Responding to evolving climate risks
There’s been a sea-change in banks’ attitudes toward climate risk as pressure mounts from stakeholders.
Despite uncertainty regarding the timing and severity of climate change, and its economic and financial impact, there is a growing sense of urgency that banks must prepare now. In 2020, for the first time, the top five global risks in the World Economic Forum’s global risk report were related to climate change. And, an EY report found that 52% of banks view environmental and climate change as a key emerging risk over the next five years, up from 37% one year ago.1 In a recent blog by Mark Watson, EY Americas FSO Board Matters Deputy Leader, Ten steps financial institutions can take to address climate change risks, he explores why firms need to be more business-minded about climate change and how they can incorporate climate risk into their risk management approach.
Calls for action are louder
While activist groups have increasingly targeted banks, the pressure on banks to address sustainability comes from a variety of internal and external stakeholders. Several participants stressed that employees are pushing banks to act. “You cannot hire and retain top talent unless you take this seriously.” Investors are also paying more attention to these issues. In his annual letter to CEOs, BlackRock Chief Executive Larry Fink wrote that environmental sustainability will become a core goal of the investment giant’s decisions. A BGLN participant said, “You cannot discount BlackRock’s influence in this. It is reflective of a societal change, but they have a lot of actual influence in the business world.”
Regulatory and policy pressures are growing
Regulators increasingly see climate change as a systemic risk to the global financial system, and most central banks have taken steps to protect it. The Network of Central Banks and Supervisors for Greening the Financial System, a 54-member group representing most of the central banks from the largest markets, aims to “green the financial system and strengthen efforts of the financial sector in achieving the Paris climate agreement goals.” Unfortunately, policymakers, regulators, and central bankers are moving at different speeds, which bodes poorly for global regulatory and policy cohesion in the short term. Hopefully, the current environment will help to move global regulatory and policy changes related to sustainability further along, and in more lock step, as we move to redefine how we work, live and interact as a global community.
Efforts increase to link sustainability to corporate purpose
Banks are increasingly responding to stakeholder demands around sustainability by articulating a corporate purpose and explaining how that purpose will drive decision making. Executing on this is not easy for large, complex organizations. To succeed, top leaders must embrace corporate purpose and make sure their institutions follow through on purpose statements with concrete actions. An executive said, “Having a statement of purpose that resonates with employees is absolutely a necessity if you want to be a relevant company for the future.”
Some participants admitted to initial skepticism about purpose statements, which sometimes sounded trite during boardroom discussions. But executives came to recognize their importance when these statements began popping up in day-to-day business discussions and were cited positively in employee and customer-engagement surveys. One participant said, “It can actually sound cornier in the boardroom than it does to employees and customers.”
Also, participants argued that banks don’t need to choose between being purpose-driven or returns-driven. A director said, “A strong sense of purpose in any job will improve performance, deliver more loyalty among customers – the most valuable commodity there is – and will deliver profits and get loyalty from shareholders.”
Grappling with response challenges
Gauging institutional risk exposure is difficult, but better sector coordination would help.
Banks’ response to ESG issues is hampered by a lack of industry-specific standards, agreed upon and relevant metrics or leading practices to guide them and establish credibility. Response efforts could be further complicated if, as some bankers fear, governments lean heavily on banks to lead their countries’ transitions to carbon neutral economies. A participant said, “I’m very loathe that the banking industry should be seen as the leader of government policy. Ultimately, the people elected by society will have to do something related to policy. It’s government that needs to lead.”
Coordination is needed across the sector
The banking sector would benefit from more collaboration. A participant said, “I’d like the industry to share more best practices. If we worked together more, we could impact policy.” Several participants said regulators could help to improve coordination and information sharing. One said, “One of the biggest challenges right now is simple benchmarking and trying to figure out if we’re doing enough. Regulators are uniquely positioned to collect information from the banks and share good practices.”
Determining institutional exposure is difficult
Firms are in the early stages of determining their direct exposure to climate change, which is critical to developing an effective response. Understanding certain risks is fairly straightforward, such as credit exposure to key players in the fossil fuels industry. But, it is far more complicated to estimate exposures to climate change more broadly. Participants discussed the ways that climate risk could manifest:
1. Physical risk
Physical risks arise from increased destruction of property, loss of asset value, loss of economic activity, and declining global incomes. Banks are trying to determine their direct exposure to physical risks through financial instruments, such as mortgages and other real estate investments, which might be particularly vulnerable to climate events.
2. Transition risk
Transition risk stems from efforts to transition to a low-carbon economy, spurred by policy, technological developments, or public opinion. The scope of this risk is potentially vast. A study by the Network of Central Banks and Supervisors for Greening the Financial System estimates the losses associated with the devaluation of assets as a result of transitioning to a low-carbon economy could be as much as US$20t.2
3. Reputational risk
Given public sentiment and attention to climate issues, reputational concerns could be as significant as the direct risks of climate transitions that we see manifesting themselves during this pandemic.
More banks are starting to incorporate these risks into their risk program. In our Tenth annual EY/IIF global bank risk management survey with the Institute of International Finance, over a quarter of banks have already done so, with 14% and 12%, respectively, quantitatively assessing physical and transition risks.3
Strategic questions persist
Whether the planet truly faces a “climate emergency” is still debated and politicized across countries and stakeholders. Some bank leaders have argued that their institutional exposure to climate risk is mitigated because loan books turn over relatively quickly, which gives them time to adjust as risks evolve.
Ultimately, each bank must decide how proactively it wants to address climate change, and it is without question a complicated decision. One bank leader noted that even seemingly straightforward initiatives, such as divesting from fossil fuels, are in reality quite complex. “We cannot just cut the energy off in Poland, where a lot of the economy is still powered by coal.”4 Several participants advocated for engaging clients about the sustainability of their business models and transition strategies. One participant said, “Oil and gas is an enormous industry and it is still the foundation of many economies. You can’t just turn off that tap overnight. So as banks, the question is how do you help them to transition?”
Exploring opportunities in green finance
Green finance is a growth area that will accelerate rapidly as economies transition to being carbon neutral.
While climate change poses risks, there are also significant opportunities related to green and sustainable finance. One executive said, “There’s so much focus on the risk agenda that I don’t think we are paying nearly enough attention to the opportunity side.” Massive investment will be necessary to transition economies to cleaner energy and production and achieve international goals.
Banks are beginning to scale sustainable finance
According to the Global Commission on Economy and Climate, the transition to a low-carbon, sustainable economy could lead to an economic boost of US$26t by 2030, creating more than 65 million new jobs.5 Sustainable finance has been an area of particular growth. Corporate lending tied to a sustainability metric – such as reducing emissions or waste – increased by 800% in 2018 to US$36.4b.6 In response to the growing investor demand for sustainable options, the green bond market, which emerged in 2007, has grown to a global total of US$521b.7
Demand for green banking products is expected to increase rapidly in the coming years, particularly as younger people become more active banking customers and investors: “What we are seeing, particularly with our younger customers, is that they are crying out for green products, green credit cards, whatever we can come up with. We have just started to dip our toes in the water and are totally overwhelmed by the response so far.”
Participants highlighted some other issues related to green finance:
1. Banks may lack necessary expertise
Some participants said that large banks are not suited to investing in small-scale initiatives and start-ups, areas where the greatest investment may be needed. Banks can be most helpful financing larger-scale projects, such as major infrastructure projects. That, however, will require additional coordination with political leaders.
2. The green finance market is still maturing
Participants said there is little agreement on the basic aspects and vocabulary of green finance. One participant said, “Perhaps the biggest challenge on the opportunities side is not knowing how to measure the opportunities, or how to price them.” Another concern is “greenwashing”– or the tendency of some companies to misrepresent their products’ environmental credentials. Participants stressed the importance of weighing the opportunities with sound risk management practices to protect their firms’ reputations and support their long-term value.
3. North American banks could invest and scale quickly
While it appears some North American financial institutions are not aggressively addressing climate risk, they will pursue green finance opportunities aggressively. One participant cautioned, “I think it would be very foolish for anyone to think that the big American banks are behind on this. They have the capital to be fast followers and scale their efforts very rapidly, and we’re already seeing huge investments on their part.”
Articulating and operationalizing sustainability approaches
Putting sustainability goals into practice and communicating with stakeholders is critical for credibility.
There has been solid progress among many banks in terms of implementing sustainability efforts and explaining their approach to stakeholders. The 2019 EY/IIF risk management survey highlighted that almost two-thirds of banks globally have conducted some kind of climate-change risk impact analysis.7
Management roles and board oversight
To carry out firm-wide sustainability strategies, banks have been rethinking management roles and responsibilities. Several of the largest banks have named a chief sustainability officer. However, the role’s definition and responsibilities vary significantly, and some participants argued that putting a single executive in charge of sustainability will not be effective. One said, “Ultimately, for sustainability to be the center of the plate, it needs to be part of everyone’s jobs and not siloed off.”
At the board-level, companies are in the early stages of determining how they will oversee sustainability risks and opportunities. More specifically, boards must decide if they need to significantly alter board governance to oversee sustainability, or if they can adapt current structures. One participant said, “We didn’t want to create a whole new bureaucracy to interact with the rest of the bureaucracy. The function of the board is not to duplicate and replace what’s going on in the other functioning areas; it’s to ensure we don’t have gaps.” EY’s recent survey on board risk oversight highlights that directors believe there is room for improvement in how their risk programs manage atypical or emerging risks, such as climate change.8
More financial institutions are making their sustainability commitments public. In 2019, the United Nations introduced its Principles for Responsible Banking, which include commitments by banks to contribute to climate change mitigation and adaptation. As of 2019, 130 banks representing US$47t in assets, have adopted the principles.9
Yet, some participants wondered if some public commitments are more about rhetoric than action. It remains difficult, they noted, to know how effective such commitments are.10 One study found that 57% of banks that have made commitments do not publicly disclose their accounting methodology, and a third do not have plans to report on the progress of keeping their commitments.11
Being opaque about methodology and results can undermine an institution’s attempt to create a narrative around its commitment to sustainability. One participant urged bankers to communicate clearly with stakeholders in order to create and control their narratives – and do so sooner rather than later: “The transition is the great opportunity for banks. You are not trusted by society. You are not trusted by investors. You need to find a narrative on transition before it is imposed upon you.”
ESG concerns – specifically climate change risk – have risen to the top of banks’ agendas – with even more heightened urgency due to the pandemic. Calls for action among stakeholders are louder, regulatory and policy pressures are growing, and banks are already trying to link sustainability initiatives to corporate purpose statements. This is forcing banks to grapple with how to respond to ESG issues concretely and how to operationalize those responses across their organizations. Some banks will choose to lead on ESG issues and try to stay ahead of competitors and regulators, and some will choose to be fast followers, but it’s critical that each bank develops a coherent long-term strategy. The pandemic will pass; ESG concerns will not.
For more detail, download the full report (pdf).
This article is based on the Viewpoints from the Bank Governance Leadership Network (BGLN) meetings held on February 26th in London, and on March 4th in New York, and aims to capture the essence of these discussions and associated research.
Show article references#Hide article references
- EY, Four Major Themes Dominating the Regulatory Landscape in 2020, (London: EYGM Limited, 2020).
- Network For Greening The Financial System, A Call for Action: Climate Change as a Source of Financial Risk (pdf), 17.
- EY and the Institute of International Finance, An endurance course: surviving and thriving through 10 major risks over the next decade, November 2019.(https://www.ey.com/en_us/banking-capital-markets/how-banks-can-elevate-risk-management-over-the-next-decade)
- “Santander's Botin on Profitability, U.S. Growth, Tech Regulation Gabriel Bernardino” (interview, Bloomberg TV, November 20, 2019).
- Katharine Rooney, “These Countries are Leading the Way in Green Finance” World Economic Forum, September 12, 2019.
- Jacqueline Poh, “Banks Can’t Afford to Ignore the $23 Trillion Market for Doing Good,” Bloomberg, March 6, 2019.
- Rooney, “These Countries are Leading the Way in Green Finance.”
- EY Global, How to enhance board risk oversight in financial services, April 2020. https://www.ey.com/en_us/financial-services/how-to-enhance-board-risk-oversight-in-financial-services
- Regulatory News, “UN and Leading Banks Launch Principles for Responsible Banking,” Moody’s Analytics, September 22, 2019.
- Avery, “Sustainable Finance’s Biggest Problems, by the People Who Know Best.”
- Avery, “Sustainable Finance’s Biggest Problems, by the People Who Know Best.”
As stakeholder voices grow louder for a response – to climate change in particular – banks have been making efforts to link sustainability to corporate mission statements. They have also been trying to design their responses concretely and figure out how to operationalize their responses across large, complex organizations. In the midst of these risk discussions, some banks are also zeroing in on green finance as a source of significant new business growth.