Skip to navigationSkip to contentSkip to footerHelp using this website - Accessibility statement
Advertisement

ESG is the new big risk for banks: law firm

James Eyers
James EyersSenior Reporter

Subscribe to gift this article

Gift 5 articles to anyone you choose each month when you subscribe.

Subscribe now

Already a subscriber?

Banks have been put on notice they face ongoing “regulatory evangelism” as agencies jump on national commitments to net zero emissions, exposing them to a slew of new risks such as enforcement actions for greenwashing and even new capital penalties linked to fossil fuel lending.

Law firm Herbert Smith Freehills said banks will need to confront rising pressure from institutional investors and climate activists along with intense scrutiny from regulators, even as climate-related disclosures still lack standardised terms.

Climate change activists read mock newspapers in George Square, Glasgow, on Sunday outside COP26. Getty Images

While banks appear “culturally inclined” to get on board with environmental, social and governance (ESG) requirements, tackling them will require a “fundamental reappraisal of their systems and processes,” said the report overseen by the firm’s three co-chairs for global banking, Hannah Cassidy, Simon Clarke and Tony Damian.

“Prodding and rhetoric will be soon replaced with the threat of enforcement and spectre of sanctions as a host of new requirements come in,” they said.

“Within five years, banks will face far tougher scrutiny of their climate exposures and the tools they are using to identify, measure, monitor and manage them. Within 10, they will likely have to set their capital buffers to reflect the climate risks in their loan books.”

Advertisement

For now, most of the focus is on the amount lent to fossil fuel emitting companies in various sectors. National Australia Bank will release its full-year results on Tuesday, which could contain its new oil and gas lending policy, as activists pile on pressure over loans to gas companies. ANZ is also expected to release a new fossil fuel policy this month.

Activist shareholder pressure will continue, Herbert Smith Freehills said, and while campaigns targeting banks have so far been “mostly limited to groups of institutional shareholders voicing concerns, rather than one individual fund making climate change demands as part of a broader investment thesis”, if such campaigns fail, then “funds may turn their attention to financing players”.

But bank regulators could even pose larger risk challenges, including from prudential stress tests underway, and from consumer protection, and competition, enforcers.

“As pressure to tackle climate change mounts, regulators are likely to favour decisive action even if the precise form of that action remains unresolved,” the report said.

The Australian Prudential Regulation Authority is currently conducting Climate Vulnerability Assessments (CVAs), similar to tests in other jurisdictions including Europe. In September, the European Central Bank pointed to around one-third of loans having “a significant or increasing degree exposed to climate risks from extreme weather events” and ECB president Christine Lagarde told banks in Europe that “while transition costs may be higher in the short term, they are much lower in the long run than the costs of unrestrained climate change”.

But the law firm points to numerous challenges for regulators as well, as they seek to monitor bank exposures. For example, in France, climate stress tests revealed problems identifying the geographical location of exposures at a group level, modelling challenges, gaps in counterparty data, and a lack of integration of climate considerations into risk architecture.

Advertisement

Capital ‘only a matter of time’

APRA is preparing a new practice guide that will assist banks and insurers to identify, monitor and manage the climate-related risks they are exposed to. APRA said last week the new guidance will provide guidance “on prudent practice in the management of financial risks arising from climate change, including with respect to governance, risk management, scenario analysis and disclosure”.

The Bank of England and APRA have said their climate stress tests currently underway will not influence capital requirements.

However, Herbert Smith Freehills reckons this is a risk banks should be planning for.

Former US vice president Al Gore said before COP26 that banks’ regulatory capital requirements should be changed to incorporate climate change.

“While UK and Australian regulators state stress testing will not trigger immediate changes to capital requirements, it seems only a matter of time before such considerations influence capital policy,” Herbert Smith Freehills said.

Advertisement

Other regulators could hamper the collaboration global authorities say is necessary to work out solutions that reduce the rate of planetary heating, because banks coming together to talk about common approaches could rub up against competition laws.

The ACCC has been considering some applications for authorisation to permit firms to collaborate on ESG initiatives and to reduce risks. The firm says collaborative initiatives “should be open to all comers, and not leveraged as an opportunity to improve the market position of some banks only”.

The Australian Securities and Investments Commission, meanwhile, could consider more actions for greenwashing, given a review of managed funds and superannuation funds to assess whether investment strategies were “as green or ESG-focused as claimed”. ANZ Bank CEO Shayne Elliott also called out growing greenwashing risks last month.

“The next five years will bring far greater risks attaching to perceived overstatements in green rhetoric than anything the industry has yet witnessed,” Herbert Smith Freehills said.

With Macquarie estimating the Asian region will see up to $US250 billion of new investment flow into utility scale renewable energy projects by 2025, the quality of disclosure from potential borrowers presents another risk, as banks work out new models for assessing credit applications for funding of green projects.

“Warning bells are already being sounded about the risk of the current investment boom in clean energy and sustainable investments creating a ‘green bubble’, in which pricing is driven by investor sentiment rather than fundamentals,” the law firm says. “If that eventuates, losses incurred in a subsequent correction will surely stoke litigation and mis-selling claims.”

James Eyers writes on banking, payments and fintech. He is a former legal and investment banking editor at the AFR, has degrees in commerce and law from UNSW, and is co-author of Buy now, pay later: The extraordinary story of Afterpay Connect with James on Twitter. Email James at jeyers@afr.com.au

Subscribe to gift this article

Gift 5 articles to anyone you choose each month when you subscribe.

Subscribe now

Already a subscriber?

Read More

Latest In Financial services

Fetching latest articles

Most Viewed In Companies