Sustainable Finance and Climate Risk
Nations attending the recent G-20 summit in Hamburg, Germany, reaffirmed the principles of the Paris Agreement, committing to a new “climate and energy action plan.” A communiqué from the summit declared the Paris accord “irreversible.” On the surface, the new commitments were encouraging. But, of course, glaringly absent from the joint plan is the world’s largest economy: the United States.
President Trump’s decision to pull out of the Paris Agreement complicates existing challenges and poses new ones in the worldwide fight against climate change. For banks and other financial institutions, the reality of climate change — magnified by the U.S. reversal — is a risk management curveball, throwing a wrinkle in financial institutions' plans to manage everything from physical risk, to asset valuation, to the creditworthiness of both high-carbon and carbon-mitigating industries.
Trump’s decision was not only criticized by several political leaders around the globe, but financial leaders as well. Goldman Sachs CEO Lloyd Blankfein said, in his first tweet ever, “Today's decision is a setback for the environment and for the U.S.'s leadership position in the world.” JPMorgan Chase CEO Jamie Dimon said, “I absolutely disagree with the administration on this issue.”
Given their integral role in all sectors of the economy, financial institutions are inherently susceptible to the risks of climate change, but are also well positioned to play a prominent role in the transition to lower carbon economies.
Understanding these risks and opportunities, global financial leaders have become increasingly adamant that financial institutions must explicitly consider climate change in their long-term business strategies, risk management processes and reporting frameworks.
Additionally, there has been considerable push for increased transparency and consistency surrounding environmental reporting which would allow financial institutions to adequately measure and respond to their exposure to climate change risk.
Large banks — in addition to cities and states — have been among those trying to step up policies to try and counter the effects of the U.S. policy. Earlier this month, the United Nations Environment Initiative announced a pilot project launched by 11 global banks to strengthen environment-related reporting standards.
With all that being said, President Trump’s decision stands to dramatically alter the trajectory of U.S. climate policy and will quite possibly impact broader global mitigation efforts. So, what does this decision mean for financial institutions? And in particular, how will it affect the risks they face and the returns they seek?
Let us begin by considering what is, perhaps, the most obvious climate change related risk: the physical risk. Insurers, in particular, are well aware of the increased extreme weather-related losses associated with climate change. The number of worldwide weather-related loss events has more than tripled since the 1980s, resulting in an increase in inflation-adjusted insured losses of approximately $40 billion.
But financial institutions’ real estate-related investments are also vulnerable to losses caused by weather-related physical damages and the subsequent operational disruptions they may cause. In addition, as climate change increases the frequency and/or severity of damage to real estate assets, commercial and residential mortgage default rates may rise and collateral values may fall, particularly in geographical areas prone to fires, flooding and other extreme weather events.
Beyond the direct physical risks of climate change there are secondary physical risks which include but are not limited to the disruption of global supply chains, resource scarcity and potential macroeconomic or political shocks. These risks can reduce economic growth and weaken financial markets.
A 2016 article in Nature by Simon Dietz and three other co-authors said climate change could result in a devaluation of financial assets by $2.5 trillion. Their assessment was based on a relatively new risk measure known as “climate value at risk” (or climate VaR). A more recent article, entitled “A climate stress-test of the financial system,” warned of “adverse systemic consequences. It said “that exposures to climate-policy-relevant sectors represent a large portion of investors’ equity portfolios” and “the portion of banks’ loan portfolios exposed to these sectors is comparable to banks’ capital.”
Similarly, a University of Cambridge report found that short-term shifts in climate sentiment may reduce the value of global investment portfolios by as much as 45%. Moreover, this report suggested that up to half of this risk cannot be hedged unless action on climate change is taken at a system level.
Meanwhile, President Trump’s policy reversal — which increased the uncertainty surrounding the trajectory of U.S. climate policy — will undoubtedly add to the complexities of managing transition risk, or the risk associated with the transition to a low-carbon economy. Policies may now vary widely across cities and states, causing further carbon risk disparities between similar assets that lie in different geographical locations. Moreover, geographical variation in climate policy may provide competitive advantages to areas with less stringent polices.
Introducing additional uncertainty around the timing and extent of both climate policy and future climate change itself may also lead to the mispricing of assets if the risks associated with climate change-related transition pathways are not fully reflected in asset prices.
For example, fossil fuel companies are valued based on all known exploitable reserves. This means that approximately 50% of oil and gas companies’ market values are derived from long-term cash flows based on the extraction of reserves over a 10-year-plus time frame. However, in order to reach climate change mitigation goals laid out by international standard-setters, no more than one-third of the identified fossil fuel research can be consumed before 2050. This will, no doubt, put companies at risk of asset stranding and devaluation. Along a similar vein, both HSBC and Standard and Poor’s have reported that the market capitalization and creditworthiness of carbon-intensive energy companies will be negatively impacted by emissions-reducing policies.
Although these facts may seem to support President Trump’s decision, that is not the case. Avoidance of sufficient emissions reduction policies will have broader economic impacts that far outweigh any short term benefit realized by high carbon energy companies. Moreover, policy uncertainty paired with the increased severity of unimpeded climate change will likely be met with a rise in market volatility. Looking farther down the line, it is wholly possible that the federal government will buy back into climate change, at which point climate policies may need to be comparatively more severe to remain on track with global climate targets. This may lead to more drastic and widespread devaluations.
Irrespective of the White House’s stance on climate change, financial institutions should be aware of the strengthening customer sentiment around climate change. An unprecedented example of this came just two days before President Trump’s decision to pull out of the Paris agreement. ExxonMobil, the largest Western oil and gas firm, saw 62% of its shareholders vote in favor of assessing and disclosing both the short and long-term effects of carbon mitigation pathways on its performance and viability.
In general, the population is becoming more aware of the pervasive impacts of climate change, including those that are financial in nature. Consequently, financial institutions’ customer bases are increasingly seeking out sustainable and environmentally friendly investment and banking opportunities. Aside from the financial benefits of green investing, it is also beneficial from a reputational risk perspective for financial institutions to support renewable energies and clean technologies.
U.S. participation in Paris may not have a material impact on many of the risks — or the opportunities — that climate change and the transition to a low-carbon economy pose for financial institutions if (and likely only if) states, cities, businesses and investors pick up the slack and actively work toward upholding the Paris agreement and its carbon reduction goals. Without climate change mitigation, financial institutions should expect higher weather-related losses, greater uncertainty surrounding transition pathways and increased market volatility, among other things.
This is a summary of the original report as published in American Banker. For the full report, please visit the link at the top of the page.