How is Nordic Credit Risk Management Adapting to Emerging Climate Risks?

Climate risk is a growing concern influencing credit risk. Discover how banks can adapt their risk management strategies.

In brief

• Climate risk will materialize beyond what is reflected in today's credit practice. Clients will incur transition costs that directly impact credit risk.
• Credit risk management must become more forward-looking. Risk mitigation today will result in a competitive advantage when climate risk materializes.

Climate risk is a growing concern

Climate risks are poised to become a significant financial concern in the coming years, reshaping the landscape for banks and their customers. As accelerated climate change impacts the environment, economy, and society, the urgent transition to net zero demands a fundamental shift in business models.

With increasing regulatory pressure, banks must adapt to not only comply with sector-specific regulations but also to manage the rising transitional risks faced by their customers. The regulatory toolbox is extensive, but it is not unreasonable to expect that climate risks to a larger extent should be reflected in capital requirements. 

Changes in policies, market preferences and technological advancements will inevitably lead to increased transition risks for both private and corporate customers. Hence, there is a gap between how we expect the transition risks to materialize financially and how they are currently managed.

Banks must act to account for future market conditions 

Nordic banks have implemented several measures to consider climate risk exposure in financing processes. For example, the integration of climate risk assessments in customer dialogues and credit origination processes, policy requirements that manage risk exposure, and simple models to quantify inherent risk. Several banks have also implemented scenario modeling in relation to ICAAP (e.g. exposure to extreme weather, carbon taxes etc.). 

However, our experience is that these measures have limited impact on credit decisions. Current measures have no significant impact on pricing, total loan allocation, valuations, loan-to-value ratios, etc. One of the fundamental challenges is that credit models use historical data to predict default probability and losses. This could lead to variables in the credit models being left out or significantly underweighted. One example of that could be the probability of financial fallout of clients from greenwashing risks such fines, litigation and reputational damages. As a result, the models do not account for the fact that customers' business models will have to change due to climate risk, new competitive conditions and regulatory requirements. 

Limited effectiveness must be viewed in the context of today's competitive conditions and the complexity of the drivers of climate risk. Current market forces don’t incentivize credit decisions that aim to reduce climate risk. "First movers" may risk losing competitive strength by restricting customer terms and loan allocations. 

Managing climate risks for future commercial success 

To effectively manage climate risk while ensuring commercial viability, banks must adopt a comprehensive approach that reflects the financial implications of these risks.

1. Scenario Analysis is Needed to Measure Future risks: We recommend that banks increase their use of scenario analysis to model climate risks. The recent guidelines from the European Banking Authority (EBA) emphasize the need for banks to integrate and model ESG risks using forward-looking scenarios.
2. Insights Should Be Applied at Customer Level: It is crucial that the outcomes of scenario analysis are applied at the customer level, particularly during loan origination and monitoring. Banks should leverage insights from the ICAAP to quantify transitional risks affecting a specific customer's ability to service debt or the value of their immovable property. This analysis can inform the development of covenants that not only guide the customer's business in a sustainable direction but also mitigate the bank's residual risk.
3. Innovation is Needed for a Customer Driven Transition: In a competitive landscape, banks should explore alternative methods to manage climate risk by enhancing customer engagement and developing tailored financial products. By leveraging insights into both physical and transitional risks, banks can improve their advisory services related to ESG. Additionally, they should consider structuring transitional and sustainability-linked products that assist customers in reducing their transitional risks. This dual approach not only strengthens customer relationships but also aligns financial offerings with sustainability goals.
4. Customers Should Be Profiled for Transitional  Risk: Profiling current and potential customers based on their transitional capabilities presents an opportunity for profitable growth. Currently, banks compete on a limited set of transitional parameters, such as energy efficiency scores. By gaining deeper insights into additional parameters, banks can attract low-risk customers ahead of market trends.

Banks are encouraged to implement these strategies to not only comply with regulatory expectations but also to position themselves as leaders in climate risk management. By doing so, they can enhance their customer relationships, drive sustainable growth, and reduce overall risk exposure.