By Laura Canevari
Earlier this month, the Intergovernmental Panel on Climate Change (IPCC) published a special report on global warming of 1.5°C above pre-industrial levels to examine the necessary greenhouse gas emission pathways to stay below that warming target while also comparing the likely climate change impacts of 1.5°C as opposed to 2°C warming. But what do the findings of this landmark report mean for the banking sector and why is it important for banks to consider them?
Changing the way banks invest
The special report offers compelling evidence to suggest global warming must be limited to 1.5°C (scroll down to read the report’s key messages). This will require a marked shift in investment and lending patterns, including doubling investments in low carbon and energy efficient technologies, and reducing investments in fossil fuels by at least a quarter over the next 20 years.
The total incremental investment for a 2°C-consistent pathway (including transportation and infrastructure) is estimated to be 2.5% of global Gross Fixed Capital Formation. Although there is no comprehensive estimate of investment needs to limit global warming to 1.5°C, the special report anticipates lower investment needs in adaptation under 1.5°C of global warming.
Banks will not only need to consider how to change the allocation of investments and loans in order to fuel a low carbon economy and to compensate for reductions in financial flows currently stemming from the value of fossil fuel assets. They will also have to consider how an increase in global warming from the current baseline (1°C above pre-industrial levels) to a 1.5°C, 2°C or an even warmer world would generate physical risks stemming from climate change impacts that may affect their portfolios.
Under a warmer climate, climate change poses a number of credit risks, for example:
- More intense hot extremes in all land regions, as well as longer warm spells, can decrease agricultural productivity in multiple parts of the world, increasing default rates for agricultural loans.
- An increase in sea level of between 0.26 to 0.77 m by 2100 in a 1.5°C warming scenario alone, could significantly increase the risk of coastal erosion and coastal flooding, affecting property values in coastal areas. This in turn can translate to changes in loan-to-value ratios and affect mortgage loan portfolios.
- An increase in the number and intensity of extreme weather events can augment damages and losses to property and assets (potentially increasing costs from insurance premiums to clients) and can generate supply chain disruptions. This in turn can reduce revenue flows for borrowers across a number of productive sectors, according to the level of climate sensitivity of their assets and their exposure to extreme weather events, as well as to companies’ strategies to manage supply chain disruptions.
- A significant decline of coral reefs of 70-90 percent under a 1.5°C global warming scenario could significantly affect the performance of assets and investments of tourist operators reliant on these ecosystems, as well as increase exposure of coastal properties to further erosion and flooding.
Managing market risks
Additionally, banks are faced with a number of market risks. For example, increasing frequency of severe weather events can affect macroeconomic conditions such as economic growth, employment and inflation. It can also generate changes in supply and demand for products and services as a result of high scale human migration.
Risks to global aggregated economic growth due to climate change impacts are projected to be lower at 1.5°C than at 2°C by the end of this century, excluding the costs of mitigation, adaptation investments and the benefits of adaptation. It is projected that countries in the tropics and in subtropical areas of the Southern Hemisphere will experience the largest impacts on economic growth.
Room for opportunities
But climate change also presents various investment opportunities for banks. For example, banks can take advantage of their customers’ needs to mitigate physical climate risks by offering loans to increase the resilience of their asset and infrastructure.
They can also tap into emerging markets for adaptation technologies and help companies increase their shares on adaptation investments, whilst shifting holdings away from carbon intensive industries.
Now is the time to act
It seems clear however that, under both a 1.5°C or a 2°C global warming scenario, the time for action is now. Banks should not wait for governments to strengthen their pledges in order to start evaluating the climate exposure of their portfolios. They should mitigate and take advantage of any emerging risks and investment opportunities now.
Aligning with the Taskforce for Climate Related Financial Disclosure (TCFD) recommendations, and mainstreaming climate change considerations in their governance, strategy, risk management and metrics & targets offers a very solid starting point.