Climate change and banks: clear and present danger?

Banks face pressure to stop financing fossil-fuel companies.

In the world of global finance, bank loans, new bond issuances and project finance are arguably more important than traditional equity for providing companies with working capital. But this financing, when directed to the most carbon-intensive forms of energy, is an inefficient use of financial capital and a key contributor to climate change.

Stopping funding for fossil-fuel industries immediately is not an option because there is no fully fledged global alternative energy system that eliminates the need to burn fossil fuels. Creating a global alternative energy system is a huge financial, industrial and technological challenge. Demand for fossil fuels, even in Paris-aligned scenarios, is expected to continue for at least the next 30 years, although the likely pace of phasing out use of different commodities is a source of significant debate.  

But climate change poses a clear and present danger to banks. The financial risk from climate change can occur through the following mechanisms:

1. Corporate loan defaults: the bankruptcy of the world’s largest coal miner, Peabody, was a powerful example that climate change can affect the ability of a fossil-fuel business to continue operating. Demand for fossil-fuel commodities is expected to increase over the next 10-20 years, mainly owing to emerging-market growth. But over the next 30 years the industry is expected to enter structural decline, potentially causing bankruptcies and defaults.
2. Industry exposure in loan books: typically, banks have diversified loan books so any negative impact through defaults or delayed interest/loan repayment is relatively small in comparison with the overall performance of the bank. Industry breakdowns of loan books is often poorly or inconsistently disclosed so shareholders are rightly demanding more information.
3. Underwriting new equity or debt issuances: in an underwritten capital-markets offering for shares and bonds (IPO or follow-on or syndication), banks guarantee a minimum price. There is a risk that banks overestimate market demand for fossil-fuel equity or debt issuances and end up taking the risk on their own balance sheets or risk taking losses.
4. Damage to collateral that underpins loans from extreme weather events: flooding, wildfires and hurricanes can damage the value of property which acts as collateral against mortgages or loans.
5. Reputation: a poor reputation can lead to depressed share prices, even if the business looks like it has strong future cash flows. We believe reputational risk is the most likely near-term climate-related concern for the banks. Furthermore, we struggle to see why the small fees generated from financing Arctic or ultra-deep-water exploration are worth the reputational risk and the potential negative consequences from this.

Of course, on the flip side, banks can positively respond by understanding and mitigating the downside risks highlighted above as well as taking advantage of the burgeoning renewable, clean tech and green product financing opportunities that are available. For instance, the Royal Bank of Scotland has announced recently that it aims to make its own operations net carbon zero in 2020 and climate positive by 2025. Additionally, it aims to at least halve the climate impact of its financing activity by 2030 and identify £20 billion of climate-financing opportunities.

Banks perceived as laggards can expect to attract attention from shareholders. At its upcoming AGM in May 2020, Barclays is expecting to face a shareholder resolution asking the bank to disclose its targets for phasing out lending to those energy and utility companies that are not aligned with the Paris Agreement. Barclays is being targeted as the largest European financier of fossil fuels and the sixth largest globally, with total financing amounting to US$85.2 billion between 2015 and 2018.¹ The shareholder resolution highlights an important issue and we expect to support it. We also suspect other banks will soon face similar resolutions from their shareholders.

Sources

[1] Banking on Climate Change Report from Rainforest Action Network (2019).

Authors

Newton responsible investment team

Responsible investment team