The absence of beneficial capital weights has not stopped the development of, for instance, sustainability-linked loans (SLLs) with pricing benefits for borrowers that deliver positive environmental outcomes. Financial institutions (FIs) globally have also come under increasing stakeholder pressure to make capital-allocation decisions that align with a low-carbon future.

At the same time, many FIs have made the point that environmental transition is not a black-and-white issue – thanks to, for instance, the intersection of social and environmental outcomes in fossil-fuel industries.

The SLL is one mechanism used to deal with this dilemma. This type of lending offers margin incentives for corporations – often in heavy emitting sectors – to meet various environmental, social and governance-related KPIs.

SLLs are billed as a way for banks both to incentivise transition among their clients and reduce the climate risk on their own balance sheets. While the product has seen rapidly building momentum, including in Australia and New Zealand, there is a lingering underlying challenge.

In effect, SLL lenders can be argued to be in a lose-lose situation: they lose profitability if a company with an SLL succeeds but take a hit to their climate credibility if the borrower fails.

In Europe, FIs and corporates have been able to issue sustainability-linked bonds based on the same principles as SLLs – but the developing norm is for these only to include a pricing penalty for failing to meet targets rather than any incentive.

It should be possible, however, to incentivise banks to provide SLL-type financing arrangements by factoring environmental and climate risk into overall risk weightings. Mark Spicer, head of ESG and responsible investment at KPMG, tells KangaNews this would likely be a welcome development among FIs and could also encourage larger and more precise step-up and step-down margins.

At the moment, KangaNews understands a standard SLL margin variation is typically only 2-5 basis points either way.

“Having a capital mechanism for banks would be a good step. Without it, there is dislocation between the metrics being used and the perceived credit enhancement gained from meeting targets,” Spicer explains.

The Australian Prudential Regulation Authority (APRA)’s draft prudential practice guide 229 on climate change financial risks makes some mention of the possibility for climate risk to be factored into weighted-capital assessments.

APRA says lenders could identify economic sectors with higher or lower climate risk using criteria such as vulnerability to extreme weather events, greenhouse-gas emissions and exposure to policy change.
They could then measure the impact on capital adequacy of climate risks via the internal capital-adequacy assessment process (ICAAP), according to the draft guidance. The ICAAP determines the capital banks need to hold over time to match the risk profile of their assets.

Zoe Whitton, executive director at Pollination Group, says capital benefits and penalties are already implicitly being levied on FIs in global funding markets as a result of regulatory pushes such as the EU’s taxonomy for sustainable finance.

The taxonomy asks FIs to report the proportion of their investments that are aligned with the Paris Agreement under categorisations put forward by the European Commission.

“Everyone wants their investments in Paris-aligned assets to be greater than they currently are, which has created a race among investors in Europe to acquire and invest in Paris-aligned projects. This is visibly changing multiples and effective capital weights,” Whitton explains.