While banks are still in the early stages of formally mapping climate risk onto credit risk, the work is already bearing fruit by helping to clarify threats that might not be adequately priced into markets, experts say.
Starting with the relatively simple exercise of identifying exposures to carbon-intense economic sectors has sparked useful deliberations on what comes next, according to Judson Berkey, managing director for sustainability strategy at UBS Group AG. Berkey said the bank has about $5 billion in industries where the transition away from fossil fuels will be the most demanding — "basically energy plus utilities minus renewables" — and about $37 billion or $38 billion in a broader category of "climate-sensitive" sectors.
"I've observed some very heated internal conversations about, what exactly is in that $5 billion? What are the names? Who are we still doing business with? What are their transition strategies?" Berkey said, speaking at a May 26 virtual conference hosted by S&P Global Sustainable1.
Using a top-down heat map of carbon intensity across a bank's portfolio is instrumental in moving toward a more granular assessment of risk, agreed John Colas, partner and vice chairman in Oliver Wyman's Financial Services Americas unit. "If we take a sector like mining, there will be some mining firms that will do exceptionally well because we'll need scarce minerals in order to power new technologies, and there will be other resources that we do not need," Colas said. Banks need to understand how the transition will play out and "who has the capital and the resources to increase their [capital expenditures], to pivot and finance that transition."
The object is to link unique climate factors to the traditional risks that banks evaluate — credit, market, operational, liquidity — with various transition scenarios supplied by organizations like the Network for Greening the Financial System providing a baseline, Berkey said. Such scenarios offer hypotheticals for "when phase-outs will occur in certain industries or certain technologies. That gives you the anchor point you really need then to drive back and say, what does that really mean for the sector? Within the sector, what does it mean for this counterparty? How prepared are they? If that really were the phase-out date, are they retooled by that point in time?"
"It ultimately needs to come back to the parameters we're used to working with inside our credit process" — the probability of default and loss given default, Berkey said. "And that gives us a view on is there risk their that has not been appreciated before, that has not been priced before."
Big banks around the world have started to describe the climate scenario analysis and stress-testing procedures they are developing in public reports and to regulators.
In its environmental, social and governance report in May, JPMorgan Chase & Co. said it had conducted a pilot exercise to evaluate counterparties' exposure to transition risk in seven carbon-intensive industries. It said it has also started to model the impact of sea-level rise on its real estate portfolios and that it conducted a special analysis of its real estate loans in California, exploring feedback loops among socioeconomic, climate and other risks.
The Basel Committee's climate task force, which has held workshops with large, international banks, said in a report in April that banks' work to date has been focused on building capacity to understand the scope and intensity of the risks but that the banks are also identifying "counterparties which need to be engaged to support their transition." Banks also tend to concentrate on potential impacts to credit performance, by, for example, estimating the impact of higher energy prices — an approach that anticipates carbon taxes or tighter regulation — and by using data on borrowers' carbon footprints as an indicator of transition risk.
Banks said "climate-related financial risks are not yet fully understood," according to the report, with only minimal evidence that they are being priced into financial markets.
At a conference in April, Kevin Stiroh, a senior Federal Reserve supervisory official who is helping to lead the Basel Committee's climate effort, said the industry outreach showed that banks' efforts to assess climate risks "have so far focused on mapping near-term transition risks and the work is at an earlier stage in capturing exposures to physical risks. So far credit risk measurement has attracted the most attention, with lesser focus on market risk and a very limited focus on liquidity and operational risk."
In the Basel report, some banks said they have been approaching "clients when they are flagged by a bank's risk officers as being vulnerable to climate-related risks, which are in some cases mandatory according to the bank's regulations."
However, at the conference in April, Citigroup Inc. Chairman John Dugan said the bank is "not going to abruptly pull the carpet out from [clients] in terms of our financing activities," saying that the transition must be managed carefully. Climate risk evaluations are currently "really embryonic," but "people are learning fast," Dugan said.
