Climate risk: how does it impact the financial sector?

The climate all around the globe is changing. Although this is a gradual process, some of the consequences are already visible in the world today. Also in the Netherlands more extreme weather conditions could be observed over the past years.

The negative consequences of climate change are recognized and are translated in plans for change. These plans have resulted in the Paris climate agreement in 2015. Overarching goal of this agreement is to limit the increase in the average earth’s temperature to 2 degrees Celsius until 2100. Studies have shown that without action the temperature is expected to increase by 3-4 degrees Celsius.

Both the climate change as well the actions required to limit climate change impose risks for financial institutions. In order to outline these risks RiskQuest has set up a series of three blogs related to this topic. In this first part, the specific climate risks for Dutch banks will be outlined. The second blog provides an overview of the current status of climate risk management at banks, with a main focus on the Netherlands. In the third blog we will provide our vision on how banks should incorporate climate risk in their business.

Types of climate risk

Within climate risk a distinction should be made between physical risks and transition risks.

Physical risks consist of natural phenomena such as drought, extremely high or low temperatures, perspiration, storms and flooding. Such events can result in damages to premises and products, thus resulting in losses. As not all of these risks are covered by insurances, part of the losses are borne by the households, businesses and/or the government. This will also have an impact on the exposure which banks have to these parties, e.g. in the form of mortgages, corporate loans and stocks/bonds.

Thus far, banks have often excluded such physical risks from their financial analyses, as those risks are perceived to be very uncertain. There is, however, sufficient proof that the climate is changing and although the timing of extreme events is uncertain, its effects are likely much more predictable than forecasts of the financial market which currently are included in their analyses.

Transition risks on the other hand focus on the risks borne by financial institutions in relation to changing policies, rules and regulations which aim to limit climate change. Most of the increases in temperature are caused by greenhouse gas emissions. In order to limit these emissions, measures are taken, which will be felt the hardest by sectors with high emissions such as fossil fuel producers, energy and transport sectors, the built sector, heavy industry and agriculture, but also individual households will be impacted.

Physical climate risks

One of the major physical climate risks in the Netherlands which is generally not covered by insurances is flooding. Ever since the North Sea flood (Watersnoodramp) in 1953, protecting the Netherlands from high water, has been a top priority for the Dutch government. The sufficiency of the dikes is investigated regularly and if required actions are taken. However, future rises of the sea level are uncertain. Within the Netherlands 60% of the land is susceptible to flooding, so although the likelihood of a flooding is limited, it can have significant consequences.

Most eminent risks of flooding for financial institutions are:

1. Damages of premises and products of clients, impacting the (credit quality of) exposures which financial institutions have within the flooded area.
2. Damages of their own premises, impacting their operations.
3. A large flooding can impact the perceived credit quality of the Netherlands, resulting in a downgrade of Dutch sovereign bonds.
4. There could be secondary effects from a flooding such as lower economic growth in future years and political instability.

The assets on the balance sheet of the major Dutch banks are not limited to exposures within the Netherlands. However, in their report Waterproof, the Dutch Central Bank (DNB) has investigated the exposure towards countries with higher physical climate risks and it has concluded that this exposure is limited.

Estimating the impact of a flooding for a bank and its exposures and subsequently the amount of capital it should reserve is not a straightforward process. It concerns situations which have not happened before and the amount of available data to make such estimations is therefore limited. In its report DNB therefore advises to perform scenario analysis in order to make an estimation of the impact. Furthermore banks should analyze their geographical concentrations in order to test their vulnerability towards such an event.

Transitional risks

Reducing climate change requires actions to be taken. Largest impact on the climate comes from greenhouse gas emissions, so especially sectors which depend on this, such as fossil fuel producers, the energy, transportation and agricultural sectors, will need to change.

For banks this could have an impact on the value of exposures towards companies in these sectors and countries which depend to a large extent on these sectors. Such risks could materialize in the form of lower profitability, resulting in lower stock prices, but also downgrades in their bonds and the credit ratings of their loans.

How quickly such sectors change depends on government policy, technological developments and consumer behavior. Abrupt changes might have a bigger impact as more gradual changes provide sectors with time to prepare.

DNB has investigated that on average 11% of the balance sheet of Dutch banks concerns exposures towards carbon intensive and fossil fuel sectors, see figure 1 below. It is therefore important for banks to keep track of (required) climate change reducing measures within these sectors and even support and facilitate them. The latter is possible by providing favorable financing for such measures and issuing and purchasing green bonds.

It is noted that most of the exposure towards carbon intensive and fossil fuel sectors concerns products with a maturity of less than 5 years giving banks the opportunity to act timely.

The numbers is figure 1 below concern an average over the banking industry in the Netherlands. Individual banks should investigate their specific exposure towards carbon intensive sectors.

Dutch banks also have a significant exposure towards real estate. This concerns both retail and commercial property finance. Tightened regulation in this sector to reduce greenhouse gas emissions, e.g. in requirements related to energy labels should therefore also closely be monitored.

If sustainability investments in real estate have to be financed by the owner of the real estate, this could impact their ability to repay the loan they have with their bank. Banks should therefore gain insight in the current energy labels of the real estate serving as collateral to their loans.

Figure 2: overview of label distribution commercial real estate of banks in the Netherlands (source: DNB)

DNB has investigated that currently 46% of the collateral of commercial real estate of Dutch banks, for which the energy label is known, has an energy label of D or worse, see figure 2. For office buildings at least a level C energy label is required as of 2023.

Actions are therefore required, which for banks should start with identifying, quantifying and monitoring these specific transition risks within their portfolio. Next, banks should mitigate their transition risks by starting to finance sustainable solutions and by excluding clients in sectors which are harming the climate goals.

Measure, monitor and manage climate risks

The previous sections provided an overview of the climate risks for banks. Being able to make proper estimates of these (potential) risks can bring competitive advantages to banks; it will allow the banks to steer on the existing risks, but also to incorporate it in their pricing strategy and to develop new products which support reaching its climate related goals.

As it takes time to execute these measures, e.g. it takes time to build a mortgage portfolio with the desired average energy label, it is import to start timely. Next to direct financial benefits, contribution towards reduction in climate change can also result from banks’ internal ethical compass and it can improve its reputation.

But also regulatory requirements (SFDR) force banks to report on ESG measures, with additional requirements for products that support sustainable objectives. The goal of these requirements is twofold. It provides a more transparent comparison between companies and ensures that products which are marketed to be sustainable are actually sustainable. As of 2022 banks are required to disclose these items in their financial statements. Also the Task Force on Climate Related Financial Disclosures) recommendations (TCFD) has issued guidelines on reporting on climate risks, which many Dutch financial institutions intend to follow.

Also with the deadline of these regulatory requirements approaching, banks have already started to address these risks and to develop a strategy on how to limit these risks and to contribute to reaching the goals of the Paris climate agreement.

In our next blog on this topic, we will provide an overview of what various banks currently already do on this topic. We envision that banks can improve their climate risk management. Partly this will be the consequence of more data and more information of future legislation becoming available. But more improvements are possible, by not only considering climate risk on a standalone basis, but by integrating it directly into other risk models, such as credit risk models and pricing models. Our vision on the future of climate risk within financial institutions will be provided in our third blog on this topic.

For more information on this topic contact Vincent Schothuis (Manager), Johannes Lont (Manager) or Diederik Hemmes (Senior Consultant)

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