Climate change presents both risk and opportunity

According to OakNorth’s Climate Consortium survey in February of this year, 59% of banks attending the consortium have already begun plans to mitigate climate risk in their commercial loan book. Three quarters (74%) of the banks in attendance, whose assets ranged from $22B up to $3.3T, see managing transition risk as their top priority when it comes to climate change.

Transition risks can arise from the process of adjustment towards a low-carbon economy. A range of factors influence this adjustment, including: climate-related developments in policy and regulation, the emergence of disruptive technology or business models, shifting sentiment and societal preferences, or evolving evidence, frameworks, and legal interpretations.

While climate change creates many unknowns and can impact the creditworthiness of even the most profitable businesses, it can also give banks an opportunity to support sectors and businesses in reducing their carbon emissions and transitioning to the green economy.

For example, earlier this year in California where I live, the California Air Resources Board announced an aggressive plan to mandate a steady increase in the sale of electric and zero-emissions vehicles, banning new gasoline-powered cars by 2035. As a result of this, it’s very possible that businesses such as delivery companies might be considering how they can shift their fleets to EVs (electric vehicles) over the next few years. Not only would this reduce the carbon footprint of these businesses, which would in turn reduce the bank’s scope 3 emissions, but it could also help the business attract new customers who are seeking a more environmentally-friendly alternative.

Another example is in the restaurant industry where approximately 9.7 million Americans identify as vegan — a significant jump from just a decade ago. As a result, most fast food restaurants now offer vegan-friendly products from companies such as Beyond Meat.

These are just two examples but both would require significant investment from the businesses — investment which could be supported by a loan from a bank.

Let data do its job

Data and modern technology remain pivotal in helping banks and businesses adapt to an ever-changing world. Due to the frequency of extreme weather events and the speed at which technology is evolving, climate analysis requires ongoing data collection and insight.

However, many banks still rely too heavily on manual data gathering, basic Excel spreadsheets and their portfolio managers' intuitions. Longer term, they will need to develop clearer data strategies and evolve current data capture and aggregation into more sophisticated, automated systems. This will help reduce the time spent reviewing data and help relationship managers and credit analysts identify risk factors much earlier.

For example, a borrower may appear to be in good financial health based on previously collected data, but different scenarios — climate change, geopolitical tensions, rising inflation, supply chain issues, etc. — could create additional stress or increase the risk of default. Technology can provide early warning indicators in situations such as these, enabling the bank to work with the borrower to agree on the best way forward and hopefully minimize or completely avoid a credit loss.

Many banks are exploring new and innovative ways to obtain more data from customers — some through working with third-party data providers and partners such as OakNorth, and others through trying to gather more data directly from customers. For example, one bank shared at OakNorth’s most recent Climate Consortium earlier this month how they have created a rigorous climate questionnaire that is shared with borrowers at the time of initial underwriting / onboarding, and again at the annual review. The questionnaire helps the bank assign a climate risk score to the borrower — for those that score on the higher end, the bank is monitoring them more closely and working with them to put a climate transition plan in place if they don’t already have one.

As the world adjusts to new challenges such as climate change, banks will need to take a new approach to scenario analysis and evolve their existing risk and credit processes. They will also need to invest significant time and resource into building climate confident teams and first lines who are equipped to have these conversations with borrowers, identifying both the risks and opportunities.

By Peter Grant, OakNorth President and COO

This article is the second in a three-part series discussing how finance-function professionals can use scenario analysis to effectively assess a pandemic, climate change and supply chain shortages. Part three focuses on how portfolio diversification remains crucial when it comes to commercial lending.