Risk assessment, disclosure and analytics must be improved to manage threats to loan portfolios.
US banks face substantial losses from direct and indirect exposure to climate transition risks, according to a new report by US non-profit Ceres. The report, ‘Financing a Net-Zero Economy: Measuring and Addressing Climate Risk for Banks’, estimates banks could lose almost 20% of the value of syndicated loans to medium-impacted sectors, including energy-intensive manufacturing, buildings, transportation and agriculture.
The report’s analysis of the syndicated loan portfolios of the largest US banks identifies three core sources of exposure to climate transition risks.
First, more than half of bank lending analysed is vulnerable to climate transition risk because clients are from sectors which have so far prepared inadequately for emissions reductions in line with the Paris Agreement. To mitigate, Ceres said banks should assess their resilience against disorderly climate transition scenarios, triggered by a sudden shift in investor and/or public sentiment following a policy change.
Second, banks could lose up to 18% of the value of loans to non-financial climate-relevant sectors in the months following a major sentiment shift. The scale of such direct exposures may have previously been under-estimated because exposure to fossil fuel and electricity sectors would yield losses of only 3% of the value of the average bank loan portfolio. According to Ceres, six of the largest US banks face above-average risk to wide-impact (i.e. non-financial, climate-relevant sectors) exposures.
Third, the extent to which banks lend each other could lead to indirect transition risk from exposure to other banks’ direct risk. Banks could potentially face ‘balance-sheet contagion’, forced to sell rapidly devalued assets to comply with regulatory capital requirements.
To offset the risks, Ceres called on banks to enhance assessment and disclosure related to clients’ climate risks, strengthen their analytics methodologies through science-based valuation approaches that can be shared with clients, and mitigate risk through the decarbonisation of portfolios.
Ceres emphasised engagement with clients throughout its recommendations. “Engagement only reduces risk if it leads to target setting and emissions reductions by clients, so banks need ac-countability mechanisms to ensure this occurs,” the report said.
The report also made a call for all banks to set Paris-aligned emission targets before the next UN climate conference, in November 2021. It recommends banks set interim targets as well as specified timelines to achieve net-zero carbon emissions by 2050.
A number of major banks have already begun to take climate-focused action. Earlier this month, JPMorgan Chase announced adoption of Paris-aligned financing commitment to make the transition to a low-carbon world.