This whitepaper discusses the incorporation of climate factors into a bank's pricing framework and explores the unique set of challenges presented by this integration.
Introduction
In the dynamic world of banking and finance, the concept of a comprehensive yet granular pricing framework has endured as a critical strategic tool. Used correctly, this has been deployed as a comprehensive approach to how banks set prices for their services that reflects the merits and risks of the overall relationship with a customer. By accounting for costs like funding, liquidity, credit risk, capital concentrations, operational expenses, and service delivery, banks can boost profitability, improve customer satisfaction, and strengthen competitive positioning, thereby effectively aligning the business strategy to Banker incentives. However, as the financial landscape evolves, a new factor is making its way into this complex equation: climate impact considerations (i).
Key regulators have already established that climate change falls within their supervisory objectives and have articulated expectations for the management and disclosure of related risks (ii), while a number of financial institutions have made public commitments to align their portfolio to net zero pathways by 2050. The Net Zero Banking Alliance (NZBA) at present counts more than 130 banks, covering in excess of 40% of global banking assets (iii). At the same time, net zero transition financing poses commercial opportunities for banks. Depending on policy outcomes, as much as USD 2.5 trillion of net zero finance is expected to flow through the banking system every year through 2050, with another USD 1 to 1.5 trillion anticipated through equity investments (iv).
This paper explores the integration of climate considerations within a bank’s pricing framework. It will delve into the intricacies of how partially it may already be embedded within pricing relationships today. It will also discuss some of the challenges and potential solutions for incorporating climate factors into a pricing framework. As we journey from the snowfall predictions affecting a company’s earnings to the concept of greeniums in sustainable finance, ultimately this paper seeks to anchor the discussion to a quantifiable point of reference, so components of climate risks and opportunities can effectively be deployed in the banking sector.
Role of a Pricing Framework
Business Strategy
A comprehensive pricing framework is a strategic tool used by banks to set prices for their services based on the overall commercial relationship with a customer. This approach considers a multitude of factors including the nature and volume of the business, the composition of services used, the duration of the relationship, the market cost of debt and equity capital, and the customer’s creditworthiness. The relationship pricing framework allows for a more holistic view of the customer, going beyond individual transactions and instead focusing on the dynamics of the entire relationship.
Essentially, the relationship pricing framework is a dynamic way to align the cost the customer pays for banking services with the true value of the customer to the bank. It takes into account not only the direct revenues generated from the customer through interest and fees but also the indirect benefits such as the customer’s impact to the bank’s funding stack, as well as the overall contribution to the bank’s portfolio diversification. This framework also plays a vital role in maximizing profitability for banks. By adjusting prices based on the customer’s value, banks can incentivize desirable customer behavior, such as maintaining a larger account balance or using a wider range of services, ultimately aligning to the bank’s critical strategic objectives. Finally, the comprehensive view of the customer’s activities allows banks to identify drivers of risk and costs and mitigate or manage those more effectively, improving overall profitability, and operational efficiency.
Ultimately, a thoughtful and comprehensive pricing framework can drive improvements in a bank’s competitive positioning in the marketplace. In an increasingly competitive banking environment, the ability to provide bespoke pricing based on a deep understanding of the customer’s relationship can differentiate a bank from its competitors, enabling customer attraction, satisfaction, and retention.
Over time, pricing frameworks have evolved to thoroughly integrate risks and costs, better capturing the value that banks deliver to customers. In his 1993 address to the Federal Reserve Bank of Kansas City’s annual Economic Symposium, Charles S. Sanford, Jr. the then CEO of Banker’s trust, laid out a vision for how finance would evolve over the following 27 years. His paper, “Financial Markets in 2020” (v) begins with:
"At Bankers Trust, we spend a lot of time anticipating trends in the financial markets, not only those affecting short-term price movements but also those that are responsible for the long-term evolution of the system itself.
Anticipating the longer term is especially compelling today considering the speed at which the financial system is changing. Even our inherent romanticism doesn’t let us forget that we are straddling the twentieth and twenty-first centuries, a period when more than ever the future seems just around the corner."
Referring back to Sanford’s address, he introduces the idea of “particle finance”. Under this idea, he predicts that financial attributes will continue to be decomposed into their component parts “creating order from apparent disorder (and) providing building blocks that will allow the more effective packaging and management of risk in an economy whose structure is constantly changing.” Applying this idea to a comprehensive pricing framework, a bank will seek to decompose the value that is being delivered to the client, as well as the risks that the relationship with that client poses to the bank. Once this is complete, the bank can explicitly charge accordingly, and even begin to drive execution of its strategic objectives, current priorities, incentivize banker behavior, and encourage the adoption of certain products and services by the bank’s clients. Conceptually, these two categories in a pricing framework can be thought of as costs and risks. Examples of these include:
Costs & Risks
1) Costs to Sell, Service, and Deliver
Funding Costs: Known as “Funds Transfer Pricing” or FTP, this pertains to the expenses a bank incurs to secure the funds necessary for a particular transaction. This includes interest paid on deposits, borrowings, and other funding sources. Specifically, banks attempt transfers the market interest rate ‘cost’ of raising liability funding onto both short- and long-term balance sheet assets; effectively through matched-maturity funding. This is often referred to as an interest rate component of FTP, with the other component being a term liquidity premium, that is highlighted below.
Capital Costs: This refers to the costs associated with holding capital to absorb potential losses for a particular transaction. This includes the cost of equity and the cost of debt. Banks strive to optimize their capital structure to minimize capital costs while maintaining adequate capital levels to ensure continued safe and sound operations in the event of a loss, as well as to meet regulatory requirements.
Operational Costs: This encompasses the day-to-day expenses involved in running the bank. These costs include salaries, overheads, technology costs, and regulatory compliance costs. Depending on which combinations of products or services a customer of a bank may utilize, certain costs may be more or less applicable to their relationship. For example, a shared national credit is not using the residential mortgage team’s resources and should not be charged for that portion of a bank’s operations, but they may be utilizing the bank’s broker dealer or trading teams if they participate in a back-to-back interest rate swap – and should be charged accordingly.
2) Risk and Contingent Events
Credit Risk: Credit risk represents the potential losses a bank may face due to a borrower’s non-payment of a loan pursuant to the terms and conditions of the loan agreement. It includes provisions for bad debts and write-offs and should reflect the expected value deterioration in the loan, derived from the probability that the borrower will default, and the loss that the lender will incur in the scenario in which the borrower does default.
Market Risk: Loss in the value of a loan caused by changes in market variables that are relevant to that loan. Examples of this could be changes in reference interest rates Indices, foreign exchange rates, equity prices, commodity prices, and many others.
Liquidity Risk: Once capital is extended, at any moment a bank may be faced with a situation where they have to maintain or extend a cash outflow position either expectedly or unexpectedly. This requires banks to hold sufficient liquid assets in order to meet these contingent obligations. Sometimes, these events can be part of the features of a loan, such as with revolving lines of credit or credit cards, where the borrower has the option to execute a drawdown of credit that the bank is obligated to fund, while others could be the result of changes in the funding markets like we have seen in the first half of 2023. To summarize, these risks constitute situations in which the bank may be required to commit capital contingent on certain criteria or events, so they must maintain a capital buffer in order to meet these potential obligations over the term of those obligations. As such this is referred to as a “Term Liquidity Premium” and is also commonly incorporated into FTP frameworks.
In addition to these components, pricing frameworks commonly include other items such as tax implications and regulatory costs as they are relevant. By considering all these various factors, a bank can set prices that accurately reflect the costs and risks associated with its services. In contemplation of integrating climate considerations into this type of framework, we will examine how these components can be influenced by climate factors, adding a new dimension to this financial architecture.
Introduction of Climate
To consider how best to begin including emerging risk considerations into how a bank prices for value, one useful place to start would be where they are being compelled to engage in certain behavior, or report specifics of their business – in other words, what specifically are regulators requiring? One of the most notable areas that has emerged as requiring explicit action and reporting driven by regulators across the globe, is climate and the environment:
Regulatory Developments
» World leaders have identified climate change as a significant facet of sustainable development. To that end, 196 Parties at the 2015 UN Climate change conference (COP21) entered into a legally binding treaty aimed at holding “the increase in the global average temperature to well below 2°C above pre-industrial levels” and pursue efforts “to limit the temperature increase to 1.5°C above pre-industrial levels.” (vi)
» More recently, the UN Special Envoy on Climate Action and Finance and the COP26 presidency, in partnership with the UNFCCC Race to Zero campaign launched the Glasgow Financial Alliance for Net Zero (GFANZ), as a global coalition aimed at accelerating transition to a net-zero global economy. Current membership counts more than 650 firms across eight net zero financial sector alliances, like the Net Zero Banking alliance (NZBA), the Net Zero Insurance alliance (NZIA) and the Net Zero Asset Managers Initiative (NZAM). (vii)
» The Financial Stability Board established a task force aimed at developing disclosures to provide stakeholders, such as investors, information relating to potential financial risks from climate related considerations. The Task Force on Climate-related Financial Disclosures (TCFD) recommendations were published in 2017, and although voluntary they have already been endorsed and adopted by a number of banking supervisors and financial reporting standard organizations such as the International Financial Reporting Standards Foundation (IFRS) and the European Financial Reporting Advisory Group (EFRAG). (viii)
» In May of 2020 the European Banking Authority (EBA) released an update to the guidelines on loan origination and monitoring which specifically addresses new supervisory priorities that account for the growing importance of ESG factors. Specifically, in section 4, which addresses internal governance for credit granting and monitoring, clause 4.36 (Environmentally sustainable lending) states (ix):
Institutions that originate or plan to originate environmentally sustainable credit facilities should develop, as part of their credit risk policies and procedures, specific details of their environmentally sustainable lending policies and procedures, covering the granting and monitoring of such credit facilities. These policies and procedures should, in particular:
a. Provide a list of the projects and activities, as well as the criteria, that the institution considers eligible for environmentally sustainable lending or a reference to relevant existing standards on environmentally sustainable lending that define what type of lending is considered to be environmentally sustainable;
b. Specify the process by which the institutions evaluating that the proceeds of the environmentally sustainable credit facilities they have originated are used for environmentally sustainable activities. In cases of lending to enterprises, the process should include:
[i] collecting information about the climate-related and environmental or otherwise sustainable business objectives of the borrowers;
[ii] assessing the conformity of the borrowers’ funding projects with the qualifying environmentally sustainable projects or activities and related criteria;
[iii] ensuring that the borrowers have the willingness and capacity to appropriately monitor and report the allocation of the proceeds towards the environmentally sustainable projects or activities;
[iv] monitoring, on a regular basis, that the proceeds are allocated properly (which may consist of requesting that borrowers provide updated information on the use of the proceeds until the relevant credit facility is repaid).
Reporting Developments
Ultimately, this regulatory work is being codified in reporting requirements. A recent example of this can be seen in the form of specific financial disclosures. Article 8 Delegated Act of the EU Taxonomy Regulation requires financial institutions to disclose how and to what extent their activities are associated with environmentally sustainable economic activities that are aligned with the EU Taxonomy Regulation. For credit institutions specifically, the primary attribute that this requires is the Green Asset Ratio (GAR), which represents the proportion of the institution’s assets invested in taxonomy-aligned activities as a share of that institution’s total covered assets. In addition to the GAR, a breakdown for the environmental objectives pursued by environmentally sustainable assets, the type of counterparty and the subset of transitional and enabling activities is also required, as well as taxonomy aligned off-balance sheet exposures, information about their trading portfolio, and finally commissions and fees related to other non-financing activities.
Given the nature of these disclosure requirements, banks are seeking to identify both existing, and new loans that they can link to these sustainability reporting requirements – referred to as “sustainability-linked loans”. In practice, the terms of these loans, specifically the interest rate, are directly linked to the borrower’s performance against predetermined sustainability targets. These targets can encompass a broad range of factors, such as reducing carbon emissions, improving labor practices, or enhancing corporate governance. If the borrower achieves or surpasses the set targets, they benefit from a reduced interest rate on the loan, whereas failure to meet the targets can result in a higher interest rate. This structure provides a financial incentive for borrowers to improve their sustainability performance, thereby contributing to the broader goal of sustainable development.
While setting and monitoring these targets can be challenging, referring back to Sanford’s idea of particle finance, Bankers are indeed pursuing a more complete and granular view of risk with this concept; as a borrower’s sustainable performance over a time horizon beyond the lender’s holding period of the credit exposure was a previously unmeasured point of risk. By linking loan pricing to climate performance, lenders can encourage borrowers to adopt practices that can mitigate climate risks. At the same time, lenders can attract climate-conscious customers and investors, thereby seizing climate opportunities.
Climate Considerations in a Bank's Overall Pricing Framework
In assessing and setting appropriate and relevant sustainability targets, credit institutions are seeking data and information that can help inform the overall process. Some of the more robust datasets are focused on climate risk and highlight how traditional risk metrics included in a bank’s pricing framework may be impacted by a changing climate. In certain situations, climate factors can have an explicit and direct impact on the primary indicator of a firm's credit quality – its earnings potential. Further, financial performance of the firm and that of its counterparties can be impacted by either acute physical events, which may be more likely or more severe as the climate changes, or transition risk associated with mitigation of those physical risks. An apt illustration of transition risk is the shutting down of the Hummer brand in 2010 due to a combination of rising fuel costs in an economic downturn and changes in consumer preferences. Acknowledging the transition in consumer trends, GM recently revived the Hummer brand as a fully electric vehicle.
Financing Impact
Looking at examples of how this is manifesting in the marketplace, one clear area is sustainable and green finance, which has been growing significantly in recent years, with total sustainable bond issuance expected to reach almost USD 1 TN by the end of 2023, and account for approximately 15% of global bond issuance (x). Geographically Europe has consistently been the leader in new sustainable bond issuance, with financial institutions accounting for over a fifth of new issuances.
Notwithstanding the growing popularity of sustainable and green finance, there is some evidence that green bonds attract higher prices at issuance than similar non-green issues. This phenomenon has been termed a “greenium” and a 2022 estimate for European issuances placed it at approximately 6bps (xi). The implications of this greenium are such that issuers who deploy their capital towards activities that align with the green taxonomies for their particular regulatory regime will enjoy a more advantageous cost structure for their capital stack, further allowing those issuers to pass on the lower funding costs to their respective sustainability focused lines of business. This greenium however is not universally established, and observations of its existence are sometimes tenuous. The Green Bond Initiative reports that out of a sample of 50 green bonds in the first half of 2023, only 16 received the benefit of a greenium compared to their secondary market equivalent (xii). Furthermore, an academic study on US municipal bonds found no evidence of a greenium (xiii).
Credit Impact
Climate, perhaps unsurprisingly, has been shown in certain circumstances to have a direct impact on the durability and volatility of a firm’s earnings. This can be seen clearly in an example of another firm, Douglas Dynamics Inc. NYSE: PLOW. This industrial manufacturer of commercial truck attachments and equipment, primarily snowplows, has been mentioning projected annual snowfall in their footprint in their guidance materials for years. As highlighted in their August 2023 investor materials, we can see that annual snowfall is a key driver of financial performance for the firm. The company’s earnings guidance is in fact heavily influenced by projected annual snowfall, representing a clear example of an environmental factor impacting a company’s financial outlook. President and chief executive officer of Douglas Dynamics, Bob McCormick specifically had this to say during their 1Q 2023 Earnings call with investors:
"Snowfall this winter was well below the 10-year average, and the location and timing of snow and ice events missed some of our most important markets,”…“As we’ve said historically, where and when it snows is almost as important as how much it snows, and while cities out West were inundated with snow, almost all of our core markets on the East Coast saw the lowest snowfall season in decades. This negatively impacted reorder patterns and resulted in our first quarter performance coming in well below our initial expectations. In addition, our pre-season orders will likely be lower, as dealers respond to season ending elevated inventory levels."
To translate changes in projected financial performance into climate adjusted credit risk, and therefore a potential consideration for a pricing framework, we leverage Moody’s Analytics Climate Adjusted EDF methodology. The methodology enables us to assess the potential effect of climate change scenarios (xiv) on the firm’s Expected Default Frequency (EDF). In Figure 4, we show the 5-year horizon EDF of Douglas Dynamics Inc. under three different climate change policy scenarios, and we consider the contributions of physical and transition risk impacts to combined risk. If we only consider transition risk, Douglas Dynamics Inc. appears to benefit from proactively adopting a policy that addresses these risks directly, with its EDF at 5-year horizon showing improvement over the baseline estimate. However, and because the impact of climate change is also manifested in physical risk through weather events, the total projected EDF at 5 years is worse than the baseline case under both an early and late policy scenario, although that impact is somewhat mitigated if early climate policy is implemented.
Douglas Dynamics has even adopted a “low snowfall playbook” which in effect is conceptually aligned with the type of early policy that we mention here. This playbook focuses on cost control measures and establishes investment criteria, towards the end of mitigating the impact of low snowfall on the company’s earnings. They even reference this playbook as one of the reasons why they were able to reaffirm their earnings commitment to investors in the subsequent quarter’s earnings call held in August of 2023.
Further Considerations
Incorporating climate factors into a bank’s pricing framework presents a unique set of challenges. Conceptually, the scenario dependent nature of climate impact makes it less straightforward to integrate into a pricing model that relies on a single measure of each risk factor. How a bank quantitatively incorporates multiple climate scenarios into a loan price point is not a trivial exercise.
From a stakeholder perspective, there are currently no standardized guidelines or frameworks for incorporating climate factors into pricing models. This lack of standardization can lead to inconsistent approaches across different banks, making it difficult for stakeholders to ensure fairness and transparency in pricing. Furthermore, stakeholders should be contemplating the potential for subjective interpretations of non-quantifiable climate factors, potentially leading to unintentionally discriminatory pricing practices.
Ethically, there are concerns about the potential for greenwashing, where counterparties may overstate the extent and effectiveness of climate risk management into their business models in order to capitalize on available incentives like more attractive costs of capital, or perhaps even banks that want to buttress their GAR by pushing the envelope on what is taxonomy aligned. There is also the question of whether it is fair to penalize companies with higher interest rates based on climate factors, especially when these companies may be operating in regions where it is more challenging to meet decarbonization standards, or in industries like raw material extraction, that while large consumers of fossil fuels, are necessary to enable the societal transition towards renewable sources of energy.
Despite these challenges, it is important to consider the potential benefits of climate factors into a bank’s pricing framework. These factors can provide a more holistic view of a company’s risk profile and potential for long-term success. They can also help banks align their operations with the broader goals of sustainable development and social responsibility. Banks will need to navigate these challenges carefully, using a combination of innovative thinking, robust data collection and analysis, and close collaboration with regulators and stakeholders. Furthermore, banks will need to maintain a strong commitment to transparency and fairness in their pricing practices, to ensure that they are truly contributing to a more sustainable economy.
Conclusion
In the evolving financial landscape, banks are increasingly recognizing the necessity of integrating climate considerations into their pricing frameworks. The incorporation of climate factors not only aligns with the global trend towards sustainable development, but it also enhances risk management, drives innovation, and strengthens competitive positioning. Continuing to refer back to Sanford’s speech 30 years ago, his clairvoyance is impressive, as he concludes by saying:
"These concepts will not flourish unless society blesses them. A social critic may say they are nothing more than a financial engineering exercise designed to enrich a few at the expense of many-a zero-sum game.
Not true. For as risk management becomes ever more precise and customized, the amount of risk that we all have to bear will be greatly reduced, lowering the need for financial capital. This will have a tremendous social value because financial capital that had been required to cushion these risks will be available elsewhere in society to produce more wealth to address society’s needs. In addition, this will liberate human capital by the greater leveraging of talent.
And these concepts will not flourish unless our clients bless them. As valuable as macro capital generation may be, it is not enough. On a micro basis, individuals and organizations must see value for themselves; clients must buy the service. Their trust must be earned by delivery of objective diagnostic help and solutions of value to them. We shall earn it."
The inclusion of climate factors into a formal pricing framework adds a new dimension to the financial landscape. SLLs, greeniums, and the like are examples of the first iterations for the banking industry of integrating these concepts into how they conduct their business. However, this is not without its challenges, with a number of hurdles that require careful consideration, including consideration of multiple climate scenarios, lack of standardized or commonly accepted approaches and concerns about potential greenwashing.
Despite these challenges, as the understanding of how business decisions impact our environment evolves, the need to quantitatively integrate climate considerations into pricing frameworks will grow. Accomplishing this will ultimately enable banks to gain a more holistic view of a company’s risk profile, incentivize sustainable practices, and align their operations with broader sustainable development goals. In conclusion, the integration of climate considerations into a bank’s pricing framework represents a complex yet rewarding endeavor. With innovative thinking, robust data collection and analysis, and a commitment to transparency and fairness, banks can successfully navigate this journey. As they do so, they will not only enhance their own profitability and competitive positioning but also contribute to a more sustainable economy.
