Climate Change Will Restructure the Economy. Here’s How Banks Can Prepare.

As scientists deliver ever-more-serious warnings about climate change, companies are beginning to size up the potential effects not only on their businesses and industries but across the entire global economy. 

Banks wouldn’t seem to be on the frontlines of these emerging risks. But because they make loans and grease the wheels of commerce for clients in virtually every industry, all over the world, their exposure to climate change is potentially enormous.  

Measuring the potential effects of climate change on banks is no simple task. But opportunities are beginning to emerge from the shift to a lower-carbon economy, and if banks measure and manage their growing climate risks, they will be in a better position to seize these opportunities. 

Pressure Is Mounting

The stakes of climate change are high for many industries: Physical risks are beginning to materialize, regulatory pressures are increasing, new opportunities are emerging — and investors are demanding more transparency. The first step is understanding what, exactly, is at risk. 

For banks, one of the biggest threats is credit risk, or the risk that borrowers will default. In home mortgage lending, for example, a bank’s loan portfolio can be impacted by climate risk in two ways — either through persistent, 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. 

Home loans, of course, are 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. Such potential shifts make up a category of risk known as “transition risk,” and for lenders and borrowers alike, they are substantial.

Then there is regulatory risk. As credit risks increase, central banks and supervisors are ramping up scrutiny on financial institutions. In December 2019, the Bank of England’s Prudential Regulation Authority suggested banks perform a climate stress test covering a large part of their balance sheet, assessing the impact of various climate scenarios (covering physical and transition risks) at a borrower level. 

Investors, meanwhile, are pushing corporations for more disclosure of their exposures to climate risk. The Task Force on Climate-Related Financial Disclosures, established by Financial Stability Board Chair and Bank of England Governor Mark Carney and Michael Bloomberg, aims to do just that. 

On the other side of the ledger, there are also opportunities for banks to boost revenue from climate change activity. Massive amounts of capital and new financial products will be required to fund the transition to a lower-carbon economy, creating fresh demand for bank services. In all, roughly $1 trillion of new financing will be required annually to fund the transition. Banks that identify these opportunities can help reduce their overall risks and, potentially, boost their returns.

Managing Climate Risk

With all of these forces bearing down on banks, their leaders need to adopt comprehensive, firm-wide approaches to managing climate change risk. That requires integration across the entire risk management framework. We highlight below four ways to do that. 

Consider all the what-ifs. Analyzing the potential impacts of both physical risk and transition risk is critical for planning. Climate scenario analysis, essentially a “what-if” analysis, is a useful method to quantify all the potential exposures. In our work with the United Nations Environment Program, we’ve developed Transition Check, a tool that can be accessed by all UNEP Finance Initiative members that provides a framework and calculation to assess climate scenario impact on lending portfolios. We’ve also joined up with S&P Global to develop Climate Credit Analytics, which contains powerful bottom-up models by industry sector that are fed by S&P Global’s rich universe of corporate and industry data to evaluate the impact of scenarios on borrower credit risk.

Incorporate borrower risk assessments. Once the emerging risks are identified and quantified, they need to be reflected in the risk ratings of the borrowers. Many institutions haven’t yet started the journey, while others are looking at ways to capture climate risks within the credit-rating process. 

Build into strategic planning. Climate risks should inform key business applications such as pricing or strategic planning. Measurement of risks and expected losses under different climate scenarios can help identify potential downsides. At the same time, assessing the potential future market helps bank executives identify promising lending opportunities and steer the organization.

Expand governance efforts. Early efforts in integrating climate considerations are often driven by the sustainability and environmental and social risk teams — often focusing on the potential negative impacts of projects and reputational issues. But climate change is rapidly becoming a financial risk and should be governed by financial risk management teams. Given the increasing financial stakes and rising external pressures associated with climate change, both the Task Force on Climate-Related Financial Disclosures and the Prudential Regulation Authority advise banks to have their board of directors oversee climate risk.

A Virtuous Circle

The impact of climate change over time will force major structural adjustments to the global economy that will inevitably affect banks’ operations and balance sheets. Climate risk management will take its rightful place at the risk management table, and sound new practices will become commonplace. Investors are likely to respond in kind, as the information created by climate disclosures drives their own capital decisions. A richer data environment can fuel more efficient capital markets overall. 

Through all these changes, increasing awareness of climate risk within the banking industry will ultimately generate broad benefits for other industries — and for society as a whole.