Sustainability challenge: Why should banks manage transition risks of its corporate clients?

The significant sustainability challenge for global banks is how the banks should manage the transition risks of their corporate banking clients given their existing and increasing exposure to various high-carbon sectors. According to a report by Boston Common Asset Management, we have seen almost USD2 trillion of bank financing for fossil fuels since the Paris Accord came into force.

As defined by TCFD (2017), there are two major categories of climate-related risks: (1) Transition Risk - risks related to the transition to a lower-carbon economy and (2) Physical Risk - risks related to the physical impacts of climate change. Transition risk is usually caused by the extensive changes in policy, regulations, technology, and the contingent adaptation requirements.

The magnitude of this challenge to banks is tremendous. Taking HSBC as an example, who is one of the largest lenders in the world and the size of credit exposure to transition risks is immense. HSBC should applauded given that it is one of the few global banks that are leading the industry for TCFD disclosure. By the end of 2018, USD139 billion out of total wholesale loan portfolio (USD668 billion) was exposed to corporate clients in high-carbon sectors, namely Oil & Gas, Building & Construction, Chemicals,

Automotive, Power & Utilities and Metals & Mining (Exhibit 1). That size of exposure is almost equivalent to three times of HSBC’s annual revenue.

Expectations from regulators and investors

In Financial Services, regulators jointly formalise their agendas on transition risk management. Since December 2017, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) has been established and has grown to 42 Members. The NGFS urges financial institutions to enhance their role in the greening of the financial system and the managing of climate-related risks. It acknowledged (2019) that climate-related risks are a source of financial risk but they are not fully reflected in asset valuations.

Institutional investors took action at the world’s largest banks in 2017, coordinated by ShareAction and Boston Common Asset Management, by combining almost USD2 trillion in Assets under Management and calling for disclosure of the banks’ responses to climate change risks and opportunities. They conclude (2017) that shareholders expect banks to have the obligation of developing scenario analysis and strengthening policies on high carbon sectors to be in line with <20C scenarios.

Concerns from clients

In 2019, HSBC conducted Sustainable Financing and Investing Survey, a poll of 500 investors and 500 issuers (corporates) from the Americas, Asia, Europe and the Middle East.

By analysing this database, key finding is that environmental and social issues are going to have a huge influence on how companies/investors allocate capital (Exhibit 2). Over the next five years, two-thirds of companies are expected to make substantial or noticeable changes in capital allocation towards positive environmental outcome, while only 6% do not anticipate any change. One component of sustainable finance that has captured widespread attention is green, social and sustainable bonds. These are normal bonds from a legal and credit perspective, but the issuer pledges to allocate the proceeds to green or social projects. 63% of investor respondents globally expect to buy these bonds for the first time in the next two years. These results highlight the foreseeable transition risks for any of the global banks.

Industry trends

The best practices across the industry commonly involve key elements such as clear disclosure on transition risk management approaches, a well-defined climate scenario, and specific sector-based transition risk targets and policies. A consensus among leading banks is that climate scenarios are essential tools to forecast the transition pathways, but individual banks have the right to adopt the most suitable climate scenarios based on its footprints and businesses coverage.

In summary, regulators, investors and clients across the world are requesting banks to manage transition risks by factoring in asset valuation in environmental risk analysis and shifting risk portfolio away from high-carbon assets. Industry players’ best practices have identified some critical elements of existing transition risk management approaches. Nonetheless, the challenge of transition risk management still remains and requires a global industry leader with robust solutions. From a business perspective, instead of penalising these high carbon sectors with no/much less financing, the author advocates a constructive and progressive approach for global banks to advise and support their clients’ transition towards a low carbon economy.

The article is extracted from Benjamin Zhongyang LU’s full report. If you are interested to get in touch with the author, please send your request to