Banks face two kinds of risks – risk from physical events and risk from transition to a net zero economy. A recent report in Bloomberg raises an important question about the time frame in which losses from loans made to high-carbon industries that contribute the most to global warming may become financially material for the bank. Take the case of Standard Chartered Bank, which has committed to reaching net zero carbon emissions from its operations by 2025 and from our financing by 2050. The bank’s head of carbon accounting and net-zero delivery believes that climate risks won’t hit the bank’s loans until 2030 to 2035. The analysis is based on the bank’s assessment of expected credit losses when considering the financial impacts of 1.5ºC climate scenarios. In its 2022 annual report, the bank estimated credit-related losses at $603 million based on a materiality threshold of 0.4% of its equity.
It is important to understand where in the climate change scenario credit risks for a bank come from. These are:
Physical risks: These arise from damage to property, infrastructure, and land due to climate shocks, such as hurricanes, floods, and wildfires.
Transition risks: These result from changes in climate policy, technology, and consumer and market sentiment while adjusting to a lower-carbon economy. Banks can be exposed to transition risks through their financing portfolios, as many carbon-intensive activities may become unprofitable or even stranded assets in a low-carbon economy.
Sectoral risks: Climate change has differential impacts on each sector of the economy, and banks should adopt a sectoral approach to analysing climate risk in their credit portfolios.
Default risk: Climate risks can lead to increased default risk of loan portfolios or lower values of assets.
Reputational risks: Banks that are perceived as not taking climate change seriously may face reputational risks, which can lead to a loss of customers and investors.
While these risks are relevant, the extent of the risk depends on the extent of the climate impact. HSBC depicts the impact of various climate pathways on credit losses for its customers and portfolios. The image below is a great representation of the risks faced by a bank and the different climate pathways that it can follow. It is imperative that banks look closely at the impact of climate change on their portfolios and assets.
Utkarsh Majmudar 