On the rim of the Arctic Circle, Iceland is one of the most striking places on our planet. Its moniker – the Land of Fire and Ice – paints an accurate picture: this frozen landscape is set right on top of a volcanic melting pot. The result is a landscape of stark beauty. During the winter, waterfalls freeze and the Northern Lights dance across the sky. Over the summer the interior becomes much more accessible, exposing a true wilderness to those wanting to explore it.
Iceland is particularly famous for its glaciers; they cover 11% of the island and number more than 400. However, it is estimated these glaciers are collectively losing 11 billion tons of ice a year. At the current pace of melt – which is accelerating – all Iceland’s glaciers will have disappeared within the next 200 years. The people of Iceland are watching this unfold before their eyes and, a couple of years ago, local anthropologists marked the ‘death’ of one of their glaciers by mounting this plaque on the site, which was once the Okjökull glacier. Whilst relatively small, by Iceland’s standards, Ok – as the glacier was known locally – turned out to be not OK, becoming the first of Iceland’s named glaciers to lose this status through anthropogenic (human-induced) climate change.
The banking sector and climate change
It is now accepted the world is facing a series of urgent and interlinked environmental challenges. To avoid the most dangerous consequences of climate change, global greenhouse gas emissions must drop by 50% over the next decade. Even with this reduction, some impacts are already inevitable, necessitating a transition towards climate resilience. If we look at the EU – a world leader in going green – its contribution to the global challenge of greenhouse gas emissions is to reduce them by 55% by 2030 and to reach climate neutrality, across the whole continent, no later than 2050. The energy sector has a central role in this transition and is responsible for the majority of the EU’s emissions. There is no single, agreed scenario for the energy transition but multiple analyses indicate the need for a sharp and sustained reduction in emissions intensity of electricity generation. This, of course, can only be achieved by burning less fossil fuels. In the context of this, it is disappointing the world’s biggest 60 banks have provided US$3.8tn of financing for fossil fuel companies, since the Paris climate deal in 2015 (Source: Banking on Climate Chaos 2021). Despite the global pandemic, overall funding remains on an upward trend and the finance provided in 2020 was higher than in 2016 or 2017. US and Canadian banks made up 13 of the 60 banks analysed, but account for almost half of global fossil fuel financing over the last five years, the report found. JPMorgan Chase provided more finance than any other bank.
JPMorgan Chase topped the list of banks financing fossil fuel projects (2016 to 2020)
Whilst it is easy to be critical here, we do need to keep the lights on and the transport system operational; as highlighted by the current situation across Europe with respect to gas prices and fuel shortages. Nurses need to get to the hospital and teachers to their schools. There are number of causal factors in play, but one of them is a chronic underinvestment in fossil fuel energy infrastructure. Banks and bond markets are the primary lenders to both the green and brown energy sectors. The maturity of these borrowings are usually multi-year, meaning creditors cannot simply exit this lending overnight, rather it has to roll off at redemption. What we need to see is governments and industry share clearly defined transition plans, which provide a managed pathway to net zero. If banks stop lending to ‘dirty’ companies today, the resultant economic chaos would likely make the recent Covid pandemic pale into insignificance.
CO2 in bank loans - is this an investment risk?
The 11 largest banks in the European Union, including BNP Paribas SA, Deutsche Bank AG and UniCredit SpA, have 532 billion euros (US$648 billion) of investments and loans financing everything from extraction to transportation of fossil fuels; equivalent to 95% of their total common equity tier 1 capital (CET1), according to another report (by Rousseau Institute, Friends of the Earth France and Reclaim Finance). It has been argued a rapid and chaotic energy transition, leading to stranded assets, would also leave Europe's biggest banks in financial peril, comparable to the subprime crisis that US lenders faced in 2008. The European Banking Authority (EBA) is one of the bodies in place to prevent this happening, advising banks to take this credit risk – and tighter environmental regulation – very seriously and start adding to their equity cushions. Upcoming stress tests, in the euro zone, should start to reveal how much pain climate-related objectives could cause to loan books. Understanding this involves banks gathering and reporting much more information about their exposures. Against this backdrop, many banks are for the first time publishing relevant data on criteria such as lending to fossil fuel industries. Unfortunately, there is no one set of disclosure standards that banks are obliged to follow and they differ on how to measure key information and what they should release publicly. As a result, investors, regulators and the public face difficulty in determining the lenders facing the highest risks and which are taking the most determined action. For example, some banks are currently failing to disclose risks beyond their most carbon-intensive clients. In a recent study, of 29 banks, the EBA found that 58% of their total exposure to big companies was in sectors that could be sensitive to transition risks. In terms of climate change, regulators want to make banks think much harder about what kind of companies they lend to and at what cost. Many institutions have already stopped funding coal-fired power plants. However, stress tests involving climate-related risks will lead to higher capital requirements and can help create a rising scale of financing costs, which should help support cleaner business activity and discourage dirtier practices across industries. Carbon is under the spotlight for reasons we are familiar with. However, financing businesses with wider implications around sustainability – such as those responsible for damage to ecosystems, etc. – will increasingly be in focus. The asset-quality of banks lending to the ‘wrong’ sectors will be increasingly scrutinised, with management having to react quickly as regulation and investor expectations pivot.
Implications for portfolios
Risk management is, of course, a core skill-set of banks – as is making profits from lending money and providing advisory services to the growing sectors of an economy. The sustainable financing opportunity is huge and most banks’ green annual commitments are now bigger than their 2020 financings of fossil fuels. On the chart which follows, you will observe that JP Morgan is one of the banks leading the pack in financing more green than brown.
Most banks’ annual green commitments are now bigger than their 2020 financings of fossil fuels
Moreover, investment bankers – used to advising on mergers and share sales – are now assisting executives to account for environmental risks in transactions and incorporate sustainability into overall strategy. Across our responsible and sustainable strategies we do have exposure to financial institutions financing the energy sector. Banks are held by our value managers (Polar UK Value Opportunities and Oldfield Global Equity) as the sector is very attractively valued. In the bond space we have owned PIMCO Capital Securities for a number of years, as the yield on offer for an investment grade portfolio is compelling. All of these managers actively engage with the banks to advocate for change and discussions around fossil fuel lending are a key focus. It is important to consider the materiality of systematically important banks putting in place strategies to reduce and exit lending to ‘dirty’ businesses. In our sustainable mandates, and at the other end of the spectrum, we have a number of holdings in specialist lenders who only provide sustainable finance; spanning micro- lending and real estate, as well as development capital (e.g. African Development Bank). One such business, held in client portfolios, is Hannon Armstrong Sustainable Infrastructure, a US listed company whose business model is solely dedicated to financing climate solutions. This ranges from behind-the-meter assets, such as energy efficiency improvements of buildings, to renewable energy, such as solar land. To conclude, banks will be the ‘gatekeepers’ of the transition towards a greener and more sustainable economy, due to the key role they, and the broader financial sector, play in providing funding to economic activities. We have zero chance of hitting the Paris targets without the banking system financing it and it is estimated current corporate cash flow can only finance 50% of the capital spend that is needed. The banking system must fulfil the rest. We need them to get it right if the world is going to be ‘OK’.
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