Nowadays, banks around the world are under greater pressure from the political, social, but also economic worlds to also commit themselves as soon as possible to mitigate the risk that climate change poses to the planet and the consequent damage to the economic system and the well-being of millions of people. Indeed, an uncontrolled rise in temperatures would be lethal to a very long range of business activities. The economic losses from a failure of this large number of sectors would be colossal.
Climate risk
In contemporary financial circles, climate risk is increasingly spoken of as something that banking institutions around the world must learn to manage if they do not want to see billions of dollars go up in smoke. Managing such risk is one of the fundamental tasks of a bank, and if not executed properly, it often causes its failure. According to an analysis by financial consulting firm McKinsey&Company, about 15 percent of EU banks' balance sheets are at risk. Also, not to be overlooked, are the transition costs that a highly environmentally harmful industry will have to go through in the future.
This new kind of risk, however, is only one side of the coin. For while the investment world presents new pitfalls, new revenue opportunities are emerging that could not have been imagined before. The UN Adaptation Gap Report estimates that the annual costs of adapting to climate change would amount to about $500 billion; a considerable sum that could represent an opportunity should one see it as a demand for investment in new sectors, infrastructure, or technologies profitable over time.
Where we stand according to the ECB
At the present stage, the situation is far from rosy and, to use the ECB's language, the glass is not even half full. In fact, Frank Enderson, a member of the institution's executive board, estimates that 96 percent of EU banks fail to correctly identify these new risk factors or do not identify them at all. Moreover, although most banks refer to climate change in documentation related to their investment strategy, this is only a facade that rarely results in large-scale strategy changes.
The ECB goes on to say that about 8 percent of the average bank's portfolio could be at risk of default, an alarming figure although lower than that presented to us by McKinsey&Company (15 percent). A study examining 112 banks with combined assets of $24 to $27 trillion, concludes that half of these will suffer losses due to weather. Of the banks examined, only 28 percent incorporate climate risk into their risk calculations.
Along with the ECB, other notable banking institutions, such as the Federal Reserve and the Bank of England, have also been emphasizing the risk posed by climate change for years.
What could be done about it? One of the options
A universally recognized and enforceable law does not exist, however, there are numerous reports and analyses that suggest new strategies for banking institutions.
One of these was compiled again by McKinsey&Company and consists of two major elements. First, there is the need to form an internal apparatus specifically designated to manage climate risk, which must be considered in all types of investment activities of a bank, from loans to capital allocation. Second, possible damage caused by climate change must be considered in one's "stress tests," or analyses of hypothetical scenarios in which losses are incurred, to determine the bank's ability to cope with such losses.
These two elements, along with others, are then organized in 3 steps, which can be carried out in a time frame of 4 to 6 months, to develop a comprehensive approach to the problem in a phased manner. As a first step, it is necessary to designate an officer, or at least establish a section, to deal with climate risk. Next, comes the methodological part, that is, developing a strategy and appropriate methods, accumulating data on possible sources of risk, possible damages, conducting the aforementioned stress tests, and so on. The last step is to integrate climate risk into every decision-making process of the institution to routinize it and make it part of the system.
These are only general guidelines and are not the only ones formulated on the subject. In fact, the ECB has already published its own guidance on how best to manage this issue.
The data problem
Proper management by a climate risk bank cannot take place without reliable and complete data on the problem. Data collection is precisely the thorniest part of the issue, as well as the most important one since it allows one to see or predict the risk factor and take corrective action.
The most relevant data to be collected, as can be imagined, are those concerning greenhouse gas emissions, which are crucial, not only for proper risk management, but also for achieving a neutral climate footprint by 2050. The idea behind collecting this type of data is that the higher the climate impact of a company or project in which a bank has invested, the greater the risk of loss due to the high transition costsof that industry or project. Increased awareness of transition costs, moreover, would make it possible to turn a loss into a gain by investing in new industries that can reduce climate impacts and make significant profits.
The risks posed by transition costs, however, are only one of many risks that climate change poses in terms of economic damage. A bank must also consider the risk that a natural disaster, or a simple rise in average temperature, poses to a business in which it has invested: this is the case, for example, with large-scale agricultural operations that are exposed to an increasingly abnormal climate. In time, not only banking institutions, but all human activities will have to account for being increasingly exposed to damage from climate change.
Translated by Denise Praticò.
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Sources:
https://unsplash.com/it/foto/W...
https://www.bloomberg.com/professional/blog/climate-risk-data-challenges-facing-the-banking-sector/
https://www.ecb.europa.eu/press/blog/date/2022/html/ecb.blog221102~7599e5851e.en.html
https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr201127~5642b6e68d.en.html
https://www.bankingsupervision.europa.eu/about/climate/html/index.en.html