5.2.2 Transition risks

To avoid a dangerous climate change to actually happen, a transition is needed towards a carbon-neutral economy. New climate-related regulations, advancing technologies and changing consumer preferences give shape to this transition. This transition is essential in reaching the Paris-set goals and ambitions. However, the transition will also confront the financial sector with new risks.

A DNB survey shows that the Dutch financial sector has considerable exposures to sectors that emit high levels of greenhouse gasses, like energy, transport, heavy industry and agriculture. These exposures have even slightly increased compared to 2015. New climate policy measures and rapidly advancing carbon neutral technology may hit these high emission companies and assets hard, leading to a (sudden) loss of value and making it necessary for financial institutions to prematurely write-down their loans and investments.1

A well-known term, in this respect, is the “carbon bubble”. The carbon bubble hypothesis posits that the value and credit quality of fossil fuel producers, which is partly based on the level of reserves they now have, is actually lower than the present market value. When this suddenly becomes apparent, e.g. as a result of more stringent climate regulation, it could lead not only to considerable write-downs but also to shocks on the financial markets.2

Another example is the upcoming stricter climate regulation for the Dutch commercial real estate sector. In the Netherlands, as of 2023, all office buildings will have to meet minimum energy efficiency requirements (“Energy label C”), or face closure.3 In 2017, it was estimated that half the offices in the Netherlands did not meet this requirement. A DNB- investigation also revealed that a large share of the buildings used as collateral scores poorly in terms of their energy labels. A revaluation of this collateral will be necessary, should these buildings not meet the required standards in time.4

The speed of the energy transition has a key impact on how these risks will materialize. When businesses are able to gradually adjust to reduced levels of greenhouse gas emissions, this will limit the risk of premature write-downs for financial institutions. The adjustment costs will be much higher if the transition has to take place quickly. However, limiting global warming to two degrees Celsius, as is agreed in the Paris Agreement, requires a very steep transition and it is therefore possible that governments will take stricter measures over the coming years. This will lead to much higher adjustment costs.5

DNB repeated this warning in October 2018, after performing a first energy transition risk stress test for the financial system of the Netherlands.6 In this stress test DNB analyzes four global scenarios. The scenario which is found to be the most probable one, combines a “policy shock” scenario (meaning that a set of policies designed to reduce CO2 emissions is abruptly implemented, pushing the carbon price up by $ 100 per ton) with a “technology shock” scenario (meaning that the share of renewable energy in the energy mix doubles, due to a technological breakthrough). In this double shock scenario, Dutch banks, insurance companies and pension funds together would stand to lose € 159 billion. In (just) a technology shock scenario, these institutions would lose €48 billion, while in (just) a policy shock-scenario this would accumulate to €111 billion.

However, if no technological breakthrough is reached and no concrete policy measures to combat climate change are taken, the discrepancy between the (Paris set) ambitions and actual practice may lead to a “confidence shock” in society and €98 billion of expected losses. Also, taking insufficient action or taking action too slowly (“too little, too late”), may lead to a dramatical increase of physical risks.

New climate-related rules and regulations can be expected on both a European and a national level. As mentioned in paragraph 5.1, the European Commission is determined to reach the Paris-set goals and ambitions and regards the financial sector as instrumental in reaching those goals. In May 2018, The Commission adopted its first package of measures, implementing several key actions announced in its Action Plan. The package includes a proposal for a Regulation on the establishment of a unified classification system (‘taxonomy’) on what can actually be considered an environmentally sustainable economic activity.7 The Commission also adopted a proposal for a regulation on disclosures relating to sustainable investments and sustainability risks.8 A third proposal involves amending the benchmark regulation, creating a new category of benchmarks comprising low-carbon and positive carbon impact benchmarks. This will provide investors with better information on the carbon footprint of their investments.9

The Commission has furthermore announced that requirements to integrate sustainability considerations in investment decision-making processes, as part of institutional investors’ and asset managers’ duties towards investors and beneficiaries (fiduciary duties), will be further specified through delegated acts. In addition, the Commission is working on delegated acts to include environmental, social and governance (ESG) considerations into the advice that investment firms and insurance distributors offer to individual clients.10

Other points, formulated in the Action Plan, concern e.g. establishing EU labels for green financial products, fostering investments in sustainable projects, better integrating sustainability in ratings and market research and incorporating sustainability in prudential requirements, introducing a ‘green supporting factor’ in the EU prudential rules for banks and insurance companies.11 Further progress on these action points may be expected.

On the national level, the new legislative proposal for a Climate-Act (Klimaatwet) in the Netherlands may also lead to new rules and regulations that will affect the financial sector. The ambitions set in the Dutch Climate-Act go even further than the Paris-set goals and ambitions.12 Up until now, it has proven difficult to translate these high ambitions into actual, stricter regulation,13 but the Urgenda-judgement dated 9 October 2018 may well speed up the process.14 In this remarkable case, the Court of Appeal in The Hague ordered the Dutch State to reduce greenhouse gas emissions by the end of 2020 with at least 25%. The Court of Appeal concludes that a real threat of dangerous climate change exists, resulting in the serious risk that the current generation of citizens will be confronted with loss of life and/or disruptions of family life as mentioned in articles 2 and 8 ECHR. It follows from these human rights provisions that the State has a duty to protect against this real threat.

At the time of writing, the Dutch government was still considering lodging an appeal to the Dutch Supreme Court, but it has also confirmed that the State will give appropriate effect to the judgement of the Court.

New climate-related legislation as described above, combined with rapid technological developments and changing consumer preferences, may necessitate financial institutions to reconsider and revise their business models, business practices and strategies. Transition risks may arise when financial institutions are insufficiently aware of these changes and the implications thereof for their companies. This may result in adapting too slowly to the new reality, resulting, for instance, in legal violations and/or severe risks to the financial viability of the company.

In the transition towards a carbon-neutral economy, “green finance” is emerging. The market for green bonds, for example, is expanding rapidly.15 The same holds true for sustainable investments.16 These developments are furtherly propelled by the increasing commitment of financial institutions to sustainability Codes, Guidelines and Principles. Examples are the OECD Guidelines for Multinational Enterprises,17 the United Nations Principles for Responsible Investment,18 Climate Action 100+19 de Equator Principles III,20 and the Principles on Climate Obligation of Enterprises.21 Dutch initiatives are, for example, the Climate-statement Banks 2017, issued by the Dutch Banking Association (Klimaatstatement Banken),22 the Code for sustainable investments (Code Duurzaam beleggen) and the Agreement for international socially responsible investment in the insurance sector (IMVO Convenant Verzekeringssector), dated July 2018.23

Green finance can be a very powerful stimulus in the transition towards a carbon-neutral economy. However, as green finance is emerging, the risk of bubble creation increases. This can happen if it is (suddenly) realized that financial markets’ expectations about new technologies and “green” firms were too optimistic. DNB warns that investors and lenders must beware of such risks in the course of the energy transition.24 These risks are also related to liability risks and reputational risks, to be discussed hereafter.