Banks at risk due to slow pace of climate transition by companies

The Paris Climate Agreement implies significant changes for society, the economy and the financial sector. If companies lag behind the required transition path, they may find themselves squeezed by tighter government policies, legal rulings and changing consumer preferences. This could lead to risks for banks because of the associated write-down of these companies. These risks prompt us, as a supervisory authority, to advocate both at the global level (in the Basel Committee on Banking Supervision, the international standard-setter for banking regulation) and at the European level (at the European Banking Authority, the EU banking regulator) for the appropriate treatment of climate risks in the capital framework, for instance by setting concentration limits. 

Theoretical framework: a forward-looking analysis of banks' loan portfolios

Dutch banks' loan portfolios were analysed using the Paris Agreement Capital Transition Assessment (PACTA) method, making use of two measures: the change in technology mix and the production trajectory. Applying this theoretical framework to the automotive industry, the technology mix reflects the share of electric cars, hybrid cars, hydrogen-powered cars and traditional combustion-engine cars in total car production. If the technology mix deviates from the transition scenario, this could be due to an overproduction of combustion-engine cars, or because too few electric cars are being manufactured. This is why the production trajectory is also examined alongside the technology mix. When applied to the automotive industry, this second measure reflects the planned production of each type of car in the next five years. We compared the results to an International Energy Agency (IEA) scenario in which global warming is limited to 1.5°C.

Companies need to switch faster to sustainable alternatives

Based on both measures, we conclude that the companies in the most carbon-intensive sectors in the loan portfolios of Dutch banks are not transitioning quickly enough. The analysis reveals that car manufacturers are not switching from producing combustion-engine cars to electric cars rapidly enough to meet the Paris climate goals. The switch from fossil-fuel-based power generation to renewable sources is also progressing too slowly. In addition, oil extraction by companies in the loan portfolios of Dutch banks will increase in the coming years, while a decrease is needed. In the natural gas production sector on average the companies are adapting quicker than the transition scenario calls for (Table 1).

Table 1 Summary of transition scenario results

A red x indicates that the companies in the loan portfolios of Dutch banks are lagging behind the transition scenario. A green tick indicates that companies are aligned with the scenario or are even ahead.

Sources: Asset Resolution, PACTA, DNB.

Production of combustion-engine cars increasing

Continuing with the example involving cars, Figure 1 shows the change in the production of combustion-engine cars in the coming years. The figure reveals that, taken together, companies with loans from Dutch banks will continue to produce more combustion-engine cars in the years to come than the transition scenario allows. The solid line indicates the companies' business plans; this line rises in the first few years and is flat from 2023. The green area becomes smaller and smaller because the production of combustion-engine cars will have to decrease significantly over time according to the IEA scenario to meet the Paris goals: by around 30% by 2026. In addition, cars with combustion engines will be banned from sale in the European Union starting in 2035. The difference between the projection of the production and the transition scenario increases in the coming years. This leads to transition risks. Results for other sectors are shown in the analysis. 

There are major differences between banks when it comes to transition risks

The aggregated loan portfolio of Dutch banks as analysed conceals differences between banks and between companies in their loan portfolios. Figure 1 shows the bank with the loan portfolio that is most ahead of the transition scenario and the bank that is lagging most behind. Because of the significant differences between banks and between companies, banks should perform this or a similar analysis for the different sectors and companies in their portfolio.

Figure 1 Production of combustion-engine cars

The solid line represents the projection of the production of companies in banks' loan portfolios. The dotted line between the green (lighter) and red (darker) areas represents the production path needed to limit global warming to 1.5°C by 2050. If the solid line moves into the red area, the projection of the production of companies in banks' loan portfolios is insufficient to meet the climate goals. If this line is in the green area, companies are adapting faster than the transition scenario requires. The lower dotted line represents the portfolio of a Dutch bank that is most ahead of the transition (the vanguard). The upper dotted line represents the portfolio of a Dutch bank that is lagging the most behind the transition path (the rearguard).

Sources: Asset Resolution, PACTA, DNB.

Results represent a lower boundary of actual transition risks

This analysis concentrates on sectors with high carbon emissions such as the power generation and automotive sectors. However, it only looks at the part of the value chain where the transition needs to be concentrated to bring the entire value chain into alignment with the Paris Agreement. Banks' exposure to these activities is 2.5% of the total portfolio of loans extended to non-financial companies. Downstream companies are also exposed to transition risks, depending on their specific activities. A producer of automotive gearboxes, for example, will be significantly affected by the transition, but a producer of car seats or windscreen wipers is unlikely to experience much impact because these components are also used in electric vehicles. It is not yet possible to use the PACTA methodology to determine exactly whether and how these companies will be affected by the transition. This means that actual transition risks are greater than our analysis reveals.

Supervising transition risks

The results of this analysis underline how important it is for banks to pay sufficient attention to transition risks. It is encouraging that a large number of financial institutions have signed the Climate Commitment, and, starting in 2022, should publicly disclose what actions they are taking to help meet the goals of the Paris Agreement. As a supervisory authority, we ensure that financial institutions take appropriate steps to manage sustainability risks. Transition risks are receiving more and more emphasis in prudential banking supervision. For example, the ECB published its supervisory expectations for how banks should address such climate and environmental risks, and we published a Good Practice for banks with guidance on how banks can integrate climate risks into their risk management. In addition, the European Commission published a proposal last year to set standards in the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR) for how sustainability risks should be integrated into banks' risk management policies and procedures and in the prudential supervision of banks.