Climate Change: An Issue For Banking And For Bank Supervision

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“There is no financial system without the environment and we need oxygen before we can think of bonds”- Christine Lagarde

Greenhouse gases have a significant effect on climate change and can be viewed as the single biggest externality of our times. Large scale greenhouse gases emissions will impact migration flows, technological progress and also have economic consequences in the long run. The economic consequences will ultimately impact the financial sector. This impact is one which has not been exhaustively debated.

 The impact of climate change on the financial sector was brought to the forefront by China during its Presidency of the G-20 in 2015. China put Climate Change on the Agenda during this summit and Germany followed through during its Presidency of the G-20 in 2016. The Paris Climate Change Agreement in 2015 helped put it into concrete perspective, targets for global emissions standards and steps to be taken in achieving these goals. The Governor of the Bank of England (BOE) Mark Carney in a 2015 speech in London also framed the conversation for the impact of climate change on the financial sector.

Dombret raised the question of “how can the financial services industry contribute to mitigating climate risk?” One answer is by steering funds towards green technology. Another is by identifying the climate risks to the financial services industry and mapping out strategies for adaptation. The elephant not so silent in the room is “Are we underestimating climate risks and how do we transition to a green economy?”

Dombret asserted that the financial services industry is indeed underestimating risks and classified them into two categories, first - Direct risks- that arise from cataclysmic events such as extreme weather events e.g. floods, hurricanes, etc. which result in losses of billions of dollars. These risks also have a significant impact on crop yield, food security and the agricultural sector which would impact the economic output and potentially disrupt local and global supply chains.

Second, transition risks- that involve the uncertainty of the adoption of climate risk mitigating strategies such as the Paris Agreement's long-term goal of below 2 °C above pre-industrial levels that can only be achieved by green, low carbon economies which requires significant changes in policy. In order to have a 50% chance of achieving this, annual emissions have to be less than 1,100 Gigatons of CO2. To that end, there may also be an increase in "Stranded Assets" on the balance sheets of fossil based industries which may impact market valuations.

Dombret pointed out that historical data is of little or no use in predicting the future and because risks are long term, their effects and outcomes may be uncertain. Most financial analysis derive a 5-year projection and base terminal values on a growth projection from the final year’s values. The uncertainty in predicting future events further adds to the inability to incorporate climate in financial industry valuations.

In his concluding remarks, Dombret outlined the steps to be taken to improve climate risk estimation such as improving the availability of data and enhancing analytical tools for climate data projection. Additionally, environmental effects need to be incorporated in business valuations. Similarly, banks should include climate risk in their risk management practices. Lastly, identification of high-risk areas of finance in terms of climate risk is essential.

• Ebuka Emebinah, CFA (MPA-EPM’20)