What are climate and ESG risks and how can lenders and insurers reduce them?

Thanks to new climate-risk regulations, measuring the carbon emissions of customers in their portfolios is now an urgent priority for lenders and insurers.

But in trying to do so, they face a problem. The emissions produced by 97% of UK businesses are effectively invisible to them. These businesses make up:

• a third of the UK’s total emissions
• two-thirds of corporate emissions

They are the UK’s 5m Small and Medium-sized Enterprises (SMEs).

A new category of risks- climate risk

Lenders are facing a whole new category of risks to manage.

Banks and insurers have sophisticated methods for managing credit risk. But managing climate risk in portfolios is much less familiar territory.

Climate risk management climate change works in 2 ways, firstly from financial-services firms being held accountable by investors, customers and regulators not just for their own carbon emissions, but also for those of customers they lend to or insure.

What is climate risk and why is it on the agenda?

Transformation of businesses to meet sustainability goals is an increasingly reality in the marketplace.

The Prudential Regulation Authority is now insisting that lenders and insurers can quantify, and manage the climate-related financial risk related to both themselves and their counter-parties (customers).

Alongside managing the risk from climate change, the FCA is demanding an increasing number of corporates and financial services businesses to measure and disclose their climate change impact, including their direct and indirect, scope 3 emissions. For lenders and insurers, these indirect, or financed emissions are those produced by customers, whose operations are enabled by capital provided by the lender or insurer. Beyond measurement, new regulation under consultation will see scrutiny of plans and progress against public Net Zero and financed emissions goals.

With this new and intensifying focus from regulators, lenders must act now to shine a light on the climate status of their customer portfolios.

The problem- reliable emissions data to act on

But these excellent sustainability aims beg a difficult question. How can these emissions from downstream customers be quantified and managed?

• How can lenders establish a baseline for emissions hidden in a portfolio and track progress, against previous years and against the UK average?
• How can lenders who have committed to cutting downstream emissions make plans, or show they have succeeded, if they are not clear what the starting point is, or have only a very loose estimate?
• How can a lender understand its exposure to climate transition risk within its portfolio, and feed that into capital risk calculations, as the PRA demands? How can it then build application policy rules to manage this exposure in the future?

The answer, until now, has been that they can’t, at least not robustly. This is because there is a blind spot in the data.

The SME blind spot

There is a near-total lack of accurate emissions information for SMEs. Research suggests that only 3-7% have done work themselves to calculate their carbon footprint.

So, until now, lenders have been stuck between two unappealing options:

• Ask SMEs to undergo an onerous full emissions assessment, which causes customer friction and dissatisfaction.
• Rely on misleading broad-bush sector-wide emissions averages as a proxy. These are unlikely to be accurate enough to be fit for purpose on a reliable basis for action.

Existing estimates fail to see, for instance, that not all shops are the same when it comes to emissions. Grouping all retail customers in the same emissions bracket fails to take into account critical factors. For instance, what specific type of shop are they (for example, a florists or a frozen food shop)? What is the size of the company, where are their sites, and what is their potential energy mix?

In practice, this oversimplification typically leads to overestimation. Our research suggests that these methods overestimate SME carbon emissions by nearly 200%.

This leaves lenders in the dark. They can’t establish a reliable baseline for financed emissions, can’t develop emissions strategies built on firm ground, can’t manage their portfolios towards sustainability, and can’t easily judge progress against ESG goals.

Lenders now want assurance that their decision-making processes are founded on trustworthy intelligence.

Climate-risk analysis is now a must-have

Regulators and the market are demanding that lenders report on – and manage – financed emissions. But to act, they have to be able to see.

Financial-service providers need to understand more about their SME customers than ever before – what a firm does, how much it does of it, and – crucially – a sense of how it does it.

That means looking for a data partner with an extensive collection of global company information, and trusted solutions providing trade credit data. Partners of this type can expand from this core position, and extend their data sets to cover climate risk requirements.

Summary

Lenders cannot afford to ignore the financed emissions of their SME portfolio. Until ‘actuals’ exist, they must rely on proxies. However, any estimate of total downstream emissions not based on accurate SME data will be unreliable and volatile. And, with the regulator watching, lenders must move fast to fill any data blind spot here.

SMEs cannot yet reasonably be expected to provide their own carbon footprint data. Any figure will be based on models and estimates, an approach the regulator accepts. But not all estimates are equal. Make sure you have the most reliable baselines and figures available for your portfolio and build your climate strategy on firm ground.