Climate-related and environmental risks in loan pricing

July 2023

Integrating climate and environmental factors into loan pricing is a complex and far-reaching challenge for European banks. It goes to the heart of their business – balance sheet management. There is much to do, and little time. This article introduces the key implications for banks, and some suggested steps to tackle this challenge.

European banks need to integrate climate-related and environmental (C&E) factors into their loan pricing by the end of 2023,and to meet all the European Central Bank’s (ECB) C&E expectations by the end of 2024¹. This requires a whole-bank, top to bottom transformation. Specifically, the ECB² expects banks’ loan pricing frameworks to reflect their credit risk appetite and business strategy for C&E risks, and for loan pricing components to be C&E sensitive.

Time therefore is short, and many European banks still have a long way to go. In the first half of 2022³, more than 40 percent of Significant Institutions (SIs) and Less Significant Institutions (LSIs) still had taken no action to implement C&E risks into loan pricing (see Figure 1). A recent KPMG survey on ESG risk in May 2023⁴ shows that while further banks are envisioning to work on this topic, some do not have any plans in place yet.

Note: The figure shows the level of maturity of banks’ of integrating C&E aspects in loan pricing, covering 107 significant banks under the direct supervision of the ECB and 79 less significant banks supervised by their national authorities.

The new requirements for integrating C&E in loan pricing are drawn from the EBA’s Guidelines on loan origination and monitoring⁵ and the EBA report on the management and supervision of ESG risks⁶. The ECB also identifies C&E risks as a key supervisory priority⁷. This is in line with the EU’s policy focus on its Fit-for-55 green finance package⁸, which aims to reduce EU emissions substantially by 2030, while being mindful of the resilience and capacity of the financial system required to achieve this goal, as ‘green’ does not necessarily mean less risk⁹. Investment, including C&E-sensitive lending, will play a crucial role in achieving this goal.

So, what do banks need to do?

Loan pricing framework and banking strategy

Banks’ business strategy and risk strategy need to be updated in line with banks’ C&E vision (e.g., each bank’s targets on reducing financed emissions and increasing green finance)¹⁰ that reflects banks’ impact and risk-driven motivations¹¹. These C&E-related updates need to then be integrated in loan pricing frameworks¹². In fact, C&E-risk-sensitive differentiation in loan pricing is a tool that banks can use to operationalise their C&E vision - and align their portfolio composition accordingly¹³ (see Figure 2). The challenge for banks is to commensurately reflect this impact and risk-driven motivations in loan pricing frameworks, since adopting solely an impact-based malus/bonus approach may be dangerous from a risk point of view.

Note: Banks have various tools to operationalise the integration of C&E considerations outlined in their business strategy and risk strategy. C&E-differentiated loan pricing is one of these tools.

With that in mind, it’s also essential for banks to consider their competitive environment. Business units have discretion to alter the margin component of loan pricing in response to market conditions. To remain competitive, some business units are offering financing to 'green' borrowers or specific 'green' assets at a discount. Some may also charge a premium to ‘brown’ companies or when financing ‘brown’ assets.

However, in the process of growing their green market share or reducing their financed emissions, C&E differential pricing – if not done properly - could lead banks to take on excessive through-the-cycle risks, or ceding market share to competitors still willing to finance companies making a slow (or no) transition from ‘brown’ to ‘green’. Therefore, it is essential to get loan pricing right – allowing banks to build market share without compromising their long-term profitability.

Finally, the interest rate environment needs to be considered. In recent years, low interest rates and fierce competition left banks with little room for price differentiation, but the current higher interest rate gives more scope for banks to adjust their loan pricing – presenting an opportunity not seen in a decade.

Loan pricing components

To explore how to reflect the different cost impacts of C&E risks into loan pricing as expected by the ECB¹⁴, it is important to look closely at the margin and costs components of the interest rate of a bank loan (see schematic illustration in the Figure 3). Each component poses its own challenges when it comes to integrating C&E factors.

Note: Simplified, client’s interest rate includes Margin and Costs components, whereas Costs can be further differentiated between Credit risk costs, Capital costs, Funding costs and other (e.g. administrative) costs.

Profit margin is the component which most institutions with differentiated loan pricing frameworks focus on, by providing tailored pricing for green loans (which ring-fence loan proceeds for environmental objectives) or sustainability-linked loans (which typically offer reduced interest charges to borrowers that achieve specified sustainability-related or transition-related targets) (see Figure 4). Also, the offering of products such as sustainability-linked loans may reflect lower funding costs that result from a funding advantage passed through to green assets linked to a green funding source.

Note: The figure illustrates the mechanism of a sustainability-linked loan with a client receiving a more beneficial loan interest rate when achieving predefined green targets (e.g., GHG emissions reduction rate is above predefined threshold). When the green target is not achieved, the interest rate returns to the basic level.

Funding costs need to reflect the cost of liabilities, such as deposits, issued stocks and bonds, and interbank borrowing. Banks’ Funds Transfer Pricing (FTP) frameworks typically quantify funding costs based on estimates of liquidity risk and interest rate risk. However, as banks make greater use of green deposits and sustainability-linked liabilities to fund green and sustainability-linked loans, FTP frameworks will need amending to introduce new ‘green pricing curves’ that reflect the benefit of funding green asset with green liabilities (see Figure 5). This shall lead to a reduction in the funding cost component in the loan pricing (see Figure 3).

Note: Banks may introduce new green pricing curves, that, in terms of spread levels, may tend more towards existing unsecured or secured curves. Source: KPMG International, 2023

Credit and capital costs need to reflect a range of novel C&E risks. Banks use various performance metrics in loan pricing, such as return on equity (ROE), risk adjusted return on equity (RAROE) and risk adjusted return on risk adjusted capital (RARORAC). These metrics typically incorporate credit risk and capital-related elements, such as:

• IFRS 9 expected credit losses¹⁵ (ECL) and CRR expected losses (EL) in the context of credit risk costs; and
• Economic Capital (ECap) and risk-weighted assets (RWA)-based estimations in the context of capital costs¹⁶

The main challenges for integrating C&E risks in these elements via Probability of Default (PD) and Loss Given Default (LGD) are twofold. First, banks need to develop an approach to integrate C&E risk measurement into conventional risk differentiation, while considering different time horizons (e.g., rating horizon versus IFRS 9 lifetime horizon). Second, banks need to overcome the C&E data challenge. Ultimately, banks need to ensure that models and processes adequately reflect C&E risks in a way that avoids under or overpricing loans.

Next steps

Given the EU’s ambition for achieving its Fit-for-55 vision by 2030, we expect supervisors to continue their high intensity focus on climate-related risks over the next 2 to 3 years – gradually widening to include other environmental factors such as natural capital¹⁷.

Banks face a significant challenge to integrate C&E risks into their loan pricing frameworks in a robust and reliable manner that increases transparency of lending decisions. Many banks still have a lot of work to do to comply with the mounting pressure from supervisors and other stakeholders.

While considering the progress they have already made, banks should consider creating a roadmap for fully integrating C&E factors into loan pricing. This can be used internally, and in consultation with supervisors, to plan, monitor, and communicate their progress. In KPMG professionals’ view, a high-level roadmap should reflect the following key priorities for banks:

1. Align pricing with strategy: Ensure that loan pricing is advancing the bank’s business and risk strategies, helping it to achieve its C&E targets.
2. Pursue holistic integration: Integrate C&E factors into all cost elements of loan pricing (capital, credit, funding costs), not just the margin component. Moreover, C&E integration into loan pricing should also take place in conjunction with other bank-wide C&E initiatives, while addressing ECB expectations and relevant regulations. Considering the efforts this requires , some banks start the integration of C&E risks in loan pricing for selected portfolios only, with aim of expanding at a later stage to further C&E-material portfolios.
3.  Involve stakeholders (internal parties): Engage all relevant teams and functions in planning and implementation. One key group – including (credit) risk management and modelling, treasury, legal, finance and IT – needs to redefine the pricing framework and its controls, processes, and data. The second group – business units and relationship managers – needs to change their day-to-day loan pricing operations to incorporate C&E risks. A joined-up and holistic approach is vital to ensue that C&E risks are assessed appropriately while avoiding double counting.

Achieving the correct pricing of C&E risks can provides tremendous opportunities for early movers in the market, particularly in the current environment of evolving risk management standards and also benefiting from the highest interest rates in more than a decade. Moreover, by getting pricing C&E risks adequately, banks can establish themselves as a reliable partner and financial advisor for clients on their low-carbon transition journey. On the other hand, the late movers shall meanwhile take on comparable C&E-risky business at inappropriate prices - due to adverse selection. It is therefore essential to clearly understand the potential broader implications for the bank when defining the timing of the roadmap to implement.