By Carlos Castillo
Banks are fundamental to a functioning modern economy
A question that we often get asked at Melior is, ‘why own a bank in an impact fund?’. In short, we believe that whilst the banks continue to have room for improvement in their operations, they make an important net positive contribution to the UN Sustainable Development Goals (SDGs) through the crucial role they play in the economy.
As financial intermediaries, the banks provide essential financial services to both individuals and business customers. The banks provide access to banking services for all (SDG 8.10), including mortgages that enable millions of people to achieve the security of home ownership and transaction accounts into which wages and salaries can be paid and savings held.
The banks also remain the primary source of financial services for small and medium-sized businesses (SDG 8.3). Companies with less than 200 employees employ approximately 65-70% of the Australian workforce, make up an even larger proportion of the growth in jobs and account for over half of economic activity in the economy1. These small and medium-sized businesses rely heavily on the banks to finance their operations and growth given the relatively small size of each limits access to other forms and sources of capital.
But have the banks improved their behaviour?
This month it is three years since the findings of the Royal Commission2 were released. “The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry” revealed the way the banks previously operated failed to meet community expectations for such trusted institutions. Since then, the banks have admitted guilt, paid hundreds of millions of dollars in customer compensation and penalties and significantly refreshed boards and management teams and incentive structures.
An independent review by Promontory on bank remediation suggests banks such as CBA (held) and Westpac (held) have made significant strides in the right direction to rectify the cultural shortcomings of the past. The final Promontory report for CBA noted “in many ways, CBA is now almost unrecognisable as the institution described in the Inquiry Report3″.
Whilst the big four banks have made significant progress in their culture and corporate behaviour, there is still room for improvement across all aspects of their operations.
The banks can do a lot more to support climate action
A key area the banks continue to fall short on is their lending to high emitting industries that detract from the SDGs, including fossil fuels. Melior actively advocates for further positive change by the banks in the area of climate action given the significant positive impact that can be achieved by banks as critical financial intermediaries. In this edition of Insights we explain how banks can play an important role in climate action.
Why are emissions embedded in bank loan books important?
The banks can make their biggest contribution to climate change through their loan books and investment portfolios. “Financed” emissions (Scope 3) significantly exceed a bank’s scope 1 and 2 emissions and present the largest opportunity for the banks to influence greenhouse gas (GHG) reduction ambitions4. Limiting access to, or increasing the cost of, debt finance for carbon emission intensive businesses can support the transition to a low emissions economy, as can improving the availability of debt funding for developers and users of low emissions technology.
Financed emissions represent a source of increasing risk for the banks. Deficiencies in how banks identify, measure, monitor, and control the potential physical and transition risks associated with climate change could adversely affect banks’ capital strength and, as the Reserve Bank of Australia (RBA) notes, these risks could be substantial if not properly managed5. For example, in December 2021 the Office of the Comptroller of the Currency (OCC) in the US announced draft principles designed to support the identification and management of climate-related financial risks by banks6. As the OCC notes, “climate change presents risks to the financial system. The increased frequency, severity, and volatility of extreme weather affects the value of financial assets and borrowers’ creditworthiness7.”
Global warming of 1.5°C – 2°C will be exceeded during the 21st century unless deep reductions in GHG emissions occur in the coming decades. Limiting warming to 1.5°C will require a marked shift in investment patterns which the banks have the power to influence via lending decisions. For example, the International Energy Agency (IEA) concludes that “there is no need for investment in new fossil fuel supply in a net zero pathway8”. This statement by the IEA encompasses not only thermal coal and oil, but also gas.
Climate action involves more than just the fossil fuels sector
The Banks have attracted criticism for their ongoing financing of the extraction of fossil fuels and power generators that use fossil fuels. However, fossil fuel extraction and thermal electricity generating clients are a very small part of the banks’ loan books; fossil fuel related lending is less than 1% of total lending for all the big four banks.
Lending for fossil fuel extraction and consumption is a tiny part of the loan book for the banks
Note: The banks use slightly different terminology when reporting loan book exposures. CBA and WBC use total committed exposure (TCE). ANZ and NAB use exposure at default (EAD). The concepts are comparable. Source: Melior. Data from 2021 company reports.
There is however a significant opportunity in the remainder of the loan book to drive further climate action. Westpac’s FY21 disclosures highlight the extent of the opportunity, with the caveat that the data ignores material scope 3 emissions for fossil fuel extraction clients. Westpac’s manufacturing customers emit about as much carbon as miners and utility providers combined. Likewise, the bank’s mortgage and agricultural customers are not far behind the emissions contribution from manufacturers. Whilst the mix is slightly different for each of the banks, the emission reduction opportunity is similar. Hence, Melior’s climate action advocacy efforts are focussed on the emissions across the entirety of the loan book for each bank.
Westpac’s financed emissions by sector (scope 1 & 2)
Source: Westpac Presentation and Investor Discussion Pack, p.53
What are the current plans for targeting emissions in the loan books?
The big four banks have been reviewing their climate action plans for many years and are yet to implement emissions intensity targets for their entire loan books. While the banks delay appropriate target setting for their loan books, the climate outlook deteriorates and the cost of action for the banks and the general economy escalates.
Australia’s major banks have made commitments to exit the financing of thermal coal mining by 2030, materially reduce the emissions intensity of their lending to electricity generation and three of the four banks have set some limitations around lending to oil and gas projects.
NAB and WBC both expect to develop emissions intensity targets for their lending to high emitting sectors, if not the entire loan books, by the end of 20229 10. While that means up to another 12 months before targets are set for these banks, NAB and WBC could be up to two years ahead of ANZ and CBA. ANZ’s management team surprisingly believe they will not have enough data to set comparable targets potentially until 202411. CBA’s management team is developing sector-level, science based glidepaths but has not set any timeline for broader, specific emission intensity targets beyond those already in place for fossil fuels and an ambiguous goal for average emissions intensity in the loan book to decrease over time12.
Approach and targets for emissions intensity in each bank’s loan book by sector
Source: Melior – paraphrased summary of respective bank disclosure in 2021
What climate risks are banks exposed to?
In Melior’s view the climate related lending targets from by banks are, to date, narrowly focussed on the fossil fuel industry and inconsistent with their own net zero ambitions. This creates numerous risks for the banks, including:
- greater probability of default for business loans to owners of stranded assets;
- regulatory intervention and oversight to protect stability of the financial system;
- litigation by individuals or community groups13;
- exposure to mortgage and small business customers with greater risk of natural catastrophes (floods, bushfires, extreme storms)14;
- potentially higher cost of capital in global funding markets given international lenders, that provide a large amount of funding to the Australian banks, are increasingly incorporating climate policies of the countries and companies to which they lend; and
- potential equity valuation discounts to reflect either actual risks in the business or investor uncertainty that comes from insufficient disclosure to quantify the exposure to climate change across the entire loan book.
Bank mortgage books look more risky when house prices are adjusted for climate risk
Sources: ABS, Securitisation system, RBA, XDI – Climate Valuation, 30 June 2021.
New energy transition lending opportunities
The banks also have a role to play in positively supporting the transition to a low emissions future. In fact, the decarbonisation of the economy is a huge opportunity for the banks. Globally, $125 trillion in investment is required and more than half of that needs to be spent in the Asia Pacific region15. Inevitably a large proportion of that spend will be debt funded.
The banks are already contributing to the transition. Some of the activities include:
- Lending to renewable power generators. The scale of bank lending to renewable power generators already dwarfs lending to fossil fuel power generators (see earlier chart) and that gap will only widen with time;
- Sustainability-linked loans. The banks are increasingly offering loans that provide lower interest costs for large corporates that hit relevant sustainability targets;
- Household solar system loans. Very low interest loans are available for households installing solar electricity systems;
- Finance for electrification. Asset finance is available to assist companies with the electrification of vehicle fleets;
- Finance for extraction of critical minerals. The banks provide debt funding for companies to extract minerals like copper, lithium and nickel required in larger quantities to enable the electrification of transport and expansion of battery storage capacity that supports the shift to renewable electricity.
The development of green hydrogen capacity is a good example of the opportunity for the Australian banks to grow the loan book in a climate positive fashion. By 2050, hydrogen could power 20-25% of global transport, including more than 400m cars, 20m trucks and 5m buses16. Australia’s proximity to Asia makes it uniquely positioned to become a global leader in clean hydrogen production. Such a large amount of demand will require similarly large amounts of capital to fund the construction and ongoing operation of hydrogen production capacity.
Melior actively engages with the major banks to advocate for improved science-based emissions reduction targets, disclosure and emissions tracking across the entire loan book. To comprehensively de-risk the loan books we are calling on the banks to set and disclose Paris-aligned targets to reduce the emissions intensity of their entire loan books and to further incentivise and assist all their clients to materially reduce emissions.
Specifically, we are advocating for the banks to:
- honour existing commitments to exit lending to thermal coal miners and coal-fired electricity generators
- cease all new lending to oil & gas extraction projects and set Paris-aligned targets to exit lending to existing oil & gas clients
- set and disclose Paris-aligned targets to reduce the emissions intensity of their entire loan book
- designate a board member with specific responsibility to oversee climate action
- link short- and long-term incentive payments within remuneration structures for senior managers, in part, to emission intensity targets for the loan book
The final point is critical. Incentives drive behaviour. The targets, once set, are more likely to be achieved when aligned with the remuneration of those with leadership responsibility for the banks.
2 Interim and final reports available at https://www.royalcommission.gov.au/banking
3 Independent Review of the Commonwealth Bank of Australia’s Remedial Action Plan, Promontory Australia, page 8, 30 September 2021, available
Latest Westpac report available at https://www.westpac.com.au/content/dam/public/wbc/documents/pdf/aw/media/WBC_promontorys_third_report_october_2021.pdf
4 Scope 1: Direct GHG emissions that occur from sources that are owned or controlled by the reporting company, i.e., emissions from combustion in owned or controlled boilers, furnaces, vehicles, etc. Scope 2: Indirect GHG emissions from the generation of purchased or acquired electricity, steam, heating, or cooling consumed by the reporting company. Scope 2 emissions physically occur at the facility where the electricity, steam, heating, or cooling is generated. Scope 3: All other indirect GHG emissions (not included in scope 2) that occur in the value chain of the reporting company. Scope 3 can be broken down into upstream emissions that occur in the supply chain (for example, from production or extraction of purchased materials) and into downstream emissions that occur as a consequence of the use of the organization’s products or services.
9 NAB 2021 Annual Review, page 31, available at https://www.nab.com.au/content/dam/nab/documents/reports/corporate/2021-annual-review.pdf
10 WBC Sustainability Supplement 2021, page 29, available at https://www.westpac.com.au/content/dam/public/wbc/documents/pdf/aw/ic/2021_Sustainability_Supplement.pdf
11 ANZ ESG Roundtable presentation pack, page 19, available at https://www.anz.com/content/dam/anzcom/shareholder/2021-investor-roundtable-esg-update.pdf
12 CBA Annual Report, 2021, page 23, available at 2021 Annual Report – CommBank
13 There are multiple examples in Australia and other parts of the world of litigation against organisations where the actions of the company are not consistent with its own net zero statements and ambitions or government legislated targets, including Santos and Royal Dutch Shell.
14 Independent analysis estimates the proportion of Australian dwellings exposed to high climate risk will rise from 3.5% to 8% by the end of the current century and house prices in 1,438 suburbs will experience house price declines greater than 10% solely as a result of climate risk – see RBA, Climate Change Risks to Australian Banks, 16 September 2021.
15 Vivid Economics, McKinsey, see ANZ Environment, Social and Governance (ESG) Investor Pack, 26 November 2021, page 7.
16 Hydrogen Council. (2017, November). Hydrogen scaling up: A sustainable pathway for the global energy transition. https://hydrogencouncil.com/wp-content/uploads/2017/11/Hydrogen-scaling-up-Hydrogen-Council.pdf
This content is for general information only. In preparing and publishing this content, Melior Investment Management Pty Ltd (ACN 629 013 896, authorised representative no. 001274055) does not seek to recommend any particular investment decision or investment strategy and has not taken into account the individual objectives, financial situation or needs of any investor. Investors should consider these matters, and whether they need independent professional financial advice, before making any investment decision.