Assessing Environmental Risks – Implications for bank credit lending and corporate access to capital

The New York Times today has an interesting article “Banks Grow Wary of Environmental Risks” which talks about the fact that we’re seeing some of the world’s largest banks implementing new lending policies which examine risks within their credit portfolios that previously had not been considered – in particular environmental risks.

Let’s make it clear, we’re not talking about corporate activity that illegal. We’re talking about areas of corporate actions that are legal according to laws and regulations (i.e:  emission of greenhouse gases). It’s simply that some in the global banking community are raising the bar of “acceptable lending practices”. These new standards are beginning to be used in consideration for the viability of projects they finance.  The article notes that banking analysts and others suggest:

the heated debate over climate change, water quality and other environmental considerations is forcing lenders to take a much harder look at where they extend credit, and to whom.

Why does it matter?  Let’s use carbon as an example.  Although we don’t currently have an actual price for carbon, the question we must ask is “will there likely be a carbon price regime in place over the lifetime of this financing / investment?”  If so, then in one’s model you would do a variety of scenary planning at difference carbon prices; one would assess the impact to returns based on variations in carbon prices; what does it then do to the weighted average cost of capital (WACC);  ultimately determining the discount rate that one would use for pricing.  Given the results of these pricing scenarios, it begins to offer a view to the risk potential of a project.  Ultimately, access that capital will be priced accordingly!

The article quotes a spokeswoman from the National Mining Association that says “companies are still getting financing for their projects”.  That’s true at the moment.  However, if you’re a corporation and you begin to hear this news, do you not need to begin to consider that as major lending institutions implement these policies over time… who will be financing your projects and at what price?

As a shareholder of banking stocks,  do we not want to know what our banks are doing on this front?  Are they leaving themselves open to additional risks on their corporate lending books because they are not yet aware of this movement and its implications?  Could that impact each of us here in Canada in one way or another, given the heavy weighting of the banks in our market and indexes?

So which banks are getting involved?  According to this article there are a few:

  • Wells Fargo last month noted what it called “considerable attention and controversy” surrounding mountaintop mining and that its involvement with companies engaged in was “limited and declining”.
  • HSBC  (London) has curtailed its relationships with some producers of palm oil which is often linked to deforestation in developing countries.
  • Rabobank (Dutch) has applied a nine-point checklist of conditions for would-be oil and gas borrowers that includes commitments to improve environmental performance and protect water quality.

In addition, my own research shows that:

  • Citi-Bank, Morgan Stanley and Credit Swiss have put into place carbon-focused due diligence process for any future lending to coal-powered and other carbon intensive projects.
  • Bank of America has set a goal to reduce the rate of GHG (Greenhouse Gas Emmissions) in its lending to the utility sector by disclosing publically that is is using a $20 to $40 per tonne cost of carbon in evaluating loans.

As someone who spent many years working within the banking sector, I certainly understand that these are very important actions.  In my judgement, actions that should not be underestimated.  In the banking industry, it’s hard to go against the groove.   There is always someone else willing to do the deal if you’re not.  It’s a very competitive industry. This has been true in the “traditional” business model, but in the evolution that we are encountering, one has to ask “who will end up with the best commercial loan books in the long run?”

The banks are also feeling pressure from society at large to move in this direction. In this article, the authors highlight two incidents that are forcing the banks to take some kind of action to increase their understanding of the issues:

  • Royal Bank of Scotland (Edinburgh) just last week had protestors outside of their facilities demonstrating against the bank’s financing of the oil sands development in Canada.
  • Royal Bank of Canada (Toront0) who has been under intense pressure by activists denouncing their financing of the oil sands projects, hosted 18 international banks in Toronto last February for a “day of learning” on the “regulatory, social and ennvironmental issues” surrounding the oil sands.

All in all, it becomes apparent that the banking community collectively is beginning to hear the message that there are potential risks that they may not be assessing.  As a bank, do you want to be left behind?  Will those lending books be as profitable as you think?  As corporate clients, I would suggest that you begin to prepare for how your bankers and your shareholders are going to be looking for additional data and information going forward.

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