SPONSORED CONTENT PRESENTED BY CERES
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As the lynchpin of the global economy, financial institutions 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 is critical. Whether banks act proactively and ambitiously or reactively and modestly is reflective of how they measure and analyze their exposure to climate risk.
In the fall of 2020, Ceres analyzed the risks banks face from climate transition risk. Those findings indicated that banks that fail to prepare for the energy transition face far higher risks than what has been disclosed. The cumulative exposure could be over $500 billion from just the syndicated loan portfolios of the nation’s largest banks. The total balance sheet exposure is much larger, meaning that without a deliberate carbon transition, a future where well-prepared banks can thrive along with the rest of society will not be possible.
Transition risk, though, is only one part of the climate risk equation. The world is increasingly experiencing all-year forest fire seasons, catastrophic flooding, years-long droughts, and deadly heat waves. In fact, as this report was being finalized the National Oceanic and Atmospheric Administration reported that July 2021 was the Earth’s hottest month on record. The physical impacts of climate change are already here and they are growing. Failing to take a proactive approach to the clean energy transition will turbocharge these physical risks that banks—and broader society—face. In addition to the human toll, these impacts have the potential to grind down our economy, challenge the stability of some bank portfolios, and punish us year after year, decade after decade, for our failure to take action. And, perhaps unsurprisingly, the burden of that failure will fall disproportionately on developing countries and historically marginalized communities in all countries, including the United States.
In addition to their societal toll, these physical risks present major threats to banks’ portfolios, some of which are already playing out through changes in asset prices and insurance premiums. Ultimately, these physical risks, combined with the potential transition risks, could impact the safety and soundness of certain financial institutions. Beyond the incentives banks have to support the transition and capture its enormous opportunity, the reality is they—and the sectors they finance—need to be prepared for an increase in physical climate risk that is already baked into our collective future.
So far, analyses of physical risk disclosed by banks have been piecemeal, covering only a few elements of the problem. This is in part due to model uncertainty, data limitations, and the long timescales involved. While these challenges are real, they don’t change the fact that comprehensive analysis of physical risk is needed across sectors and asset classes. Banks must better understand how these risks fit together and—critically—how they can generate indirect, systemic effects across the economy, disrupting supply chains, national economies, and the lives and livelihoods of individuals.
Ceres’ report, Financing a Net Zero Economy: The Consequences of Physical Climate Risk for
Banks, presents a framework for this kind of comprehensive analysis of the physical risks being
unleashed by climate change.
Banks should prioritize the most important climate hazards, understand how climate change will affect them going forward, and convert economic impacts on physical assets, labor productivity, and agricultural yields into financial risk metrics. Additionally, the indirect economic impacts on supply chains and national economies must be accounted for—a difficult challenge that no U.S. bank has yet overcome.
To give an idea of how the extreme weather impacts of climate change—more frequent and more devastating droughts, floods, heat waves, storms, and fires—could impact banks, Ceres and academic experts from the consultancy CLIMAFIN conducted an illustrative analysis that uses natural catastrophe and credit risk models adjusted for climate impact scenarios, downscaled macro-economic data, and publicly available syndicated loan information for major U.S. banks. As was the case in our transition risk report, these syndicated loans were used because there is abundant publicly-available data on them. It is important to note, however, that physical risk has potentially significant implications for other asset classes as well. This is another reason why this indicative analysis needs to be supplemented with further work based on banks’ more complete understanding of their respective portfolios.
Looking at just $2.2 trillion of exposure for syndicated loans, the climate value-at-risk to 28 of the largest U.S. banks from physical risk could amount to more than $250 billion. This analysis echoes the findings of Ceres’ first report on transition risk that identified $500 billion in potential risk exposure, underscoring the need for banks to collect better data, conduct risk assessments, and disclose the results in a harmonized and decision-useful way.
Key Finding
In a worst-case scenario, our analysis suggests that annual value-at-risk from physical climate impacts on the syndicated loan portfolios of major U.S. banks could approach 10%, even if adaptation measures are taken. About two-thirds of this risk comes from indirect economic impacts like supply chain disruptions and lower productivity, with coastal flooding (driven by sea level rise and stronger storms) representing the largest source of direct risk.
Source: CLIMAFIN
Recommendations
Assess & Measure Physical Climate Risk
1. Assess all elements of climate risk and opportunity. Banks should, as a first step, understand the risks that may affect their businesses and communities (including transition, risk, physical risk, and litigation risk), and disclose an overall assessment to investors and other external stakeholders.
2. Measure the current impact of climate hazards on the value of financial assets. Banks should build a strong framework for assessing climate physical risk that includes an understanding of how climate hazards affect their portfolios, both directly and through their indirect economic effects. Banks can then use this analysis to recalibrate their credit scoring and rating models so that they take these risks into account.
3. Project the future cost of climate change. Banks should engage experts and develop internal expertise to estimate how disaster losses will increase due to ongoing climate change. This helps clarify the materiality of physical risks for each bank.
4. Perform climate stress tests. Banks should perform climate stress tests (defined as a quantitative analysis of balance sheet resilience to risk). This should cover all asset classes in lending, underwriting, and other lines of business and all types of hazards that have been identified as potentially material. It is likely that climate stress tests will be a focus of prudential supervision in the future, so internal stress tests should be done with an eye on expected regulatory requirements.
5. Collect asset-level data about exposure and loss vulnerability. Banks should seek out information about firms’ exposure to and preparedness for future climate events. Unfortunately, local assessments of losses by sector and firm- and asset-specific data are still limited. Banks should address this by implementing a process to collect the relevant data from their clients as part of the lending process, as insurers do.
Take Action
6. Build connections with external experts. Banks should cultivate internal issue expertise where appropriate but stay regularly updated on external developments by engaging with the scientific community, stakeholders (particularly those representing marginalized communities disproportionately affected by climate change), and state and federal financial supervisors.
7. Integrate climate into product and service pricing. In addition to stress tests and scenario analysis covering the whole portfolio, banks should embed climate physical risk into client-level risk assessment and from there into pricing. Changes in firms’ probability of default and financial risk metrics are highly sensitive to the choice of the climate scenarios. Thus “tail risk” climate scenarios should not be neglected.
8. Engage clients on physical risks. Banks should engage clients on the increasing risks they are facing (and contributing to) and help them design solutions to reduce that risk. After integrating climate into credit risk assessment, banks should provide incentives to their clients to reduce risks by increasing the availability of capital for sustainable activities and lowering its cost.
Capitalize on Opportunities
9. Understand the changing insurance landscape. Banks should work to understand how physical climate risks are driving changes in the insurance industry. Premiums and uncovered risk are already increasing. This will affect the most vulnerable bank clients and also hurt banks’ loan metrics. Banks should learn from the insurance industry’s more sophisticated physical risk assessment tools but not rely primarily on insurance to mitigate their own risk.
10. Focus on adaptation projects to mitigate credit risk. Banks should know that because physical risk cannot be mitigated in the short and medium term, adaptation is one of the only avenues available for reducing their risk, though it is often a neglected part of banks’ sustainable finance programs.
11. Develop innovative adaptation financing solutions. Banks should recognize that financing public investment in adaptation has strong positive externalities for the banking sector as it reduces the risk for everyone, especially those in disadvantaged communities. Some of these adaptation investments can even come at a negative cost by limiting the physical impacts of climate change on workers, assets, and insurance premiums. Because adaptation finance is still in its infancy in the private sector, banks need to develop innovative approaches that are attractive to clients and structure the corresponding products in ways that are attractive to long-term investors.
12. Advocate for smart financial regulatory and policy actions on adaptation. Banks should seize on adaptation finance as a big opportunity. Without smart policy, however, the scope and scale of the opportunity could be reduced. Banks have a financial interest in promoting policy change that incentivizes the development of new infrastructure and the remediation of industrial pollution, which would reduce risk for banks and also benefit disadvantaged communities and society broadly.
Meet the Moment
13. Set and disclose financing portfolio targets. Banks should align their strategies with the goals of the Paris Agreement and 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.
14. Publicly commit to and begin work on the 13 recommendations above within the next
year.
