Banks ‘to face Lehman moment’ over stranded fossil fuel assets, report warns

Exposure to fossil fuels is almost equivalent to the exposure of the whole financial system to subprimes before the 2007-2008 global financial crisis.

Published today by NGO Finance Watch, the research uses data from 31 December last year to assess the exposure of banks to risks related to the fossil fuel sector, based on their financial flows. It prices the exposure at $1.35trn.

This exposure, the paper argues, puts banks at increased risk. The primary focus is on transition risk – that the energy transition will result in decreased demand for oil, gas and coal. It is noted that physical risk is likely to reduce the value of energy infrastructure, with this risk being higher the more that the planet warms and weather patterns change.

“Currently, the risks associated with fossil fuel assets are being underpriced, as regulation does not oblige banks to have sufficient funds to cover potential losses on the value of these assets,” the report states. “In the event of a banking crash, the burden of bank bail-outs could fall on the shoulders of taxpayers rather than being absorbed by the market.”

Many previous pieces of research have sought to assess how fossil fuel finance could be reallocated by the financial sector to drive the energy transition using a ‘just transition’ approach that also upskills, reskills and supports workers. This report takes a slightly different approach, outlining the case for international regulators to adjust banks’ capital requirements for fossil fuel exposures.

Finance Watch imagines a situation in which fossil fuel assets are classed as ‘higher risk’ and assigned a risk weight of 150%. The decision on whether to change this classification rests with the Capital Requirements Regulation in the EU and the Basel Committee on Banking Supervision globally.

In this situation, the report states, the 60 banks would collectively need to access between $157bn and $210.2bn in extra capital – equivalent to around three months of their profits. Finance Watch believes this additional capital should be funded from profits and that the adjustment to capital requirements could be phased in over time.

Now is an opportune moment to take this “reasonable, precautionary step”, the report states, with the Capital Requirements Regulation currently under review and with banks reaping more profits at present as interest rates rise. The Basel Committee on Banking Supervision notably implemented reforms during the 2008 financial crash, with the capital increases required for their implementation achieved through the retention of profits in the financial sector.

Report co-author Julia Symon said: “Delivering on international climate commitments, such as the Paris Agreement, means a significant number of fossil fuel assets will become stranded. Without concrete policy action reflecting this reality, the risks of disorderly transition and climate disruptions are going to be more than the financial system can handle”.

Bank of America

In related news, the Bank of America has published its third report aligned with the Task Force on Climate-Related Financial Disclosures’ (TCFD) recommendations – the first of these reports to be published since the TCFD enhanced its guidance in 2021 and since the Bank set 2030 emissions targets for its financing activities.

The report states that the bank has “enhanced its climate risk inventory with new climate-related risks and creating risk watch lists for climate-sensitive sectors” However, the inventory is not publicly provided.

Similarly, the bank states that it has conducted “enterprise-wide climate scenario exercises in order to better understand the impact of climate risks on key business activities” – but the results are not listed. Scenario exercises or scenario analysis is used to map out potential risks to an organisation in a range of future climate scenarios, including those outlined in the Paris Agreement.

The TCFD published its last annual status report in October 2021. That report revealed that the number of organisations voicing support for the Task Force’s recommendations increased by more than one-third year-on-year to 2,600 – the biggest annual increase to date. At that point, the combined market capitalisation of all supporters was $25.1trn.

But voicing support does not automatically equate to producing a high-quality report. Around half of the companies to have voiced support for the TCFD had produced at least one report by October 2021. The TCFD has reported a slow and steady increase in reporting quality, and has recorded that the uptake of good scenario analysis has been slower than the adoption of many other parts of its framework.