News and Insights
Climate Change and Banks’ Risk Management: Can It Affect Investment Decisions?
By Miriam Breitenstein, Technische Universität Dresden, Germany; Duc Khuong Nguyen, IPAG Business School, France; and Thomas Walther, University of St. Gallen, Switzerland
In a recent article, International Banker reported on the joint open letter of the governors of the Bank of England and Banque de France calling for more action from central banks, but also private banks, against climate change, therefore fostering awareness of the corresponding risks involved with climate change for banks. While those climate-related risks can be categorized into physical risks (resources availability, physical damage) and transitional risks (changes in technology and policy), the nature of their impacts on banks’ operations, balance sheets and performance is not yet understood in a holistic manner.
What we certainly know is that, without good management of climate risk, banks’ risks rise in a climate-led business environment. The growing societal concerns about the harmful and disastrous effects of climate change and the new regulations put in place have led banks around the world to gradually adopt environment-friendly policies through, among other strategies, their CSR (corporate social responsibility) rules and practices. However, the sustainability of “just being responsible” is no longer sufficient. Proactive actions are urged to cope with the severity of climate change and the increase in the total risk of financial institutions and firms.
Our recent systematic literature review about environmental hazards and risk management in the financial sector shows that firms that are strongly committed to environmental responsibility and performance see their risks reduced. As a matter of fact, investing in a non-environmental firm drives up a bank’s risk. Thus, not only a bank’s investment decisions but also operations can have a substantial impact that matters for combating climate change. This so-called “impact investing” brings more than just the financial dimension into an investment decision and also analyses the environmental, sustainability or corporate governance aspects of the firms to be funded. More interestingly, it is also recognized as the new frontier for the global community of investors who look beyond financial returns and seek to widen the impacts of their investments. In its recent report of April 2019, the Global Impact Investing Network (GIIN)—an industry network of more than 1,300 impact investors worldwide—estimates the current size of the global impact-investing sector at US$502 billion.
Since the roots of environmental risk management can be found in concepts such as corporate environmental performance (CEP) and environmental, social and governance (ESG) criteria, strong, fundamental knowledge on the relationship between environmental hazards and financial risks is typically needed. This is especially important in theory and in practice, because it outlines the consideration of environmental hazards in current and past financial performance, and thus gives incentives to assess and manage environment-driven risks.
Our analysis finds that CEP positively affects not only market-risk measures but also performance measures such as shareholder value. Directly proxying environmental hazards corroborates these outcomes and exhibits negative impacts on market-risk measures. This aspect of research provides evidence for the dependency of a company’s financial risk on environmental concerns and its engagement in environmental responsibility, consequently pronouncing the necessity of environmental-risk management in the financial sector. Striking was that the combination of environmental concerns (instead of environmental engagement) and financial risk was rarely investigated, calling for future research on this subject. As for banks, they need to understand more completely the characteristics of climate-related financial risk and to adequately estimate and assess the financial consequences of environmental hazards.
Banks’ current practices of climate-risk management need structural adjustments to match investors’ views on climate risk and impact investing. This could be done by especially quantitative and qualitative interviews, such as the research by Philipp Krueger (University of Geneva), Zacharias Sautner (Frankfurt School of Finance & Management) and Laura T. Starks (University of Texas). It shows the development of climate-related financial-risk awareness and engagement in assessment approaches among investors and analysts, who now believe that the financial risks originating from environmental hazards have already begun to materialize and that this will have financial implications for their portfolios and the corresponding portfolio firms.
A further subject of investors’ concern is the risk of assets becoming stranded for different electricity-industry sectors. Common assessment approaches can be found in carbon-footprint and stranded-assets analyses, portfolio diversification or ESG ratings. However, the limitations of disclosures restrict the possibilities of assessment of carbon footprints, return-impact measures, scenario analyses and stress testing. Thus, investors and analysts are hindered in employing more sophisticated and comprehensive analyses.
The current challenges remaining for not only banks but also regulatory bodies are the disclosure of standardized, publicly available data concerning companies’ exposure to environmental concerns, suitable assessment and pricing instruments.
Close attention must be paid to climate-risk assessment approaches. In this regard, assessment approaches—and anticipating risk—form another central subject of necessary academic and professional research but have been greatly restricted until now. The development of climate-risk measures and portfolio strategies is relevant to investors and analysts, as they face challenges in the assessment of environment-driven financial risks. Research shows that carbon-risk measures (such as beta carbon) depict company- or sector-specific carbon-emissions sensitivity and can be considered in analysts’ forecasts, investment and portfolio-allocation decisions. Hedging strategies following ESG-based, low-carbon-weighting index-tracking portfolios show that these portfolios can successfully hedge climate-change news and achieve the same or even improved risk-return performances.
At the moment, it appears quite complicated to assess climate change and environmental hazards from a bank’s perspective. The little toolset that is available draws mainly from measures such as carbon emissions. However, environmental hazards come in different guises, such as real estate’s proximity to the sea or increasing risks of drought for agricultural sectors. Thus, it remains still completely unclear how especially the physical dimensions of climate change will affect the operating and financial performance of banks.
Overall, banks’ operations and performance are significantly affected by environmental hazards stemming from climate change. In addition to proactive behaviour that gets them ahead of climate change, they really need to develop efficient assessment methods to effectively reduce their risks, considering a long-term view and taking into account more dimensions than just their carbon-dioxide footprint. Last but not least, their position in the frontier between the economy and financial markets would help them counter climate change by changing the behaviour of their clients toward more environmental protection.