Current and former central bankers are saying that the coronavirus pandemic offers a unique chance to green the global economy. Yet in the UK, we have seen a signalled approach from the Bank of England, even before the crisis arrived, that did not align with the speed of change needed in the banking industry to address climate change.
Net-zero targets and commitments from big banks show great intention, but in this article I would like to explain that without strong asset-level steering, such as ‘green supporting’ or ‘brown penalising’ factors, the Bank of England’s planned macro-level approach will not be sufficient given the scale of the challenge ahead. The central bank must be bold and go beyond stress testing and reporting to strong asset steering, incentivising or penalising banks based on their behaviours related to climate change and potentially other environmental issues that are creating similar global systemic risks.
It was nearly twenty years ago when I first realised that our current banking system undermines the sustainability goals to which I have spent my career trying to contribute. It took me most of those intervening years to understand many of the complexities and dynamics that need to change in banking. But I hope, being an untypical banker, I can also communicate the issues in a way that is accessible to those not familiar with banking.
Our financial system encompasses stock markets, pension funds, banks and more. These are all important and all need to change to play a role, not just in addressing climate change, but in delivering the UN Sustainable Development Goals (SDGs). However, I believe it is changing ‘retail banks’ that is most key. Retail banks means those that take deposits from, or provide loans to, real people and real businesses, often referred to as the ‘real economy’.
The reason retail banks are so important is because through their connection to the real economy they are the banks in which climate-change-related risks and impacts will crystallise first, and by contrast it is also where we have the greatest opportunity to deliver widespread diffuse change in the real economy. Banks could play a positive role through steering the flows of money to more sustainable businesses and activities, and through creating products that incentivise behavioural change amongst their individual customers too.
The risks associated with climate change
The issue of climate risks crystallising within banks has been argued by many for some years now. Central banks such as the Bank of England, which have the responsibility for regulating banks to ensure the stability of the system, now also recognise that banks are exposed to huge risks through climate change.
Banks are exposed to ‘physical risks’ through flooding, wildfires and other extreme events affecting the organisations and people they finance and their ability to make repayments. They may also be supporting industries which will face ‘transition risks’ through high costs or challenges in adapting their business models to a sustainable approach (e.g. fossil fuel companies). Businesses banks finance may also be exposed to ‘litigation risk’ if climate change impacts or other environmental disasters can be traced to their activities, indeed banks themselves may face litigation. Finally, banks have ‘reputation risk’, and various NGOs are now targeting banks financing of fossil fuels, palm oil deforestation and other environmentally damaging activities. Ensuring banks take reputational risk seriously is something we all have a responsibility for and hold more power than we perhaps realise in that respect.
These risks cannot be managed in the same way banks have historically managed individual industry or economic risks. Climate change risks will correlate and come on a scale not previously anticipated as we are starting to see with extreme weather events and wildfires occurring at unprecedented scale. The financial markets are even starting to recognise this with some fund managers seeking to ‘short’ or bet against the Residential Mortgage Backed Securities (RMBS) market in flood prone areas of the US in the same way they did against the subprime mortgage market ahead of the 2007/08 financial crisis.
Multiple points of influence
We not only need to force banks to manage climate change risks in order to ensure future stability with the wider financial system and economy, we also need to recognise that banks are part of the problem in fuelling climate change as well as other environmental crises. These crises are creating systemic risks for our society and economy, and we must change the role of banks in that.
There are multiple points of influence to change banking, including government, central banks or regulators, banks themselves, shareholders and all of us as customers of banks. The role of regulators is particularly key, and existing mechanisms of regulation can be adapted to turn banking into a positive environmental and social force.
The Bank of England had led the way in one respect through becoming the first central bank to announce that it would require banks to undertake climate-risk-related stress tests, which will provide transparency on their future financial exposure to climate events (physical risk) or to governments having to react much faster in legislating against activities in which banks have already invested (transition risk). The vision of the Bank of England’s approach is to push banks to own climate change risk and make them accountable to regulators for both how they are managing the risks they are exposed to and for the systemic risks they are creating in financing projects that fuel climate change. Given the coronavirus crisis, the Bank of England has now announced it will no longer be pioneering the climate stress tests for banks and insurers later this year. Whilst the Bank of England’s advocacy on climate change action drew much praise, its approach was questionable in terms of the speed at which it would have any effect, and in postponing its stress tests, other central banks are now leading the way.
Within the EU and European Central Bank (ECB) they have been creating a ‘taxonomy’ to define what should be seen as ‘green’ and what is ‘brown’ across seven industrial sectors and 67 different business activities, and this is in consultation stages with an associated eco-label available for qualifying funds and products. The importance of agreeing such definitions is so we all know something is genuinely making a positive contribution to addressing climate change and we are agreeing what is causing environmental harm.
However, the taxonomy is not without its challenges, as some disagree with the definitions or categories adopted, and others say it is too complicated. It can also be argued that it doesn’t go far enough and should be broader than simply ‘green’ to encompass all of the Sustainable Development Goals (SDGs) so that banks are aligning their activities and reporting with those. Nevertheless, the progression of such a taxonomy is essential and I hope it will improve and broaden in time to align to the SDGs. Other questions over the taxonomy approach include accuracy, consensus on definitions and how it can be future-proofed and kept up to date as new technologies and science emerge – but surely that is all manageable. As I will explain, having such a taxonomy is essential to then being able to influence what banks use money for and the impacts it has.
The issue emerging with the UK’s departure from the EU is two contrasting approaches in how banks will be regulated in respect of climate change and their role in creating it – at either a ‘macro’/bank level, as the Bank of England has signalled, or at an individual ‘asset’/loan level as per the EU taxonomy. The ultimate tool at the regulators’ disposal is to require banks to hold additional capital (money they have to keep in case of a rainy day and to buffer them against shocks). The amount of capital that banks have to hold against individual loans and as an overall organisation defines the profitability of both.
In the UK, Triodos Bank is a large lender to social housing, as part of a focus on only financing organisations and projects that deliver positive social or environmental benefit. The sector is seen as low risk because there will always be a need for social housing; even if a housing association failed, then a bank can sell the properties to another association or seek approval to sell on the open market to repay the loans. Therefore, banks are only required to hold 35% of the capital they would hold verses a standard business loan. The use of such percentages is called ‘risk weightings’, and the impact of a lower weighting in the case of social housing is to make the loan more profitable for the bank and drive down the interest rates charged to that sector. Imagine the impact on low-carbon industries if the same were to apply, or conversely if the costs of borrowing were pushed up through higher than 100% weightings for fossil fuels or other ‘brown’ assets.
The ECB had already indicated it would apply 75% weightings to renewable energy assets from 2021 but accelerated this to June 2020 as part of its response to the coronavirus pandemic, enabling banks to lend more. Due to the fact the UK was still in the transition period, we have been obliged to adopt this reduced weighting but the UK’s approach on such issues in the longer term has not been confirmed.
The ‘dirty secret’ in risk weightings is that fossil fuels are estimated to benefit from just a 20% weighting, meaning they benefit from some of the cheapest borrowing available. This low weighting is because fossil fuel companies are large corporates, usually with a strong credit rating. If central banks really believe in avoiding the global system risks from climate change then this has to be tackled. Addressing climate change does not simply mean encouraging banks to own the future risks they are fuelling but changing the role of central banks so – rather than propping up the current economic paradigm through risk management – they strongly influence the emergence of a new future economy through how banks use money.
Do we have time?
Neither the macro nor asset-level approach to steering banks is perfect, but the Bank of England’s signalled approach creates a number of issues:
- Speed of response to the climate crisis. In reality, UK banks will now produce their first stress tests in late 2021 at the earliest. Then they will be given feedback on these, and I’m sure a second round will happen as regulators and banks standardise methodologies and understanding. Only then will regulators start to challenge banks on their climate impacts, and banks will first have to be given a chance to implement action plans to reduce their impacts and be monitored against those. Finally, banks may face capital penalties if they are not changing or making sufficient progress against their action plans. In summary, I foresee this will take three or four years before there are any real penalties imposed on banks continuing to finance climate change. Relying on the banking industry to change itself with the threat of future regulatory penalties will mean the speed of change will be too slow relative to the speed of response needed.
- Penalising sustainable and proactive banks. The other issue is that steering banks only at a macro level means that sustainable banks, which have never engaged in the likes of fossil fuels, are potentially worse off when we need them to be growing and doing even more to support renewable energy, as well as using their expertise to support pioneering solutions to the climate emergency. Furthermore, the macro-level approach in isolation may benefit the laggards most. Many banks are taking steps to reduce the carbon footprint of their loan books and working in partnership to create methodologies for industry adoption (like the Partnership for Carbon Accounting Financials which Triodos has been involved in developing). Without any asset-level steering there is no reward for those proactively shifting their portfolios or developing methodologies for the wider industry’s benefit, meaning that the laggards will continue to profit from financing climate change yet benefit from all the investment in methodologies by others.
The combined effect of the above two issues is that the Bank of England’s approach undermines its aspirations to create greater competition and consumer choice in the UK banking sector. The absence of any adopted taxonomy for asset-level steering also leaves the potential for greenwash and banks promoting their own take on what is green, as we have already seen in some green bond issuances.
Therefore, whilst celebrating the Bank of England’s leadership on seeking to embed responsibility and ownership of climate change with banks themselves, I would argue that macro-level steering of banks alone is not sufficient given the scale of the climate emergency and speed of response we need. They are trying to think decades ahead in how they act, but do they have that time? Might a no-regret action by the Bank of England be to apply a lower risk weighting to green loans to free up capital for further growth and reduce the future cost of borrowing for the green technologies and sectors?
Arguments can be made that a detailed taxonomy is needed to be able to apply any asset-level steering. But surely common sense could be applied to some specific sectors, mirroring the EU taxonomy, with some level of application of weightings made given the extent of climate crisis we face? Some might suggest I have a vested interest in calling for a lower weighting for renewable energy assets because Triodos Bank finances a lot of them and it would significantly increase our ability to finance change. The reductions that have just been introduced have significantly benefited Triodos Bank, but we have consistently maintained that the fastest impact would be made on applying premiums (e.g. 125%) to the capital weightings of fossil fuels and other ‘brown’ assets. We were one of the few to oppose reducing ‘green’ factors when the European Commission first launched its action plan on sustainable finance. Penalising ‘brown’ is ultimately the approach that best aligns with the traditional risk-based approach of the banking supervisory framework, where the capital that banks are required to hold is a function of risk.
If I could do one thing in order to prompt the speed of reaction needed it would be to apply penalising risk weightings to high carbon or polluting activities. However, I recognise it is laced with controversies and claims of destabilising banks with huge fossil fuel portfolios. We shouldn’t destabilise banks and the economy for the sake of it, but we must recognise the potential destabilisation from climate change is perhaps much greater. There is a lot of talk about ‘build back better’ after the Covid-19 crisis but this will not happen at any scale unless we shift the relative costs of capital for green vs CO2 intensive industries through risk weightings.
There are real dilemmas in all this, not least the political aspects. Whilst the Bank of England is independent of government, it is undoubtedly influenced by government, and the corridors of power must be filled with thoughts on how not penalising banks will give them a competitive advantage internationally. Although in this day and age one hopes that thoughts over protecting the City fade as we’ve realised ‘it’s about the
economy environment, stupid!’.
There are other geo-political issues. I’m sure the Bank of England’s approach is partly trying to influence the US Federal Reserve, demonstrating there is real climate risk within the banking sector and prompting the engagement and action that is sadly lacking amongst US banks. On such issues, the Glasgow COP next year can play a role. The global banking sector must adopt meaningful targets to reduce carbon emissions, as well as agreeing standard methodologies for measurement and commitments to publish progress reports.
Steering the banking sector to ensure positive impact
At the heart of all of these discussions on taxonomies, methodologies and reporting are detailed discussions about data and our confidence in it. There is a danger this becomes the only discussion, focusing on a burden of proof to show activities are genuinely ‘green’ rather than focusing on the harmful sectors we have to stop financing and the rapid need for change. That change is really about values and not the data kind!
Climate change impacts and risks are the first frontier of regaining control over our banking sector and steering it to ensure it has a positive impact on our social and environmental development. In years to come I am sure that transparent reporting and risk weightings will be commonplace across a range of banking activities, aligning them to the SDGs and a social purpose. This is the start of a debate on the very purpose, and indeed the sanity, of banks and how they operate.
The UK is a G7 economy and a significant contributor to climate change, and we have a responsibility to act. Acting on banking regulation is just one issue. Ensuring that quantitative easing (QE) is green and aligned to SDGs is another major intervention needed, and there are many more. Triodos will continue its advocacy on such issues. Whilst there is lots of positive progress, the regulatory action currently being muted will be too slow, and too few banks are doing too little to change. This is why consumer pressure has never been more important.
About Bevis Watts
Bevis Watts became Chief Executive Officer of Triodos Bank UK Ltd, the wholly-owned subsidiary of Triodos Bank N.V., in May 2019. Prior to this he was Managing Director of Triodos Bank UK for three years, having previously been Head of Business Banking at Triodos for almost five years.
During his time as MD, the bank has delivered strong growth, launched a new personal current account and a crowdfunding platform. He has 20 years’ experience in the wider sustainability field across the private, public and voluntary sectors.
Bevis has always worked for values-led organisations, and before Triodos was Chief Executive of Avon Wildlife Trust and Head of Business Support at The Waste and Resource Action Programme (WRAP). He has held numerous Directorships and Trusteeships and was a Board member of Bristol 2015, the delivery company for Bristol European Green Capital 2015, inaugural Chair of the West of England Nature Partnership, and he was elected to represent Local Nature Partnerships at a national level on the ESI Funds National Growth Board (2013-2015).