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Risk management begets risk. It’s what makes the practice so fiendishly complex.

Often, the work of a financial risk manager resembles nothing so much as a game of whack-a-mole. One risk — once identified, analysed, and minimised — gives birth to another, and another and another. But the task shouldn’t be to blindly eliminate each threat as it comes. Instead, it should be to oversee the portfolio of risks as a whole, and avoid actions that reduce one while inflaming others.

Climate risk is no exception. One concern gaining traction among academics and practitioners alike is that a myopic approach to combating climate change could give rise to sociopolitical risks that lead to systemic crises. In short, a cure as bad as the disease.

This is the theme of a new report by the London School of Economics, University of Leeds and Grantham Research Institute on Climate Change and the Environment. Its conclusion is simple, but stark: the financial system has to embrace a ‘just transition’ — one that delivers climate action with a positive social impact — to avoid its actions undermining efforts to slow global heating.

The perils of ‘greenlining’

A just transition requires banks to juggle multiple variables when working to avoid, offset and minimise their climate risks. A ‘hard’ transition would see banks pull financing from carbon-intensive industries and pump it into climate-friendly activities instead — simple. A just transition, however, would have lenders use the profits made out of a solar works in Vermont help renew a defunded coal community in Virginia.

Why is this important? Because a systematic denial of financing for climate-harming sectors — what the report’s authors call ‘greenlining’ — could see banks blamed for “stranding” workers and communities along with the carbon-intensive assets that produce their livelihoods.

This could stoke anger, social unrest, and ultimately a backlash against transition efforts. As the UK Committee on Climate Change explained in 2019, “if the impact of the move to net-zero emissions on employment and cost of living is not addressed and managed, and if those most affected are not engaged in the debate, there is a significant risk that there will be resistance to change, which could lead the transition to stall”.

The risks to individual banks are nothing to sniff at, either. Today, lenders including Chase face boycotts from climate-conscious retail depositors and investors. It’s not hard to imagine communities that fall victim to an ‘unjust transition’ blacklisting lenders that leave them high and dry.

Banks that neglect the social aspects of climate risk management could also be downgraded by ESG ratings vendors. Sure, a lender pursuing a hard transition could boost their environmental scores, but this would come at the cost of their social and governance scores. One knock-on effect would be the exclusion of that bank’s securities from ESG investment mandates and indexes.

Worse, an unjust transition could also set off a chain reaction of loan defaults and bankruptcies that eat into banks’ loss-absorbing capital buffers.

Take the example of Port Talbot in Wales. The local Tata-owned steelworks is the town’s largest employer, paying the salaries of 4,000 workers. Today, the coronavirus crisis has pushed it to the brink of collapse. If it goes over the edge, the suddenly unemployed could fall behind on their mortgage and personal loan payments, and the firms that provide goods and services to the steelworks may also go under. In short, there’s a reason why firms like Tata Steel are called ‘anchor businesses’.

Communities like Port Talbot exist across the developed and developing worlds. If funding from their anchor businesses are pulled, they face complete deracination — and their one-time lenders both reputational and financial fallout.

Prudence vs Justice

So how can the financial system avoid these spillover effects without compromising on their climate risk management practices? The report’s authors lay out eight recommendations to put the “just transition at the heart of banking”. They emphasise the education of bank boards and twinning the goals of climate risk management and social justice within risk management frameworks.

Certain operational changes are endorsed, too. Employee and executive remuneration should be tied to just transition-related targets, the authors suggest. In addition, sustainable finance frameworks should be set up to govern banks’ own security issuances, thereby ‘ring-fencing’ funding for socially responsible and climate-friendly projects.

Two recommendations stand out, though: the first on creating transition-focused financial products and the second on a ‘place-based’ investment strategy. Each makes sense in the context of accomplishing a just transition. But each could also complicate internal risk management and compromise financial stability.

First, transition-focused products. The report rightly states that “banks will need to develop expertise to think about what different customers require and how this should influence the range of products offered to retail and wholesale customers ... to ensure they are consistent with the need for both climate action and positive social change.”

This could translate into so-called “flexible finance” — loans and financing where repayment terms are eased if the client is facilitating a just transition. Rightly, the reports’ authors note this could produce perverse incentives if appropriate safeguards aren’t put in place. For example, bank loan officers may be pushed to offer cheap funding to otherwise un-creditworthy businesses simply because they have signed up to a just transition. There’s also the danger that companies ill-equipped to assist in the realisation of a net-zero economy flock to the cause purely to win preferential access to capital.

Another concern is that “flexible finance” becomes “impenetrable finance”. Loans festooned with special terms, time-limited rates and knock-in options may attract businesses large and small, but that doesn’t mean they are suitable for everyone. Not long ago, UK banks were embroiled in scandal for foisting complex interest rate derivatives on small and medium-sized enterprises. It’s not hard to imagine the uproar that would follow the mass sale of transition-linked loans if borrowers found themselves on the hook for higher-than-expected repayments.

Second: place-based finance. This is the idea that climate action should be tailored to each region of a given polity so that no area is left behind. A hard transition would see capital flee communities built around carbon-intensive industries and overload those at the cutting edge of the net-zero economy. Clearly, this is to be avoided in order to minimise the risk of social backlash and the growth of ‘green bubbles’.

Still, from a prudential standpoint it’s full of contradictions. Certain regions are simply not equipped to make the leap to the new economy absent massive government intervention. What green business could replace all the jobs lost if Port Talbot’s steelworks were to disappear, for example?

Banks that extend financing to these localities risk being saddled with non-performing loans down the line, which will sap their profitability and tie up capital — not good for the health of the financial system in the long run. From a risk management standpoint, replacing a policy of credit-based finance with place-based finance would thus be unwise without the help of the public sector.

Banks know this. The European Banking Federation, for example, told the European Commission only last week that it needed to “[d]evelop minimum social criteria and ensure just transition” as well as “enhance the viability of sustainable activities” as part of its Renewed Sustainable Finance Strategy.

But while the industry knows what it needs of policymakers to get a just transition on the road, it’s not clear whether policymakers know what the industry needs. On their face, some of the policy actions floated could hinder, rather than help, the cause.

Take the example of differential regulatory capital treatments for green and non-green assets. This mechanism, applied bluntly, could stimulate the very stampede out of carbon-intensive assets that would undermine a just transition. Climate-related stress tests could have a similar effect, by revealing those exposures lenders have that are vulnerable to transition and physical risks.

What’s clearly needed is tough scrutiny of micro- and macro-prudential regulations to guard against an uncoupling of climate action from positive social action. The banking sector will also have to get used to asking government to step up, rather than to get out of the way, if a just transition built on place-based finance and the managed replacement of anchor businesses is to occur.

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Navigating a 'just transition'

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