September 2020 was the warmest month on record worldwide. For the first time in recorded history, the main nursery of Arctic sea ice has failed to freeze by late October. In recent years alone, we observed several global climate change-induced events, having far-reaching effects on livelihoods and inflicting vast economic damages. As we approach the fifth anniversary of the Paris Agreement, it becomes clear that reaching the goals set in the Agreement requires an unprecedented financial support from financial institutions worldwide to help private companies shift to a more sustainable business mindset. This article examines the potential impacts of climate change on financial intermediaries and their role in the transition to a low-carbon economy. It focuses on the effects of climate change and climate-related risks on the banking lending process and the investment process within the asset management industry.
Lately, the focus of global firms has been shifting towards greater transparency on physical and transition risks arising from climate change, as witnessed by the enactment of voluntary (such as the Task Force on Climate-related Financial Disclosures’ recommendations) and legal (European Union Action Plan on Sustainable Finance) instruments. The banking sector plays a crucial role in sustaining cross-industry companies in the transition to a green economy through the injection of financial resources. Nonetheless, banks face numerous challenges in this process, the most cumbersome of which will have an impact on their lending process.
Integrating climate risks into the lending process will not be an easy task to accomplish. Albeit banks have traditionally prioritised the financial soundness of borrowers (with a mostly automated evaluation system based on financial indicators), they will have to shift their focus to the borrowers’ approach to selecting projects (ie follow a forward-looking methodology and consider the expected cash flows). As highlighted by the Organisation for Economic Co-operation and Development, due diligence can support banks in managing adverse environmental and social impacts, contributing to global sustainability goals, improving stakeholder relationships and protecting their reputation. Additionally, the supportive role of regulators and industrial companies will be an underpinning factor for banks to succeed in this transition. Regulators will undertake responsibility for ensuring that climate risks are well defined, managed and mitigated by the financial sector. In this respect, the European Union has already endeavoured enacting a risk reduction package (the CRD V) that entrusts the European Banking Authority with the role of assessing the possibility of including climate risk within the Supervisory Review and Evaluation Process. Companies across the market face an increasing pressure to improve transparency beyond the regulatory requirements, which will in turn contribute to the market discipline effect.
In this regard, banks should prioritise the management of their financial exposures and protect their own balance sheet. McKinsey estimates that up to 15% of the banks in the European Union balance sheet is at risk due to climate change. It is worth noting that, according to the consultancy, the sectors most exposed to disruptive climate change-related impacts include oil and gas, real estate, automotive and transport, power generation, and agriculture. The CDP has found that 215 biggest global companies report almost $1trn at risk from climate impacts, with the majority likely to hit within the next 5 years. On top of that, another $250bn in potential losses is expected due to the write-offs of assets. Nonetheless, the authors of this article believe that this data highlights an opportunity for banks to re-assess their legacy investment portfolio and embrace a leadership role by providing appropriate financing mechanisms to ‘brown’ sectors on their journey towards sustainability.
Leaders in the banking industry are already accelerating bank-wide evolution and redefining their strategies in alignment with the Paris Agreement, the United Nations Principles for Responsible Banking and the Equator Principles. The front-runners not only commit to group-wide climate risk strategies but also ambitiously prioritise financing that drives companies across the economy toward sustainability initiatives, for example, by issuing green bonds. It is noteworthy that the Bank for International Settlements has raised concerns that so far green bond projects have not necessarily translated into comparatively low or falling carbon emissions at the firm level, entailing incentives for the financial industry and investors to enhance the status quo of the green bond rating system. In practical terms, lenders will need to review their exposure to ‘brown’ companies and activities by applying a clear and structured exclusion policy, and determine their capital mobilization and allocation strategies by integrating environmental, social, and governance (ESG) metrics into the lending criteria. Banks will not only need to integrate environmental risks into their credit decision-making process, but also assess the impact of a borrower’s current environmental performance on its future success.
By the same token, investment managers will need to shift their focus to speed up the review of their investment process, and include indicators assessing the project portfolio of their investee companies. According to the CFA Institute’s report ‘Climate Change Analysis in the Investment Process,’ 40% of investment managers surveyed already include climate-related information into their investment decision process. Furthermore, 75% of the executives working in this industry believe that climate change is an important issue to address. According to a PwC report, in 2019, ESG assets held by investment managers accounted for €1.66trn (or 15% of the total) in European fund assets. By 2025, the consultancy expects ESG assets to jump to between €5.5trn and €7.6trn, constituting between 41% and 57% of the forecast €13.4trn in total mutual fund assets in Europe. Moreover, ESG funds have been observed to outperform traditional investment funds since the Covid-19 outbreak, and the crisis is seen as a catalyst accelerating climate change integration into investment strategies.
The transition will not happen overnight. When addressing climate change, investment managers will need to develop a new set of skills in line with the tasks to be performed. Skills to detect the potential impacts of physical and transition risks on the assets held by investment managers will be of utmost importance. Correspondingly to banks, it is highly unlikely that investment managers will be able to completely dismantle their investments in ‘brown’ companies given the high demand for energy. In contrast, their role of change drivers will be underpinned by a sophisticated evaluation framework for investee projects, coupled with risk modelling and scenario analysis capability.
In summary, the authors of this article strongly believe that financial intermediaries play a leading role in driving the transition to a low-carbon economy. Whereas the challenge faced by the financial industry may seem disconcerting, embracing it will be critical to success. As Charles Darwin once said: ‘It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.’
The views and opinions set forth herein are the personal views or opinions of the authors; they do not necessarily reflect views or opinions of Banca d'Italia or Credit Suisse.