Banks can hasten transition into a low carbon economy

Launched at Paris “One Planet Summit” in 2017, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) aims to buttress the global response needed to meet the goals of the Paris Agreement on greenhouse gas emissions and to amplify the role of the financial system in managing risks and mobilising capital for decarbonisation investments.

The increase in the prevalence of nature-related disasters and other environmental shifts could significantly erode the value of damaged assets and put a strain on borrowers’ ability to service loans – leading to increased levels of default and losses.

As a result of growing bad loans, climate change can trigger a decline in lending activity, which ultimately slows economic growth, fuelling unemployment.

A sharp spike in provisioning for bad and doubtful debts will dent banks’ profitability, shrinking their balance sheets and threatening their survival in the long run.

Moreover, operational risks in banks occur as a result of disrupted business continuity due to some extreme events such as floods that would hamper their operation or that of any of their branches, translating into loss of business.

Reputational risks to banks could also arise from investing in carbon-intensive assets and borrowers as some might view such conduct as breach of fiduciary duty for failing to consider long-term investment value drivers.

The financial system can be a powerful lever to drive a credible and inclusive transition to green energy. Banks can help reduce risks associated with climate change and sustainability, mitigate the impact of these risks and bolster growth by reallocating financing to climate-sensitive sectors.

Banks boast a unique market position as they enjoy deep market knowledge and extensive experience across all economic sectors.

Acting as a bridge between the financial industry and environmental conservation, banks can guide businesses looking to tap from the vast pool of green financing, spurring them to adopt eco-friendly practices as a critical starting point in development.

Banks can also incorporate sustainability into their services by offering carbon-cutting loyalty programmes that incentivise their clients to consume environmentally friendly products and services.

For banking regulators, climate change brings new climate-related financial risks, which arise through two main channels: transition risks arising from the considerable structural changes required for economies to transit towards a low-carbon economy in the form of disruptive innovations, policy shifts including carbon pricing models and changes in consumer preferences; and physical risks arising from the increasing frequency and severity of extreme climate and weather-related hazards such as ferocious hurricanes, catastrophic floods, fierce wildfires, and chronic shifts in weather patterns.

The materialisation of either risk can result in significant financial losses and impair asset values through unanticipated changes in their expected cash flows, impacting the creditworthiness of particular issues, and giving rise to systematic risk.

A report published by the NGFS in 2021, “Adapting central bank operations to a hotter world: Reviewing some options”, examined a range of practical options for central banks to incorporate climate risks in their operations.

Firstly, central banks should adjust pricing accordingly to reflect counterparties’ climate-related lending. Secondly, accept sustainable collateral so as to catalyse banks to lend or capital markets to fund projects and assets that support environmentally-friendly activities, which include green bonds and sustainably linked assets.

Contingent on their mandate, central banks have an enormous responsibility on their shoulders of periodically reviewing their operational frameworks to ensure they remain resilient to emerging climate-related risks.

- Mr Maosa is a banking and finance expert. [email protected]