Rush to phase out fossil fuels could trigger financial instability

Commodities investor Rick Rule believes he has spotted a tantalising opportunity. Thanks to environmental, social and governance (ESG) policies, a growing number of established banks are pulling back from financing oil and gas explorers, leaving an opening for new lenders.

“It didn’t occur to me in my wildest dreams that I could compete in the sector, given the fact that on a global basis, [energy finance is] the province of the largest multinational banks, organisations and investors on the planet,” says Mr Rule. 

One way he is taking advantage of this opportunity is by teaming up with banker Frank Trotter to co-found Battle Bank. The bank, which is expected to be operational around the second quarter of this year, will offer high-yield chequing accounts, precious metals dealing, multi-currency accounts and various investment products. It will also look at providing bespoke financing for extractive industries. 

“We’re looking at some of the fossil fuel items … We have the sophistication in somebody like Rick to be able to identify some opportunities and see if we can get a higher risk adjusted rate of return,” says Mr Trotter. “We’ll look at projects across a wide array of areas. But there’s no formal decision at this point about where the money is going.” 

Meanwhile, policy-makers are making a concerted effort to steer the financial sector away from supporting fossil fuel producers. They are concerned that carbon emissions from fossil fuels are causing global temperatures to rise, which could threaten ecosystems in parts of the planet. The EU, for example, drafted a green taxonomy designed to gradually choke off financial support for fossil fuels.

Banks with big fossil fuel exposures face activism from institutional investors, environmentalists and also from prudential regulators who are edging towards imposing higher capital charges. Prudential regulators are concerned that banks could end up exposed to stranded fossil fuel assets that cannot support the financial claims against them. They also worry that climate change could hit other parts of their loan portfolios. 

A worrying portent 

Monsur Hussain, senior director, financial institutions, Europe, the Middle East and Africa at Fitch Ratings, highlights that the Netherlands is providing a taste of what could be awaiting the oil and gas sector. The Dutch government wants farms emitting the most ammonia and nitrogen oxide to drastically cut their emissions or sell their properties to the state. “Certain agricultural sectors are revisiting the economics of their business models, which in turn directly affects bank impairments in those sectors,” he says.  

Specialist commodity lender Rabo Bank is feeling the pinch on its Dutch agricultural exposures. In August last year, it was already warning that its stage-two exposures – those at higher default risk – surged by 35%. 

This is a number that makes prudential regulators sit up and take notice and ponder how such interventionism might play out with fossil fuels. “It’s been clear that the prudential authorities have been struggling to come to a consensus on whether or not to incorporate malice factors as it relates to so-called brown assets or brown exposures,” says Mr Hussain. He notes that policy-makers at the Bank of England and the European Banking Authority are trying to be measured about the transition to clean energy without damaging banks. 

There has been much debate among regulators over imposing discretionary capital charges on banks with big fossil fuel exposures via the supervisory review and evaluation process (Pillar 2) in the Basel framework. Mr Trotter is not phased, noting that Battle Bank intends to hold more capital than stipulated under current prudential rules anyway. 

“There is a growing expectation from regulators and supervisors for entities to integrate ESG and, in particular, climate and environmental factors into their risk management processes,” confirms Julia Lucena, climate risk manager at CaixaBank. She cites as an example the European Central Bank issuing its “supervisory expectations guide on climate-related and environmental risks” in November 2020. It is requiring banks to fully align with those expectations by December 2024. 

Mr Hussain says European bank exposures to oil and gas amount to around 1.5% of assets, but warns that this obscures big differences between individual institutions. Also, banks have exposures to high-energy intensity industries such as steel, which also face carbon emission challenges. 

Sounding the retreat

Mainstream banks are taking this on board. Late last year, HSBC and Lloyds Banking Group announced that they will no longer finance new fossil fuel projects. 

However, climate activities claim that many bank ESG lending policies are riddled with loopholes. For example, they may make loans at group level that end up being channelled to subsidiaries for new fossil fuel projects.  

They also stress that banks are moving too slowly. They point to reports such as the one by advocacy group Reclaim Finance called ‘Banking on Climate Chaos’, which claims that the 60 largest banks advanced nearly $4.6tn for fossil fuels in the six years to March 2020. 

Still, many banks are now reducing their fossil fuel exposures for business reasons. “CaixaBank has identified the coal (energy subsector) and oil and gas sectors as the highest priority sectors in terms of transition risks,” says Ms Lucena. She explains that those risks are associated with the regulatory push toward a low-carbon economy, energy-efficient alternatives, obsolescence or changes in the preferences of consumers and market participants.

“Therefore, our efforts are now focused on better managing the loan portfolio in order to seek alignment of indirect impact on climate change with our risk appetite and commitment to sustainability objectives,” says Ms Lucena. 

She explains that embedding climate factors into CaixaBank’s overall risk assessments does not necessarily mean that it will only finance renewable-type projects. “There are a lot of great companies that may be in fossil fuel industries now but that are actually very committed to do this transition,” she says. “Hence we can also get to net zero by incentivising our clients through innovative financial structures, to ensure that they comply with targets or even exceed those key performance indicators related to sustainability.” 

And this shift in lending priorities is having an impact. Mr Rule, who also owns several oil and gas properties, says the pool of banks he can do business with is changing. Many of the big North American household name institutions are withdrawing from the sector, leaving certain regional and specialist lenders to fill the void.

He explains that loans to smaller producers in the $50m-$100m range have seen rates spike to 200-250 basis points (bps) above the prime rate from 50bps a few years back. This comes with more restrictive loan covenants. Also, these smaller institutions have less balance sheet flexibility to ride oil and gas market  cycles. 

Stranded threat

However, there is no escaping the fact that many banks are concerned that the politically mandated shift away from carbon-intensive activities could see them saddled with stranded assets. 

The University of Massachusetts calculated last year that $1.4tn in oil and gas projects could lose value if global policy-makers manage to slash carbon emissions. Furthermore, financial institutions could end up with $681bn in worthless assets on their balance sheets. Indeed, some experts are already drawing comparisons with the implosion of subprime mortgages, which triggered the global financial crisis in 2007-9. 

In 2020, the University of Cambridge did a deep dive and found that more than 6500 financial institutions have $2.81tn in exposures to the 26 largest listed oil and gas companies. In particular, it found that bonds issued by these companies could be a particularly big threat. For example, they accounted for nearly 60% of potential stranded fossil fuel asset exposures of insurers.  

This also has implications for some sovereign credit ratings and the banks exposed to them. Carbon Tracker, a think tank, estimates that stranded fossil assets could cost oil producers more than $28tn in revenues within the next two decades, with the Arabian Gulf producers being particularly vulnerable.

However, the threat to banks from fossil fuel exposures might be overstated, at least for now. 

“The rate of bank lending to fossil fuel companies is increasing at a reasonable pace, not a bubble-inducing pace. So there is little evidence that loans to energy companies have a greater than normal risk of sliding to subprime,” says DR Barton, chief investment strategist at Finiac, a provider of investment portfolio management tools. He believes that the dangers of even moderate duration fossil fuel loans defaulting due to climate change is actually decreasing because energy prices remain firm.  

Besides loan tenors tend to average around six to seven years. “Most of these transition regimes are four to five years away … so banks should be able to actually turn their books away from the most sensitive sectors,” says Mr Hussain.  

Underinvestment dilemma

The UN’s Intergovernmental Panel on Climate Change warned in 2018 that there would be severe climate implications if average global temperatures rose by 1.5 degrees Celsius above pre-industrial levels and that it would be significantly worse at 2 degrees Celsius. It added that to remain below 1.5 degrees, carbon emissions would need to peak before 2030 and net zero emissions globally needed to happen by around 2050. A growing number of countries have set legally binding net zero targets and are co-ordinating their efforts through the UN’s Climate Change Conference. These include achieving carbon neutrality by 2050 and keeping global warming below an increase of 1.5 degrees Celsius. This equates to dramatic reductions in fossil fuel usage. 

However, many industry experts warn that the timetables pursued by some countries are unrealistic and will likely not be met. 

Illustrating the colossal task ahead, Mr Rule says $4.6tn has been invested in alternative energy sources so far, which has only nibbled at the market share of fossil fuels. Even more disappointing for climate activists is that the most polluting of fossil fuels, coal, saw record demand last year, according to the International Energy Agency.  

This disconnect between ambition and reality is making many oil and gas professionals more relaxed about transition risks than policy-makers.

“The regulators, I think, would do well to recognise that one billion people on earth have no access to primary electricity. There are another two billion people that have access to intermittent or unaffordable electricity,” says Mr Rule. “The consequence of all that is that I suspect that peak oil demand doesn’t occur, like the big thinkers think, in 2030, but rather 2045 or 2050 and then with a 35- or 40-year tail.”

Also, they warn that the dash for renewables, at the expense of fossil fuel investment, could have unintended consequences. 

On January 11, Morgan Stanley pointed out in a report that under-exploration in the oil and gas sector is a concern. Indeed, many of the supermajors, particularly European ones, are diverting chunks of their investment budgets away from fossil fuels and into renewables instead. Reflecting on such decisions, Morgan Stanley said that in real terms investment in exploration showed another real-term decline last year. It explained that spending on oil and gas exploration was practically unchanged in 2022 at $55bn, similar to the lows of the past 20 years, even in nominal terms. This has resulted in a 10-year low in the drilling of new wells, while discoveries remain around historical lows despite a recent modest uptick. 

“Spending on field development rebounded, but much of this was to absorb cost inflation, which accelerated strongly,” the report’s authors wrote. They also found that oil and gas projects need to demonstrate ever higher returns on investment to get funded. 

It highlighted that the reserve replacement ratio to global consumption is a mere 17%. “To be clear, this figure does not need to be 100% to have sustainable oil supply. Upwards revisions to reserves in already-producing fields can also contribute to aggregate reserve replacement. Still, 17% from new discoveries is very low,” the report’s authors wrote. If fossil fuel production capacity atrophies, prices could skyrocket before renewables are able to take over. 

Opec estimated in its 2022 World Oil Outlook that $12.1tn of investment is needed to avert an energy crunch. But some energy analysts believe it is too late to completely avert a crisis given long ramp-up times for new fossil fuel projects. This could lead to financial instability as economies lurch from boom to bust in sync with fluctuating energy prices. In turn, many loans to businesses and households could sour. 

Coming backlash? 

Mr Barton argues that political obligations to ensure populations have their basic energy needs fulfilled along with changes in suppliers – namely Russia being ostracised from Western markets due to its war in Ukraine – likely means the transition away from fossil fuels will be slower. Meanwhile, an increasingly hostile backlash against climate activism coalescing around the Republican party is brewing in the US. This could have consequences for US climate change policy in the years to come.

Larry Fink, CEO of asset manager BlackRock who also reckons fossil fuels will be used for decades to come, is pushing for greater investment in carbon capture technologies as a bridging solution. 

Societies could face the unpalatable choice of either having to manage significant climate change or decarbonise so quickly that the global economy becomes severely damaged. This is a particularly difficult environment for banks to navigate. With the encouragement of prudential regulators concerned about systemic risk, they will likely lean towards more conservative lending policies as an insurance against harder-to-predict impairments. 

This article first appeared in Global Risk Regulator, a sister publication of The Banker.