The Paris Agreement, the global climate change accord crafted by 196 nations at a United Nations conference in December, and formally signed Friday, has huge and mostly positive implications for banks.
The agreement seeks to limit the rise in global temperatures this century to 3.6 degrees Fahrenheit or 2 degrees Celsius. Developed countries are to make binding reductions in their carbon emissions and to submit their progress for international review. In all, 168 countries, including the U.S., pledged to sign the agreement when it opens for signing Friday.
Lending Opportunities and Related Policies
The agreement is widely expected to be the catalyst for large-scale lending and investments in greenhouse gas (GHG) reduction technologies and infrastructure. The International Energy Agency has estimated that the investment required to meet the Paris Agreement goals could be a towering $1 trillion annually. Bank of America Merrill Lynch calculates that investments in renewable energy alone will need to grow to $900 billion by 2030.
Barriers to investment to date encompass both financial and nonfinancial challenges. The immaturity of many green technologies presents an unattractive risk-return profile. Analysts note financial modelling challenges, lack of collateral, high upfront investments, longer credit payback periods, and lack of awareness or lack of technical capacity, and the adverse financial regulatory environment.
Evaluating the risk of climate change-driven opportunities for financial institutions is particularly challenging because of the complexity and dynamic nature of decisions required to deploy climate-related solutions. Climate solutions include disruptive technologies in mobility, buildings, manufacturing, infrastructure and energy production. Banks considering opportunities to finance, underwrite and invest in these technologies must consider the likelihood of necessary changes in policies, infrastructure, market conditions and consumer behavior.
Consider, as one example, carbon-reducing options for coal-fired power plants. As investments in coal-fired power plants and related assets – including coal mines – are at increasing risk due to their high GHG emissions, there are business opportunities to convert coal plants to biomass fuel. Those types of projects will likely open the door to new lending opportunities, but any credit analysis is subject to uncertainty. There is the technology risk from new fuel types, the infrastructure risk from there not yet being an established fuel supply and policy risk. Will environmental regulators consider biomass emissions as carbon neutral?
Still, banks appear ready to take on the challenge of low-carbon investments. For example, Bank of America committed $125 billion by 2025 to lending, investing, capital-raising, advisory services and development of financing solutions for low-carbon businesses. Those include renewable energy, energy efficiency and sustainable transportation. This commitment follows on a previous $50 billion commitment. As part of its initiative, B of A specifically extends lending and credit to lower-carbon companies.
The agreement is meant in part to improve the investment environment for low-carbon technologies, in particular by compelling nations that are party to the agreement to encourage carbon-reducing projects, programs and technologies from their respective business sectors. The agreement also requires developed countries to provide $100 billion annually to the Green Climate Fund for climate-friendly infrastructure construction in developing countries.
To benefit from funding available through the newly formed GCF, financial entities require accreditation. In 2015, Deutsche Bank became the first commercial bank to be accredited, which allows Deutsche to act as a channel through which the fund will deploy resources to developing countries, including through lending, equity investments or guarantees.
Steps to Reduce Economic Risks of Climate Change
In addition to the enormous lending opportunities it facilitates, the Paris Agreement will also help protect financial institutions and their assets from the potent economic fallout of rising temperatures. Potential climate change-related losses are projected at $43 trillion in present value for the public sector alone, or 30% of current assets.
In September, Mark Carney, governor of the Bank of England and chairman of the Group of 20's Financial Stability Board, warned that climate change posed a stark risk to global stability: "The challenges currently posed by climate change pale in significance to what might come. The far-sighted amongst you are anticipating broader global impacts on property, migration and political stability, as well as food and water security."
It is therefore critical for financial institutions to apply stress tests to their commercial lending portfolio to determine and address climate-related risks. Companies must contend not only with physical property risk but also vulnerability in portfolio business modelling. In order to help financial market participants understand their climate-related risks, the FSB formed a task force at the end of last year to facilitate climate-related financial risk disclosures from companies.
Physical property risk stems from the increase in frequency or magnitude of severe weather events or sea level rise. Because climate modelling and the ability to assess regional risk are evolving, even insured products may be exposed should insurers undervalue the potential for climate effects.
Risk may manifest as well from vulnerability of commercial borrowers of business loans sitting on banks' portfolios. This would include carbon-intensive businesses subject to increasing carbon regulation, or businesses subject to shifts in consumer behavior away from carbon-intensive products.
A comprehensive portfolio assessment should consider the carbon footprint of assets, vulnerability of business models to customer preference for low carbon products and services, and vulnerability of assets to extreme weather events and drought.
These practices will demonstrate to investors that the bank is strategic and effective in protecting assets from climate risk. Doing so will also help banks to meet Securities and Exchange Commission requirements for disclosure of material nonfinancial information. The Sustainability Accounting Standards Board, for example, identifies credit risk to the loan portfolio presented by climate change as a material disclosure issue.
The Paris Agreement also will focus more attention on dynamic legal issues dealing with U.S. efforts to reduce GHG emissions. The U.S. Supreme Court is expected to rule in 2017 on the Obama administration's Clean Power Plan (CPP) rules to significantly reduce greenhouse emissions from U.S. power plants. While the court took the unusual step of issuing a stay on the CPP regulations until it decides the case, it previously ruled that the government can regulate these emissions.
Meanwhile, several large states, including California, New York and Washington, continue to pursue aggressive carbon-reduction goals and will continue to do so regardless of the court's forthcoming decision.
The Paris Agreement and other efforts to reduce GHG emissions mean profound changes and opportunities. As such, banks should seek to understand the accord and track its ongoing implementation.
Lisa Grice is the global director for sustainability services for Ramboll Environ, a global environmental and health consulting firm.