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Insight

Climate risk and its impact on loan books and investments

This year's Atlantic Hurricane season and, previously, storms in New York and New Orleans are distressing and highly expensive indicators that the potential effects of climate events may be felt by banks, insurers, investors and other businesses.

This year's Atlantic Hurricane season and, previously, storms in New York and New Orleans are distressing and highly expensive indicators that the potential effects of climate events may be felt by banks, insurers, investors and other businesses. Estimates for the cost of Hurricanes Harvey and Irma combined are as high as $200 billion. Judiciously side-stepping the link between climate change and the intensity of recent storms, it is clear that the consequences of significant weather-driven events are not simply an academic discussion point or something that is experienced by people and businesses overseas.

On 29 June 2017, weeks before Harvey developed off the west coast of Africa, the Task Force on Climate-related Financial Disclosures (established by the G20 Financial Stability Board) issued disclosure and financial reporting guidelines warning that lenders can be exposed to climate risk through their borrowers, particularly if they provide loans to the businesses with a significant environmental nexus and that lenders may be exposed to litigation related to their financing activities.

The task force report contained voluntary recommendations to ensure effective disclosure of climate-related financial risks for companies to use in their publicly-available financial reports to inform investors, lenders, and insurance underwriters about the financial risks companies face from climate change. For the insurance industry, the ClimateWise Principles provide voluntary guidelines to help insurance businesses understand climate change risks and factor them into their decision-making processes. Indeed voluntary environmental reporting, whether driven by the Equator Principles, corporate social responsibility or other industry initiatives, is not new (and, as this know-how demonstrates, there is a wealth of guidance out there) but there is increasing recognition that climate-related risk should be added to the credit-risk stress tests that banks, funds and insurers are running in the post global financial crisis environment.

Another area that has recently drawn attention is "natural capital". Alongside, other more familiar forms of capital (financial, human etc), natural capital refers to the renewable and non-renewable natural resources that provide benefits to humans. It includes clean air and water, food, shelter energy but also flood defences, pollination and recreation. An assessment of natural capital aims to identify the impact (monetary value) of a company's environmental footprint and the footprint of its customers. It is not an easy thing to assess and, not being traded or included in orthodox accounting, it lacks visibility. However organisations are beginning to make these kinds of calculations. In 2011, German sportswear giant, Puma, published an "environmental profit and loss" (E-P&L) attempting to quantify the environmental impact of its business, including its supply chain. The cost was put at €145 million, albeit a symbolic amount with no real-world adjustment to its accounts. Since then numerous other companies have published their own E-P&Ls. A report published by EY notes that "natural capital with become as prominent a business concerns in the 21st Century as the provision of adequate financial capital was in the 20th Century" (EY, Natural Capital: the elephant in the boardroom).

As a more pertinent use of the concept, a recent "natural capital" stress test in the UK commissioned by conservation charity WWF found that flooding in 2050 on a scale similar to the winter of 2013 to 2014 would affect nearly 2.5 million homes if current policies continued (for example those allowing development on flood plains).

In 2016, the Natural Capital Coalition, published its protocol, a standardised framework for companies to identify, measure and value their impacts and dependencies on natural capital, enabling natural capital to be included in internal management decision making. In April 2017 the European Investment Bank (EIB) and the European Commission announced the first loan agreement backed by the Natural Capital Financing Facility. The €6 million loan agreement with Rewilding Europe Capital is intended to provide support for over 30 nature-focused businesses across Europe. It is part of a "Bank on Nature Initiative" supporting nature and climate adaptation projects through tailored loans and investments, backed by an EU guarantee.

The issue for commercial lenders, insurers and other investors is the extent to which an assessment of natural capital will begin to factor in to their lending and investment decisions. In the UK alone, the built environment is responsible for almost 40% of energy consumption and 36% of carbon emissions. Forward-thinking UK lenders are beginning to recognise the importance of incentivising and supporting "green" businesses and sustainable assets. That is, understanding that environmentally prudent and sustainable businesses, those who consume "natural capital" wisely or invest in projects that sustain or promote biodiversity and climate change adaptation, are destined to be the better bet, longer term.

The direct lending sector is particularly active in investing in sustainable assets, including renewables. A Fieldfisher team has recently advised RM Secured Direct Lending plc (RMDL) in respect of two separate loan facilities to acquire and develop solar energy farms in South Wales and Warwickshire. 

Further, like green bonds that may be tied to sustainability ratings, there is evidence that a number of European borrowers are taking syndicated loans that directly link the margin element with the borrower's progress on sustainability objectives or "green KPIs". For example, a recent €600m loan to Unibail-Rodamco, arranged by Lloyds Bank links pricing to how well the company reduces carbon-dioxide levels relative to footfall in its shopping centres. Unlike the take-it-or-leave-it nature of green bonds, green loans can provide more specific discussions on criteria, ratios and margin and the relationship-driven approach implies more flexibility on breaches. However one spanner in the works for these kinds of structures is the monitoring burden.

Another spur to the industry might come in the potential for a development of prudential rules – for both the banking and insurance industries - that reflect long-term sustainability risks (and, conversely penalising non-green investments).

Accordingly, assessing opportunities for credit risk alone may no longer be sufficient. Analysing climate-related risk in transactions and the management of natural capital by customers (including prospective customers), will be increasingly important and it is likely that, as time goes on, credit assessment processes and sector lending policies, loan books and financial product innovation will evolve to recognise the environmental impact of institutions' lending and investment decisions.

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