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Western EuropeMay 26 2021

Are banks ready for their green stress tests?

As the ECB and the Bank of England launch their first green stress tests, lack of data, poor disclosure and inadequate governance may get in the way of meaningful results. 
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Are banks ready for their green stress tests?

Stress testing is well known in the world of science. From medicine to engineering, stress testing is commonplace and, since the financial crisis, it has become a well-known term in banking too. In addition to deep recessions and market crashes, central banks are beginning to look at how lenders’ balance sheets would cope in the worst climate change scenarios.

“Clearly, climate change matters for the environment and for our planet. What has become self-evident now, even if it was not five years ago, is that climate change creates financial risks,” said Sarah Beeman, an executive director at the Bank of England (BoE) at an industry event in July 2020. Climate change is “the defining issue of our time”, added Ms Beeman, who is involved in the institution’s work on climate.

Under its previous governor, Mark Carney, the BoE was among the first to warn about the dangers that climate change poses to financial stability. Now, the British central bank is set to launch its Climate Biennial Exploratory Scenario in June. According to a paper published in April, the BoE expects participants’ initial submissions by mid-October, with a decision over whether to conduct a second round at the end of January. Barclays, HSBC, Lloyds Banking Group, Royal Bank of Scotland/NatWest, Santander UK, Standard Chartered and Nationwide Building Society have been invited to take part, along with 10 insurance groups and 10 selected managing agents that are part of the Society of Lloyd’s insurance market.

European stress testing

In Frankfurt, the European Central Bank (ECB) is also conducting its first climate stress test this year. The US Federal Reserve and other supervisors are beginning to study the matter too. 

The ECB will begin with a ‘top-down’ macroeconomic analysis, studying the physical and policy implications of climate change on companies and banks under its jurisdiction. It will look at about four million companies and 2000 banks — nearly all lenders in the eurozone — as the ECB’s vice-president, Luis de Guindos, explained in March. In 2022, it plans to carry out a ‘bottom-up’ supervisory test on individual banks, which will be required to provide their own assessment on the climate risks they are exposed to and their ability to manage them. 

Climate change is perfect for stress testing because it is about things getting out of control in a certain dimension and affecting the [whole] economy

Carmelo Salleo, ECB

“Europe’s financial system is largely bank-based, so banks are playing a pivotal role in greening the economy,” said Frank Elderson, vice-chair of the supervisory board and member of the executive board of the ECB, in an April speech. He is also the chair of the Network for Greening the Financial System (NGFS), which counts 90 members between central banks and supervisory authorities: from the Banque de France to the Banco Central do Brasil, the South African Reserve Bank, the People’s Bank of China and, more recently, the US Federal Reserve. 

In its initial analysis, the ECB will use the climate scenarios that the NGFS has built in partnership with an academic consortium. This includes the Potsdam Institute for Climate Impact Research, the International Institute for Applied Systems Analysis, the University of Maryland, Climate Analytics and the Swiss Federal Institute of Technology in Zurich. The resulting climate scenarios look as far ahead as 2100 and attempt to translate what a complete lack of policies to curb emissions and the highest levels of pollution would mean in terms of gross domestic product, the implication of strong policy shocks on climate-sensitive industries and a combination of scenarios between the two extremes.

The BoE will also base its climate scenarios on the NGFS work and, like the ECB, will consider a 30-year time horizon in its stress tests. Typical stress tests in the UK and the EU (carried out by the European Banking Authority for the eurozone) look only five and three years ahead, respectively.

Getting the right data

Concerns over finding precise correlations between climate and the economy, as well as generally insufficient or poor climate data, have held back others’ work in this area.

In a 2020 survey by the Bank for International Settlements (BIS), regulators and supervisors confirmed the importance of understanding climate-related financial risk, with 24 out of 27 saying they had conducted some research into this field. However, 15 respondents noted the operational challenges of such efforts and, among them, 10 named lack of sufficiently granular or reliable data for their risk models as the key impediment. “Consistent emissions/climate-related data are needed across jurisdictions and across sectors to undertake further comparable risk analysis,” reported the BIS.

Carmelo Salleo, head of the stress test modelling division of the ECB, confirms this is a huge challenge. “There’s a big exercise in the central banking world to procure data for climate change,” he says. Mr Salleo’s team sources emissions data from Urgentem, a specialist provider; and physical risk measures from Four Twenty Seven, a company owned by Moody’s Analytics which evaluates the physical risk caused by floods, heat stress, hurricanes and typhoons, sea level rise, water stress, and wildfires based on assets’ location.

Finding environmental data can be a challenge even on a more mundane level. “If today I were to google ‘where can I buy bitcoin’, [I’d get many more results] than if I were to google ‘where can I get certified’,” says Mr Salleo, referring to energy efficiency certificates for a residential property.

Theoretically, stress testing for climate change makes complete sense, but the exercise will need a fair amount of fine-tuning. “Climate change is perfect for stress testing, in a way, because it is about things getting out of control in a certain dimension and affecting the [whole] economy,” says Mr Salleo. “[But] this is a risk that we do not necessarily understand well from an economic perspective.” This is evident by the scarcity of professionals that have the right mix of knowledge and experience to help identify pertinent data sources and building models. Within Mr Salleo’s division, a team of five has focused purely on climate risk for more than a year and “believe me, finding five people [with the right skills] was very hard”, he says.

Internal stress testing

Commercial banks face the same struggles as they build their own internal stress testing models, while keeping an eye on what regulators may request of them.

Citibank’s head of climate risk, Piyush Agrawal, says that observing how central banks and supervisory authorities approach stress testing exercises gives useful insights into what might come next. Bankers will be keen to find out if, when and how exposure to climate risk may lead to changes in capital requirements. There is no indication that this will be the case for either the BoE or the ECB stress tests.

Carmelo Salleo

Carmelo Salleo, ECB

“Stress testing is predicated on robust models, which are grounded on empirical evidence. But there is a problem with the non-linearity of climate history in predicting what the future will be, so there should be caution in interpreting climate stress testing results,” adds Mr Agrawal. 

A better understanding of what kind of specific indicators are relevant to test financial resilience is also needed. Mr Salleo says that available indicators tend to be more suitable to direct fiscal policy action than they are at raising financial supervisory red flags. For example, a common indicator to evaluate companies’ sustainability is volumes of emissions per revenue: how many tonnes of carbon dioxide a business produces per million dollars, or euros, of revenue. With high emissions per revenue, a high carbon tax would disincentivise the worst polluting activities.

However, this ratio may not say much about an oil company’s financial risk if that company remains highly profitable, even after the introduction of extra taxation, and if it has a low financial leverage. Mr Salleo’s team is working on indicators that link more directly firms’ climate exposure to financial risk. “To understand the specific issue of exposure of portfolios to climate change risk, there is a need for more specific climate change risk-based metrics,” says Mr Salleo. “Hopefully before the end of the year, we’ll come out with what we think are risk metrics that are meaningful for the financial sector.” 

Issues with client data

This is an issue for others too, including third parties offering bank ratings and analysis. It compounds the issues around banks’ limited access to clients’ information. “At the moment, for our ESG [environmental, social and governance] evaluations, we do not expect to be able to provide the highest degree of assessment to any bank in the world because of the additional challenge for banks to assess their exposure through their lending books,” says Bernard de Longevialle, global head of sustainable finance at S&P Global Ratings. “They need information from clients. Some corporations are ahead of the game, but for the majority of them, especially smaller businesses, their level of information is very limited.” Gathering information about companies’ value chains is particularly challenging.

But Mr de Longevialle says that banks have limited information on the precise location of their clients’ physical assets too. And that when they do have it, it tends to lack details on design characteristics, deterioration caused by ageing, and the degree to which the asset is exposed to climate events or whether it has been strengthened to sustain them. Similarly, he says, banks have a partial view on customers’ exposure to transition risk.

When it comes to analysing how the economy would react to changes in climate change policy, historical data is particularly lacking. For example, there is little information on the impact of carbon taxes on businesses’ bottom line and, as a consequence, on banks’ risk. So, says Mr Salleo, “that’s where we had to be a little bit creative”; his team looked at other taxes, such as value-added tax, that may have a similar impact on corporate profitability. 

Being realistic

As things stand, an ECB initial assessment, in May 2020, found that an abrupt transition to a low-carbon economy would have a severe impact on climate-sensitive economic sectors. Re-evaluating the creditworthiness of those sectors would impact up to 10% of banking assets if only the highest-polluting clients were affected, and more than half of total banking assets if entire sectors were affected, noted Mr Elderson in his speech.

More widely, there are concerns about policy-makers’ decisions on how to get the economy green faster. Environmental non-governmental organisations (NGOs) have long called for stronger exclusion policies for banks, effectively closing the financing taps for high polluters. Rather than easing off those sectors, the Rainforest Action Network’s latest report on fossil fuel finance found that the world’s largest banks have collectively increased their financing to highly polluting industries since the Paris Agreement, totalling $3.8tn between 2016 and 2020 for the 60 lenders it analysed. NGOs’ and other observers’ stance is unlikely to change. Greater pressure may be put on banks, as well as policy-makers, after the International Energy Agency (IEA) warned of a worrying surge in carbon dioxide emissions for this year, second only to that experienced after the financial crisis. 

“This is shocking and very disturbing,” Fatih Birol, executive director of the IEA, told The Guardian. “On the one hand, governments today are saying climate change is their priority. But on the other hand, we are seeing the second-biggest emissions rise in history. It is really disappointing.” 

Bankers say that more realistic results would come through financing those emitters’ transition towards more sustainable business models, rather than stop financing altogether.

When banks appoint chief sustainability officers, it sends a signal that sustainability is important to them

Åse Bergstedt

“The dialogue should be about how the most carbon-intensive industries are also the ones that are key to the transition to a greener economy,” says Mr Agrawal. 

However, the vigour of such transition plans vary from company to company, as they announce their intentions to become carbon neutral by 2050. “For many clients, you can see investment going towards that net-zero goal, but there are some that have not done anything at all,” one banker says. “This doesn’t mean they won’t [act on those announcements], but as capital markets react, the cost of capital [for those clients will] get more expensive. They need to act with more urgency: they can’t wait until 2049 to get to a 2050 target.”

Growing greener

According to the Institute of International Finance (IIF), green and, more generally, sustainable finance continues to grow. The value of sustainable debt issuances and loans arranged in the first three months of 2021 was three times higher than in the same period a year earlier, bringing the volume of total outstanding debt related to green and social factors to $2.27bn — on track to reach $3tn by the end of the year, says the IIF. Green bonds, in particular, tend to come with a ‘greenium’ — a premium with which investors reward these types of issuers. In a research note last year, BNP Paribas wrote that between January and the beginning of November 2020, investors in green, social or sustainable bonds were willing to pay up to seven basis points more than they would for ‘regular’ bonds.

ase-Bergstedt

Åse Bergstedt

Better data and analytics may encourage even greater volumes of capital towards green or transitioning companies. It would help the move towards greener business models. But, warns Eliza Eubank, global head of environmental and social risk management at Citi, helping clients transition to a greener business model, “is not as simple and black and white as saying this exposure is green or not green. There are a lot of nuances that can’t quite be captured when labelling assets.”

Understanding banks’ climate risk is also a matter of governance. Mr de Longevialle says that European banks, on average, are more advanced than their peers in the US, and other parts of the world, in terms of what he refers to as ESG integration. This means having a centralised governance of ESG risks that also has a view on business opportunities and policies related to sustainability. This structure would typically be supported at board level, and its strategy would seep through to executive committees and risk departments.

The emergence of a chief sustainability officer at several lenders points in this direction. But even in those cases, getting the governance structure right has not always proven successful, says specialist adviser Åse Bergstedt. Until recently, Ms Bergstedt was chief sustainability officer at private equity firm International and, before that, in charge of Nordea’s sustainability strategy. “When banks appoint chief sustainability officers, it sends a signal that sustainability is important to them,” she says. “But how will that person be able to do [their job] if they don’t have someone who understands sustainability across the banks’ businesses?”

Often, says Ms Bergstedt, sustainability is still seen as a due diligence exercise and business areas would not always have a point of reference for the centralised sustainability team to speak to.

“It is a similar journey to what risk and compliance went through [after the financial crisis],” she says. “There is a lot of screening on the appointment of chief risk officers, including from regulators. This has to happen for [the sustainability] area too, otherwise we’re not taking it seriously.” As regulators and lawmakers work towards the end goal of creating a greener, more sustainable economy, they may wish to consider how corporate and bank governance can facilitate those efforts. 

Meanwhile, all eyes will remain on climate risk metrics, and on the efforts to map the economic effects of climate change on business and finance. The EU efforts to close the data gap with a green taxonomy and related disclosures is being considered by other jurisdictions, including the UK. The application of those definitions and corporate disclosures will inevitably influence bank finance. “Consistency and harmonisation of disclosures would be helpful, whether it is on the regulatory side, or whether it is about accounting and taxonomies,” says Kunal Motiani, global lead for Citi's climate risk programme. “You can’t say that that would not be a good outcome overall for the industry.”

However, despite how crucial all these efforts are, including those made by central banks, Mr de Longevialle says that any result coming out of the first round of stress testing will need to be taken “with a pinch of salt”.

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Silvia Pavoni is editor in chief of The Banker. Silvia also serves as an advisory board member for the Women of the Future Programme and for the European Risk Management Council, and is part of the London council of non-profit WILL, Women in Leadership in Latin America. In 2019, she was awarded an honorary fellowship by City University of London.
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