The climate crisis’ threat to banks

A recent Bank of England report showed financial businesses need to work harder to manage climate risks, but does government regulation have a role to play too?
Aeral view of London from the East

In May 2022, the Bank of England published the results of its first ever climate stress test, which sought to explore the financial risks posed by the climate crisis and transition to net zero for the largest UK banks and insurers and the broader financial system.

The Climate Biennial Exploratory Scenario (CBES) outlined two types of risk associated with the climate crisis: those which arise while transitioning from a carbon-intensive to a net-zero economy, known as transition risks, and those occurring from higher global temperatures if insufficient action is taken, known as physical risks. The CBES then tested firms according to three potential scenarios, one in which early action against the climate crisis is taken, one where late action is taken and another where no action is taken at all.

The report found that while UK banks and insurers are making “good progress in some aspects of their climate risk management” they still need to do much more “to understand and manage their exposure to climate risks”. It noted that climate risks “are likely to create a drag on the profitability of banks and insurers, particularly if they are unable to manage these risks effectively” with losses of up to 10-15%, which could be passed onto customers. And that “the early action policy path has the highest probability of success in terms of limiting climate change”, while acting late would “leave governments more exposed to the risk of policy coordination failure”.

Oscar Warwick Thompson, Head of Policy and Communications at the UK Sustainable Investment and Finance Association (UKSIF) supports the need for early action from banks and investors in the energy transition to minimise climate risk. “The Climate Change Committee’s recent progress report said we’re off track in terms of delivering net zero. Acting at pace, ambition and scale is going to reduce the risk of stranded assets [from carbon-intensive industries] and future losses on company’s balance sheets for investors and their clients’ portfolios,” he says.

Warwick Thompson also warns of the transition risks to financial businesses from consumer expectations when it comes to a firm’s path to net zero. “They are less likely to use a company’s products and services if they’re not being seen to take action,” he says. While another key transition risk is the shifting regulatory and policy environment. “As that becomes clearer and more robust as we move towards net zero in 2050, those who haven’t adequately responded or taken into account the impacts of these regulations into their portfolios run the risk of investments becoming less valuable over time,” he says.

“It’s always a question of being a first mover or a laggard,” says Dr Daniel Tischer, a Senior Lecturer at Sheffield University Management School and specialist in green finance. “If you divest early on you should get out ok but if you leave it until the very end and you’re the last bank in town then whatever you’re trying to sell is worthless.”

Tischer says there is a lot of diversity and staggered positions amongst fund managers in terms of how they approach divesting from carbon-intensive industries but warns there will always be those looking to profit from the chaos. “There are a lot of sensible people out there but there are also a lot of people who have other motives,” he says. “Destabilisation creates profits so in that sense you can see how people are playing with the narrative for their own gain.”

Before Russia invaded Ukraine, Tischer thinks a lot of banks and financial actors were on the right track. “They were attempting to do the right thing by investing and supporting firms who were positioning themselves away from polluting industry practices,” he says, giving the example of Allianz Insurance, who were quite vocal on those grounds. But he worries the energy security crisis has set things back.

“Looking at the UK, we’re currently seeing more investment into taking gas out of the North Sea to reduce the impact of the windfall tax. That is a very problematic approach, and completely the wrong incentive to give to corporations. It gives the signal that fossil fuels aren’t dead, and gives the market a new lease of life,” he says. “Why didn’t we encourage [energy firms] to get a tax reduction for any ten billion they put into renewable energy in the short term? The CEO of BP made it clear they are keen to invest in renewable energy.”

Warwick Thompson believes banks and investors can still play a crucial role in steering oil and gas majors towards positive climate action in the future. “The profits enjoyed by some of these companies have been quite considerable in light of the rising oil and gas prices,” he says. “So, [we would advocate] using these huge balance sheets as an opportunity to transition to a more sustainable model in the future. And when oil and gas majors are looking to raise finance in the bond market, investors can use their stewardship to pressure oil and gas companies, in effect to do their own public policy.”

The UK is ahead of the game in terms of green finance, so banks and financial institutions are well positioned to take advantage of the energy transition. “We have been a world leader in sustainable finance for a number of years and a big part of that has come from promoting an advanced world-leading regulatory framework,” says Warwick Thompson. “In 2019, we were one of the first to legislate to reduce emissions to net zero by 2050 and the first of the G20 to bring in TCFD (task force on climate-related financial disclosures) for the largest companies.” TCFD means businesses are required by law to include climate risks in their annual reporting.

But he warns, much of this progress is now at risk due to delays to key pieces of legislation on sustainable finance, including around transparency and SDR, the sustainable disclosure requirements for corporates and financial institutions.

“There is a sense the government wanted to minimise the regulatory burden on business,” he says, “but for investors more regulation gives you a better idea of what’s going on in business and better disclosure incentivises capital to flow towards those companies.”

Whoever the next Prime Minister is, it’s hoped they’ll reaffirm the UK’s role as sustainable leaders on green finance and net zero. 

As Tischer says: “The narrative should be much more forthcoming: ‘This is a threat but also a great opportunity for us.’”