The discussions leading up to the Paris Agreement underline the ubiquity of climate change risks across most industries. Yet banks are among the most exposed.
As loan originators and corporate issuers, banks provide credit to a whole host of sectors facing their own particular threats — or enjoying new investment opportunities — from climate change. For this reason, the financial services industry would stand to gain from companies — banks included — submitting dedicated disclosures about how they expect to be impacted by climate change.
The risks and benefits from climate change that would be made more transparent through disclosures go beyond the obvious. These risks are not limited to banks' exposure to carbon-intensive industries such as oil and gas or utilities, nor are the opportunities limited to the growth in the renewable energy sector.
A recent study by the Sustainability Accounting Standards Board found that climate change will potentially have a material impact on 72 of 79 industries, making up 93% of U.S. equity market capitalization. The pervasiveness of climate-related financial risks means that banks cannot simply diversify them away by reducing exposure to the energy sector. Commercial banks need to take a holistic approach in analyzing climate-related credit risk in their loan portfolios.
Greater disclosure of climate change risk by commercial borrowers would help banks analyze how risks and benefits are different from one industry to the next. For example, in the automobile industry, climate change shows itself through growing customer demand for fuel-efficient and zero-emission vehicles as well as strengthening global regulations on fuel economy and vehicle emissions.
In the real estate and agriculture industries, sea-level rise and severe droughts pose physical risks to tangible assets. In the oil and gas exploration and production industry, climate change regulations and a global transition to a low-carbon economy pose risks to the future extractability of hydrocarbon reserves.
Yet banks should not analyze the risks of an entire industry with a broad brush; the magnitude of the financial impact on individual borrowers varies significantly. Some companies are more exposed than others, and their exposure is dependent in part on how well they manage risks that are out of their control.
In a low-carbon economy, a company's relative carbon content, combined with the organization's cost for extracting reserves, will help determine its value sensitivity. A 2013 study by HSBC found that the impact on a sample of six large oil and gas companies from reduced demand for more carbon-heavy energy sources can range from 0% to 17% of a company's market value. In addition, a significant fall in demand could put downward pressure on hydrocarbon prices, magnifying the impact even more.
That variability means there is a different level of risk inherent in banks' reserve-backed loans to different energy companies. And investors need to ask whether banks account for these variations in risk in assessing creditworthiness.
An analysis by the SASB of the largest banks' Securities and Exchange Commission filings found that half of the industry either has no disclosure or only boilerplate statements describing climate-related risks in lending portfolios. And unfortunately, the same is true about the quality of climate change risk disclosure in other industries. Over 60% of large public companies do not provide company-specific disclosure of climate risk factors.
To ensure risk is properly priced in originated loans, banks need their borrowers to provide standardized disclosure of their company-specific climate-related risks. However, metrics that measure climate-related risks and opportunities vary by industry depending on the channels of financial impact on companies. Because of that, banks must push for the standardized reporting of sustainability risks — including those related to climate — on an industry-by-industry basis. These accounting standards must be developed from both quantitative and qualitative metrics that allow companies and investors to measure and benchmark performance on an industry-specific level.
Commercial banks are in a unique position to benefit from sustainability accounting standards as loan originators and corporate issuers. Market adoption of sustainability accounting standards would allow banks to account for climate risks across their entire loan portfolios while transparent disclosure from banks themselves would help their investors understand these risks in turn, resulting in more efficient capital allocation across the entire market.
Anton Gorodniuk is the financials sector analyst for the Sustainability Accounting Standards Board, an independent nonprofit.