Four trends in climate-related financial risk to watch in 2022
Transition plans, climate stress tests, portfolio emissions, and carbon credits are set to hog the headlines next year
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2021 was an eventful year at the intersection of climate change and high finance. Impressive milestones were reached on climate disclosure, carbon accounting, and climate stress testing. Hundreds of financial institutions representing trillions of dollars of asset were pledged towards net-zero emissions goals. Many of these firms also committed to setting meaningful targets for the decarbonization of their portfolios.
On the flipside, the financing of the fossil fuel system, with all its attendant transition risks, continued at much the same pace it has these last five years, while the climate finance alliances that sprung up in advance of this year’s UN Climate Change Conference (COP26) have been criticized time and again by climate activist groups for allegedly facilitating ‘greenwash’.
2022 promises to be just as dynamic and exciting for climate finance and risk management as the year we’re about to leave behind. Here’s a series of trends Climate Risk Review will be keeping a particularly close eye on:
1) Transition plans are the new black
Climate hawks have labored these past six years to get financial institutions to publish climate-related financial disclosures. They triumphed this year when G7 finance ministers announced in June their support for making such disclosures mandatory.
Though there is still a long way to go before these are produced at the scale and quality necessary to build a convincing picture of the climate risks spread across the financial system, some authorities are already moving beyond climate reporting to press for another kind of disclosure: transition plans.
In October, Frank Elderson, Vice-Chair of the Supervisory Board of the ECB and Chair of the Network for Greening the Financial System (NGFS), said that there should be a legally binding requirement for banks to adopt transition plans that show their “alignment and potential divergences with the relevant policy objectives through which the EU implements the Paris Agreement”. UK finance minister Rishi Sunak went one step further in November when he announced the government is “going to move towards making it mandatory for firms to publish a clear, deliverable plan setting out how they will decarbonise and transition to Net Zero”.
This is a logical evolution. Governments have set their own decarbonization and net-zero goals, but for the most part will have to lean on the private sector to achieve them. Mandating transition plans is one way governments can incentivize firms to align with their own objectives.
Transition plans and climate-related financial disclosures are different beasts, however. This means firms will have to engage in another round of education, experimentation, and optimization to produce plans that are up to scratch.
There is also likely to be a surge in demand for services that assess the credibility of transition plans, so that stakeholders can have confidence that the steps described within them are actually capable of transforming firms in the ways they need to. Similarly, benchmarking solutions that can gauge a transition plan’s alignment with a given jurisdiction’s climate objectives, and/or a given climate scenario, are also likely to be in vogue.
The rough outlines for how banks and other companies can put together robust plans have already been provided by the Task Force on Climate-related Financial Disclosure (TCFD), and organizations like the Climate Safe Lending Network. Still, adherence to the letter of such guides is one thing. Embracing their spirit is another. Expect a lot of scrutiny of transition plans next year, and a mushrooming of services and solutions catering for them.
2) Climate stress tests get tough
This was the year when it became obvious that climate stress tests are here to stay, and are much more than quaint little exercises to appease environmentalists. Going into 2022 it’s now obvious these are high-stakes events that could, and indeed are likely to, influence financial institutions’ business strategies and capital allocation decisions. For example, in October the European Central Bank made clear that the outputs of its inaugural supervisory stress tests, taking place next year, would help inform the Supervisory Review and Evaluation Process (SREP) — its annual evaluation of EU lenders. The results of each bank’s SREP are used to set their Pillar 2 capital add-ons.
For its part, the Bank of England has insisted that its inaugural stress tests, which took place this year, will not affect capital. However, officials have said they see climate capital charges coming in some form or other, and in a recent paper the Prudential Regulation Authority, the BoE’s bank oversight unit, said that “setting capital requirements or buffers based on specific climate scenarios is conceptually no different than basing these on other types of stress scenarios, as long as all major banks and insurers have sufficiently granular data to map the scenarios to losses”.
No, it’s not inevitable that climate stress tests will lead to climate capital requirements. But it’s no longer such a fantastical idea, either. Clearly, the banking lobby sees it as a distinct possibility, given the flurry of papers released by financial trade bodies seeking to rein in the notion — with contributions from the Institute of International Finance and Bank Policy Institute in particular making detailed cases against.
If not climate capital charges, then it’s likely that climate stress tests will lead to some other kind of ‘soft’ sanction for those institutions that do poorly. After all, climate stress tests have to include some kind of decision criterion attached to them, as Tony Hughes explains, not to mention some pass/fail threshold. Yes, many of this year’s climate stress tests, like that conducted by the French authority ACPR, did not have these features. But if these tests are going to be repeated year after year, there has to be some mechanism involved that compels participants to improve their climate risk management over time. Otherwise they will lose their credibility, and neither supervisors nor supervisees will devote the time and resources necessary to make the process and results worthwhile.
3) Portfolio emissions take the spotlight
2021 spawned a new breed of climate metrics and targets, helped in no small part by the TCFD’s concerted efforts. The rise and rise of the Partnership of Carbon Accounting Financials (PCAF) has also put portfolio emissions metrics on the agenda of major financial institutions. Today, 184 members of the Partnership have pledged to count up the emissions financed by their lending and investment portfolios, and investors can expect to see these numbers in many more firms’ climate reports from next year.
This will open up a whole new front in climate risk (or perhaps more properly ‘carbon risk’) analysis and research. In turn, this should allow institutions to pinpoint their transition risks with greater accuracy. How firms choose to use this information remains to be seen. It could catalyze a new wave of divestments by climate-conscious investors, especially those that have signed up to the Glasgow Financial Alliance for Net Zero. Another possibility is that investors lobby investees to spin off their most carbon-intensive operations — a strategy that could be called ‘pre-divestment’. There’s already been some action in this space. Take activist hedge fund Bluebell Capital Partners’ efforts to get commodities giant Glencore to dispose of its thermal coal business. In a letter to the company seen by Bloomberg, the fund said:
“A clear separation between carbonised and de-carbonised assets is needed to increase shareholder value and remove the ‘coal discount,’ whilst simultaneously ensuring that coal assets will be managed responsibly.”
As financed emissions disclosures become more widespread, it’s not hard to imagine banks, asset managers, and other firms making similar demands of their investees in order to lighten the carbon load of their own portfolios. Whether or not an accelerated bifurcation of ‘carbonized’ and ‘decarbonzied’ assets will actually result in lower real-world emissions is questionable, though. Obviously, private finance vehicles and ‘shadow banks’ could gobble up the carbon-intensive SpinCos shorn from big public companies, therefore allowing them to continue polluting. This could cause a build-up of transition risks outside the supervised zone of the financial system. Climate activists’ attention may then turn to how such ‘shadow banks’ themselves are funded. One result may be increased lobbying of big banks to cut off their funding of these entities. Another could be louder demands for regulation that extends climate disclosure and transition planning to private equity funds, hedge funds, and family offices.
One other trend to watch in the carbon-counting space is what PCAF calls “facilitated emissions”. This refers to the pollution enabled by financial institutions’ help bringing corporations’ debt and equity to market. Put another way, when a bank acts as bookrunner or manager for a public offering, they are “facilitating” the offering entity’s emissions. Work on putting together a standard to account for facilitated emissions has just begun at the PCAF level. Like financed emissions, though, they are likely to become a preoccupation of climate-conscious investors in big banks. For some time, the research outfit Anthropocene Fixed Income Institute has highlighted the incongruity of so-called net-zero banks underwriting, bookrunning, and managing debt issuances for ‘carbon hogs’ like India’s Adani and Russia’s SUEK. Perhaps 2022 will be the year that such critiques are picked up more consistently by the mainstream — and absorbed by climate-conscious investors.
4) The financialization of carbon credits
Love them or hate them, carbon markets are here to stay. Not only that, in the wake of COP26, they are poised to expand at a rapid pace. This is because at the conference countries finally agreed on so-called ‘Article 6’ rules, named after the section of the Paris Agreement that references mechanisms for facilitating emissions reductions through “cooperative approaches” — in short, carbon offset trading.
Offset projects and carbon credit accounting frameworks that adhere to the Article 6 rules could become very popular, very quickly, as they will benefit from the imprimatur of the Paris Agreement itself. This may also unlock funding for offset projects and incentivize the development of innovative new financing structures for buyers and sellers of carbon credits alike. Insurance companies may be drawn into transactions designed to protect offset projects from natural and man-made disasters, or to indemnify buyers of carbon credits if the underlying project is found to deviate from certain standards and expectations.
In addition, carbon credit derivatives markets could also take off, as participants look to hedge the market risk of the underlying instruments. The International Swaps and Derivatives Association (ISDA) is cognizant of the risks and opportunities such a development affords banks and market-makers. Earlier this month, the trade body published a paper on the legal implications of voluntary carbon credits, which recommended greater clarity in law be given these instruments so that derivatives markets could flourish. In June, the body also weighed in on the capital treatment of carbon credits for banks, perhaps with an eye on ensuring that future market-makers in such products are not unduly penalized for their involvement.
Naturally, ISDA wants to make participation in voluntary carbon credits as smooth as possible for its members. The danger of lowering barriers to access, of course, could be the rapid financialization of carbon credits, similar to how mortgages and other credit instruments were transformed ahead of the 2008 subprime crisis. Complex structured products built on a shaky foundation of questionable carbon credits, if allowed to proliferate throughout the financial system unchecked, could cause investors, banks, and regulators innumerable headaches down the line. Expect accelerated carbon credit financial innovation — and heightened scrutiny of carbon credit instruments — to be another trend through 2022.
This column does not necessarily reflect the opinion of Manifest Climate, Inc. and its owners
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