Environmental risk management: a must for banks, says PBOC expert

One of the most promising vehicles for moving the financial system on to a greener path – risk management – is gathering momentum.

  • By Jon Hay
  • 08 Aug 2017
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Although the likely severe effects of climate change have been known for decades, the financial system has largely ignored them. Investment continues to pour into fossil fuel infrastructure incompatible with avoiding damaging global warming.

But increasingly, enlightened market participants are using risk management as a way to force climate change on to the agenda.

A seminar was held in Beijing in mid-July about Environmental Risk Analysis, at which Western and Asian financial institutions offered a variety of perspectives on the topic, sharing the work they have done so far.

Among the firms there were Industrial and Commercial Bank of China, BNP Paribas, UBS, Risk Management Solutions and Sumitomo Mitsui Banking Corp.

The opening speech was given by Ma Jun, chief economist of the People’s Bank of China, who has become one of the most prominent figures in the international effort to green the financial system.

Ma set out starkly why financial institutions should be conducting environmental risk analysis, or ERA – and emphasised that this was not a woolly issue that firms had an excuse for putting off.

“Despite the technicality of discussions at this seminar,” he said, “our message to the public is clear and straightforward: environmental risk analysis as an important instrument of financial analysis already exists and has been performed by some institutions; other financial institutions should learn about and apply these methods to prevent environmental risks.”

Waking up

Banks, asset managers and insurance companies have been slow to factor climate change into their lending and investment decisions, partly because they are uncertain how soon global warming will begin to affect the financial viability and profitability of companies.

But there is a growing realisation that this thinking cannot be put off any longer. Even if working out the answers is difficult, an attempt must be made.

Physical effects of climate change could damage organisations so severely that their financial strength is compromised. A mild example: floods in Thailand in 2011 disrupted the supply chain for the car and electronics industries.

And if countries shift decisively away from carbon-intensive technologies, or impose costs on them, that could sharply affect the investment case for those industries. A collapse in oil and gas share prices and credit ratings, similar to what has already happened to many coal companies, is an obvious scenario.

In the past couple of years, financial regulators have begun to appreciate that losses to financial institutions from such shocks pose a risk to financial stability, and have started to nudge banks, insurance companies and other regulated firms to manage such risks more carefully.

As Ma put it in his speech: “Clean energy… will reduce the demand and profitability of fossil fuels such as coal and petroleum, forcing some companies to exit these sectors. While this presents a crisis for the more traditional coal, petroleum and thermal power sectors, it represents an opportunity for new energy industries.”

The prize to be gained from such risk management is not just avoiding risk and shifting money into safer investments – but sending signals to the real economy to desist from business models that are bad for the environment.

Governments get behind ERA

The Beijing seminar was part of this drive by regulators and parts of the private sector. It was hosted by ICBC, under the guidance of the Green Finance Committee, chaired by Ma, of the China Society for Finance and Banking.

The PBOC was one of the seven ministerial agencies that produced China’s wide-ranging Guidelines for Establishing the Green Financial System, given out in August 2016. The Guidelines include instructions to financial firms to carry out environmental risk analysis.

This push by regulators is going on at international level, too. The successive Chinese and German presidencies of the G20 have both promoted green finance, and after the Hamburg summit in July the G20 adopted recommendations to encourage environmental risk analysis as part of its action plan.

Easier said than done

With the principle gaining wider acceptance, attention is turning to implementation. The difficulties are heavy.

Many companies produce only basic information, or none at all, that could help investors decide how exposed they are to climate risks. What information there is is not standardised, making it hard for investors to compare companies.

The biggest international drive to tackle this problem is the Task Force on Climate-Related Financial Disclosures, which produced its final report in June. The idea is that companies’ and public bodies’ top management will have to make their own assessment of the climate risks they face and publish this in their mainstream financial statement.

The TCFD disclosures are so far voluntary, but Ma said: “Since the environmental information disclosure system of Chinese companies is incomplete, our next priorities are to implement mandatory environmental information disclosure for listed companies and bond-issuing companies in China and promote the TCFD’s… voluntary principles… abroad.”

This is an important statement, since very few Chinese listed companies yet produce any information about their environmental performance and risks, something that is mandatory on many stock exchanges elsewhere.

Peering ahead

But this is only part of the problem. Even given detailed information about how exposed Ford Motor Co, for example, was to physical climate risks and a sudden shift away from fossil fuel use, investors would struggle to know how to evaluate the risk.

No one knows how disrupted the climate is going to get, how soon – and the worse it gets, the more unpredictable it is likely to be. If the climate warms by 2C, 2.5C, 3C, how bad will food shortages be – and where?

Firms like RMS, whose main work is modelling hurricane and earthquake risks for the insurance industry, are trying to develop models to analyse these issues.

The policy response is also very hard to predict. US president Donald Trump’s decision to pull the US out of the Paris Agreement – a choice that appeared to have been made at the last minute before it was announced – is a salient example.

Breaking down the difficulties

Ma was candid about these obstacles. He alluded to the inadequacy of data, but did not allow that to be an excuse, saying that, when it came to public environmental information: “a lot of data are available but not properly utilised due to the high cost of research and poor availability”.

Many financial institutions were not yet engaged with the issue, he said. As far as China was concerned, “The ICBC has carried out research on this topic for over two years and the Industrial Bank of China is following suit,” Ma said. “A few other banks have also expressed interest. Yet there are more than 20 large banks and national shareholding banks in China. There are thousands of small banking institutions… most of which have never even heard about environmental risk analysis.”

GlobalCapital’s experience of asking the chief risk officer at a leading European bank about this issue, to find that it was not on his radar, shows that this problem is widespread.

Ma diagnosed another problem, and a potential cure for banks’ ignorance: that the “public sector is absent”. He added: “If the central bank and other regulators also get involved and conduct environmental risk analysis at systemic, industry and regional levels, they will serve as good examples for the private sector to follow suit.”

Finally, Ma argued for efficiency in developing environmental risk analysis: “Although there are tens of thousands of banks across the world, not every bank needs to develop its own stress test method, which is costly and unnecessary. It is advisable to develop a few common methods to be used as globally shared industry practices.”

This is both essential and very thorny. What happens to the prices of oil, steel, rubber, if the climate warms by 2C? What happens to car demand? Anyone trying to put a value on Ford Motor 10 years from now needs to have a view – but what estimates you use will have a huge impact on the valuation. Vested interests will therefore dictate that there is violent disagreement about them.

It may be that only regulators have the clout to resolve such issues, by imposing assumptions – perhaps ranging from the optimistic to the pessimistic – for financial institutions to use.

Nevertheless, afternoon sessions at the seminar covered in detail efforts specific firms have made to quantify environmental risks, including from carbon, water, air pollution and land contamination.

Risk Management Solutions presented on work it has done modelling the potential effects of certain drought scenarios in the US on the risk of loan defaults by businesses. Banks generally do not model such risks, except for the industries most keenly exposed, such as agriculture.

But a drinks producer based in Chicago, with facilities also in Indianapolis and San Francisco, would be badly hit by a five year drought in the west and central US, RMS argued, by way of example. It could suffer an overall cost increase of 30% due to higher water and power costs, and a revenue decrease due to lower productivity. Depending on the structure of its balance sheet, that could lead to default after three years.

RMS acknowledged that such modelling has limits, in particular that it is based on scenarios, and not on probabilities about the full range of potential drought outcomes. But, the consultancy argued, it could give banks "context into the potential scale of drought-driven default loss" and could be used as a framework on which they could build their own, more tailored risk models.

Simon Zadek, co-chair of the UNEP Inquiry into the Design of a Sustainable Financial System, whose work on ERA has fed into the G20's support of it, told GlobalCapital there was reason to be optimistic.

"Take a different example: oil and gas and human rights," he said. "Until 1996 there wasn't a single oil major in the world that had looked at human rights as a risk issue. Then we had BP in Colombia: they were accused of complicity with paramilitaries that were assassinating people. They hadn't got a clue about how to look at human rights - but three years later they could. They hired in people, engaged Human Rights Watch and Amnesty International, they started building tools and metrics. Now there is no oil major in the world that doesn't have a highly sophisticated policy on human rights. These are multi-billion dollar companies: they absolutely understand how to build capabilities around risk."

However, individual firms and investors minimising their own risk would not be enough to solve "systemic problems when there are an infinite number of possible free rider solutions" he said - such as the problem that everyone in the world bears the costs of carbon emissions that are caused by a few.

"Large scale externalities is where the real innovations in risk assessment and management will happen," Zadek said.

  • By Jon Hay
  • 08 Aug 2017

Global Green Bonds

Rank Lead Manager Amount $b No of issues Share %
  • Last updated
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1 Bank of America Merrill Lynch 13.40 57 7.37%
2 Credit Agricole CIB 10.23 62 5.63%
3 BNP Paribas 9.92 61 5.45%
4 HSBC 9.65 70 5.31%
5 JPMorgan 8.27 54 4.55%