Climate Change for Banks: exploration, prediction or another regulatory hassle?

Written by Chiu Rex, GLOBUS Correspondent

Banks. Major funders of fossil fuel companies. Accomplices of big oil. Villains of the climate. But think again. What if banks were forced to take into account the risks associated with climate change? What if banks were forced to stop lending to fossil fuel companies? What if banks became part of the solution? 

CBES: What is it? 

Enter the Bank of England’s (BoE) Climate Biennial Exploratory Scenario (CBES). First proposed in 2019, pushed back in May last year due to COVID-19 and re-started recently. The CBES ultimately tries to test and mitigate climate risks faced by banks and insurers in the UK. By requiring banks and insurers to report back on the physical risks (i.e. changes in climatic patterns and damages caused by extreme weather events) and transition risks (i.e. businesses becoming unprofitable/ “stranded assets” due to policies designed to meet the Paris climate agreement) faced by their 100+ largest clients, and also whole corporate segments/ industries, this would, for the first time, quantify the opportunity costs and risks of trading with climate-exposed firms. Banks and insurers are then required to submit their proposed actions to mitigate these risks. While the exact methodology and results are not due till February and the first quarter next year, the prospects of this exercise are truly exciting.  

Firstly, this exercise not only signifies the BoE’s formal recognition of climate risks to the financial system, having first been raised in 2015 by (former BoE governor) Mark Carney, it also requires firms to propose and take solid actions to reduce their exposure to climate risks, hence preventing “greenwashing” of any kind. The three test scenarios were undertaken by the BoE, early policy action, late policy action and no additional policy action, also seem to be predictions on what would happen rather than just explorations (despite the BoE repeatedly denying so), bringing certain implications as discussed in the sections below. 

But that’s only applicable to the UK… 

Although this exercise only applies to the UK, many other central banks are watching closely and planning their own version of a climate stress test. The BoE has always been at the forefront of integrating climate risks into their daily roles, and if history were a prediction, other central banks around the world will closely follow its lead. Among the founding members of the Network for Greening the Financial System (NGFS) (a group of central banks that share environmental and climate risk management know-how and promote sustainable finance) the Dutch central bank has finished an internal climate stress test and the French central bank is currently conducting a climate stress test pilot, while the Singapore central bank and mainland Chinese central bank have focused their efforts more on promoting green/sustainable finance than stress testing.  

On a broader scale, the European Central Bank and the Hong Kong Monetary Authority, the latter of whom governs over a major financial centre, will be conducting climate stress tests in 2022 and 2021 respectively. As for the US Federal Reserve, they have recently joined the NGFS, and it can be expected that they will pick up the pace in the near future, especially under Biden administration. The NGFS and Task Force on Climate-related Financial Disclosures (TCFD) have also begun churning out guidelines on climate stress tests and other areas of green finance in recent months, including publications like “Guidance on Risk Management Integration and Disclosure”, “Guidance on Scenario Analysis for Non-Financial Companies” and “Guide to climate scenario analysis”, so it is expected that many central banks around the world will be focusing their efforts on developing their expertise in these areas in the near future. 

Wait… this seems too good to be true 

Whilst it is true that only the 100 or so largest clients of the seven largest banks (and 10 insurers) in the UK are required to complete this one-off exercise, this is more than enough to capture the UK banking sector’s exposure to climate change and climate-exposed firms. The seven banks collectively account for 75% of the UK’s banking sector, and top the ranks for fossil fuel financing, meaning when the BoE publishes the results of this stress test, it would sufficiently highlight the risks posed by financing fossil fuels on the financial sector’s stability, and hopefully serve as a warning signal to all banks on the dangers of engaging in this area of business in relation to their own existence. Depending on the results of the test, the banks themselves might also have to take measures (like halting fossil fuel financing) to safeguard their own future, and possibly advocate for early policy action from the government if the other options (late/ no policy action) prove to be much more expensive and damaging to their portfolios, hence becoming a supporter of climate policy in a turn of events.  

Yet, even if the results show that the banks’ current practices are sufficient to deal with climate change risks, hence requiring no additional actions on their side, the BoE has recognised that a “structural reallocation” of the economy is inevitable, implying that high-emission firms and their financiers will have to change their practices, or possibly face collapse. The BoE has also recognised that consumers may exhibit a preference for “lower-emission products” in recognition of the role of civil society on top of governments. And last but not least, if climate risks prove to be a significant risk to the financial system’s stability, there is always the possibility that climate risks will be included in the annual stress tests for banks, or at the very least, become a systematic exercise.  

What’s next? 

All eyes are on the results due to be published early next year. If the stress test indicates that UK’s banks are sufficiently equipped to deal with climate change risks despite pouring billions of pounds into fossil fuel finance every year (highly unlikely in my opinion), this exercise may prove to be just another regulatory hassle. But if the results show that much more is needed to reduce climate risks to the banks, this may be the beginning of the end for fossil fuel finance. After all, change is coming. Finance for climate-exposed firms is changing. But so are the earth’s sub-systems changing, wreaking havoc to communities worldwide. Time is running out. Let’s hope the former change comes before the latter change. Let’s hope the former change comes WAY BEFORE the latter change. We only have one planet, and the alternatives are just too grim to imagine

The Header Image retrieved from pixabay

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