Banks try to quantify the new fourth C in credit assessment: climate

When the world shut down for Covid in 2020, global carbon dioxide emissions declined by 6.4%. To achieve the Paris Agreement, the world needs them to go down by around 7.6% a year, without lockdowns.

This is something the banking industry is keenly aware of.

In March, Michael J Hsu, acting US comptroller of the currency, delivered a speech to the Institute of International Bankers in Washington DC at which he laid out some basics.

“Climate change is generating risk exposures for banks," he said. "Prudently risk managing those climate-related exposures is a safety and soundness imperative.”

He reminded his audience that the Office of the Comptroller of the Currency is “laser-focused” on the safety and soundness aspects of climate-change risks.

Hsu admitted: “Unlike regulators in some other jurisdictions, we do not yet have a mandate to help meet carbon-reduction targets. This means we cannot take supervisory measures specifically designed to accelerate the transition to a carbon-neutral economy, such as limiting credit to fossil-fuel companies.”

Rather, US regulators must focus on large banks’ ability to identify, measure, monitor and mitigate climate-related exposures as part of their competence to govern and manage all of their risks.

Hsu doesn’t sound inclined to compromise: “Weaknesses in risk management could adversely affect a bank’s safety and soundness, as well as the overall financial system.”

It is not in any bank regulator’s mandate to put up with that.

So, what is a bank to do?

Credit underwriting used to focus on the three Cs of each borrower, whether they were an individual or a multinational corporation.

Banks had to judge: the extent and resilience of their cash flows to service interest payments; collateral values to meet principal repayments in a downturn, for example by selling a house or realizing corporate assets; and the one non-financial metric of character, meaning a borrower’s willingness to repay as well as their capacity to do so.

The new fourth C, climate, means that banks used to analyzing audited financials now have to consider a whole parcel of non-financial factors potentially impacting borrowers over the two broad strands of climate risk.

The first involves the physical risks of how much their earnings and asset values might be hit by floods, droughts, fire and wind. The second involves the much harder to quantify transition risks – how badly borrowers might be hit by customers abandoning their products, such as petrol-engine cars, or governments legislating against them, for example mandating renewable energy instead of burning fossil fuels.

Banks are not waiting for regulators. They see an opportunity to lead green bonds and sustainability-linked loans for borrowers keen to demonstrate to customers, shareholders and employees a determination to reduce Scope 1 and 2 (of the Greenhouse Gas Protocol) direct greenhouse gas emissions from their own operations and energy providers, and then those of other suppliers and customers up and down their value chains – so-called scope 3 emissions.

But it now goes far beyond this. Nathalie Sarel, head of sustainable banking, small and medium-sized enterprises and mid-cap companies at Crédit Agricole CIB, tells Euromoney: “ESG risks are key now for banks looking at any borrower or counterpart. Increasingly, we assess these risks for all credits and not just for green loans and sustainability-linked loans.”

In the UK, OakNorth Bank achieved net zero for its own Scope 1 and 2 emissions back in 2019 and intends to get there for Scope 3 emissions from its borrowers in 2035.

Perhaps more importantly, as a lead supplier of credit intelligence to other banks in Europe and the US to help them improve their underwriting of new credits and monitoring of existing ones, OakNorth is now also developing the ON Climate Impact Framework to gather and assess the key data banks need to get ahead of physical and transition climate risk embedded in their loan portfolios.

The firm points out that these risks will emerge in diverse ways: lower revenue, product redundancy, demand substitution, margin pressure and increased capex requirements for adaptation and mitigation.

Lenders need to assess borrowers’ operating models, balance sheets and income statements in new ways.

“The big challenge is the lack of data, especially in the US,” explains Peter Grant, president of OakNorth Credit Intelligence. Lenders have to look beyond companies’ inadequate environmental, social and governance (ESG) disclosures and corporate social-responsibility policies.

Physical risk should be the easiest to assess. Are a manufacturer’s production facilities in a coastal flood zone, exposed to rising sea levels, for instance? And where are the assets of its most important third-party providers – data centres and even retail outlets?

Companies’ disaster recovery plans should cover much of this. Banks need to get zip codes and then make assessments for potential impact under different outcomes for rising temperatures and changing weather patterns over various time horizons.

It doesn’t sound so very difficult.

“But banks aren’t used to asking for too much information from borrowers,” says Grant. “Lending is a competitive business, and there are local, regional and bulge-bracket banks in the US all looking to put on yielding assets. If you take out payment protection programme loans, banks' commercial and industrial loan portfolios have been shrinking.”

And then there is the challenge of regulatory fragmentation. Look at real estate.

“You can’t put up a new-build in New York unless it has a sustainability rating,” says Grant. “But the rules differ on this, not just state by state but even town by town. With climate risk, you see some US regulators that ask a lot about it, while others don’t seem to care.”

He adds: “The US market is 10 years behind Europe when it comes to collecting this kind of data.”

Having shown the capacity of its conventional credit intelligence tools to assess borrowers’ rapidly changing creditworthiness through the extraordinary changes in customer behaviour during the pandemic lockdowns, OakNorth decided to do the same for climate risk.

It looks across six different climate outcomes, in which policy action starts immediately, is delayed until 2030 or doesn’t happen at all and in which temperatures rise by 1.5%, by 2% or over 3% by 2050.

“We have a consortium of US banks working with us on this, which last September consisted of 17 banks with $3 trillion of balance sheet assets and which has since grown to 29 banks with $14.4 trillion of assets,” says Grant.

OakNorth is working most closely with a core group of 10 banks of various sizes.

The company is wary of disclosing who these are, but they range from regional and community banks to some of the country’s biggest commercial lenders, it says. Customers of OakNorth’s credit intelligence suite of products include Capital One, Fifth Third and PNC.

Another is Old National Bank, a 188-year-old former community bank in Indiana with $46 billion of assets. Steve McGlothlin, Old National’s chief credit officer corporate and commercial real estate, says that the bank has a strong credit culture and capacity to review impacts loan by loan but came to OakNorth after the pandemic lockdowns.

“What you find when a pandemic or a catastrophic event hits is that it is all manual," says McGlothlin. "It was extremely difficult, time-consuming and painful to look at each credit, review those credits and feel you made the right call on credit rating.”

Historic models for hotel and lodging companies around Indianapolis or Evansville aren’t much help when occupancy suddenly drops to 3%.

“We could have gone to OakNorth and said: ‘Please put these factors in,’” says McGlothlin.

It sees the usefulness of this kind of third-party validation on climate risk.

“The framework is based on 14 data points, including last 12-month financials and cash at hand as well as location of primary assets,” says Grant. “But bank relationship managers have to be trained to ask the right questions. If they are dealing with a transport company, does it maintain a fleet of petrol, diesel or electric vehicles? You need to ask this before doing a carbon calculation.”

The world could soon be very different, even for a Mid-West bank such as Old National, which is not exposed to rising sea levels.

“We have a heavy agriculture portfolio and worry about drought conditions,” McGlothlin told a webinar audience on the Climate Framework last autumn. “We’ve had three inches of rainfall in recent days and minor flooding.”

The framework has to be practically useful in the near term and the long term. It seems obvious that the biggest transition risks are for companies in the power, oil and gas, metals and mining, iron and steel, smelting, aluminium and transport sectors. But OakNorth digs deeper to assess how different companies in 273 sub sectors might be hurt by the move towards decarbonization and how some might benefit.

“If you have 30,000 borrowers, we’ll identify the 4,000 [that] banks need to focus on first,” says Grant.

The framework starts with the Partnership for Carbon Accounting Financial data that borrowers provide, and which over 250 financial institutions around the world with $71 trillion of assets have already signed up to as the standard for disclosing their own Scope 3 emissions. It gives a climate-risk score to borrowers from the lowest risk (1) up to the highest risk (5) category.

It also points to opportunities to lend to companies that might potentially transition well to decarbonization even though they seem vulnerable at first. Think of gas stations. These will need to adapt – perhaps quite rapidly – away from petrol pumps to charging points for electric vehicles (EVs). If it takes 15 minutes to charge your EV, does that become a big opportunity for stations that also run convenience stores and coffee shops?

The automotive sector intrigues Grant.

“There are 42 leading OEMs [original equipment makers] for cars,” he notes.

The top companies in the US remain Ford, Toyota and General Motors.

“Then there are 150,000 car dealerships, maybe a quarter of a million repair shops. But electric vehicles are changing the rules. An internal combustion engine has 200 moving parts. An EV has 20. We have to think through the impact on dealerships and garages that make most of their money from maintenance and repairs. Tesla doesn’t even have dealerships. It sells direct.”

The industry is likely to be transformed. When will the price of petrol fall because the demand for it among motorists is disappearing – and which banks will be most exposed then?

As well as risk, there are also enormous opportunities for lenders.

China now makes half of all electric vehicles in the world and almost all new cars there are electric. It is a case of the biggest polluter making the biggest investment in transition. Who will fund the unfolding industrial revolution towards decarbonization – the banks or other providers?

There’s a potential conflict for lenders between the E and the S of ESG. In the US, banking is a largely regional business. Lenders feel a moral obligation as well as a practical need to support the big industries in their states that provide employment.

Banks won’t – or can’t – easily abandon them even if they are involved in fossil fuels, steel, cement or mining. But regulators and investors in bank stocks don’t want banks saddled with stranded assets in the form of loans to dying industries or companies that failed to transform.

That is why lending has to encourage transition.

“Ultimately, pricing is where we are going”, says Grant. “This is not driven by regulation. It is driven by investors in corporations and in bank stock trying to make sure they are not heavily exposed to climate risk. Banks need to get their own house in order on climate first and then start to price loans according to the extent of borrowers’ climate risks and their speed of transition. And then they can peer compare on pricing.”

Asking the right questions and getting the essential data to assess borrowers’ carbon budgets, as well as their financial budgets, has to move fast from being the job of loan portfolio and risk managers to being the job of loan originators.

But regulation is coming anyway. In March, the US Securities and Exchange Commission (SEC) proposed rule changes that would require all companies to include climate-related disclosures in their registration statements and periodic reports.

These will include data on greenhouse gas emissions and information about any climate-related risks that are reasonably likely to have a material impact on their business, results of operations or financial condition.

SEC chair Gary Gensler said: “Today, investors representing literally tens of trillions of dollars support climate-related disclosures because they recognize that climate risks can pose significant financial risks to companies, and investors need reliable information about climate risks to make informed investment decisions.”

He might get an angry letter or two during the comment period. But it really is that simple.

And banks get this. Old National Bank, which is traded on Nasdaq, published its own first ESG report last year. It was 50 pages long. Just two of those pages were dedicated to climate.

“Roughly 70% of queries our investor relations team received were related to climate control,” says McGlothlin. He was taken aback. “That’s a staggering percentage.”

It just highlights what it and other small and medium-sized US banks are bound to see more of from investors, activists and regulators.