US banks are more exposed to the financial risks associated with the transition to a lower carbon economy than they previously thought, with all six of the largest US banks facing above-average risks related to climate change through their syndicated loan portfolios, finds a new report.
The report, titled Financing a Net-Zero Economy: Measuring and Addressing Climate Risk for Banks, by the Ceres Accelerator for Sustainable Capital Markets, a US-based non-profit company, reveals that more than half of the syndicated loans issued by major US banks are to sectors that are vulnerable to climate transition risks, such as manufacturing, energy and agriculture, because their corporate clients within these sectors have failed to adequately prepare for a lower-carbon future.
This has the potential to damage financial institutions and the global economy, as well as hinder the world’s ability to tackle climate change at the speed and scale required to prevent its worst impacts.
“This is doubly true because the understanding of tail risks – risks once thought too extreme to consider – has dramatically changed, first with the 2008 financial crisis and now with the Covid-19 pandemic,” reads the report.
Bank of America, JP Morgan, Citi, Morgan Stanley, Goldman Sachs and Wells Fargo all have above-average loan risks linked to climate change through their syndicated loan portfolios.
Some banks are making progress, with lending policies adjusted for fossil fuels. The research points to global players JP Morgan and Barclays as having made positive climate pledges that cover their financing activities and align with the 2015 Paris pact.
In October, JP Morgan revealed that it is adopting “a financing commitment that is aligned to the goals of the Paris Agreement”. The bank states it will establish intermediate emission targets for 2030 for its financing portfolio and “begin communicating about its efforts in 2021”. JP Morgan will focus on the oil and gas, electric power and automotive manufacturing sectors and set targets on a sector by sector basis.
Meanwhile, Barclays aims to become a net zero bank by 2050. On its website, it says it has “made a firm commitment to align our entire financing portfolio to the goals of the Paris Agreement. That means our own operations, and the financing we do for our clients, in every sector, will support the goal of limiting global warming.”
Other banks around the world are also making progress on reducing their support for fossil fuels, including coal – the dirtiest fossil fuel. Many French financial groups are now requiring that their clients adopt a coal phase-out plan by the end of 2021, pledging to drop clients who are unable to prove their ability to exit coal. However, key financial institutions continue to lack any policy on coal, and most banks and insurers still allow direct financing or insurance cover for new coal projects.
In some instances, it is more difficult for banks to halt support for fossil fuel companies and their projects. In developing countries, new fossil fuel projects can create local jobs and improve infrastructure, benefitting a community socially, a key part of ESG criteria, for example.
That said, when it comes to banks’ corporate fossil fuel clients, a May report by Transition Pathway Initiative (TPI) suggests that oil companies are far from being on course to reach net zero carbon emissions, with investors urged to push for more stringent targets and standardised data disclosure.
Banks could face “substantial losses”
In its report, Ceres Accelerator also highlights that the current view of climate risk by most banks is fairly narrow, focusing mostly on financing to the fossil fuel sector and on policies that are too broad to make much of a difference. “It is what lies in the middle – the massive amount of financing banks provide to sectors, including agriculture, manufacturing, construction and transportation, that rely heavily on oil, gas and coal – that could threaten climate and financial stability if unaddressed.”
This wider assessment of climate risk and a general sentiment shift could result in “substantial losses” for banks on their syndicated loan books and other areas of business as the profits and market shares of unprepared clients decline.
US banks’ exposure to the fossil fuel and electricity sectors produces modest loss estimates – up to 3% for the syndicated loan portfolio of the average bank. But the wider impact view, which accounts for all non-financial, climate-related sectors, such as manufacturing, transportation and agriculture, produces much higher average loss estimates, up to 18% on these loans.
“These losses reflect a worst-case scenario, but only for a portion of each bank’s business and a single type of risk. Banks face other risks, including from physical risk (extreme weather, fires, droughts or sea level rise). They also face potential legal liability and risks from other elements of their business lines. Together, these could combine to ratchet up total exposure even more.”
The report also finds that banks’ connectivity within the financial system could lead to significant incremental climate risk. The extent to which banks finance each other leads to indirect transition risk from exposure to other firms’ own direct risk.
In response to the findings, the report makes 13 recommendations for banks to review and mitigate their exposure to climate risks, including improving their existing climate risk analysis tools and methods, requiring clients to provide more data in key climate-related areas, developing risk management techniques like scenario analysis, and building climate risk into everyday decision-making tools.
It also advises that banks act to lessen their exposure to climate risk by setting and disclosing financing portfolio targets that are aligned with the Paris Agreement, including detailed goals and specific timelines for portfolios to reach net-zero emissions.