Climate risk could trigger 20% higher loan losses, Moody’s report finds

Climate risk could pose a major threat to the quality of loans arranged by banks, a report from Moody’s has revealed.

The analysis, which examined how climate change and the transition to a low-carbon economy could impact banks’ loan portfolios, found that loan losses could be up to 20% higher under the most extreme climate scenario.

High impact could be the result of continued levels of exposure to risk across various sectors, and the fact that policy on climate change is still being formulated. The report also found that divergence from Paris targets would be a major driver for higher loan losses for banks.

“Our analysis shows that climate risk is likely a key determinant of banks' loan quality and creditworthiness," said Jorge Valez, senior vice president at Moody's. "It also highlights some differences between banks in terms of their vulnerability to the various climate scenarios and their own carbon exposures.”

The study tested four European banks and implemented three climate scenarios, based on the European Central Bank’s own global ‘heat map’ of environmental risk across sectors it’s exposed to.

The three scenarios, benchmarked against a baseline consistent with Paris targets, included a disorderly transition with limited physical risk; a disorderly transition with higher physical risk, and a scenario whereby delayed transition policies lead to high physical damage.

The report found that the least disorderly climate scenario was predicted to trigger loses of around 3.5% higher in total.

However, over the assumed 30-year time horizon of the exercise, banks are likely to substantially reduce their carbon exposure, so losses should be less likely to materialize.

Lenders today are still significantly exposed to carbon heavy sectors, while some key industry players are attempting to formulate transition plans.

Last month, BHP, one of the world’s largest mining companies, published its transition roadmap.