For the EU to be fit for 55, bank risk management needs to be fit for 22
In the run-up to the COP26, The EU has published numerous policies to support its ‘Green Deal’. ‘Fit for 55’. These policies aim to reduce The EU’s CO2 production by 55% (relative to 1990-level), with the goal to achieve this by 2030.
The policies cover multiple economic areas including:
- Expanding the scope of EU ETS (Emissions Trading System)
- Include the maritime sector and implement CORSIA (Carbon Offsetting and Reduction Scheme for International Aviation) for aviation
- Cover emissions from buildings and road transport
- Introducing new CO2 emission targets for new cars and vans from 2030
- Reforming the regulation on Land Use, Land Use Change, and Forestry
The EU had begun the legal process to meet or surpass its ‘Paris’ commitments, referred to as the ‘European Green Deal’. A preview of its implications for The EU banking sector is provided below:
EU’s fight against climate change is a critical case study given the complexities involved in achieving the radical transformation required to hold global warming to 2 degrees or less by 2100. The EU must maintain economic growth and competitiveness while transforming heavy industry, supply chain management, agriculture, transport, and energy infrastructure across and between its 27 member states.
A key point here is that the ‘just transition’ included in the plan applies to everyone equally and leaves no one behind. Creating an economic environment that supports green jobs is central to transitional planning. The vital need for this is clear in light of cost estimates and funding plans for the transition. Indeed, in its 2020 report, McKinsey estimated a total investment of $28 trillion over 30 years ($800 billion per year) to decarbonize the European economy.
Significant investments are required in several areas to meet EU’s goals:
• Power Grid
The EU power grid is a complex web but The EU has a well-established renewable sector. Further investment in storage, renewable production, and alternatives such as nuclear and green hydrogen is needed. Within the EU, there are rules that govern the power sector around production and purchase from neighbouring states. Banks and lenders play a major part in this process, ranging from funding power infrastructure to providing credit facilities for hedging, and forward purchasing of power by supply and energy trading firms.
This sector largely relates to the electrification of vehicles. With ambitious targets for electrical vehicles and economic growth, major changes have been witnessed and need to be accelerated to transform the automobile industries. From a policy perspective, tighter restrictions on combustion engines by 2030 will greatly impact the transportation industry.
The EU is a major exporter and importer, with shipping being one of its core industries. This sector is exposed in two ways: directly—to decarbonize through its fuel use; and indirectly—via restrictions on the production of goods being transported. Also, innovations such as biofuel use and fixed sails on merchant ships, are being actively explored. The shipping industry has long relied on bank credit facilities to fund its operations and manage its complex cashflows. Banks need to offer finance-related incentives to support the ‘greening’ of this sector.
Farming and land management is perhaps the most complex of all sectors as EU’s growing population requires increasing food production also to become more sustainable This includes fertilizer and land use, as well as changes to areas such as beef production, which contribute significantly to methane production. Banks play a major role in managing the cashflow for the farming sector and are in the prime position to work with farmers to make it sustainable.
• Built Environment
Constructing a sustainable and energy-efficient building is well generally well-understood however, renovating the existing building stock across 27 countries is a daunting task. This is economically and politically challenging, but can be achieved through a mix of regulations where the onus is put on the building owners, but they will need banks to aid in financing for compliance.
The EU’s GDP of around 15 Trillion Euros, the major contributor being its well-established industrial sector. This sector needs cautious policy planning as it impacts the culture and living standards across the union. Banks would need to finance the transition as policies ‘orphan’ existing firms and industries while creating high growth opportunities in the new green economy. Understanding the timing of the transition and the possibilities for innovation and adaptation would determine if banks’ balance sheets determine a greener future, or a potential credit crisis.
The EU budget and the NextGenerationEU provides roughly 140 billion Euros per year. Thus, EU would need private-sector finance for its ‘Green Deal’ to the tune of 660 billion a year for 30 years. Managing financing in the transition process through an ongoing series of policy announcements would require banks to determine:
• Regulation Timing
This includes both timing of the introduction and the allowed compliance period.
Firms will be able to refocus on greener production rather than become extinct during the transition. Adaptation can often be cheaper as it reuses existing equipment and land. Therefore financing should be encouraged for existing companies to adapt to the needs to be a significant part of the green mix.
The EU has strong history of protecting its markets, but these effort are limited to its internal markets from external competition. This needs to be considered when viewing the credit risk profile of commercial, exporting, borrowers.
Recently, the EEA released: ‘With People and for People: Innovating for Sustainability.” This report discussed the contribution of social and technological innovation towards more sustainable societies. The EU will undoubtedly encourage innovation in this sector but this carries risks for banks as competing technologies create big winners and losers from the perspective of financial lending.
• Non-CO2 Reduction Policies
Climate-related policies are often viewed as an equivalent to CO2 reduction measures. However, this ignores other greenhouse gases that are also being addressed. An example of this is the methane pledge recently made by the US and EU, with the aim of a collective 30% cut in methane production by 2030. Stringent policies on agriculture, industry, and waste management are needed to meet this pledge.
There is no doubt that the current system of scope 3 disclosures (which asks banks to audit their balance sheets and report on the CO2 production they have financed) is only a small tip of a large iceberg in terms of financial risks caused by climate change and the policies designed to combat it in the EU. These material risks to banks’ balance sheets and profitability need to be measured and managed as a specific risk category.
GreenCap believes that banks must be able to:
- Measure the impact of known and expected climate policy on their current balance sheet.
- Compare the financial impact of climate change documented to the reported ‘scope 3’ disclosures, so that the emissions reporting is consistent with the actual risks to the bank, and where it is not, the discrepancy can be explained to the management and investors.
- Put in place strategies that are understandable and well-communicated to manage the transition from a bank liquidity perspective by implementing hard green targets for the balance sheets.
- Encourage new borrowers and existing customers to adapt or innovate from the old ‘brown’ economy to the new ‘green’ one.
With a framework in place to achieve these goals, banks can become the engine of change that could realize the ambitions of the EU ‘Green Deal’, from implementing its recent policies through to the 55% CO2 and 30% Methane reductions by 2030 and beyond.