Fossil fuel lending is a financial stability issue
Aug 10, 2020
The decline of fossil fuel systems is not only a threat to investor returns, but also to financial stability. NGO Finance Watch argues this should have implications for how banks are regulated, and urges regulators to use their powers to intervene without delay
NGOs and others have been asking banks to cut their oil and gas lending for years, often using well-established moral or scientific arguments, and pointing out that the global carbon budget will be exhausted within 10 to 15 years.
But rapid progress in the renewable energy sector and shifting away from fossil fuels could also have financial consequences, overtaking the oil and gas sector and potentially endangering financial stability.
Financial regulators have a legal obligation to protect the prudential safety of banks and other financial companies. Finance Watch’s head of research and advocacy, Thierry Philipponnat, argues in a recent report, Breaking the Climate Finance Doom Loop, that prudential risks of fossil fuel lending are escalating and regulators should step in soon. .
“It’s a prudential question, pure and simple. Fossil fuel lending is becoming increasingly risky, and regulators have a legal obligation to ensure that banks are capitalized to withstand losses on their fossil fuel assets. must apply them, ”he said.
The risks of not taking action became evident in June when Shell and BP wrote down nearly $ 40 billion in the value of their oil and gas assets. The oil majors had each seen their market values halved over the past 12 months, wiping out more than 160 billion euros in investor equity.
For financial stability, however, fairness is just the tip of the iceberg. Syndicated bank loans represent an increasingly important part of oil and gas financing; in total, banks provided $ 2.7 trillion to the oil and gas industry in the four years following the Paris Agreement. If worsening conditions in the oil and gas sector cause some of these loans to write down, the losses will hit the banking sector and, if not absorbed by it, will trickle down further into the financial system.
Philipponnat, who is also a member of the board of directors of the Autorité des marchés financiers (AMF) and chairman of its climate and sustainable finance committee, argues that regulators have a duty to break what he calls the “catastrophic climate loop. -finance ”, in which investments in fossil fuels enable climate change, and climate change acts as a threat to financial stability.
“Lending for the fossil fuel activity creates two risks: it creates a financial asset that could become stranded, and it fuels broader macroprudential risks by contributing to climate change,” he says.
So far, the main response from financial regulators has been to improve transparency so that investors can more easily divest; and conduct climate stress tests, which examine how financial institutions might fare under different climate change scenarios.
However, the stress tests only examine the direct risks that climate change could bring, primarily the transition risk and the physical risk. The indirect risks of disrupting economies in general could be much greater and are almost impossible to model, as the Covid-19 crisis has shown.
Efforts by financial regulators to intervene directly have become bogged down in legal and mathematical discussions that could take years to resolve, by the time the planet’s carbon budget is nearly depleted.
This delay is rooted in a paradox: policymakers recognize the near impossibility of modeling climate-related risks, but say they need such modeling done before intervening. Unfortunately, given the short time available, late action is tantamount to doing nothing.
Central bankers are realizing this and some have already called for less modeling and more action.
According to Finance Watch, the EU already has a general legal basis for acting, based on the Treaty on the Functioning of the European Union, which establishes the precautionary principle as a guiding principle.
There is also a specific legal basis for action in the EU Capital Requirements Regulation (CRR). The CRR is designed to prevent financial instability and provides, among other things, for higher risk weights in situations where the risk of loss cannot be accurately measured even though its occurrence is highly probable.
Risk weighting is part of the Basel model of banking regulation in which capital requirements are applied to banks’ assets after each asset has been adjusted to reflect its risk. An asset deemed “safe” from the bank’s point of view, such as a mortgage or sovereign exposure, could have a risk weight of 20% or zero, for example. A capital requirement of, say 8%, is applied only to the risk-adjusted value, which means that the bank can finance the asset almost entirely with debt, which makes the asset more profitable for the bank, if there is no fault.
An asset deemed to be riskier, such as an unsecured loan to a start-up company, may have a weighting of 100%, which means that the bank must apply the capital requirement of 8% on the total amount, so that the bank can only finance 92% of the loan with debt. The rest is provided in the form of equity, which can absorb losses.
Fossil fuel loans are subject to the risk of becoming “stranded” and contributing to macroprudential risks by promoting climate change. These are risks that are very likely to materialize but difficult to model in advance, given the lack of historical data.
Philipponnat argues that CRR provides a basis for requiring banks to have more capital for assets with these characteristics. Article 128 of the CRR applies weightings of 150% to exposures associated with particularly high or difficult to value risks, such as private equity or speculative real estate loans. Loans for existing fossil fuel assets could be added to this category, he says.
Lending to finance exploration for new fossil fuel reserves is riskier, with a virtual certainty that new reserves explored today will be stranded before the end of their normal operating cycle. Article 501 of the CRR provides that risk weights must be applied qualitatively in certain categories, for example allowing lower risk weights for loans to SMEs.
Philipponnat argues that this article could be adapted to apply a risk weight of 1250% to new exposures to fossil fuels. Multiplied by an 8% capital requirement, this would require new fossil fuel exposures to be fully equity funded, which is appropriate for the level of risk involved.
These measures would require legislative work to become permanent but, with the intensification of risks, they could already be implemented as temporary measures under Article 459 of CRR, which allows the European Commission to “impose , for a period of one year, stricter prudential requirements. for exposures when necessary to cope with changes in the intensity of micro-prudential and macro-prudential risks “.
Given the global nature of the problem, Finance Watch recommends that this risk-based approach be presented for use in other jurisdictions through the Basel Committee for Banking Supervision and the Financial Stability Board.
Tackling the impact of climate change on financial stability is a realistic and increasingly urgent goal; the last thing a warming planet has is another financial crisis.
Given the enormous impact on human societies, the cost of measures to break the catastrophic loop of climate finance is rather moderate. This does not mean that these measures will not harm certain private interests in the short term but, with all the understanding that one can have for private actors defending their profitability, there is no doubt that the general interest calls for to action and that it is the duty of decision-makers to seize it, especially when they have the possibility and the tools to do so.
Greg Ford is Senior Advisor at Finance Watch.