Alert January 04, 2007

Climate Change Strategies for the Financial Services Industry

“The breaking news is the arrival of a new set of stakeholders on the environmental scene, including banks and insurance companies. When the financial services industry – which focuses like a laser on return on investment – starts to worry about the environment, you know something big is happening.” [1]

Concerns about climate change have entered the mainstream of America’s media. Major magazines, such as Vanity Fair, Time and Fortune, have printed feature stories about climate change and other environmental issues, and Al Gore’s movie, “An Inconvenient Truth,” has been a box office success. Other publications highlight the monetary upsides available in connection with addressing environmental issues. For instance, the July 2006 edition of Wired listed green and clean technologies as one of the six trends driving the global economy. In the face of such widespread media coverage, businesses, including members of the lending community, can no longer ignore the concerns, risks and potential opportunities associated with climate change.

Although the banking community has not yet been a primary focus of advocacy groups or shareholder suits demanding greater activity in response to climate change, banks are not immune from the effects of growing public and regulatory concern regarding global warming, particularly efforts to reduce the emissions of carbon dioxide (“CO2”) and other greenhouse gases (“GHG”). There is increasing stakeholder pressure for banks and other members of the financial services industry to acknowledge and address climate change as a major issue and its potential effects on their businesses and those of their customers. Indeed, as a major source of capital for industrial development and operations, lenders are uniquely positioned to have a significant impact on addressing climate change.

Banks can address climate change issues from several perspectives. First, lending institutions can adopt the same strategies used in other business sectors to measure and reduce their own direct and indirect CO2 emissions. Second, they can incorporate consideration of climate change issues into their lending policies. Finally, financial institutions may find opportunities in investing in climate‑related projects or in focusing on customers producing “clean technologies” that reduce GHG emissions. This advisory will review recent developments that have led to increasing pressure for the business community to address global warming, examine steps that banks have taken to date and suggest potential strategies that banks and other financial services companies can implement to address the business risks and opportunities associated with climate change.

Why Does Climate Change Matter?

The combustion of carbon‑containing fossil fuels, such as oil, natural gas and coal, over the last 150 years has significantly increased atmospheric concentrations of CO2 and other GHGs. Scientists predict that heat trapped by atmospheric GHGs contributes to rising temperatures, droughts, melting glaciers, increasing severity of natural weather events such as hurricanes, rising sea levels and the spread of non‑native species. Such changes may adversely affect human health (e.g., spreading tropical diseases), agriculture (e.g., irrigation demands and crop yields), water resources (e.g., supply and quality), coastal areas (e.g., erosion of beaches and damage to coastal communities), species (e.g., loss of habitats, reduced ocean productivity), with resulting adverse economic impacts across broad sectors of the economy.

The news media have recently reported on numerous scientific and economic studies regarding the impacts and risks of climate change. Recent examples include:

  • The Stern Review on the Economics of Climate Change (Oct. 2006): Projected that an investment equivalent to 1% of the world’s annual economic output by 2050 in methods to cut GHG emissions is necessary to avoid environmental costs of global warming ranging between 5% to 20% of the world’s gross domestic product after 2050.
  • National Center for Atmospheric Research Report (Dec. 2006): Projected that global warming caused by the emission of greenhouse gases is contributing to the accelerated melting of sea ice in the Arctic Ocean, which could disappear by 2040. Also in December 2006, the U.S. Department of the Interior proposed to list the polar bear as a threatened species based on the predicted disappearance of its sea ice habitat.
  • U.S. Energy Information Administration (“EIA”) (Dec. 2006): Predicted that CO2 emissions from American energy use alone will increase 1.2% per year through 2030, reflecting that voluntary efforts to‑date to control CO2 emissions may not be sufficient. The EIA also reported in 2006 that China’s CO2 emissions are projected to exceed those in the United States as early as 2009.

Although such studies have critics and skeptics, many governments and businesses have decided it is necessary to address GHG emissions without waiting for further scientific evidence or mandatory regulation. Thus, it may be increasingly difficult for companies to rely on scientific uncertainty as a rationale for not considering the impact of or reducing their GHG emissions. GE’s CEO Jeff Immelt may have summarized it best, “[w]e are in a carbon‑constrained world now.”

What Is Being Done in the United States to Address GHG Emissions?

Unlike in Europe and most of the rest of the industrialized world, in which the Kyoto Protocol requires mandatory GHG emission reductions, GHG emissions remain largely unregulated in the United States. Some American businesses have been participating in voluntary programs sponsored by governmental authorities and non‑profit organizations to track, report and reduce their GHG emissions. For instance, over 40 companies are participating in EPA’s Fortune 500 Green Power Challenge, which, in December 2006, challenged Fortune 500 companies to roughly double their current level of green power purchasing.

Mandatory regulation of GHGs in the United States is limited, existing primarily at the state level and largely confined to power generation facilities and automobiles. For instance, Massachusetts, Wisconsin, Oregon and New Hampshire have adopted rules that require some form of reductions or offsets of CO2 emissions from existing or new power plants. Ten states have adopted or will adopt California’s stringent GHG emission standards for motor vehicles, which have been challenged in pending litigation. Nearly 200 municipalities have pledged to adopt the Kyoto Protocol targets for reducing their greenhouse gas emissions.

Several recent developments suggest that broader regional and federal mandatory GHG regulations are likely within the next few years. For example, states in New England and the Mid‑Atlantic region are developing a precedent‑setting program to regulate GHG emissions: a regional cap‑and‑trade program known as the Regional Greenhouse Gas Initiative (RGGI). RGGI, scheduled to take effect on January 1, 2009, currently involves seven states (with more likely to join) and will initially limit CO2 emissions from fossil‑fuel power plants. On September 27, 2006, California enacted legislation, AB 32, to regulate GHG emissions not only from power plants, but also from any “significant” sources of emissions. At the federal level, several senators, including Senators Boxer (D-CA), Lieberman (D-CT), McCain (R-AZ), Bingaman (D-NM), Kerry (D-MA) and Feinstein (D-CA), are expected to introduce or re‑introduce legislation to mandate regulation of GHGs. Last year, the Senate passed a non‑binding bipartisan resolution calling for mandatory market‑based limits on GHG emissions.

Climate change‑related litigation appears to be on the rise. The U.S. Supreme Court is currently considering whether the federal Environmental Protection Agency (“EPA”) has authority to regulate CO2 as a “pollutant” under the Clean Air Act. The case, Massachusetts et. al. v. EPA, raises the question of EPA’s authority in the context of motor vehicle emissions. A similar case in the D.C. Circuit Court of Appeals, Coke Oven Environmental Task Force, et. al. v. EPA, involves EPA’s authority to regulate CO2 emissions from new electricity generators. Thus, it is possible that, within the next six months, the courts will rule that the EPA has the authority to regulate emissions related to climate change and therefore must evaluate whether specific regulations are necessary and, if so, develop and implement such requirements.

Plaintiffs in several pending tort suits are seeking various forms of relief against corporate defendants under nuisance and negligence theories for climate‑related injuries allegedly caused by the defendants’ GHG emissions. These include Connecticut, et al. v. American Electric Power, et al. (seeking an injunction requiring five utilities to reduce their CO2 emissions); Comer, et al. v. Murphy Oil, et al. (seeking damages from oil, coal, electric power and chemical company defendants for destruction by Hurricane Katrina allegedly caused by defendants’ CO2 emissions); and California v. General Motors, et al. (seeking damages from six auto manufacturers for public nuisance injuries allegedly caused by automotive CO2 emissions). While the outcome of these cases is uncertain, climate‑related litigation presents a risk to carbon‑intensive industries.

Climate Risks to Lenders

While not widely appreciated, lenders and their clients face a number of risks relating to climate change. A key risk and uncertainty for borrowers in carbon-intensive industries is the regulation of GHG emissions and the associated costs of controls or emission offset credit purchases. Companies in the electric power and auto industries may also be vulnerable to climate-related litigation. Another category of risks to borrowers’ (and banks’) operations are those associated with extreme weather events potentially caused by climate change and resulting in property damage and business disruption. Some industry sectors, such as agriculture, forestry, food, building supplies, construction, tourism and insurance, are particularly sensitive to the effects of drought, flooding and storms.

Other types of climate‑related risk that may affect lenders and other financial services companies are reputational and competitive risks based on these institutions’ response to climate change issues. Non‑governmental organizations (NGOs) such as CERES and the related group of institutional investor groups and the Investor Network on Climate Risk (representing nearly $4 trillion of assets), are bringing increased pressure for corporate action on climate change issues, including greater disclosure and corporate governance focus on business risks and opportunities posed by climate change. While these groups have to date focused primarily on carbon-intensive industries, their focus is beginning to include financial institutions. Banks and other financial institutions that do not have credible policies and programs addressing climate change may fare poorly in reviews by these and other climate‑focused advocacy groups, and may also be at risk of major institutional investors taking their money elsewhere. Similarly, when some banks and other financial services companies commit to take action on climate issues, it creates competitive pressure to act and may result in potential competitive disadvantage in the eyes of customers and investors and for those that fail to address this issue. These risks and pressures are likely to increase as awareness of climate change and its impact becomes more widespread.

Climate Opportunities for Financial Institutions

Several major U.S. banks are taking action to address their own GHG emissions, and in some cases those of their customers through their lending policies and investment decisions.

Internal Actions

Members of the lending community have already begun to adopt climate change policies in which the institution agrees to measure, report and reduce its own energy consumption and CO2 emissions. Wachovia states in its climate change policy that it will reduce its absolute CO2 emissions by 10% from 2005 levels by 2010. Citigroup set its goal of a 10% reduction of its GHG emission by 2011. Some banks have also elected to participate in voluntary GHG reduction programs. Wells Fargo is participating in EPA’s Fortune 500 Green Power Challenge and reports purchasing 550 million kilowatt hours of green power, or 42% of the company’s total electricity use, primarily through the purchase of wind power renewable energy credits.

Reducing internal GHG emissions can take many forms, ranging from replacing company vehicles with hybrid-powered cars to purchasing non-emitting “green” power to improving the efficiency of heating and cooling systems to motivating employees to use public transportation. Like any other property-owner, banks should also consider green building designs – which minimize emissions, limit waste and reduce utility use – when constructing new offices or renovating existing ones. Some municipalities (e.g., Boston) are beginning to require the incorporation of green design considerations into new buildings, with a few even providing an expedited permitting process for buildings that meet such requirements.

Lending Policies

Lending institutions’ existing credit underwriting criteria may already include some consideration of environmental issues, such as contaminated real estate and compliance with environmental laws. For instance, over 40 major financial institutions have voluntarily adopted the Equator Principles, a program that requires an environmental assessment for any project financing, regardless of location or industry, with total capital costs of $10 million or more.

Banks may also wish to consider whether the projected impacts of climate change, including the greater likelihood of severe hurricanes or additional regulatory requirements, may affect the risk of a particular loan. The need for such an analysis will likely differ depending on factors such as the geographic location of a borrower’s assets (e.g., in a coastal area or hurricane path), and the industry sector to which a loan is being made (e.g., investments in new energy facilities).

Although some of the risks of climate change are more likely to occur after the term of many current loans has expired, some banks are already developing tools to evaluate the climate change risk of their existing and potential clients and providing resources for their clients to reduce their impact on climate change. For example, JPMorgan Chase has committed to encouraging clients that are large GHG emitters to develop carbon mitigation plans, adding carbon disclosure and mitigation to its client review process, quantifying the cost of GHG emissions for transactions in the power sector and integrating this factor into the financial analysis of the transaction. Thus, banks can work with their clients to identify and mitigate the GHG emissions and climate-related risks associated with specific projects.

Non‑profit entities are also working to influence banks’ approach to climate change. For example, in November 2006, BankTrack, an international coalition focused on commercial financial institutions, published a report entitled “The Dos and Don’ts of Sustainable Banking,” which calls upon financial institutions to endorse six commitments to sustainable business practices. The World Wildlife Fund and BankTrack also recently published a report entitled “Shaping the Future of Sustainable Finance: Moving the Banking Sector From Promises to Performance,” which evaluates how commercial and investment banks are addressing certain environmental and social issues, including climate change. The Rainforest Action Network (“RAN”), an activist NGO, has a global finance campaign aimed at removing financing from projects that negatively impact the environment. One of RAN’s goals is to persuade other banks to join Citigroup, Goldman Sachs and JPMorgan Chase in adopting policies that protect old growth and endangered forests, stop investments in projects that exacerbate climate change and protect indigenous peoples.

Investments and New Business Opportunities

There is a growing international trend of “green” investment in renewable energy, clean technologies and other products and services that contribute to the reduction of GHG emissions. For instance, Morgan Stanley recently announced that it will dedicate approximately $3 billion to buying carbon credits and investing in low‑emitting energy projects. Goldman Sachs has committed to dedicate up to $1 billion for investment in renewable energy and energy efficiency projects. Lehman, Fortis, BNP Paribas and others recently purchased $263 million worth of carbon credits from a Chinese mining company. Numerous venture capital and private equity funds are investing in companies developing “clean” environmental and renewable energy technologies. As The Economist noted in its November 18, 2006, edition, “[i]nvestors are falling over themselves to finance start‑ups in clean technology, especially in energy.”

Another potential business opportunity for the financial sector with respect to climate change relates to the expanding international and domestic markets for GHG emission reduction credits. A recent report by the World Bank found that the market for trading CO2 emission allowances was approximately $21 billion during the first three quarters of 2006. While the European Union (“EU”) Emissions Trading Scheme accounted for the bulk of these transactions (almost $19 billion), the Chicago Climate Exchange, the first voluntary and legally binding GHG emission reduction and trading system in America, already accounts for 21% of the market for trading CO2 emission allowances, equaling approximately $27 million in value. Also, in November 2006, UBS introduced the world’s first index of global GHG allowances. Although the UBS index will initially cover only EU emissions trading schemes, the bank has not ruled out the possibility of expanding the index to additional markets in the future.

Conclusion

The financial services industry has an important stake in responding to climate change. Climate change issues present both risks and potential opportunities for lenders and other financial institutions. In evaluating whether and how to address climate change issues, banks should consider both financial and intangible costs and benefits, such as those relating to reputation and competitive position. Increasingly, the public’s perception of a company’s environmental policy, including its stance on climate change, can impact the company’s market position, especially if it is perceived as being either ahead of or behind its peer companies. The non‑profit organizations that advocate for voluntary environmental commitments by businesses can be both helpful as partners and harmful as adversaries.

To address these risks, financial institutions should consider the following strategic steps:

  • Develop and implement a climate change policy to address internal actions and decision‑making, including measuring and reducing direct and indirect CO2 emissions.
  • Incorporate climate change considerations into lending policies, for example, by:
    • identifying and assessing industries likely to be subject to regulatory requirements or clients more likely to be affected by extreme weather events potentially caused by climate change;
    • developing climate change-related due diligence policies for sectors with greater direct GHG emissions, such as energy, utilities, automotive and extractive industries; and
    • quantifying the cost of GHG emissions of a potential client and incorporating this factor into financial analysis.
    • Partner with reputable NGOs that focus on climate change in developing internal or lending climate change policies.
    • Develop tools to facilitate clients’ assessment of their own risks associated with climate change and options to mitigate such risks.
    • Seek opportunities to invest in viable emission reduction projects and focus on customers producing “clean technologies” that reduce GHG emissions.