Derivatives have the potential to increase a bank’s climate risk exposure and should be included in disclosures of firm-wide total financed emissions according to Ceres.
The nonprofit organisation that works with capital market leaders on sustainability challenges reviewed the financial risks that derivatives activities pose for the 25 largest U.S. banks in a new report, Derivatives & Bank Climate Risk: Financing a Net Zero Economy.
Jim Scott, Senior Advisor for Financial Institutions for the Ceres Accelerator for Sustainable Capital Markets at Ceres, said in statement: “Given the size of the derivatives market and its systemic importance, it is the proverbial ‘elephant in the room’ when it comes not only to banks’ calculation of financed emissions and enlarging a bank’s sustainable finance opportunity set.”
Financial institutions rank third for scope 3 emissions according to the report (see graph). Ceres highlighted that their derivatives activity is not covered in the PCAF financed emissions methodology, the recognised standard for carbon accounting by financial institutions and banks. Financed emissions disclosures by banks are currently just focused on lending.
“PCAF and its participating banks should begin to set the groundwork for the inclusion of derivatives in financed emissions over the next few years,” added Ceres. “Since almost all existing bank targets are based on financed emissions, it is critical that a methodology to include derivatives in financed emissions is developed as soon as possible so banks can begin to align with investor expectations such as the IIGCC benchmark.”
Including derivatives in the attribution of financed emissions would tend to increase the financed emissions of the largest banks and decrease the financed emissions of all other financial institutions as the top five U.S. bank derivative providers hold approximately 95% of the market.
“While this does add some complexity, it appropriately reflects the centrality of the global systemically important banks to the energy transition and gives additional weight to their unique ability to influence the energy transition through their financing and risk management activities,” said the report.
Ceres made six recommendations for banks to address the climate risk posed by derivatives – begin evaluating how derivatives can impact overall climate risk and opportunity; update internal models to include climate risk factors; advocate for smart financial regulations in support of enhanced climate risk management of derivatives activities; engage with borrowers to help them develop transition plans including derivatives; include derivatives in the disclosure of firm-wide total financed emissions; and update 2030 targets, and 2050 commitments, to include derivatives.
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