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Banks have historically ignored climate risk in their investment and financing decisions interpreting it solely as a compliance issue. Today, there is a growing consensus that climate change can exacerbate traditional bank risks and adversely impact financial stability. This blog explores how banks are exposed to climate risks and shares some of the methods being used to measure the risk.
Physical risks: Severe and more frequent weather-related events such as sea-level rise, droughts, and floods can disrupt supply chains, cause financial losses and damage to physical assets, and human and natural capital. For example, frequent floods will significantly increase the risk of default on mortgages and change the structure and cost of insurance. Insurers are more likely to hike premiums or cease insuring certain risks, leaving banks exposed to credit risk. To mitigate such risks, a transition to a low-carbon economy is necessary. However, the transition presents both new opportunities and risks.
Transition risks: Shifts in policy, changes in consumptions, and technological progress will impact banks´ investment strategies—either in an orderly or disorderly fashion (abrupt and not fully anticipated by the market). For example, unanticipated policies could cause losses in carbon-intensive sectors resulting in loan defaults (credit risk for banks).
According to Roncoroni et al. (2021), banks´ exposure to transition risks depends on their investment decisions and ability to invest in low-carbon activities. Banks´ exposure and response, in general, is uneven with some banks actively investing in low-carbon activities and others taking a passive approach.
A study on the Dutch financial sector by Vermuelen et al. (2019) shows that 13% of banks´ assets are exposures to carbon-intensive sectors (resulting in expected losses between EUR 48 billion and EUR 159 billion). Overall, in the EU, exposure to carbon-intensive sectors is concentrated in the hands of a few banks. A report by the European Systemic Risk Board (ESRB) indicates that half of euro area banks’ exposures stem from the emissions of only 20 polluting firms. However, data on climate risk exposure in banking is still scant.
Under the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD), more banks are trying to understand the impacts of climate change by disclosing and mapping their CO2 emissions to measure their exposure.
Similarly, Schoenmarker and Tilburg (2016), suggest carbon and natural capital accounting to assess banks´ value chains and measure scope 3 GHG emissions resulting from investments and lending. Such an approach is useful in identifying the assets in carbon-intensive sectors and the potential for so-called “stranded assets”. However, carbon data from clients is often not readily available. And available data is often inconsistent, insufficient, and incomplete to support quantitative assessments (Campiglio et al. 2018).
Exploratory scenario analysis and stress-testing may help banks understand and forecast the impact of climate change on their assets.
An emerging series of studies e.g., Battiston et al. (2020), Batten, Sowerbutts & Tanaka (2016), Vermuelen et al. (2019), Dafermos, Nikolaidi, & Galanis (2018) and Nguyen et al. (2020) use stress tests to examine banks portfolio-level exposure to transition risk. Several central banks and prudential regulators have either launched stress tests or have it as a priority. But, progress remains slow and, there is a need for a common framework to assess bank climate exposures. This is a top priority for banks and the NGFS, for example, has published scenarios to enable actors to assess and manage climate risks using a common framework.
Both physical and transition risks threaten financial stability and banks can play a crucial role in managing the potential impact of these risks to ensure a climate-resilient financial system. Interested in this topic? Contact Financial Intermediaries and the Real Economy (FIRE).
Written by Sascha Steffen and Alexandra Kinywamaghana.
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