Net-zero pledges bring big unknown for credit risk

Uncertainty on how governments plan to curb emissions adds political dimension to credit quality assessments

What does it take for a €10.3 billion loan ($10.5 billion) portfolio to deteriorate in quality overnight? A market seizure? A trading mishap? A pandemic?

For Rabobank, it was the unveiling of plans by the Dutch government to make the country’s air safer to breathe.

Measures outlined in June by prime minister Mark Rutte’s cabinet to tackle the Netherlands’ longstanding nitrogen oxide pollution problem – the legacy of decades of intensive livestock farming – sparked loud protests by farmers, fearing the new government targets could make their businesses unsustainable.

That prospect led Rabobank – the country’s main financier to the agricultural sector – to classify its entire exposure to the Dutch dairy industry under stage two of the International Financial Reporting Standard 9 loan-loss framework, indicating a heightened risk of default.

It’s a clear-cut example of climate transition risk – the potential that borrowers may default as new requirements to tackle the climate emergency prove too financially onerous. So sweeping would be the impact of Rutte’s reforms on the farming sector that talk of loan forgiveness has made news – although the idea was firmly rebutted by the bank.

Rabobank classified its entire exposure to the Dutch dairy industry under stage two of the IFRS 9 loan-loss framework, indicating a heightened risk of default

Transition risk forms one leg of climate risk in finance, the other being physical risk, or risk of extreme climate events leading to asset or collateral impairment. The two will be in constant interplay as nations try to drastically cut emissions while still bracing for irreversible shifts in climate patterns. But, as Rabobank’s case shows, transition risk has an added element of political uncertainty that makes it inherently finicky to model.

After all, it is one thing to set climate targets, but another to implement them, with all the trade-offs involved. Rabobank did not take issue with the nitrogen emission reduction targets themselves, which it endorsed. Rather, uncertainty around how local governments will implement national legislation is what pushed the bank to precautionarily tag the whole dairy portfolio as at risk.

It’s not hard to see the same concerns arising at a much wider, transnational level. For instance, each European Union government will each have to plot its own course to targets agreed at bloc level. Would a multinational lender apply bigger provision overlays to portfolios in countries where political deadlock makes net-zero targets tougher to meet?

Considerations about politics do, of course, already inform scores assigned by credit rating agencies, which are then fed into banks’ loan-loss models. But a small dairy farm in the Dutch countryside isn’t a rated company. The only way to assess its climate risk profile is through detailed examination of its business, adding to a bank’s operating cost.

The world’s governments are yet to clearly articulate the nitty-gritty of net-zero policies, and the costs may be borne by companies seemingly far removed from the sectors more directly responsible for most emissions. As governments set climate targets in stone through legislation, draconian portfolio-level moves like Rabobank’s may become a regular fixture of banks’ risk management.