Climate change: Three things banks must do
- Posted on October 19, 2021
- Estimated reading time 3 minutes
In my last blog, I wrote about the challenges facing many banks as they handle climate change. There are three ways banks and regulators can make the most of the opportunities while resolving some of the more complex issues: business focus, better standards and greener products and a purpose-driven approach.
- Strategy: Climate-related considerations must be integrated into corporate strategy, including executive remuneration and product strategy. Board members will need to make tough decisions on which companies/sectors should be excluded from business and what emissions thresholds for financing are appropriate for certain sectors.
- Risk management: Climate risk must be fully integrated into the risk management framework. Create scenarios to test the impact of climate change on customers, especially over longer time horizons (a 10-year horizon is not that far beyond the average maturity of most loan books).
- Scenario analysis: Simulate portfolio performance under a range of conditions (emissions, carbon pricing, temperature) up to 2050 at least (scenarios developed by NGFS in 2020 are a good benchmark). Align financial portfolios with the Paris Agreement goals using established methodologies such as PACTA.
- Disclosure: The current system – mainly voluntary reporting – fails to show the things that matter. You should reveal your full carbon footprint. Demonstrate how you expect your footprint to change and the amount of capital expenditure that goes toward low-carbon investments. Align fully with the TCFD framework.
Better standards and greener products
- Green financial standards: Given the confusion of many standards, a tiered approach makes sense. A global standard may be defined by the UN or TCFD. National standards are then aligned with the global standard. So, if there are 50 global metrics, one country could choose to implement the 20 most relevant to its context (such as carbon dioxide emissions or water quality).
- ESG ratings: Banks can get mixed signals from ESG ratings agencies about what is worth doing, which gives them less incentive to improve. Regulators could officially endorse a group of SPO (Second-Party Opinion) providers – as the Singapore regulator is doing – defining strict criteria on how to complete an ESG assessment.
- Green products: Bonds have grown rapidly since the green bond market was conceived 10 years ago and could be worth $2.4 trillion by 2023. Sustainability-Linked Loans (SLL) - interest paid by the borrower is linked to sustainability KPIs - can include targets on carbon emissions plus ESG criteria. Iberdrola received a €5.3 billion SLL from BBVA for energy efficiency and renewable energy projects. Green mortgages offer preferential interest rates if your home is energy efficient.
- Sustainability keeps customers: This is important because millennials – who make up 25% of the U.S. population alone and want sustainable investments – are poised to inherit significant amounts of wealth ($30 trillion intergenerational wealth transfer from baby boomers to their children). Firms typically lose 70% of assets when transferred from one generation to the next. Supplying millennials with green investment options will be essential to attract new assets to the bank as well as retain wealthy millennial clients.
- Purpose drives profit: Research has found that incumbent banks with a clear purpose and high levels of customer trust could increase retail revenues by 9% per year. Over the last four years to June 2020, such banks achieved an average return on equity that was three percentage points higher than that of the other banks in the study.
In my final blog, I’ll look at how banks can develop a sustainability roadmap.