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Helping lenders address climate risk: six key factors to consider

Lenders and financial institutions are facing increased accountability for the carbon emissions of their borrowing customers, which makes climate-related impact a credit risk. Virtually all stages of the credit lifecycle will likely be affected by climate risk, leading lenders to incorporate more climate-related considerations into the credit management process.

Accurately assessing all credit risks is crucial for lenders to avoid exposure to financial losses and the risk of holding assets of inadequate credit quality. However, financing businesses with large carbon footprints present real risks due to regulatory demands, investor pressure, and growing credit risks for carbon-intensive businesses.

Lenders now need to know about climate risk and how to factor customer carbon emissions into their risk management. Here’s six considerations to bear in mind:

1. Two-thirds of corporate emissions come from small businesses, but this is where the data can be the patchiest. Lenders wanting to know what level of emissions they are financing need to understand what small businesses contribute. But this has always been a data blind spot, as very few of these businesses complete carbon footprint assessments. The Prudential Regulation Authority accepts that estimates will be needed, but some are very blunt and inaccurate.

2. Micro-businesses make up the biggest chunk of small business emissions – but they are the least likely to be calculating their carbon footprint. Experian analysis suggest that micro-businesses with fewer than ten people contribute almost as much carbon as small and medium businesses combined. So a lender with thousands or millions of micro customers in its portfolios will be financing significant carbon emissions. This is only visible to lenders using accurate proxies, as micro-firms are highly unlikely to be calculating their carbon footprint.

3. Carbon emissions are concentrated in certain sectors. Manufacturing and agriculture, and forestry and fishing (AF&F) stand out as two sectors producing the most carbon emissions among small businesses. Manufacturing is the biggest producer, despite being only the tenth-biggest sector by the number of companies. Companies in this industry emit more than 60 million tonnes of carbon a year. AF&F is a clear second, producing more than 40 million tonnes, despite being only the 15th-biggest sector by the number of companies. Transport and storage (the 11th biggest sector) is the only other category producing more than 20 million tonnes. Lenders exposed to these sectors will have significant climate risks in their portfolios.

4. Not every company within a sector is the same when it comes to emissions – knowing the company’s sub-sector is critical. Knowing what sector a company is in is not enough to make a reasonable estimate of its carbon emissions. Within a sector, the exact nature of a company’s work makes a huge difference. Lenders using estimates mainly based on a business’s top-level sector are likely to be building in significant inaccuracies.

5. A company’s carbon intensity seems to mirror its credit risk. When we plot a company’s intensity of carbon usage (carbon usage per £ of revenue) against the credit risk it poses, we see something interesting as, broadly speaking, more intense carbon usage correlates with higher credit risk. There are several reasons for this:

  • Businesses using large amounts of energy are exposed to fluctuating energy prices, which is a substantial credit risk.
  • They are exposed to the risk of more environmentally conscious buyers increasingly choosing a greener alternative.
  • Net-zero targets are creating further pressure on the sustainability of their business model. All of these factors tend to make energy-intensive businesses a greater credit risk.

6. 50-90 employee companies seem to have the lowest intensity of carbon usage. This sweet spot for energy usage per employee varies by sector. But overall, businesses in the 50-90 employee range show the greatest energy efficiency. They benefit from economies of scale but are not large enough to become unwieldy. The size of a company is an essential factor in lenders accurately estimating its carbon emissions.

Next generation data insight

Today, lenders must be able to estimate borrowers’ carbon emissions effectively. These estimates build the foundations for a number of factors, including understanding credit risk, calculating financed emissions, and developing policy rules that balance financed emissions targets and revenue impact.

But making reliable estimates can be tricky, especially with small businesses as they account for most of the corporate emissions. The lenders leading the field are the ones using data that looks beyond the headline figures. By doing this, they are able to get much closer to the truth about climate risk in their portfolios and take a huge step towards including ESG matters in the heart of their decision-making.

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