BREAKINGVIEWS-Guest view: Bank balance sheets hide climate risks

The author is a Reuters Breakingviews guest columnist. The opinions expressed are her own.

By Natasha Landell-Mills

LONDON, Sept 15 (Reuters Breakingviews) - The thing about financial crises is that they surprise you. While regulators rightly fret about interest rate risk hidden in banks’ balance sheets, the threat from global warming continues to build in the shadows. Unless lenders reset their financial statements for the reality of accelerating climate change, and watchdogs adjust their models, investors and the planet will end up worse off.

There are two reasons to be worried. First, banks’ financial statements appear to be ignoring climate risks, which means financial institutions are probably also leaving those dangers out of their capital calculations. Second, a regulatory regime that understates the expected consequences of climate change is allowing the banks’ blind spot to persist.

A good place to start in scrutinising whether financial statements properly reflect the risks of higher temperatures is the assumptions banks make about expected credit losses (ECLs), also known as bad debt charges. Not only are ECL assumptions important to banks’ financial strength – higher charges reduce profits and shrink capital – but they are also subjective. To determine ECLs, banks combine forecasts about growth as well as industry and location-specific factors that could influence future default rates.

Climate change will likely impact both. Chronic and acute changes to weather patterns, including drought, flooding, hurricanes, heat stress or deep freezes, will harm economic activity and human wellbeing. Meanwhile, tighter government restrictions on carbon emissions and accelerating technological innovation will upend industries that run on fossil fuels. Without mitigating action, these developments will push up the risk of defaults, whether on mortgages in exposed coastal regions or project finance loans to oil and gas producers.

However, when we look at banks’ ECL assumptions there is silence on climate risks. Wells Fargo’s WFC.N latest financial statements, for example, use three scenarios to underpin ECL assumptions. None of these scenarios explicitly considers climate change. They forecast for two years and then assume a return to historical . But what happens if global warming or the revolution in renewable energy precludes a return to historical ?

The few banks that refer to climate risks in their accounts tend to conclude that it is material. HSBC HSBA.L, 0005.HK, for instance, states: “Management has considered the impacts of climate-related risks on HSBC’s financial position ... (and) do consider there to be a material impact on our critical judgements and estimates ...”. This raises the question of when rising risks would become significant.

To be clear, this is about banks stopping all financing of activities that involve climate risk. Rather, it’s about ensuring these risks are properly costed and reflected in decision-making. To understand banks’ reluctance to show the effects of climate change in their accounts, it is instructive to consider climate stress-testing by prudential regulators.

The Network for Greening the Financial System (NGFS), which brings together 127 central banks working on climate change, models a cumulative 8% hit to global GDP by 2050 in a scenario where temperatures rise 3 degrees Celsius above pre-industrial levels by 2100. This equates to a loss of 0.1% of global output per year; almost a rounding error. Moreover, the models assume the impacts only really show up after 2030.

Using NGFS models, the European Central Bank’s 2022 Climate Stress Test found that, under a warming scenario of 3 degrees or more, banks projected that loan losses in the decade to 2030 would rise by a vanishingly small 0.005%. Lenders projected a similar low impact under a scenario of disorderly zero transition. Even though climate-related losses rise over the years, they go above 0.2% of performing loans.

How to reconcile this relatively benign picture with scientists’ warnings of devastating economic hardship? According to recent analysis by the Institute and Faculty of Actuaries and the University of Exeter, models such as those compiled by NGFS are flawed because they assume away the most impactful climate harms. They omit tipping points that will likely result in self-reinforcing feedback loops, such as the abrupt thawing of the permafrost in boreal forests, and social responses like mass migration or war.

When it comes to the energy transition, banks’ models too often focus on a set of variables, a rising carbon tax. Lenders assume industry shifts will follow a steady path, rather than a rapid acceleration. This improbably and cautious interpretation of the clean technology revolution leaves banks unprepared for the transformation to come.

These flaws in economic modelling help explain climate complacency in the banking sector. They should also galvanise urgent action. First, the prudential regulatory regime to become more prudent. Banks should recalibrate their models to reflect scientific scenarios, while central banks should require lenders to hold more capital against financing that is exposed to potential climate risks. Waiting until those risks materialise will result in greater financial instability.

Second, banks to take a prudent view of climate risks in their financial statements. Auditors must demonstrate that they have kicked the tyres on the key assumptions. These are the expectations of more than 25 institutional investors which contributed to the development of the Institutional Investors Group on Climate Change’s Net Zero Standard for Banks, released in June. Where appropriate, regulators should sanction banks and auditors that do meet these expectations.

Global warming is a hypothetical scenario, but the reality of our changing planet. While flawed models are a problem anywhere, they amplify the economic damage when they infiltrate banks’ decision-making. The sooner the banking sector internalises climate risks in its accounting, the better the chance of building a sustainable future.

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Natasha Landell-Mills is a partner and head of stewardship at Sarasin & Partners.

(Editing by Peter Thal Larsen and Oliver Taslic)

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