Exclusion illusion? How to improve negative screening

Revenue-based exclusion criteria may understate financial institutions' climate-related risks

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Negative screening, whereby companies are excluded from a firm’s portfolio if they don’t meet preset environmental criteria, is the initial step taken by many financial institutions working to implement a climate risk management process. It’s popular among top lenders, too. The consultancy Mazars found that 73% of 30 leading banks had exclusion policies in place to reduce their involvement in carbon-intensive sectors, and that 59% of this group made them more stringent in 2018. 

To limit global heating, it’s essential that the money fountain sustaining the fossil fuel sector is shut off — so these figures look encouraging. But as always, the devil is in the detail.

Each bank defines their exclusion criteria differently, and the scope of financing prohibitions often falls far short of the lofty rhetoric used to announce them. This makes it tough to compare negative screening policies across firms. It’s often also challenging to place a given exclusion policy in the context of a firm’s overarching climate risk strategy. Splashy commitments to scale back fossil fuel financing make good headlines, but detached from a company-wide mission to decarbonise, it’s hard for stakeholders to discern which numbers are meaningful.

Clearing out of coal

Let’s take the example of thermal coal mining, an activity included in many banks’ exclusion criteria. For good reason, too: it’s an exceedingly dirty power source. Thermal coal, the kind used to produce electricity, contributed just 27% of the fuel to the US power sector in 2019, but a whopping 60% of the sector’s CO2 emissions. By choking off funds to coal mining, banks can speed up the decline of this most polluting of fossil fuels.

A rash of banks have introduced or strengthened revenue-based thermal coal exclusion policies this year, including global lenders Morgan Stanley, Citi, Deutsche Bank and Societe Generale. The thing is, no two look the same.

Two variables determine the efficacy of coal exclusion policy from a climate risk standpoint: the definition of a thermal coal mining company, and the time horizon over which the exclusion takes effect. 

Let’s take a look at JP Morgan’s policy to demonstrate this. The bank says it will “not provide lending, capital markets or advisory services to companies deriving the majority of their revenues from the extraction of coal,” and will phase-out all such outstanding exposures by 2024. 

At first glance, this looks like a monumental commitment. But the “majority of revenues” condition implies that the bank will continue to finance firms that make equal to or less than 50% of their revenues from coal mining beyond 2024. As the Rainforest Action Network, a San Francisco-based environmental lobby group, notes, the policy allows JP Morgan to continue to bankroll the biggest coal mining companies, many of which are conglomerates that get less than half of their revenues from coal.

In addition, by setting a single, short-dated target, JP Morgan gives stakeholders no way of mapping its exclusion policy to a long-term transition pathway, and as a result no insight to the bank’s long-term climate-related risks in connection with the sector.

This negative screen does little to help investors understand the bank’s exposure to an Inevitable Policy Response (IPR) scenario, for example, whereby demand for thermal coal falls steeply from 2025 onwards. Credit exposures to borrowers with a sizeable chunk of their revenues derived from coal mining — even if not a majority — may rapidly deteriorate under this scenario. It wouldn’t take much of a price shock to make thermal coal mining operations economically unviable, either. The top four US thermal coal mining companies all entered bankruptcy in the past four years, a period which coincided with a fairly steady decline in the price of coal for power generation. 

Source: US Energy Information Administration

Context is king

In order for exclusion policies to be credible, they have to be tied to an overarching decarbonisation objective — and banks have to show stakeholders how they relate to one another. 

UK-based bank Standard Chartered is an exemplar in this respect. In its latest climate-related financial disclosure, the firm maps its thermal coal exclusion policy against a series of well-established, Paris Agreement-aligned scenarios from the International Energy Agency (IEA). This allows stakeholders to gauge the extent to which its screening policy lines up with its pledge to reduce financed emissions enough to limit global warming to significantly less than 2°C.

The analysis shows that its exclusion policy, prohibiting financing of clients that make more than 10% of their revenues from thermal coal by 2030, means it will be pulling support from the sector at a faster rate than the amount required to align with the Paris Agreement. 

Source: Standard Chartered

Widespread adoption of this kind of analysis would go a long way to improving the utility of revenue-based exclusion policies.

Still, banks can and should go further. In order to provide the full picture of their climate-related exposures, they should implement exclusion policies based on the absolute production of carbon-intensive fuels by clients alongside revenue-based screens.

Reclaim Finance, a French-based environmental lobby group, says financial institutions must cut off firms that produce more than 10 million tons of coal per year, and commit to lowering these thresholds to zero, in order to support an exit from coal by 2030 in OECD and European countries, and by 2040 at the latest elsewhere.

Revenue-based exclusion criteria miss plenty of companies that produce over this threshold amount. For example, China’s Jinneng Group attributes less than 30% of its revenues to thermal coal, but produced more than 73 million tons of the stuff in 2018.

Revenue-based policies could also be “gamed” by consolidation across the fossil fuel sector. For example, a company making 100% of its income from thermal coal sales may find itself starved of funding, but by merging with a larger, more diversified firm, could slip under banks’ exclusion thresholds.

Alternatively, those mining firms with the resources and capabilities could ramp up their production of metallurgical coal — the kind used to make steel — and ease off thermal coal to hit the necessary thresholds. Because metallurgical coal is “cleaner” than thermal coal, and so essential to the steel-making process, it is exempt from most banks’ exclusion policies. In fact, pure-play metallurgical miners are already courting ESG investors, touting their superior sustainability credentials.

It’s tough to predict how an entire industry, faced with financial armageddon, will act to save itself. But if accounting gymnastics could keep thermal coal mines from going the way of the Dodo for just a few more years, who’d bet against them trying? And in the race to achieve a net-zero carbon economy by 2050, a few years could make a big difference. 

That’s why effective exclusion policies need absolute criteria, too. Otherwise they could completely miss the very reputational, policy and credit risks they were designed to mitigate.

The amorphous nature of climate-related risks also demand one more thing of exclusion policies: lender-client engagement. In short, climate-conscious banks have to work with their clients to steer them away from exclusion thresholds.

Leaving coal mining companies to die may get a thumbs up from climate utopians, but it’s not good climate risk management. Nor is it aligned with the principles of a ‘just transition’. Lenders generally want to avoid loan defaults, and their knock-on effects on income, capital and risk-weightings. Climate change activists should also want to prevent the sudden “stranding” of workers and their communities linked to carbon-intensive assets, in order to lower the risk of a backlash against transition efforts.

Hence why smart exclusion policies incorporate ongoing monitoring efforts and continuous engagement to get firms to transition alongside negative screening thresholds. French bank Societe Generale, for example, will cut off financing for existing clients that make more than 50% of their revenues from thermal coal this year, but will accommodate clients that make 25% - 50% from this source if they have a “time-bound transition plan to exit”. In addition, clients which do not meet the criteria will “be offered financing Products and services dedicated to the energy transition”, which may help them stay in business (and therefore able to honour their obligations to the bank).

This policy may not be perfect. For instance, if funds “dedicated to the energy transition” translates to “loans to develop natural gas projects” then the bank is still propping up the fossil fuel sector writ large. However, coupled with an absolute criteria threshold (perhaps linked to tons of CO2 financed) bridge loans like these may help reconcile the need for an effective exclusion policy with the demands of a just transition.

Negative screening may be the first step taken by banks on their climate risk management journeys. But it’s by no means a simple one. Clearly, exclusion policies need much more than a date and a revenue threshold if they are to be any use at all to stakeholders, clients and the planet.


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