Last weekend I decided to dedicate some time to nature. Technically, we need to understand nature if we truly want to contribute towards its welfare. We cannot talk about collapsing ecosystems, environmental degradation, as well as biodiversity loss, without connecting with the environment.
True, climate change is expediating the process of environmental risks. However, humans are contributing to the collapse of ecosystems. It can be either due to overdevelopment, increase in GHG emissions, water and marine pollution and the loss of biodiversity. For instance, the prolonged neglect of heavy fuel oil tank storages, poses problems to human health and the environment, if they are not properly maintained. Indeed, EU regulations are strict. However, what preceded the EU is still posing a health hazard to those living within the surrounding areas of heavy fuel oil storages. I saw some examples in the past, even at EU level. We must understand what risks they impose to our health and the required tools to correct any environmental damages, even for closed storages.
Bankers are now under pressure to scrutinise their clients on ESG. However, climate has been given greater attention in the past three years. It is the strategy of the EU to decarbonise the continent by 2050. Consequently, banks and financial institutions have a role to play. They have been designated as a second line of the defence for government failures and procrastination to act in the interest of the environment around Europe. Reducing CO2 emissions is crucial to prevent additional environmental risks. However, climate change mitigation on its own is not enough. The environment requires additional layers of screening to protect humans, as well as fostering healthy ecosystem and sustainable businesses. Climate change is important, and so is the environment. This is why they are presented together. However, it is also a matter of human activities affecting the environment, as well as communities.
Additionally, banks are being requested to mitigate climate and environmental risks through effective risk management practices in place, not least a strong internal governance process. To understand what I am saying, regulators are focusing on the causes of health concerns when assessing projects. The EU uses a statistical code termed NACE to designate and identify the sectors. For instance, the sectors listed under NACE codes A to H and L are all materially subject to environmental transition risks. This means that any business within the realm of the code A to H, poses a higher risk when financed by banks. These include agriculture, forestry and fishing, mining and quarrying, manufacturing, electricity, gas, steam and air-conditioning supply, water supply, sewerage and waste management, construction, wholesale and retail, as well as repair of motor vehicles and transport and storage. The NACE code L refers to real estate activities.
When assessing the credit portfolio, a bank must ensure that the above sectors are being monitored for any additional transition risks, emanating from regulatory pressure. Banking is not about credit, operational, market and liquidity risks anymore. These are the traditional risks of banks known for decades. Now we have to factor in ESG and also geopolitical risks. With the new CRR III and CRD, ESG factors would need to be included. The best way to include such risks is to first identify the measurements of ESG risks, which requires arduous data processing. Banks need to be creative on the level of detail requested from their clients. For instance, credit institutions can consider introducing a questionnaire at the time of credit origination or else periodically when reviewing their credit underwriting. The EBA guidelines are clear.
Credit institutions have the power to direct their credit towards sustainable project. Furthermore, major banks can shape the economy and push it to the point where sustainable projects would in turn help governments in the EU transit to cleaner practices. The ESG risk profiles of clients require climate and environmental risks considerations. What banks are considering today might have been a fable two decades ago. What we required to look into entails a background in biology, and engineering, too. For instance, when I was pursuing my second postgraduate degree in the UK, many of my finance colleagues were engineers. Today, their profession in banking is much more valuable than traditional economists.
According to the recent EU regulations, banks are also required to assess not just carbon dioxide CO2, but also CH4 (methane) which is the second most important GHG contributor to climate change. There are other air and sea pollutants. In fact, the NEC Directive sets national reduction commitments. It obliges member states to monitor and report the emissions of five main air pollutants, SO2, NOx, NMVOC, NH3 and PM2,5. True, the main focus is on CO2 right now. However, the above are all contributors to environmental pollution, and require strict monitoring, especially when assessing the financing of projects. Besides, banks are required to look into the forecasted emissions of the financing of new projects, the material impacts on the environment including climate change and biodiversity, fossil fuel dependency in transition, energy performance certificates for the real estate exposures used as collaterals, as well as the adverse impact on communities. This means that besides the traditional risks, banks are required to include C&E risks as part of the overall assessment of default risk on borrowers, especially in the credit scoring for those projects that are climate change sensitive, and those borrowers that are in a high transition risk.
My advice to those who have not yet already started to include these requirements, please start including them asap. It is not a matter of if, but when, the regulation will hit you. Furthermore, those economic operators that are captured by the CSRD, do start devising transition plans. Those economic operators that are not captured by the CSRD are still required to prepare transition plans, because banks are forced to take prudential decisions, as outlined in CRR III and the CRD. In the near future, those sectors highly sensitive to climate change, and with a high transition risk, will be required to provide transition plans that are scientifically approved. The responsibility of transiting to cleaner practices falls on the economic operators and not on the banks. Banks are here to assist you with credit to transit to cleaner practices. You require, concrete, and achievable annual KPIs in your transition plans. You require verifiable scientific targets on GHG reductions. If you do not prepare them, it is going to be either more expensive borrowing in the near future or else being excluded from the market due to high transition risk. These are some of the practices introduced by leading European banks, and they will soon affect us here at home. So please do take care to get your house in order.