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Local banks lead on physical climate risk

EOS Insight
6 June 2024 |
The increased frequency of wildfires and flash flooding is already hitting insurance companies. But what about the climate exposures faced by banks in their mortgage and commercial loan books? Will Farrell investigates.

Fast reading

  • Physical climate risk will vary across a country, with each house having its own physical risk profile, impacted by its unique build quality, positioning, location, and dependence on natural capital.
  • The dispersed nature of physical climate risk favours local banks as they are able to focus their assessment on specific and localised categories of risk.
  • The agricultural sector is particularly exposed to this risk, and nature plays an essential role in building farm resilience against flooding, drought, and other weather-related events.

Investor engagement with banks has tended to focus on the role that they can play in financing the low carbon transition and managing the banks’ transition risk exposure. But as extreme weather events become more frequent, physical climate risks are intensifying on bank balance sheets. How well are banks managing their exposure to physical climate risk – something insurers are more used to considering?

With a high-emitting commercial client, like a steel plant or an oil producer, the risk is concentrated, but banks face a different challenge in their residential mortgage books. Physical climate risk will vary across a country, with each house having its own physical risk profile, impacted by its unique build quality, positioning, location, and dependence on natural capital. Given this dispersal, banks have no easy way to mitigate the risk by tackling a few key customers, as they might with transition risks.

A 2023 Bain & Company and Jupiter Intelligence study modelled a bank with an Italian portfolio and estimated that, without any mitigating actions, the value of the model bank’s mortgage collateral could fall by as much as 10-15% by 2050, hitting the profitability of the bank’s mortgage lending by 7-10%.

However, other risks are similarly dispersed. Credit risk, for example, is an individual element of every transaction. For a long time, banks have “priced” this credit risk at the transaction level. If you have a strong personal credit score, you will benefit from a lower mortgage rate. To price debt, banks can tap into consumer credit scores and company credit ratings, but what tool should they use for pricing physical risks?

Mapping physical climate risk

Global banks tend to benefit from economies of scale in their risk management practices. But the dispersed nature of physical climate risk favours local banks as they are able to focus their assessment on specific and localised categories of risk. For example, Commonwealth Bank of Australia (CBA) maps three material risks to its domestic home loan portfolio: cyclones, wildfires, and flooding. For Realkredit Danmark, flooding is the primary risk to manage, although storm resilience is also a factor.

Many of these banks have completed physical risk mapping exercises and disclosed their aggregate risk exposure. CBA deems 4.6% of its home loan collateral to be at high risk of physical climate damages, while HSBC UK estimates that 3.5% of its retail mortgage portfolio is at high risk of flooding, and 0.2% is at a very high risk. National Australia Bank is even formalising credit score-like tools for assessing individual home and farm physical risk exposure. EOS is engaging with the bank on how these micro data insights could enable the efficient pricing of loans, capturing idiosyncratic asset-specific physical risk exposure.

After Greek wildfires threatened holiday resorts in 2023, Federated Hermes Limited’s SDG Engagement High Yield Credit team engaged Alpha Bank, a local bank with a significant hotel footprint. They received assurances on how the bank was taking a more granular approach to monitoring and mitigating the physical risk exposure of the collateral used to secure loans.

Building farm resilience

But banks face a further complication given the shifting physical risk profile of individual assets over time. For home loans, banks may have good visibility of the home improvements made to adapt to climate change and related extreme weather events, especially if they have financed these efforts. Local or national governments may even invest in infrastructure such as sea walls, helping to mitigate risks across a portfolio of homes. But an individual asset’s resilience to physical climate risks often depends on the health of local ecosystems, marking a critical link between climate- and nature-related financial risks. For example, deforested areas are more at risk of flooding.[1] The living nature of ecosystems can make this interrelation difficult to map accurately, especially as it shifts over time.

The agricultural sector is particularly exposed to this risk, and nature plays an essential role in building farm resilience against flooding, drought, and other weather-related events. EOS has begun engaging with banks on capturing this in their physical risk assessments, including via a bottom-up approach that considers farm-specific risk exposures.

CBA is one local bank leading this bottom-up integration. Through engagement, we learned that it requires agricultural customers to adopt regenerative practices, and offers a suite of sustainable financing products to support this transition, to restore on-farm nature, enhance yields, and build resilience to intensifying physical risks. The bank’s discounted rates on its green agricultural loans reflect an internalised and integrated recognition of the role of natural capital in mitigating balance sheet exposure to physical risks.

Ultimately, the efficient pricing of bank loans through this physical risk lens will become increasingly important if banks are to manage their capital allocation in line with their stated risk-reward appetite.

Can global banks learn from this? EOS is asking globally-diversified banks to develop the capabilities to capture and integrate customer-specific physical risk exposures into day-to-day banking. However, there is a significant data and resource challenge for large and highly diversified banks. Banks and their shareholders must appreciate the local and nature-dependent dynamic of physical risk exposures, the pricing of which will enhance know-your-customer procedures.

Ultimately, the efficient pricing of bank loans through this physical risk lens will become increasingly important if banks are to manage their capital allocation in line with their stated risk-reward appetite.

Early adopters will also be well-positioned to target customers with new financing products focused on adaptation, which the World Economic Forum expects will need US$2tn per annum of investment by 2026. Inadvertently, this integrated climate risk management mechanism will also play a broader and essential economic role in providing financial incentives to customers to invest in adaptation efforts, including through restoring and preserving nature and biodiversity.

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