Before the pandemic, there was a clear drive to ensure lenders were taking steps to understand their exposure to climate risk, so that they could mitigate the risk by making the right forecasts and adjustments. This meant examining factors, such as the volume of housing stock in flood-risk areas, and the individuals vulnerable to job losses in non-green industries. Climate risk has remained a strategic priority through the COVID-19 pandemic, but as we start to see a light at the end of the tunnel, the climate risk agenda is picking up pace.
The heat is on for lenders
Banking regulators around the world are formalising new rules for climate risk management and intend to roll out ever more demanding stress tests. In the UK, the PRA has confirmed a deadline of the end of 2021 for fully embedding the regulator’s expectations on climate risk.
Outside of this, the Network for Greening the Financial System (NGFS), a coalition of 48 central banks and regulators, is providing guides on integrating climate related and environmental risks into prudential supervision.
At the same time, the Task Force on Climate-related Financial Disclosures (TCFD) has recommended climate related disclosures across four thematic areas that represent core elements of how lenders operate. They are governance, strategy, risk management and operational metrics.
Adding to the focus, the UN recently released a report recommending the launch of robust climate-related stress tests to scrutinise the impact of climate scenarios on financial institutions and systems.
Understanding the risks
In order for financial institutions to be able to assess financial risk, it is essential to first understand the three different types of climate related risks – physical, transition and liability.
Physical risks are extreme climatic events happening as a result of rising average temperatures. Heat waves, storms, wildfires and floods are growing in frequency and severity, while droughts are intensifying and sea levels are rising. These in turn lead to transition and liability risks. Transition risks occur when moving towards a less polluting, greener economy, with some sectors of the economy facing big shifts in asset values or higher costs of doing business. And of course, the speed of transition to a greener economy will have an impact too.
As the UK transitions towards the green economy, it is quite likely that we will see some sectors booming, and new ones emerging, representing new opportunities. But, it is very clear that some sectors will become at risk and lenders will need to identify those customers and businesses working in them. For example, polluting industries or sectors under threat from shifting public attitudes, such as meat and dairy, as the popularity of plant-based food increases.
Consumer incomes and savings could also be hit by transitioning to a low-carbon economy. For example, unless government support is made available, having to make energy efficiency upgrades to their property could strain already stretched finances for some.
And finally, liability risks. They occur when people or businesses who have suffered loss or damage from the physical or transition risks of climate change, seek compensation from those they hold responsible.
The actions needed to tackle the impact of each of these risks will have both short term and long term consequences on the financial sector and credit markets.
A green future for mortgages and lending
Pre-pandemic, many lenders were making new mortgages available based on the Energy Performance Certificate (EPC) rating of the property. The higher a property’s EPC rating, the more of an asset it is considered by the lender. Recent Bank of England modelling suggests that consumers living in properties with a higher EPC rating could also be more creditworthy. These are likely to become key factors going forward, making it imperative for lenders to assess the EPC risk in their current portfolio.
We are also seeing the creation of new partnerships and products enabling a more structured and consistent approach to a ‘greener’ way of lending. For instance, NatWest has partnered with green fintech platform, Add to My Mortgage, so that homeowners can fund green home improvements through their existing mortgages. Meanwhile, Barclays has set up a Green Product Framework to finance and refinance projects that support the transition to a sustainable and low carbon global economy. They also have a dedicated Environmental Risk Management (ERM) team in place to advise on client transactions that have associated environmental or climate related risk.
Read our paper 'Credit Risk in a Climate of Change'Download
Climate risk influences many products
While mortgages are an area where Climate Risk has implications, its not the only product type. The impact of climate change risk will depend on portfolio type. Retail portfolios, as well as Auto lending are two other identified products. It is critical that appropriate measures are taken to comply with regulation and manage exposure. To do this, assessing provisions – identifying, measuring, monitoring, managing, and reporting on exposure to climate change risks is important. Performing stress tests (driven off short- and long-term assessments), will allow lenders to conduct scenario analysis that can inform strategic planning and determine the impact of the financial risks from climate change on their overall risk profile and business strategy.
|Property portfolios||Decreased value of properties located in areas with high risk of flooding, wildfires and storms|
|Decreased value of domestic and commercial properties with insufficient energy efficiency standards|
|Retail portfolios||Increased cost of living as prices for certain goods increase|
|Slow and volatile growth as the economy adjusts to structural changes|
|Car finance portfolios||Development of renewable energy technology, affecting the value of assets in the automotive sector|
|Corporate portfolios||Increased defaults of companies operating in susceptible sectors (oil, gas, m transport, agriculture)|
|Growth of Challenger companies / business models focussing on environmentally friendly technology|
|Sovereign downgrades for countries susceptible to climate change risks|
|Market risk||Disruption to financial markets due to volatility in market prices for susceptible sectors and countries (as per BOE insurance scenarios)|
|Development of new trading instruments related to climate risks|
|Operational risk||Increased operational risk events (physical risk to premises, data servers etc)|
|Reputational risks||Customers move away from organisations perceived to be environmentally unfriendly|
|Operating costs||Carbon tax changes, need for investment in energy efficient infrastructure|
As the economy recovers, the bigger challenge of climate change is at the forefront of the financial regulatory agenda. Regulators are moving quickly to set out a framework for a transition to a greener economy.There is an immediate need to extend analysis against broader economic scenarios and both historic and new data sources. Lenders will need to revisit risk models and apply scenarios specific to climate risk. For example, they will need to make specific provisions for unemployment in the at risk sectors. Traditional scores and data will need augmenting with sources including energy performance certificates and flood risk data – at both a portfolio and granular customer level. All of this is crucial to understand the changing face of affordability, vulnerability and creditworthiness.
Deploying climate risk into decisions
At Experian, we have continued to accelerate our innovation to consider the emerging risks, and opportunities, presented by climate risk. Our latest generation of economic models consider climate data within the scenarios, offering improved stress tests and provisioning across your enterprise. Our work extends into revised affordability tests and enhanced scores – for both consumer and commercial lending.One of the core areas of our investment has been centred around not only the models, but the deployment of the models into the decision environment. Lenders will have to build these policy actions into their decisions going forward. As such, traditional scores and data used within decisions, will need augmenting with relevant data – including non-traditional sourcessuch as energy performance certificates and flood risk data. This reinforces the continual need for portfolio and granular customer-level data too. Again, something we are focussed on as we continue to advance our models and scores to accommodate agility, change and future outlook. For more information, please get in touch.