More carbon, more interest:  Europe’s banks price in climate risk

Brad Lander, New York City’s Comptroller, was keeping a close eye on Bank of America’s 2024 annual general meeting. For the first time in their history, the NYC retirement systems had filed a proposal asking the bank to disclose a metric: the clean energy supply financing ratio. Put simply, the metric compares the bank’s financing of clean energy relative to fossil fuels.

“Three of the largest North American banks (JPMorgan Chase, Citi and the Royal Bank of Canada) have already agreed to disclose this important metric following engagement with my office. We expect this to become a standard disclosure for banks and an increasingly important tool for investors to evaluate a banks’ climate risk”, said Lander.

At the AGM in April, the proposal received 26% shareholder support.

The proposal speaks to a wider conversation around how climate risk determines who banks lend to and at what cost. New research by the European Central Bank (ECB) suggests that euro area banks are pricing in climate risk in their lending decisions. Banks are not only charging higher interest rates for high-emission companies but also reducing the rate if companies commit to emission reduction in the future.

New risk, new models

The ECB’s research draws on a confidential database covering all euro area banks’ lending to publicly listed companies between September 2018 and December 2022. The focus on public companies has to do with their emissions profile being more transparent than private companies.

The primary channel through which climate risk affects a bank’s lending is credit risk. For instance, a bank may expect future changes in regulations - such as a carbon tax - to negatively affect a firm’s profitability. However, given that techniques to assess credit risk are products of the past, their applicability to such risk assessments is unclear:

“The typical models that banks use to assess credit risk may be unable to capture tail-risk events such as future changes in regulation or in technology”, the ECB says. Updated climate risk models then, seem necessary.

Climate risk as credit risk

Assuming the models are in place, the next step is to break down climate risk into its two components: physical and transition risks. Each of which affect credit risk to varying degrees and over different time periods.

Physical risks to some extent, tend to be of immediate concern. For instance, researchers have found evidence that the risk of the company’s location being exposed to natural disasters - exacerbated by climate change - brings with it the prospect of higher interest rates.

Transition risks, on the other hand, play out over the long term. Changes in regulations or markets and their effect on the future financial health of a borrower are prime examples.

The ECB’s research examined emissions footprint as a proxy for climate risk, implying a greater emphasis on transition risk. The findings suggest that euro area banks charge higher interest rates if the borrowing company has higher emissions.

In addition, banks reward commitments to reduce emission in the future. The data shows that on average, companies with such commitments pay 20 basis points less in interest than uncommitted peers.

“Euro area banks charge a higher interest rate to firms with higher current carbon emissions and a lower rate to those that commit to reducing their emissions in the future”, the research finds.

Banking with an agenda

When it comes to decarbonising their financing activities, all banks are different. As the NYC Comptroller’s experience with North American banks shows, lenders vary in their commitments to reducing financed emissions. In Europe too, this seems true.

The ECB’s research considered whether a bank’s SBTi commitment affects how it prices in climate risk. The evidence suggests that decarbonisation commitments are correlated with a higher price on climate risk.

“Banks appear to live up to their word on the issue of climate risk pricing: those that signed a commitment letter within the SBTi indeed provide cheaper loans to firms that commit to decarbonization and, to a smaller extent, penalize more polluting firms”, the research concludes.

Lastly, the results also show that the central bank itself has a role to play – contractionary monetary policy increases climate risk premium in lending. As banks move to price in climate risk, they inevitably add another layer to the conversations between central bankers and climate change. 

Asset owners, such as the NYC retirement systems, are pushing banks to decarbonise their loan book and incentivise clean energy investment through their lending. The ECB’s research suggests that euro area banks might be willing to pay heed to their advice.