23 January 2024

SSM's Elderson: “Failing to plan is planning to fail’’ – why transition planning is essential for banks

The misalignment with the EU climate transition pathway can lead to material financial, legal and reputational risks for banks. It is therefore crucial for banks to identify, measure and − most importantly − manage transition risks, just as they do for any other material risk writes Frank Elderson.

Eight years ago in Paris, global leaders reached a landmark agreement, committing to limit the global temperature increase to below the calamitous threshold of two degrees Celsius. Alarmingly, the latest scientific evidence^[1] indicates that we are currently on a global heating path of 3°C.^[2] Through the risk-based lens of a banking supervisor, this is seriously concerning – the longer we wait to transform our economy, the more disruptive the transition and the greater the risks that will materialise on banks’ balance sheets.^[3] It is therefore crucial for banks to identify, measure and − most importantly − manage transition risks, just as they do for any other material risk.

How transition risks affect banks

In the European Union, the Paris Agreement has been transposed into the binding European Climate Law, which requires carbon neutrality by 2050. The commitment to reduce emissions by 55% by 2030 is further reinforced by the EU’s “Fit for 55” strategy. As the economy transitions towards meeting these goals, industries need to adjust how they operate. And since most companies in the EU with high-emitting production facilities rely on bank financing, this also has a significant impact on banks’ balance sheets. For instance, various studies suggest that phasing out fossil fuels to meet the Paris Agreement may very well leave about 80% of fossil fuel assets stranded in the absence of a timely transition^[4], which will lead to financial losses for banks that are exposed to companies with those assets. Think about higher CO₂ prices for high-emitting steel and cement producers under the reformed EU Emissions Trading System, or the ban on the sale of new petrol and diesel cars from 2035. Companies that do not adjust to these policies and fail to reduce their carbon footprint in a timely manner will face higher risks over time. Hence, misalignment with the EU transition pathway can lead to material financial, legal and reputational risks for banks^[5].

To be clear: it is not for us supervisors to tell banks who they should or should not lend to. However, we will continue insisting that banks actively manage the risks as the economy decarbonises. And banks cannot do this without being able to accurately identify transition risks and how they evolve over time.

So how, exactly, can banks do that?

Quantifying transition risks is crucial...

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