This Network for Greening the Financial System (NGFS) 2020 report assesses whether a risk-differential can be detected between green, non-green and brown financial assets (loans and bonds). It focuses on the work performed by financial institutions (banks) to track risk profiles of these assets, develop specific risk metrics, and analyse possible risk differentials. Based on survey information obtained by 49 banks, it presents a snapshot of current practices in monitoring climate-related financial risks among financial institutions around the globe in their asset allocation. The report concludes that institutions have not established any strong conclusions on a risk differential between green and brown assets, and point to a diverse number of methods, results, and motivations for whether to undertake climate- and environment-related risk assessments.

Most of the sampled 49 financial institutions have committed towards greening their balance sheets, with 57% undertaking commitments which affect their daily operations either by setting green or positive-impact targets, or by limiting their exposure to brown assets. However, their justifications for such are not based on financial risk differentials between green and brown assets, but other considerations such as corporate social responsibility and mitigating reputational, business model or legal risks.

Challenges of taxonomy

The report observes that it is only possible to track green, non-green and brown asset risk profiles in very few jurisdictions. An important reason is that prerequisites such as clear or official taxonomy and granular data are not available in most jurisdictions. Due to this, respondents most frequently decided to implement and use an international or national classification in the form of a voluntary classification or principle. The second most frequent approach was to use their own internally developed classifications.

Several financial institutions highlighted that they encountered different challenges when trying to classify different assets with taxonomy (such as loans, bonds, and investments). Since loans have a weaker link to physical assets or a project, they are particularly difficult to classify. In addition, many respondents emphasised how a lack of harmonised client data was the main obstacle to defining the greenness of an asset. One root cause was the lack of legal disclosure requirements requiring companies to report verified data on this. Another cause was the internal challenges of integrating climate and environment-related risk assessment into their processes as it would require investment and an accumulation of internal knowledge on the subject.

Different views

Survey respondents (banks) held different views on the methodologies for assessing risk of green and brown assets. Diverging views were expressed on whether existing methods and models are compatible for conducting this risk assessment, with some highlighting the need to implement a forward-looking approach through scenario analysis. Notably, forward-looking studies were performed by 12 respondents (22%), most respondents using scenario analyses or stress tests. Respondents broadly agreed that the methodologies should consider key environmental issues that could impact the repayment ability of clients or the value of an asset.

Overall, this report recommends the implementation of clear taxonomy and forward-looking methodologies to accurately assess the impact of green and brown assets on financial institutions.

1. In their 2019 report, the Network for Greening the Financial System (NGFS), conclude there is no clear definition of the terms green, non-green and brown assets. Survey respondents used different terms for green assets such as climate or environmental green assets. For example, some respondents defined palm oil as green since it could replace aircraft fuel from a climate perspective, while other institutions consider palm oil to be unsustainable as it is relates to deforestation. This supports the need for a clear taxonomy of terms.
2. Most financial institutions respond that they are unable to detect any risk-differential for green financing compared to non-green or brown financing.
3. Some institutions mention various risk-based rationales for providing green loans. These include: green buildings have a higher value and are more marketable; corporates with ESG projects tend to have better risk-management as they are more in control of the environment; and corporate investing in energy-efficiency projects are more likely to increase in profitability due to cost savings.
4. One respondent performed a scenario analysis on its mortgage loan portfolio which analysed how different climate scenarios might affect the Probability of Default (PD) performance and Loss Given Default (LGD) performance. The results find higher costs from tax and insurance could impact PD. The main factor affecting LGD is the location of the mortgage security asset, such as closeness to the coastline and increased impact of sea level rises due to global warming.
5. In terms of credit risk assessment, financial institutions use various methods of environment, social, and governance (ESG) scoring, (for both investment and credit granting), but rarely integrate those ESG scores into their overall customer credit ratings. In fewer cases, some financial institutions use the results in their internal rating models. One of the most common approaches of ESG scoring is via negative screening (used by 11 respondents), which excludes financing of new coal mining or coal-fired plants.
6. Several institutions emphasise there are challenges with how to categorise different types of financial assets under a taxonomy. For example, many corporate loans are extended to general corporate purposes, which can be financing both green and brown activities of the company. If the company separates the green and brown financing via single-purpose loans, it could result in a deteriorated credit quality of the loan if either were to deteriorate in value.
7. Given the current limitation of historical data, forward-looking methodologies are good alternatives for exploring the impact of climate change. The NGFS is currently working on global and regional scenarios that will be available in the future as solid building blocks for conducting such analysis.
   
8. Institutions should not overlook climate-related risks in their existing risk management framework. For example, the Basel Committee on Banking Supervision (BCBS) standard for credit risk management states that banks should identify and analyse existing and potential risks inherent in any product or activity.
9. Based on current practices from supervisory authorities, the Guide for Supervisors published by the NGFS encourages members of the NGFS and banking and insurance supervisors to integrate environmental and climate-related risks into their work. This can be achieved by setting supervisory expectations to create disclosure or transparency standards for financial institutions in relation to climate-related and environmental risks.