Climate change is on everyone’s lips, but what does it mean for financial institutions? Banks are looking closely at the risks it poses and some, including ING, are taking bold steps to quantify and mitigate them. With a new working group on climate change, yearly progress reports, and a so-called ‘Terra Approach’ to encourage sustainable banking, ING is seeing a tangible impact on its business.

Jim Banks talk to Anne-Sophie Castelnau, the Dutch bank’s new head of sustainability, as well as a representative of the European Banking Authority, to explore the unique nature of climate risk and how it will affect banks’ activities.

Climate change can be a divisive topic. A quick search online will reveal wildly different ideas about its underlying causes – and whether it’s even genuine. Nevertheless, consensus is building around two key concepts: that climate change is actually real and that it’s caused, at least in part, by human activity.

The Sixth Assessment Report by the Intergovernmental Panel on Climate Change, published in 2021, casts human-influenced climate change as a major threat to the environment, bringing risks of rising sea levels, melting glaciers, heatwaves, droughts and flooding.

The World Economic Forum’s Global Risks Report 2021, for its part, highlights the potentially disastrous impact on biodiversity. Both emphasise that concerted global action is needed – fast.

Regulators have been quick to act on carbon emissions and other greenhouse gases. The EU, for example, has now enshrined its net-zero carbon targets into law, with new legislation being proposed to cut emissions by 55% by 2030.

National governments are following suit. For banks, this means operational changes to tackle their own emissions, but for the financial services industry there is a much more immediate consideration – what does action on climate risk mean for their lending activities?

“Climate change is increasingly contributing to society’s exposure to a range of acute and chronic physical risks,” says Anne-Sophie Castelnau, the new head of sustainability at Dutch bank ING.

“These risks and the financial implications attached will inevitably impact both our clients and our balance sheet, hence a critical process is required to assess these risks and integrate them into our overall risk management framework. You can’t look at financing anymore without also looking at climate risk.”

A rational view of climate risk

For banks, there are two kinds of climate risk – physical risks and transition risks. Physical risks are those that arise from the tangible effects of climate change, including extreme weather events or rising sea levels, on business operations, workforce, markets, infrastructure, raw materials and assets.

Transition risks result from the policy, legal, technology and market changes occurring in the shift to a lower-carbon global economy, which could include carbon taxes or restrictions on land use.

“Transition risks could result in stranded assets, or even markets, by the loss of value of assets that are no longer part of a more sustainable world,” Castelnau explains.

“For ING, managing climate risks covers both physical risks and transition risks,” she continues.

“To get an understanding of our exposure to climate risk and the impact on our business, we are focusing our analysis on those sectors likely to be most severely affected by climate change and advancing our work on the identification and covering of climate risk. All relevant risks should be considered in our risk management framework and integrated into a forward-looking approach.”

That’s especially true given new regulation coming round the bend. The 2021 Biennial Exploratory Scenario (BES) by the Bank of England will be devoted to the financial risks of climate change.

From this, new requirements could emerge that would force many institutions to ramp up their capabilities for the collection of data about physical and transition risks, modelling methodologies, risk assessment and risk management.

At present, many European banks fail to disclose risks beyond their most carbon-intensive clients, according to a survey by the European Banking Authority (EBA).

“For ING, managing climate risks covers both physical risks and transition risks.”

“Climate risks are relatively new risks that require different and additional information to be assessed,” says an EBA spokesperson. “This forces banks to also update their internal data infrastructures accordingly. There are different dimensions to consider when comparing climate risk data to the one used for standard financial risk assessment.

Regarding data availability, some of the key information like carbon footprints or transition strategies are not yet fully available and, therefore, in many cases this leads to using proxies, which are less accurate. Historical observations are not good predictors for future patterns and cannot help in bridging these gaps.”

In May, the EBA published the findings of its first EU-wide pilot exercise on climate risk, for which the main objective was to map banks’ exposures to climate risk – and provide an insight into the green estimation efforts banks have carried out so far.

“In general, the experience gained with the pilot exercise helped us to understand where banks stand in terms of data capabilities to assess climate risk,” the EBA source explains.

“In this regard, banks are making a significant effort in expanding their data infrastructures but there is still a lot of work to be done, especially concerning client specific information at activity level.

“Banks are more aware now of the significant challenges needed to measure and assess climate risks and that additional effort should be put in terms of governance, resources, analytical tools and data infrastructure to make their portfolios less carbon-intensive and more resilient to climate risk shocks.”

Some banks have been very open about their exposure to climate risk and are taking steps to address both physical and transition risks.

Deutsche Bank, for example, is facilitating over €200bn in sustainable financing and investments by 2023 to support sustainable economic development.

It is also working to align its credit portfolios with the goals of the Paris Agreement, which encompasses a commitment to introducing methods of measuring climate impact by the end of 2022. Deutsche Bank also plans to end global business activities in coal mining by 2025.

Perhaps the bank with the most comprehensive plan, however, is ING. As part of its commitment to developing an industry-wide standard for climate risk and increasing transparency around its activities, in 2018 it signed up to the Katowice Commitment.

A pledge to steer portfolios towards the well-below two-degree goal of the Paris Climate Agreement, the commitment was also signed by BBVA, BNP Paribas, Société Générale and Standard Chartered. In 2019, this laid the foundation for the UN-backed Collective Commitment to Climate Action, signed by ING and more than 30 other banks that together represent $13tn in loans.

More recently, ING has helped to shape the Net-Zero Banking Alliance and the accompanying guidelines for target-setting. All of this is part of its so-called Terra Approach, which seeks to measure climate risk in new and innovative ways that go beyond traditional measures of risk – by creating detailed scenarios for how the bank and its clients can achieve decarbonisation.

Steering the world to zero carbon

Thanks to carbon offsetting, ING’s own operations have been carbon neutral since 2007, though the bank still continues to lower its greenhouse gas emissions across its buildings and business travel requirements.

As a result, the key thrust of the Terra Approach is the effort to align ING’s €700bn lending portfolio with a net-zero future by 2050 (or sooner). Initially, this involves creating a loan book that will help to keep the rise in global temperatures to a maximum of 1.5°C.

“While the decarbonisation pathways foresee a rather linear decrease in emissions, we believe a paradigm shift is more likely once low-carbon alternatives become commercially viable and scalable, which is not yet the case,” believes Castelnau.

“But progress is being made and more and more capital is being allocated to further these technologies. Overall, our Terra Approach provides much-needed transparency to carbon-intensive sectors, and we continue to take a proactive role in supporting our clients to transform their business models as well as calling on governments to create the right incentives and policy environment.”

In practical terms, ING is aiming for an energy-positive portfolio in both its Dutch commercial real estate portfolio in the Netherlands and its mortgage lending. It will also reduce financing to coal power generation to nearly zero by 2025 – and review lending to the power generation, automotive, shipping and aviation industries, among others.

“As a bank, we are a participant in the real economy and believe in dialogue and transition over exclusion,” says Castelnau. “That’s why we choose to be part of the solution by providing transition finance for best-in-class assets and by developing industry-guiding standards.

“And for some sectors, we see a decrease is necessary. For instance, we aim to decrease funding to upstream oil and gas by 12% by 2025, which is a new, intermediate target that can help us steer and be held accountable.”

The Terra Approach heavily relies on analysing scenarios that ING’s economics department have developed from policy and technology drivers. The bank created four short to medium-term scenarios, choosing the two most extreme examples to translate into financial risks and business decision-making processes.

In the automotive sector, for example, the bank measures the current mix of clients’ production of internal combustion engine vehicles compared with zero-emission vehicles and how clients plan to shift this balance over time.

This can be compared with the projections made by the scientific community about how the automotive sector might seek to transition to net-zero carbon by 2050, and tracking each client’s progress along that pathway.

“What we learn helps us make our business decisions,” Castelnau explains. “And how we do this continues to evolve in line with developing regulations and methodologies. This is why our inclusive approach around climate change is so important. Only through engagement with our clients are we able to detect the right risks and, with that, also support them in becoming more resilient.”

Banks, in short, are not simply waking up to the broad notion of climate change. Rather, they are fully engaged with the detail of climate risk.

More to the point, they not only manage their own environmental impact, but also battle to steer their lending activities towards a carbon neutral future. Though there is certainly a long way for the financial services industry to go, in other words, it has set out on the journey with purpose.

This article originally appeared in Future Banking winter 2021.