This report investigates banks’ climate-related financial risks and their exposure to a disorderly transition. Based on the finding that a majority of bank lending is in climate-exposed sectors, the report also lays out a blueprint for bank action with key recommendations for how banks can discuss their climate risk exposure and the mitigation strategies they can use to address this risk exposure and broader climate-related societal impact.
As the lynchpin of the global economy, banks have an essential role to play in minimizing the worst impacts of climate change. How banks respond to the climate risk that they individually and collectively face depends heavily on how they measure and analyze their exposure to it.
The climate risk banks face stems from the failure of their clients to adequately prepare for a lower-carbon future. This risk has the potential to significantly damage financial institutions and the broader economy—and impede society’s ability to tackle climate change at the speed and scale required to avoid 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.
Many banks have begun to act. Some lending policies are being adjusted for risky fossil fuel companies. Some banks have called on policymakers to address systemic climate risk. Global players including Barclays, JPMorgan Chase and Morgan Stanley have even made climate commitments that cover their financing activities.
But for most banks, the current view of climate risk is incomplete—it focuses narrowly on fossil fuel sectors or broadly on the need for policy action. 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 report investigates the syndicated loan portfolios of the largest U.S. banks and their exposure to climate transition risk, which arises from the policy, regulatory, consumer preference and reputational impacts of the transition to a lower-carbon economy. It complements other leading-edge approaches and highlights the imperative for banks to use their proprietary data to fully test its findings.
Key Finding #1
Over half the syndicated lending of major U.S. banks is exposed to climate transition risk because many bank clients in a wide range of sectors have inadequately prepared for emissions reductions in line with the Paris Climate Agreement
Figure 1: Climate-relevant sectors in U.S. syndicated loan portfolios ($ billions).Â
Given this potential exposure, every bank should assess its resilience against disorderly climate transition scenarios (brought on, for instance, by a sudden shift in investor and public sentiment around climate risks following a policy change). The limited publicly available data show that in a worst-case scenario, banks could sustain heavy losses on their syndicated loan book and, by extension, other areas of their business, as the market shares and profitability of unprepared clients decline.
Key Finding #2
Banks may face substantial losses from direct exposure in the months following a major sentiment shift.
The “Core-Impact” view of banks’ exposure to the fossil fuel and electricity sectors produces modest loss estimates—up to 3% for the syndicated loan portfolio of an average bank.
But the “Wide-Impact” view, which accounts for all non-financial, climate-relevant sectors (including energy-intensive manufacturing, buildings, transportation and agriculture) produces much higher average loss estimates—up to 18% on these loans
The six largest banks in the U.S. all face above-average risk in the wide-impact results.
Figure 2: Percentage losses on the syndicated loan portfolios of major U.S. banks (by sector) in the months following a shock.
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. Just as critical but perhaps less obvious is that banks also face indirect transition risk from interbank lending and other exposures within the financial system itself. This key driver of the 2008 financial crisis has not been factored into publicly disclosed climate risk analysis to date.
Key Finding #3
Banks’ level of leverage and connectivity within the financial system could lead to substantial incremental climate risk.
The extent to which banks finance each other leads to indirect transition risk from exposure to other firms’ own direct risk.
Additionally, banks could face balance-sheet contagion (or “fire sales,”) where assets are rapidly devalued and banks are forced to sell them to stay in compliance with regulatory capital requirements.
These results are not the final word. Individual banks have the power to substantially change this narrative and differentiate themselves from peers. Methodologies for stress testing and scenario analysis are robust enough to be widely used and provide a starting point for the urgent work of conducting more granular risk assessment at the client level. By improving client selection and engagement, banks will not just lower their risk and create new upside, they will help propel the transition to a zero-carbon economy. That will, in turn, minimize risks to financial stability and the entire banking sector and help catalyze more momentum to curb the most severe impacts of climate change by meeting the objectives of the Paris Agreement.
Further dialogue and analysis around these complex issues is required, which is why Ceres views this report as the next step in a deeper collaboration with the sector on how to act on the report’s recommendations, which fall into three broad categories:
âžś Assess and Disclose Risk (Recommendations 1-5)
Most firms in climate-relevant sectors today are exposed to climate risk, but there are a growing number that would greatly benefit from a low-carbon transition scenario. Quantifying the upside (and downside) at both the firm and portfolio levels will improve banks’ client selection and identify a larger number of investable opportunities that could offset potential losses.
âžś Improve Tools and Methods (Recommendations 6-9)
Existing analysis can be strengthened by developing science-based, transparent valuation approaches that can be used to meaningfully engage clients on their own climate strategies. Key improvements needed as part of this include:
Requiring that clients provide more data in key climate-related areas, such as energy technology and emissions profiles • Aggregating those data using methods such as carbon accounting
Further developing risk management techniques, including stress testing and scenario analysis
Building climate risk into day-to-day decision-making tools, such as client earnings models
âžś Act to Mitigate Climate Risk and Ultimate Impact (Recommendations 10-13)
Good analysis allows banks to decarbonize their portfolios through client engagement, which is critical for achieving real economy emissions reductions. Engagement only reduces risk if it leads to target setting and emissions reductions by clients, so banks need accountability mechanisms to ensure this occurs.
That is why Ceres is calling on every bank to set a Paris-aligned emissions target before the next major UN climate conference in November 2021. This should include detailed interim targets and specific timelines for sectoral portfolios to reach net-zero emissions— some sectors as soon as 2030, others by 2040 or 2050.
This will ensure that client engagement is focused on results and also serve as an external signal about the bank’s own risk. Banks that set such targets will send an unambiguous message that they are serious about reducing their own climate risk and about building a just and sustainable global economy.
Ceres’ Recommendations for Banks
1. While this report focuses on transition risk, banks should assess all elements of climate risk and opportunity that may affect their business (including transition risk, physical risk and litigation risk), and disclose an overall assessment to investors and other external stakeholders.
2. Banks should assess their entire balance sheet to identify which assets may be exposed to climate transition risk (including indirect risk from elsewhere in the financial system).
3. Banks should disclose a portfolio risk assessment that identifies the sectors that the bank considers to be climate relevant and the percentage of assets in these sectors that the bank considers to be at risk.
4. Risk assessment should include stress testing based on both backward-looking data (such as past emissions) and forward-looking data (such as planned expenditures). The findings of these analyses should be disclosed at a high level.
5. U.S. banks should align their policy positions and lobbying with the regulatory recommendations outlined in Ceres’ June 2020 report Addressing Climate as a Systemic Risk.
6. Banks should use, improve and develop internal valuation tools that translate climate-relevant information into securities prices, earnings forecasts and value-at-risk estimates.
7. Banks should seek industry agreement to use their market power and relationship leverage to incentivize clients to voluntarily disclose additional forward- and backward-looking climate data.
8. Banks should internally prioritize and reward their employees for integrating climate considerations into day-to-day decision-making.
9. Banks should recognize the risk mitigation potential of constructing a more fundamentally sound, equitable and sustainable economic system.
10. Banks should publicly state that they will use engagement and leverage to accelerate client transition plans and wind down relationships that do not include such plans.
11. Banks should communicate to employees and investors any risk-mitigation value they ascribe to their sustainable finance programs.
12. Banks should set and disclose financing portfolio targets that are aligned with the goals of the Paris Climate Agreement and should include detailed interim targets and specific timelines for sectoral portfolios to reach net-zero emissions—some sectors as soon as 2030, others by 2040 or 2050.
13. Banks should publicly commit to and begin work on the 12 recommendations above within the next year