Climate Change’s Impact on Global Banks

By Marilyn Johnson and Tom Lyons

In today’s edition of On the Trading Desk®, Tom Lyons, Head of Climate Investment Research, and Robert Montague, Senior Analyst for Global Credit Research, share some of their findings regarding climate change’s impact on global banks.

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Marilyn Johnson: I’m Marilyn Johnson and you’re listening to On the Trading Desk®. In this podcast, we’re focusing on the impact of climate change on global banks, which is the focus of the recently published report titled, Climate change’s impact on global banks: A matter of degrees.

Our guests today are Tom Lyons, Head of Climate Investment Research, and Robert Montague, Senior Analyst for Global Credit Research, who are two of the report’s authors. Tom and Robert, welcome to the program!

Tom Lyons: Thanks, Marilyn.

Robert Montague: Good to be here.

Marilyn: So Tom, let’s start at the beginning. What was the motivation behind this analysis?

Tom: Three years ago actually, when we started our Climate Change Working Group, the goal was to, number one, acknowledge at the firm level just how consequential climate risks were to all of our investment strategies, but then also to create a game plan as to how we were going to supply the needed research and investment decision-making that all of our clients depend on and how to express those through our various investment teams.

So we did a lot of research, and two of the most staggering observations that came out of the research really were the motivation for this paper.

They were, first of all, the extreme scale of the investment required to have any hope of really aligning with the Paris Accord’s objectives. The IEA, or International Energy Agency, estimates the amount of investment of something that could well exceed $150 trillion equivalent. So extremely big, roughly one and a half times the size of either the global equity or credit markets.

But also the incredible speed with which we need to act. Last week, the Intergovernmental Panel on Climate Change reminded us, this time in even starker terms, that if we continue to emit at current levels, we will exhaust the carbon budget that remains within the bounds of the Paris Accord to keep warming well below 2 degrees by the end of the century, and we’ll exhaust it before the end of this decade.

So massive scale, very quick pace, and, therefore, urgency to get to the bottom of how we’re going to decarbonize. The banking sector’s at the spearhead of all this, as we’ll talk about more in this conversation.

Marilyn: You know, it’s interesting that the market has had trouble figuring out climate change’s possible impacts on banks. What do you think has made this difficult?

Tom: That’s a very interesting question, and we did try to consider it in some detail in our note.

Two of the observations we made are as follows: First of all, the question’s tough. The various mechanisms with which climate risks filter through things like the physical effects expressed through weather and temperature, the technology responses that the economy is presenting to us and to banks each day, the regulatory responses of the various bank regulators around the world are all very tough to be specific about right now and, therefore, they make it difficult to talk about the implications for banks.

And the very long timeframe that’s involved here doesn’t make life any easier. And in fact, there have been many leading management consulting firms, economists, and other experts that have argued that as we get into the second half of the century, the physical effects of climate alone could easily cause global gross domestic product to contract.

So although there is research out there, the complexity involved in the research over the very long term is so serious that I just think it’s been hard for the market to digest.

Now that’s a statement about the very long-term. Add to that, the near-term reality, say, over the next 10 years, that the massive amount of investment that the global economy is likely to make to combat climate change could turn things around and expand banks’ opportunity set.

Banks are going to not only need to lend to help governments and companies make necessary investments, they’re going to raise additional capital, they’re going to syndicate it, affiliates of theirs are going to manage it and even insure it. So you might actually in the near term, 5 to 10 years, see a positive impact for banks. All this makes for tough analysis.

Finally and very briefly, I just add that there’s a practical obstacle, which is the current approach that most analysts take to valuing banks is relatively short-term focused. So clearly, that focus is going to need to extend to pick up and really try to reflect the conflicting trends that we see for banks.

Marilyn: From what you’ve just described, this must’ve been a truly complex project. Who did you partner with to conduct the analysis and produce the results?

Tom: So in our firm, we have a Climate Change Working Group that comprises credit and equity team members from around the firm, mainly portfolio managers and analysts.

We also have a Sustainable Investments Team, led by Chris McKnett and Hannah Skeates. We have 14 permanent members that include all these groups and we meet every week. And then we have about 30 or 40 observers from other parts of the business that attend when the topic is relevant to what they’re doing day-to-day.

So we draw on contributions from all of these folks, as well as interviews with companies and regulators outside the firm.

Marilyn: So I have a question for you Robert. I think it’s important to hear why banks are so important to you and your clients. Can you tell us about that?

Robert: Sure, Marilyn. There are a couple of important reasons.

First of all, banks account for about 40% of the global and U.S. agg corporate indices, which I don’t need to tell you is a very significant portion of those indices.

Secondly, banks at first glance appear to be marginal offenders when it comes to climate change with minor scope 1 and scope 2 emissions compared to much of the industry. But they fund most of the world’s heaviest CO2-emitting sectors, so they have huge scope 3 emissions, three times the size of scope 1 and 2 emissions.

Finally, I think it’s worth pointing out that banks have been at the epicenter of many of society’s greatest catastrophes. For example, financing wars and causing financial crises, but they’ve also led the recovery out of them, be it recessions or pandemics, just as one we’re currently experiencing. And they have enabled huge advances to industrialization. It’s only logical that governments globally who are determined to combat climate change will look to banks to channel capital to the best solutions and financial innovation will be key.

Marilyn: So what were the main conclusions from the analysis, Robert?

Robert: Marilyn, we’ve drawn four main conclusions.

Firstly, more risk and higher cost of capital at the sector level. Climate change is making the economy, and therefore, bank assets riskier.

Also, more growth near-term at the sector level as hundreds of trillions of dollars must be invested to meet Paris goals, even if climate change may reverse growth over the long term.

We also foresee more dispersion at the company level over time as the ability to manage climate risk will vary greatly among firms.

And finally, we see an increase in premiums for good security selection. With this in mind, our climate transition framework gives us a good start in choosing the right firms to invest in.

Marilyn: So Tom, based on everything that’s been learned from the analysis, what’s being done and what’s in the works?

Tom: We’re doing our best to mobilize all of the investment teams that focused on corporates around not only the bank analysis that we’ve done, but on how we applied our analytical construct, the transition framework, to all industries in all parts of the economy.

So for example, right now, our firm has in excess of two dozen different investment strategies. We’re working to collaborate with the leadership, analysts, and other team members in each of these strategies to share insights and try and adapt what we’ve done in this note to how they approach value and risk.

And the most immediate step we’re taking, Marilyn, is really to collaborate with the teams as seamlessly as we can to allow them to process our insights and apply them in their own signature fashion.

After that, as we go forward, we’re going to do our best to take feedback from the investment teams and our investors themselves to try and refine our approach and make it better.

And from there, it will just be a matter of applying it day-to-day, investment decision-making around the various strategies, to try and deliver the best climate results and financial results for our clients.

Marilyn: Well, thank you, Tom and Robert, for sharing some key insights from your research on the effects of climate change on the banking industry. Do you have any final thoughts you’d like to leave with our listeners?

Tom: Yes, in fact, there are. This is the fifth in a series of papers that we’ve written on how climate change affects the value today of companies throughout our portfolios. We’d be happy to speak more with any of the listeners, share with them the other research we’ve done, and, if helpful, talk to them about how to apply the insights to their own investment decision-making. So thanks everybody and we look forward to continuing the dialogue.

Robert: Yeah, and thanks for having me on, as well.

Marilyn: Well, thanks to both of you for taking the time to speak with us today. And that wraps up this episode of the On the Trading Desk podcast. If you’d like to read more market insights and investment perspectives from our investment teams, you can find them on our AdvantageVoice® blog, as well as by visiting our firm’s website. You’ll also find there the report titled, Climate change’s impact on global banks: A matter of degrees.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on iTunes, Spotify, Stitcher, Overcast, or Google podcasts. Until next time, I’m Marilyn Johnson; thanks for joining us.

Originally Posted on August 19, 2021 – Climate Change’s Impact on Global Banks

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