Thread by @jeuasommenulle

It’s finance day at the #COP26, so time to fulfill an old promise: a thread about climate change and banks!

First things first: please no debate about whether climate change is real or not, it’s boring – so let’s use it as a postulate and discuss the rest.

The topic is endless so I will only make a few important points.

1st point & THIS IS THE MOST IMPORTANT:

ENERGY TRANSITION WON’T HAPPEN WITHOUT THE BANKS ON BOARD.

Forget green bonds, they’re (almost) useless, for many reasons. Banks finance 70% of the European economy and bonds just a tiny fraction. So green bonds a microscopic fraction.

Moreover, green bonds mostly finance existing assets (cash is fungible with cash!) so issuing a green bond literally changes nothing to a bank’s balance sheet.

In fact, one bank has already said it will finance all its MREL with green bonds – with no balance sheet impact.

2nd point: forget ESG.

The worst enemy of “green finance” is ESG.
Why?

Because ESG mixes so many different things, you end up with environmental issues being less important than board meeting attendance or # independent directors.

I mean, most ESG rating providers will say that environmental factors count for approx. 10% in a bank’s ESG rating (which is fair, if you’re interested in risk assessment.)

So if you build you ESG fund and put banks in there, you can’t have “green banks”.

You could argue that you can just discard other ESG factors, i.e. keep only the E factor, but no, SFDR does not let you do that.

If you go for a super green bank with poor S and G, then your ESG rating will be low, which is not accepted in a ESG fund!

So the outcome is basically that for a ESG fund it's extremely difficult to focus on environmental issues for banks. (At least in Europe).

How smart is that?

3rd point: forget the “climate change risk” for banks.

This is total bullshit and if you look at the details of the framework for climate stress tests published by the ECB, it’s crystal clear.

They’re just modelling GDP changes over 30y and then regress loan losses – LOL

But why bullshit?
It’s pretty simple: energy transition risk is a 30-year risk. Banks’s lending books are 3 to 4-year risk.
There’s no way what happens in 30 years, or even 10 years, is a risk to a bank’s balance sheet.
They’ll just change the loan book as the economy evolves.

If you don’t believe me, just take the example of one of the shittiest books out there: Monte Paschi’s SME lending book.

Average maturity is 3 years.

If you really think climate change will change that risk, please subscribe to my substack for only 100k per month.

So why all the noise about climate change risk for banks? Just my opinion, of course, but basically governments are too weak to impose strict lending / business rules. So they go to the central banks and say “hey, could you do my job, please? *You* don’t need to be reelected”.

But of course, central banks reply

“Hey, we don’t have the powers to direct lending! This is still a free-market economy… oh wait! We can say this is *risky*! We can say “Pillar 2 add-ons”. We can say “more capital” because risky!"

So the fake risk is just a backdoor way of making the financing of some businesses more expensive.

But it’s a very poor & inefficient way of doing it: it’s messy, unclear, full of poor modelling assumptions, cross subsidies, etc.

4th point: NGO & “dirty deals” monitoring is sometimes useful, but not always.

NGOs do a great job of pointing out how the big banks still finance controversial projects (pipelines, Arctic drilling, etc.) but this is still a tricky topic .

Why?

Reason 1: Unless the businesses are banned, it’s hard to stop all financing. If banks don’t do it, others will, probably with bigger returns but less regulatory oversight.

Reason 2: those are big projects, it’s always going to be big IB banks which finance it, not your favourite micro-lender.

Reason 3: it’s nice to flag bad deals, but often they’re 0.01% of a bank’s balance sheet! I’d rather have a bank invest in tons of businesses with low emissions and one ugly pipeline then a bank which invests in 0 controversial deals but has only carbon intensive clients!

In other words, if you want to understand how much a bank contributes to climate change, you have to do the full package: an extensive analysis of the loan book.

When I see some ESG raters looking at the way a bank manages its waste or its travel policy… I’m laughing.

Sure, it looks good to say at Davos you’ve reduced the use of corporate jets but, errrr… this is like the tiniest drop in the ocean of your balance sheet.

5th point: climate/environmental reporting is necessary but so far it’s very messy.

I spent a huge amount of time trying to score banks based on their environmental disclosures. And then I spent a huge amount of time trying to score banks based on their actual loan books. And…

SURPRISE SURPRISE: the correlation between the two scores is very negative (approx. -40%)

Who would have guessed that the dirtier the bank, the more it says it’s clean?

Yeah, I know, everyone, but it’s still nice to see the hard facts.

So, when a bank goes all-in on environmental disclosures, it’s time to be VERY careful.

Where does this leave us? I don’t think there’s a choice: bank should disclose the carbon footprint of their loan books in a very granular way. Obviously, this is easier said than done because there are many possible methodologies and pitfalls

See this excellent report :
gsf.institutlouisbachelier.org/publication/th…)

To make things even trickier, I’m not sure we can trust the banks on this, as the following chart shows. Which means it has to work with everyone on board: investors (with sufficient “Pillar 3” disclosure), supervisors and climate modelers. Not an easy task!

What’s the bottom line here?

I think we just need to be more honest.

This is a big topic which is NOT about ESG, NOT about Green bonds, NOT about risk taken by banks, NOT about dodgy deals that make the headlines, NOT about capital requirements shenanigans.

This is about doing an X-ray of each bank’s loan book and estimate how much it contributes to climate change.

This is where all efforts should go.

The rest is a sideshow that does nothing but delay the solution.