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The threat of the climate crisis for banks

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In May 2022, the Bank of England published the results of its first-ever climate stress test, which aimed to explore the financial risks posed by the climate crisis and the transition to net zero for Britain’s largest banks and insurers and the broader financial system.

The Biennial Climate Exploratory Scenario (CBES) has described two types of risks associated with the climate crisis: those that arise during the transition from a carbon-intensive economy to a net-zero economy, called transition risks, and those that arise from higher global temperatures if they are insufficient. measures are taken, called physical risks. The CBES then tested the companies under three potential scenarios, one where early action on the climate crisis is taken, one where late action is taken and another where no action is taken at all.

The report found that while UK banks and insurers are making “good progress in some aspects of their climate risk management”, they still need to do much more “to understand and manage their exposure to climate risk”. He noted that climate risks “are likely to create a drag on the profitability of banks and insurers, especially if they are unable to manage these risks effectively” with losses of up to 10-15% , which could be passed on to customers. And that “the policy path of early action has the highest probability of success in terms of limiting climate change”, while acting late “would leave governments at greater risk of policy coordination failure”.

Oscar Warwick Thompson, Head of Policy and Communications at the UK Sustainable Investment and Finance Association (UKSIF), supports the need for early action by banks and investors in the energy transition to minimize climate risks. “The recent progress report from the Committee on Climate Change indicates that we are behind in terms of net zero. Acting with pace, ambition and scale will reduce the risk of stranded assets [from carbon-intensive industries] and future losses on companies’ balance sheets for investors and their clients’ portfolios,” he says.

Warwick Thompson also warns of transition risks for financial firms related to consumer expectations when it comes to a company’s trajectory to net zero. “They are less likely to use a company’s products and services if they are not seen in action,” he says. The changing regulatory and political environment is another key transition risk. “As this becomes clearer and more robust as we move towards net zero in 2050, those who have not adequately responded to or considered the impacts of these regulations on their portfolios run the risk that investments become less valuable over time,” he says. .

“It’s always about being a frontrunner or a laggard,” says Dr Daniel Tischer, senior lecturer at Sheffield University Management School and specialist in green finance. “If you divest early you should be fine, but if you leave it until the very end and you’re the last bank in town, everything you’re trying to sell is worthless.”

Tischer says there is great diversity and staggered positions among fund managers in terms of their approach to disengaging from carbon-intensive industries, but warns there will always be those who seek to profit from the chaos. “There are a lot of people with common sense, but there are also a lot of people with other motivations,” he says. “Destabilizing creates profit, so in that sense you can see how people are playing with the narrative for their own gain.”

Before Russia invaded Ukraine, Tischer thinks many banks and financial players were on the right track. “They were trying to do the right thing by investing in and supporting companies that positioned themselves away from the polluting practices of the industry,” he says, citing the example of Allianz Insurance, which was heard on this land. But he fears the energy security crisis has set things back.

“With regard to the UK, we are currently seeing more investment in the extraction of gas from the North Sea to reduce the impact of the windfall tax. This is a very problematic approach, and absolutely the wrong incentive to give to companies. It sends a signal that fossil fuels are not dead and breathes new life into the market,” he says. “Why didn’t we encourage [energy firms] obtain a short-term tax reduction for 10 billion euros invested in renewable energies? BP’s CEO has made it clear that he wants to invest in renewable energy.

Warwick Thompson believes banks and investors can still play a crucial role in steering oil and gas majors toward positive climate action in the future. “The profits made by some of these companies have been quite substantial given the rise in oil and gas prices,” he says. “So, [we would advocate] use these huge balance sheets as an opportunity to move to a more sustainable model in the future. And when oil and gas majors seek to raise money in the bond market, investors can use their stewardship to pressure oil and gas companies, in effect to make their own public policy.

The UK is ahead of the game when it comes to green finance, so banks and financial institutions are well positioned to take advantage of the energy transition. “We have been a global leader in sustainable finance for a number of years and this is largely due to the promotion of an advanced world-class regulatory framework,” says Warwick Thompson. “In 2019, we were one of the first to legislate to reduce emissions to net zero by 2050 and the first in the G20 to set up the TCFD (Task Force on Climate-Related Financial Disclosures) for bigger companies.” The TCFD means that companies are required by law to include climate risks in their annual report.

But he warns that much of that progress is now at risk due to delays in key pieces of sustainable finance legislation, including on transparency and SDRs, the sustainable disclosure requirements for companies and financial institutions.

“There is a feeling that the government wanted to minimize the regulatory burden on business,” he says, “but for investors, more regulation gives a better idea of ​​what is going on in business and better disclosure incentivizes investors. capital to flow into these enterprises”.

Whoever the next Prime Minister is hopefully will reaffirm the UK’s role as a sustainable leader in green finance and net zero.

As Tischer says: “The the narrative should be much clearer: “This is a threat, but also a great opportunity for us.”