Introduction

The financial sector is beginning to face up to the reality of climate change.[1]  Increasingly, banks and other financial institutions are managing the immense pool of capital they control with an eye towards the risks posed – and the opportunities presented – by the changing climate.[2]  With respect to risks, they are taking the first steps towards effectively incorporating climate change into the due diligence inquiries they perform in making loan and investment decisions.  This article discusses the emerging diligence frameworks the financial sector is establishing to address climate change risks, and their efforts to develop a standardized approach to assessing those risks.  At the same time, financial institutions are aware that a challenge on the scale of climate change can present significant business opportunities, so this article also discusses how they are beginning to deploy immense amounts of capital towards energy efficiency, renewable energy, infrastructure and other projects aimed at reducing greenhouse gas (“GHG”) emissions and adapting to the impacts of the changing climate.

Background and Recent Developments

There is a consensus among climate scientists that the earth’s climate is undergoing a profound change, which in the absence of effective near-term action aimed at reducing GHG emissions, is likely to result in unprecedented environmental damage and socio-economic disruption.[3]  Over the last ten years, a patchwork of state and regional programs has emerged in the United States to reduce GHG emissions by imposing restrictions on power plants, encouraging energy efficiency, and spurring the installation of renewable energy resources such as wind and solar.  In 2015, the Environmental Protection Agency (“EPA”) promulgated the “Clean Power Plan,” a regulatory program under the Clean Air Act aimed at reducing carbon emissions from major power plants.  Those regulations formed the basis for the commitment made by the United States in the Paris Agreement, which has been signed by more than 190 countries, and entered into force just before the 2016 U.S. election.[4]  The parties to that agreement have pledged to adopt their own mix of mandates and incentives to achieve the emission reductions to which they have committed.

However, a sea change occurred in the regulatory outlook on climate change in the United States on March 28, 2017, when President Trump issued an executive order directing the USEPA to begin the process to rescind the Clean Power Plan, and seeking to unwind the previous administration’s numerous other initiatives on climate change.[5]  But while the Federal Government may be turning a blind eye to the climate problem, other levels of government are stepping up to confront it with regulatory programs crafted on local, state and regional levels.  This “bottom up” approach to climate change is likely to engender an increasingly complex and uncertain regulatory situation in the United States with respect to climate regulation. 

Furthermore, there is uncertainty regarding the nature, extent, and timing of the economic disruption that can be expected as climate change impacts take hold and countries around the world impose increasingly stringent GHG emission controls necessary to prevent the climate from spinning out of control.  Notwithstanding such uncertainty, the economic and social stakes are conservatively predicted to be massive and transformative.[6]  Indeed, some analysts have raised the specter of a “carbon bubble,” warning that much the world’s stock of coal, oil and gas reserves would be unburnable under future regulatory regimes and would thus become “stranded assets” – which would have a dramatic impact not only on the energy sector, but the global economy at large.[7]  Thus concerns regarding the risks, consequences and liabilities associated with climate change are growing as the enormity of the problem comes into focus.

This situation has grabbed the attention of the financial industry.  Because the foundation of the U.S. financial system is predictability, banks are becoming increasingly alarmed by what the future may hold for a world in the throes of climate change.  On a macro-level, that is why some of America’s largest banks supported a strong outcome in the Paris climate negotiations, and called for “[p]olicy frameworks that recognize the costs of carbon are … needed to provide greater market certainty, accelerate investment, drive innovation in low carbon energy, and create jobs.”[8]  At a more tactical level, banks are developing new tools to assess climate risks, and are directing massive – and steadily increasing – amounts of capital to energy and infrastructure projects necessary to cope with the problem.  

Banks are Beginning to Account for Climate Change in Due Diligence

Environmental due diligence has been a matter of routine in the financial industry for decades.  To date, the focus of traditional environmental inquiry in transactional due diligence has been limited to regulatory compliance and the potential for remediation liability associated with contaminated property.  But as concerns have mounted with respect to issues such as climate change, resource shortages, social inequity, corporate integrity and other environmental, social and governance (“ESG”) factors, the scope of financial due diligence is changing and expanding.[9]  More particularly, leading banks signed on to the “United Nations Principles for Responsible Investment” (“UN-PRI”) and the “Equator Principles,” whereby they have committed to address ESG issues in decision-making on investments.[10]  Moreover, certain of the nation’s largest banks, including Citi, JP Morgan Chase, Morgan Stanley, Wells Fargo, Bank of America Merrill Lynch (“Bank of America”), and Credit Suisse, adopted more specific “Carbon Principles”, whereby banks pledge to consider GHG emissions and the current and potential effect of climate-related regulatory policies when evaluating the financing of fossil fuel generation in the United States.[11]

A number of major banks have scaled up their in-house expertise and have engaged outside experts to assist in developing internal protocols to consider ESG factors in business decisions.  Some of the larger banks already have due diligence policies applicable to environmentally-sensitive sectors like energy, coal, oil and gas, agriculture, forestry, mining and timber.[12]  For example, Bank of America “maintains environmental and social risk policies related to climate change, forests, energy and certain high risk sectors.”[13]  Among other things, these internal policies require enhanced due diligence for projects presenting potentially significant climate change-related risks.  Significantly, Bank of America is working on a comprehensive ESG framework to establish “the parameters for how [it will] identify, measure, monitor and control risks related to environmental and social issues.”[14]

Likewise, JP Morgan Chase recently updated its ESG risk policy to create a “standardized process to refer certain transactions to [the bank’s] Global Environmental and Social Risks Management (“GESRM”) team” for enhanced due diligence review,[15] which involves “a tailored approach to ensure a comprehensive understanding of the transaction and associated risks.”[16]  Among the activities singled out for particular attention are those involving oil sands development, hydraulic fracturing, projects affecting the Arctic, coal mining and coal-fired power generation.  The framework prohibits the financing of certain activities altogether.  For other transactions coming within the scope of the policy, “GESRM will determine the requisite level of diligence according to the financial service or product being provided, and the nature of the underlying … risks.”  JP Morgan’s review will assess its client’s approach to environmental/social risk management at the corporate level, the asset level or both, and will focus on its client’s commitment and capacity to manage the risks relevant to its activities.  Its internal review team relies on in-house expertise and considers information disclosed by “publicly-available documentation and direct client engagement, where appropriate.”[17]  JP Morgan Chase reports that it focuses specifically on climate risks in its transaction and portfolio reviews, seeking “to better understand (i) how [its] clients manage their contributions to climate change …, and (ii) consider how [its] clients manage climate change related risk factors ….”[18]  In 2015, JP Morgan Chase referred a total of more than 1,500 transactions for enhanced review under the framework.[19]

Two separate, but related problems exist with respect to the assessment of climate risks by financial institutions.  One challenge is the difficulty associated with obtaining reliable and consistently-reported information about the physical and regulatory/policy risks their clients face at the project and operational levels.  Even where there is adequate information available, another challenge is determining if it is decision-useful and will illuminate the nature and extent of a client’s risks at the transactional and portfolio levels.

(a) Availability of Reliable and Consistent Data

With respect to the first issue, financial institutions performing due diligence reviews can collect climate-related information about major companies from “sustainability” or “corporate governance” reports those companies publish voluntarily on an annual basis.  Some of those reports are prepared in accordance with recognized standards, such as those established by the Global Reporting Initiative (“GRI”), which maintains a database accessible to financial institutions.[20]  In addition, each year, thousands of entities voluntarily report their GHG emissions and climate change strategies to CDP (formerly known as the Climate Disclosure Project), so CDP now has compiled an extensive repository of information on climate change, water and forest-risk, which investors may look to for information.[21]  CDP’s 2016 questionnaire solicited information on GHG emissions, climate change risks and opportunities, and governance and business strategy with respect to climate change.[22]

Disclosures made by companies under the U.S. securities laws may also provide useful information about a company’s climate-related risks, but only those risks deemed to be “material” are subject to such disclosure.[23]  Securities Exchange Commission guidance issued in 2010 identified three areas of risk that could merit disclosure, including: (i) legislation and regulation that could affect operating costs, (ii) indirect consequences of regulation or business trends and (iii) physical impacts.[24]

Compounding the problem relating to the availability of reliable information on climate risks, is the lack of uniformity in the manner and methods companies follow in compiling or reporting information -- to the extent they choose to make climate-related disclosures at all.  However, some progress has been made on this score.  The Greenhouse Gas Protocol developed by World Resources Institute (“WRI”) and World Business Council on Sustainable Development (“WBCSD”) provides a standard protocol for how to measure and report GHG emissions.[25]  In addition, the Sustainability Accounting Standards Board (“SASB”) has developed voluntary accounting standards to guide companies in disclosing sustainability and climate risks in SEC filings.[26]  SASB describes its mission as standardizing industry-specific protocols for disclosing information to “provide the capital markets with material, decision-useful, trustworthy information in a cost-effective way.” [27]  The SASB has developed standards for 79 industries in 11 sectors thus far.[28]  ASTM also has issued guidance for financial disclosures related to climate change for audited and unaudited financial statements.[29]

            In January 2016, the G20’s Financial Stability Board organized a task force, chaired by Michael Bloomberg, to develop recommendations for a uniform framework for the disclosure of financial risks and opportunities related to climate change.  On December 14, 2016, the Task Force released its final recommendations, which are intended to assist “all financial and non-financial organizations with public debt or equity” in determining what climate-related issues merit disclosure.[30]  The report characterizes the “catastrophic economic and social consequences” of unchecked climate change as “[o]ne of the most significant, and perhaps most misunderstood, risks that organizations face today.”  It notes that numerous climate-related disclosure frameworks already exist, but posits that the information produced under existing frameworks has been inconsistent, non-comparable, and lacking in the context necessary for a full understanding of its importance.  The report acknowledges that companies are often uncertain about what information to disclose and how to present it to potential investors, because there is no standardized disclosure protocol.  The Task Force’s recommendations and “implementation guidance” that accompanied the report, aim to address this problem by creating a framework for disclosure that allows companies to provide “consistent, comparable, reliable and clear” information.  The main recommendations are structured around four thematic topics—governance, strategy, risk management, and metrics and targets.[31]

Further, it bears emphasis that when red flags appear as a result of a due diligence review of publicly-available reports and other written information, banks may – and often do – engage with clients directly with respect to potential climate-related risks associated with their projects or operations.  Nuanced information may be derived in enhanced due diligence by posing specific questions, conducting site visits, and holding discussions with clients on their potential climate problems and how they are dealing with them.

(b) Assessing Risks in Decision-Making from Available Information

The second problem in climate-related due diligence relates to how a bank should go about assessing the risks once the necessary information has been gathered.  In addressing this issue, a distinction should be made between the physical, tangible and measurable risks of climate change and those non-tangible physical risks associated with the burning of fossil fuels and GHG emissions.  The assessment of physical impacts can be a daunting task, for several reasons.  First, the breadth of such risks is extraordinary, and may involve such wide-ranging problems as physical damage to facilities from storms and flooding, sea-level rise, fuel supply uncertainty, supply-chain disruptions from droughts, water shortages, and problems from socio-economic unrest.  Moreover, the timing and severity of such impacts are uncertain.  Since many companies have not done the work needed to develop reliable information on how climate change could affect them, there also is considerable uncertainty about the causality and materiality of such potential risks.  Banks are increasingly realizing the need to enlist the assistance of qualified environmental experts to assess such tangible risks inherent in large transactions involving far-flung and complex business operations.

Substantial progress is being made with respect to how banks might assess non-tangible climate risks.  The World Resources Institute and United Nations Environment Programme – Finance Initiative have worked with more than 150 representatives of the financial industry to prepare a report”[32] that provides risk managers with a conceptual framework to “think more consistently and systematically about [non-tangible] climate risk.”[33]  The report focuses on four categories: policy/legal risks (such as emerging governmental regulations), technology factors (for example, the disruption caused to the lighting industry by LED technology), market/economic factors (like the declining price of climate-friendly renewable energy) and (iv) reputational factors.  It distinguishes between “operator carbon risk” faced by the companies themselves, and “carbon asset risk”, which is the “[p]otential for a financial intermediary or investor to experience financial loss due to unmanaged operator carbon risk in its clients or investee companies.” [34]  The report provides a step-by-step guide on how to screen and assess risk exposure vis-à-vis each of the risk categories at both the sector and company levels, and offers suggestions as to how such risks might be managed.

Banks are Pursuing the Emerging Opportunities Presented by GHG Emissions Reduction and Climate Adaptation Efforts.

Massive projects – requiring the expenditure of trillions of dollars in the coming decades – will be needed to address climate change by displacing fossil fuel-fired generation with low and zero-carbon energy, protecting coastal areas from rising sea levels and storm surges, providing potable water to areas where existing supplies are disrupted, and otherwise preparing the world for the changing climate.  Public funds are one source of the capital needed for such projects, but significant private investment also is necessary.  Large American banks are already providing some of that capital, as is clear from their recent reports.  Bank of America reports that since 2007, it has provided approximately $53 billion in financing for low carbon activities, and has pledged to direct $125 billion more to low-carbon businesses by 2025 through lending, investing, capital raising, advisory services and developing financing solutions for clients around the world.[35]  Likewise, Citi already has provided more than $50 billion in climate financing, and has established a $100 billion goal to “lend, invest and facilitate … environmental and climate solutions” over the next ten years,[36] and Wells Fargo reports that “[i]n 2015, renewable energy projects owned in whole or in part by Wells Fargo, generated 10% of U.S. renewable energy.”[37]

The major banks also are acting as thought leaders in the development of the tools that will be needed to finance climate-related projects.  For example, Bank of America, JP Morgan Chase, Citi and others have collaborated to draft the “Green Bond Principles,” which provide transparency and disclosure guidelines for “green bonds” -- financial instruments used to raise funds dedicated to environmentally friendly projects.  Among other things, the Green Bond Principles provide issuers with guidance on the key components for launching a credible green bond and a process to evaluate the environmental impact of projects seeking green bond financing.[38]  A broad coalition of banks and other investors continue to advise the International Capital Market Association on refining the principles based on market experience.

Conclusion

In light of the actions taken by President Trump in the early days of his administration, there is considerable doubt as to whether the United States government will continue to play a leadership role on climate change, or even acknowledge its existence.  But political considerations are not obscuring the financial institutions’ perspective on the problem.  They are squarely addressing the climate risks that will confront businesses and the economy in the 21^st century, and are bringing their financial resources to bear in developing solutions.  This is one of the many reasons that substantial progress can be made in addressing climate change in the coming years, with or without the participation of the Federal Government. 

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