In recent years, climate risk has gained increasing attention as an emerging risk in the banking sector. As regulated entities, it’s essential for banks to evaluate, quantify and mitigate risks – and to understand how climate risk fits within existing risk frameworks.
However, the proliferation of standards, metrics and new governance models for climate risk (with associated acronym soup like CSA, TCFD, ISSB, NGFS, and PCAF) has created complexity and the potential misconception that climate risk [can be / should be] isolated in a silo, separate from routine risk management processes.
For example, bank executives may perceive that traditional credit risk management covers expected credit loss over 1-3 year horizons, while climate risk quantifies carbon emissions and produces qualitative narratives for reports focused on 10-30 year horizons.
This view is a misconception. When banks assess credit risk, they aim to quantify the impact of changing conditions on two critical factors:
- The borrower's ability to repay their loan, and
- The value of the borrower's collateral (i.e. PD, LGD, and hence ECL)
Evaluating a borrower’s exposure / sensitivity to climate risk is possible and indeed appropriate within this existing credit risk assessment framework. The “changing conditions” are different climate scenarios – which will directly have impact on borrowers' ability to repay and collateral value – and in the near term.
Let's explore a few commonly considered climate scenarios – and how they can affect borrowers' ability to repay loans and the value of their collateral – using the example of an auto mechanic business:
One impact of climate is that changes in consumer preferences will impact business economics and supply chains, ultimately influencing profitability. If, for instance, consumers continue to favor electric vehicles (EVs), the mechanic may face higher labor and parts costs, decreased demand for traditional services related to internal combustion engine (ICE) vehicles, and lower equipment value. Failure to adapt can lead to lower profitability, reduced cash flow, and lower asset values.
Regulatory and Policy Risk
Government incentives and regulations, such as carbon taxes, can swiftly impact borrowers' capacity to repay loans and the value of assets. Carbon taxes reduce available cash for debt service, and assets tied to emissions may decrease in value. For an auto mechanic, this might look like additional tax expense tied to electricity consumption, production and shipment of auto parts, and disposal waste petrol products, as well as devaluation of capital equipment like industrial vehicle lifts.
One benefit of decarbonization is that technology and equipment tend to be more efficient, leading to decreased operating and maintenance costs. The repayment risk for borrowers that do not make investments in new technology is lower margins relative to their peers, and thus lower earning potential. Another risk is stranded assets in the form of inventory and capital equipment. Using the example of the auto mechanic, failure to invest in new diagnostic tools for EV or more efficient auto lift equipment will impact both revenue and cost.
Insurance Costs and Insurability
Increased insurance costs and reduced insurability due to climate-related factors reduce cash flow, implying lower asset values and, in the worst case, plummeting collateral values. For an operating business, like an auto mechanic, these costs are difficult to pass through to customers, which results in contracting margins.
Adverse weather events disrupt operations, incur remediation costs, disrupt supply chains, and degrade infrastructure, leading to downtime, decreased revenue, and business risk. Again in the case of the auto mechanic it is not only property damage to the shop that matters, which itself can cause significant downtime. Weather that impacts customers, employees, or inventory delivery can disrupt business resulting in lost revenue without damaging the shop.
We can see that in each of these scenarios, we’re considering relevant factors that a bank would want to consider as a part of standard credit analysis – whether at initial origination underwriting or as part of periodic review & re-rating.
As such, climate risk is not a new risk factor for banks, but rather a critical aspect to incorporate into existing risk factors, including credit risk. Failing to consider it can have immediate and long-term consequences for borrowers' ability to repay and the value of their collateral – and hence on bank’s profitability, safety & soundness.