since the Paris Agreement the institute has increasingly been looking at new risks and models, says Mirabelle Muûls, a lecturer and assistant professor in economics at Imperial’s business school.

Meanwhile at Ca’ Foscari University of Venice – a city all too aware of the risks of rising water levels – researchers led by Carlo Carraro, econometrics professor and vice-chair of the Intergovernmental Panel on Climate Change, a UN-supported scientific body, are working on models to predict the effects of climate change on territories as small as 30 square kilometres, which would have obvious practical implications for businesses and their financiers.

Copious work on climate change is being carried out by many governments, supervisors, think tanks, universities, supranational organisations, energy companies as well as across many parts of the financial sector but this has to be pushed further. Whether demanded by the market or imposed by regulators, the need for information on climate risks is clear and overwhelming. In order to avoid the next potential financial catastrophe, the unthinkable scenarios of the future must be addressed now.


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