Adapt or Die
the Risky Business of Carbon Transfer

10th September 2021

Financial institutions will be hit with a range of carbon-related legislation and taxation in the imminent future. Darwinism applies: the financial institutions that adapt best to change will survive, and there’s no time to delay. Upcoming carbon legislation will put the slower movers out of business. It’s as simple as that.

So, what should financial institutions do about it? Building on my previous posts – creating sustainable finance and the likely impact of Basel V – I want to discuss carbon risk transfer. Once financial institutions understand the reasons behind the move to environmental reporting, and what existing and future legislation means for them, the next step is to plot a path to get on top of their carbon risk.

What is ‘carbon risk’?

Carbon taxes are coming soon. These could present an existential threat to many financial institutions over the long term, especially the smaller ones. Currently, fund managers want to compare companies on their profitability and can do that from their financial statements. However, what they will find nearly impossible to measure is their carbon impact with the sheer amount of data that it involves.

That’s why it’s important to have a policy for decarbonisation across the organisation so you can map your business against future carbon tax impacts. The drive is on to reduce carbon risk, even to the point of being carbon negative – i.e., actively removing carbon from the environment beyond net-zero.

In anticipation of the direction in which the market is moving, some financial services companies have engaged Environmental, Social and Governance (ESG) specialists to help them frame their future investment decisions. For example, BlackRock has prioritised ESG – a relatively recent strategic pivot, led from the very top. The evidence suggests that certain types of ESG funds are already outperforming non-ethical funds. So, factoring ESG into business models already makes business sense. This will be the case especially for the ‘E’ part, given the coming legislation on carbon.

So, what practical steps can organisations take to achieve what will be asked of them regarding their carbon risk? What services can we expect to see?

What does carbon risk transfer look like?

It’s still early days for the sustainable finance market. The market is not quite ready yet. The catalyst will come when carbon hits the capital of banks due to action at a national and international governmental level, or via Basel V, which I anticipate will place a significant emphasis on climate risk capital adequacy.

I expect to see financial institutions using even more intensive securitisation to recycle their capital. The biggest near-term issuance of financial securities that is likely to happen in sustainable finance is green bonds – whether to fund a firm or to recycle their assets as securitised assets. It’s already quite a broad market but the volume will be huge. Substantial issuance will come from governments, driven by their large-scale infrastructure and social funding plans, legislation, and general momentum towards sustainability.

We could see a lot more synthetic risk transfer happen as the wave of sustainable finance engulfs the world. This is nothing new. The origins of synthetic risk transfer can be traced to the late 1980s with Collateralised Mortgage Obligations (CMOs). The techniques developed here led to the explosion of asset-backed securities and most notably to the huge transfer of credit risk in the form of Collateralised Debt Obligations (CDOs) and Credit Default Swaps (CDS). I fully expect that the next innovation in securitisation and synthetic risk transfer will be for carbon and sustainability and will be based on the same business principles and mathematical structures.

Who is leading the way on carbon risk transfer?

Just as in the 1980s, when CMOs changed the world of structured securities forever, we will likely see new products emerge to help financial institutions meet existing and future carbon obligations.

We are starting to see examples of innovation in the carbon risk space. For example, in February 2020, NatWest and Macquarie Infrastructure Debt Investment Solutions agreed a £1.1 billion securitisation deal. This enables NatWest to recycle capital and increase lending to sustainable or renewable energy projects, such as offshore wind turbines, hydroelectric and solar power. In early 2021, Glennmont Partners completed its first synthetic risk transfer via its fund for renewable-backed securities. It was the first green synthetic risk transfer transaction in Italy and among the first in Europe. These are modest examples in a new market, but from small acorns grow mighty oaks.

Direct hedging tools will also evolve. One can expect to see a spot market in carbon, with different trading hubs, like we have had in the past for other major commodities like oil (e.g. WTI and Brent). This will lead to futures and swaps and related derivatives.

Don’t delay! Act now on carbon risk transfer

To remain compliant and competitive in an age of carbon risk reporting, financial institutions are really going to have to understand environmental, as well as financial, data. This is going to take an incredible amount of expertise in data management – from knowing where to access accurate environmental data; how to process it and model it using artificial intelligence (AI) and machine learning (ML); and then applying smart humans who can make sense of it all.

The cost of this brand-new capability in any financial services firm is huge. In terms of computational complexity, running a climate risk model would be as challenging as the most complex things that banks are running today. Smaller firms, in particular, are going to struggle. Moveover, the regulatory and stakeholder environment is driving a need for substantial standardisation and transparency in order to avoid many of the opacity problems of the past that brought about huge risk management failures and consequential systemic risk.

This is where expert help is essential. First Derivative can help you take a data-led approach to your carbon risk transfer and prepare your organisation for the complex regulatory decade ahead. We can help you make sense of your environmental reporting obligations and understand the best way to approach your carbon risk.

I’ll be writing more on climate risk, so visit our blog regularly and follow us on social media so you don’t miss a new post. And if your organisation is struggling to understand what climate risk means for you in the coming years, do please get in touch.

Johnny D Mattimore Managing Director, Global Head of Risk & Sustainable Finance