Giovanni Covi, James Brookes and Charumathi Raja
Climate transition will undoubtedly expose UK banks to new risks and opportunities. Hence, we quantify the UK banking sector’s share of total assets allocated towards climate policy relevant sectors (CPRS). Using The Global Network data set mapping the network of UK banks’ loan and security exposures, we find that the UK banking system’s direct CPRS exposures amount up to 6.1% of total assets, or 45.7% of non-financial corporate (NFC) exposures. When considering also indirect CPRS exposures towards other financial corporates, the share of total assets subject to CPRS classification increases up to 10%. While 83% of these assets are tied up in carbon-intensive sectors, 17% will likely benefit from climate transition plans. We do not measure exposures subject to climate-related physical risks.
Climate-related transition risk and opportunities
In its first progress report, released in October 2018, the Network for Greening the Financial System (NGFS) unanimously concluded that ‘climate-related risks are a source of financial risks’. Central banks and financial regulators need to ensure that the financial system is resilient to these risks.
In doing so, they should set key priorities to construct a framework to assess and potentially curb climate-related financial risks. According to NGFS, the key task in achieving this objective is the disclosure of existing exposures in the financial sector – in other words, the creation of a risk map of climate-related financial risks.
However, the transition towards a climate-friendly productive economy will not only pass through risks, but also opportunities. Therefore, assessing the trade-off between risks and opportunities is key to providing a holistic assessment on the future of the financial system’s resilience.
Climate policy relevant sectors and the Taxonomy Alignment Coefficient
We follow Battiston et al (2017) in classifying economic activities into CPRS. This approach allows us to assess the economic and financial risk and opportunities that firms may experience given a climate transition, that is, an economy reaching net-zero emissions by 2050 as specified in the Paris Agreement. CPRS have been classified by using three main criteria: (i) their direct and indirect contribution to greenhouse gas emissions; (ii) their relevance for climate policy implementation; and (iii) their role in the energy value chain. The starting point for this classification is the four-digit NACE classification of economic activities, which is mapped into six main climate policy relevant sectors – fossil fuels, utilities, energy intensive, buildings, transportation and agriculture. The CPRS classification is regarded as a reference for climate financial risk assessment.
On the other hand, to distinguish climate transition risks from climate transition opportunities, we make use of the Taxonomy Alignment Coefficient (TAC) methodology developed by Alessi et al (2019) to quantify the share of banks’ CPRS exposures that could be identified as ‘green sectors’, ie those benefiting from the climate transition.
Big granular data sets
To calculate the UK banking system’s exposure to CPRSs, we use the Global Network data set, covering the UK banking system’s assets using a granular approach. This data set is made up of six supervisory data sources covering loan, debt and equity security exposures as well as derivatives exposures. In total, the Global Network captures £9.4 trillion of gross exposures out of £10.6 trillion of total UK assets in 2021 Q4, roughly 90% of UK banking system’s assets. The data set is divided into two main sets of exposures. The granular component accounts for 43% of total exposure amounts (£4.1 trillion). When the granular component is not available, we add aggregated exposures by the counterparty’s country and sector as the residual component which contributes to 57% of the total coverage (or £5.3 trillion).
For this specific exercise (Table 1), we use loan and security exposures to the NFC sector, to capture the size of CPRS exposures. In 2021 Q4, we have £1,200 billion UK banks’ exposures, of which 37% of NFC exposures are mapped with granular bank-to-counterparty information. The counterparty identification via Legal Entity Identifiers allows us to associate each counterparty with a four-digit NACE code and in turn with a CPRS classification. We further decompose the exposures into loans and securities. The residual component (63% or £757 billion) has been mapped with aggregated exposures by country and sector of the counterparty and this classification will be used to estimate total CPRS exposures.
Table 1: UK Banks’ exposures to non-financial corporate sector (£ billions)
Direct and indirect CPRS exposures
For 2021 Q4, we calculate that out of £444 billion of granular exposures towards the NFC sector, almost £201 billion were directed towards CPRSs (45%) (Table 2). In this respect, 83% are likely to be subject to climate transition risk (RISK CPRS), whereas 17% are likely to benefit (TAC CPRS) from the climate transition. Overall, looking at the composition of CPRS sectors, the ‘Buildings’ sector is the most relevant CPRS component, accounting for £82.5 billion of total CPRS granular exposures, out of which £55.5 billion is subject to transition risk, and £27 billion to transition opportunities. The second most relevant CPRS sector is ‘Fossil Fuels’ with £38.1 billion, followed by ‘Transport’ with £37.7 billion, out of which £32.8 billion subject to transition risk, and £4.9 billion to transition opportunities and ‘Energy Intensive’ with £31.3 billion.
Table 2: UK Banks’ exposures to climate policy relevant sectors (£ billions)
We also estimate CPRS exposures for the aggregated exposure component, taking as reference the share of CPRS exposures calculated on the granular component for loans and securities. Table 3 provides the total amount of CPRS exposures (calculated and estimated) for the UK banking sector.
We find that the UK banking system was exposed in 2021 Q4 to £546 billion of CPRS exposures, that is, for 6.1% of total assets, or 45.7% of total NFC exposures. In this respect, Table 3 also provides a comparison with other studies in the literature using the same CPRS methodology, ie EU banking system, EU insurance corporations and Austrian banking system. In order to compare the results with the EU banking system, we collect evidence from EBA (2021) exercise on EU banks’ loan exposures and from Alessi et al (2019) for EU banks’ security exposures. The coverage of the two data samples is not identical. The EBA (2021) exercise covers all EU-27 countries plus Norway and the United Kingdom, but focuses only on a subsample of banks which account for 50% of EU banks’ exposures. In this respect, we rescale all estimates provided by EBA (2021) by a factor of 2, thereby assuming that the share of CPRS exposures remains constant as estimated for the UK banks on aggregate exposure amounts. In contrast, Alessi et al (2019)’s exercise excludes security exposures from UK banks. In this respect, we augment their estimates with our CPRS estimates on UK banks’ security exposures. Overall, compared to the UK banking sector, the EU banking sector’s share of total assets exposed to CPRSs is relatively higher, close to 8.5%.
Table 3: UK banks’ total CPRS exposures
We should however note that these estimates capture exclusively direct exposures towards the non-financial corporate sector, which only account for 13% of total UK banks’ exposures. The other £3,700 billion or 39% of total exposures are directed towards other credit institutions and non-bank financial entities, which fall outside the scope of the CPRS classification. Hence, it is critical to know the share of CPRS exposures the financial sector holds in order to derive also an indirect measure of CPRS exposures.
In this respect, by making use of the Global Network data set, we are able to quantify £528 billion of exposures towards EU banks and an additional £314 billion of exposures towards EU non-bank financial corporations. By weighting the former by 8.5% and the latter by 13%, respectively the CPRS share over total assets of EU banks and EU insurers, we derive an additional £45 billion and £41 billion of indirect CPRS exposures for the UK banking sectors, leading to a total (direct CPRS plus indirect CPRS) of £632 billion or 7% of total assets. In the end by assuming a 10% CPRS share for the remaining £2,858 billion of UK banks’ exposures towards financial sector entities, we end up with a total of £918 billion of CPRS exposures or 10% of total assets.
Conclusions and policy implications
Climate transition plans bring with it risks and opportunities for the financial system that central banks need to be alert to. Indeed, there is a pressing need for central banks, regulators and financial firms to accelerate their capacity to assess and manage these risks as was recently scoped out by the Bank of England’s CBES exercise.
Complementary to the CBES exercises, we have sized UK banks’ direct exposures according to the CPRS classification, which sum up to 6.1% of UK banks’ total assets in 2021 Q4. Nevertheless, we have highlighted that also exposures towards financial firms incorporate a carbon footprint, and they represent a large chunk of the UK banking sector’s assets. In this respect, by considering also indirect CPRS exposures, UK banks’ total assets exposures to CPRS increase further to 10%, an additional 40%.
The greater number of CPRS reference estimates for the financial sector and subsectors across jurisdictions, the better researchers and policymakers will be able to estimate indirect financial CPRS exposures, and so construct a global map of financial assets subject to climate-related financial risks and opportunities. We hope this study may help to fill this gap.
Giovanni Covi works in the Bank’s Stress Testing Strategy Division, James Brookes works in the Bank’s Advanced Analytics Division and Charumathi Raja works in the Bank’s Banking Capital Policy Division.
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