Banks’ Ignoring of Climate Risks Poses Threat to Investors and the Planet, Analysts Warn
LONDON, Sept 15 – Financial institutions are failing to properly account for the risks posed by climate change, according to experts. This oversight could have severe consequences for both investors and the planet, they warn.
Regulators have long been concerned about hidden interest rate risks in banks’ balance sheets. However, the threat of global warming continues to grow unnoticed. Analysts argue that unless banks update their financial statements to reflect the reality of climate change, and regulators adjust their models accordingly, the consequences could be dire.
There are two main causes for concern. Firstly, banks’ financial statements appear to be overlooking climate risks, meaning that these dangers are likely being left out of capital calculations. Secondly, a regulatory regime that underestimates the impact of climate change is allowing this blind spot to persist.
One way to assess whether financial statements accurately reflect the risks posed by rising temperatures is to examine the assumptions banks make regarding expected credit losses (ECLs). ECL assumptions are crucial to banks’ financial strength, as higher charges reduce profits and shrink capital. However, these assumptions are subjective. Banks rely on forecasts about growth, as well as industry and location-specific factors, to determine ECLs.
Climate change is expected to have an impact on all of these factors. Changes in weather patterns, such as droughts, floods, hurricanes, heat stress, and extreme cold, will harm economic activity and human wellbeing. Additionally, stricter government regulations on carbon emissions and advancements in renewable energy will disrupt industries that rely on fossil fuels. Without action to mitigate these risks, the likelihood of defaults will increase, whether it be on mortgages in exposed coastal areas or project finance loans to oil and gas producers.
However, when examining banks’ ECL assumptions, climate risks are often omitted. For example, Wells Fargo’s latest financial statements use three scenarios to establish ECL assumptions, but fail to explicitly consider climate change in any of these scenarios. These projections cover a two-year period and then assume a return to historical norms. But what if global warming or the revolution in renewable energy prevent a return to these norms?
The few banks that do mention climate risks in their accounts often conclude that they are not material. HSBC, for instance, states that it does not consider climate-related risks to have a significant impact on its financial position. This raises questions about when the rising risks will become significant.
It is important to note that the issue at hand is not banks completely ceasing to finance activities that involve climate risk. Rather, it is about ensuring that these risks are properly accounted for and reflected in decision-making. To understand why banks are reluctant to show the effects of climate change in their accounts, it is helpful to consider climate stress testing conducted by prudential regulators.
The Network for Greening the Financial System (NGFS), which brings together 127 central banks working on climate change, models a cumulative 8% decline in global GDP by 2050 in a scenario where temperatures rise 3 degrees Celsius above pre-industrial levels by 2100. This would equate to an annual loss of 0.1% of global output, which is relatively insignificant. Furthermore, the models assume that the impacts will only become evident after 2030.
Using the NGFS models, the European Central Bank’s 2022 Climate Stress Test found that, under a warming scenario of 3 degrees or more, banks projected that loan losses in the decade leading up to 2030 would rise by a minuscule 0.005%. Even under a disorderly net zero transition scenario, lenders projected similarly low impacts. Although climate-related losses would increase over the years, they would never exceed 0.2% of performing loans.
The relatively benign picture painted by these models contradicts the warnings of scientists regarding the devastating economic hardships that could arise from climate change. Recent analysis by the Institute and Faculty of Actuaries and the University of Exeter found that models like those used by the NGFS are flawed because they fail to account for the most impactful climate harms. They do not consider tipping points that could result in self-reinforcing feedback loops, such as the sudden thawing of the permafrost in boreal forests, or social responses like mass migration or war.
When it comes to the energy transition, banks’ models often focus on a narrow set of variables, primarily a rising carbon tax. They assume that industry shifts will follow a steady path, rather than a rapid acceleration. This overly cautious and narrow interpretation of the clean technology revolution leaves banks ill-prepared for the dramatic changes that lie ahead.
These flaws in economic modeling help explain the complacency regarding climate change in the banking sector. However, they should also serve as a wake-up call for urgent action. Firstly, the prudential regulatory regime needs to become more cautious. Banks should adjust their models to reflect scientific scenarios, and central banks should require lenders to hold more capital against financing that is exposed to potential climate risks. Waiting until these risks materialize could
More detail via Reuters here… ( Image via Reuters )