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Sub-prime and carbon: an eerie similarity

Supporting renewable energy is a first step, but banks must also come clean about fossil fuel financing.

Amidst the enormity of the current sub-prime lending crisis, it’s easy to see how an issue like climate change might not command much attention from the investment community. Yet climate change and sub-prime lending bear some eerie similarities—namely that banks may be failing to account for underlying risks to a huge class of assets, with tremendous repercussions for the global economy going forward.
While the banking sector itself is not a big emitter of greenhouse gases that contribute to global warming, it is the primary financier of industries that are the major emitters. As regulatory controls and market prices are put on these emissions, this will have a tremendous influence on how banks price securities, assess credit risks and make future investment and lending decisions. At the same time, banks face new opportunities to engage in carbon trading, develop new climate-focused products and services, and invest in the emerging clean technology sector.
Clearly, the time for the banking sector to prepare for these emerging risks and opportunities is now. News out of Greenland and Antarctica is that their glaciers are melting surprisingly fast and could start to swamp our coastal cities, where half the world’s population lives, assea level rises. Owners of long-lived coastal assets—and those who finance them—should take heed, as the value of this property far exceeds the amount exposed to the sub-prime lending crisis.
Of more immediate concern is that the United States is now poised to follow Europe—albeit belatedly—in controlling its carbon emissions. The U.S. Congress has introduced no less than seven congressional bills in the past year to place a cap on GHG emissions. And all three leading candidates in this year’s presidential election—Senators Clinton, McCain and Obama—have made it clear that the issue would be high on their agenda after entering the White House in January 2009.
In January of this year, RiskMetrics Group released a study of how 40 of the world’s largest banks are responding to climate change in terms of their corporate governance and management strategies. For this report, we used a “Climate Change Governance Index”—a benchmarking tool developed in conjunction with the Ceres coalition and the Investor Network on Climate Risk (INCR), an institutional investor group with $4 trillion in assets under management. (Ceres and INCR commissioned this report.)
The index is comprised of 14 key indicators, and many
sub-indicators, to evaluate five main governance areas: board oversight, management execution, public disclosure, emissions accounting and strategic planning—all in relation to climate change. For this report, we adapted the index to reflect the particular circumstances of the banking sector. Individual scores were based on a 100-point scoring system; the U.K’s HSBC plc posted the top score of 70 points. Overall, big, diversified banks like HSBC, Barclays, Deutsche and Citi were found to have the most developed climate governance strategies. The U.S. investment banks of Goldman Sachs, Merrill Lynch and Morgan Stanley followed closely behind. The custodial banks and asset managers had the lowest average scores in our study.
There was a regional disparity as well. Seven of the top 10-scoring banks are based in Europe. This is consistent with previous work we’ve done previously on industrial firms, and isn’t really a surprising result, given that Europe has adopted the Kyoto Protocol and already has a cap and trade system in place on greenhouse gas emissions.
While most of the banks in our study are beginning to focus on their own emission footprints—and in many cases pledging to go “carbon neutral” in their operations—only a handful are factoring a price for carbon in their lending and investment decisions. This led to a key recommendation in the Foreword of our report: banks ought to “explain how they are factoring carbon costs into financing and investment decisions, especially for energy-intensive projects that pose financial risks as carbon-reducing regulations take hold worldwide.” Three Wall Street banks have already taken up this charge. On Feb. 11, Citi, Morgan Stanley and JPMorgan Chase announced the “Carbon Principles,” a set of guidelines for advisors and lenders to evaluate carbon risks associated with new investments in the U.S. powersector. Their announcement came after nine months of dialogue with two leading U.S. environmental groups. Seven of the nation’s largest coal-burning utilities also were consulted and express support for these guidelines. This is a promising step forward. Banks cannot merely promote their increased financial support of renewable energy, as important as this is to combat climate change. They also have to come clean about their continued financing of carbon-intensive energy sources like coal. With the Carbon Principles, this should happen. More important, under the “Enhanced Diligence” framework called for by these principles, more emphasis will be put on demand-reducing efficiency measures and low-carbon distributed energy sources that serve as alternatives to new baseload power plants.
But the proof will be in the pudding. One question going forward is whether the Carbon Principles eventually will extend beyond the United States to these banks’ financing of new power generation around the globe. Another question is price they will place on carbon emissions as they go about making these financing decisions. If the assumed price is set too low, the result may be business as usual investment strategies that keep real risks of climate change hidden from investors in carbon-intensive projects.
If that happens, the mistakes of the current sub-prime lending crisis might pale in comparison. Let’s hope that transparency and realistic assumptions about the costs of carbon emissions turn this emerging crisis into an historic investment opportunity.

Doug Cogan is lead author of Corporate Governance and Climate Change: The Banking Sector. He is director of climate change research for RiskMetrics Group. Copies of the banking study are available for download at . This commentary expresses the views of the author alone.