Credit risk

Net zero liabilities bring a big unknown for credit risk

What does it take for a 10.3 billion euro ($10.5 billion) loan portfolio to deteriorate overnight? A market take? A business mishap? A pandemic?

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

Measures outlined in June by Prime Minister Mark Rutte’s cabinet to tackle the long-standing problem of nitrogen oxide pollution in the Netherlands – the legacy of decades of intensive farming – have sparked strong protests from farmers, fearing that the government’s new targets would make their businesses unsustainable.

This prospect has led Rabobank – the country’s largest lender to the agricultural sector – to classify all of its exposure to the Dutch dairy industry in Stage 2 of the International Financial Reporting Standard 9 loan loss framework. , indicating an increased risk of default.

This is a clear example of climate transition risk – the potential that borrowers may default as new requirements to address the climate emergency prove too financially onerous. The impact of Rutte’s reforms on the agricultural sector is said to be so drastic that talk of canceling the loans has made headlines – although the idea has been firmly rebuffed by the bank.

Rabobank has classified all of its exposure to the Dutch dairy industry in the second stage of the IFRS 9 loan loss framework, indicating increased risk of default

Transition risk is one branch of climate risk in finance, the other being physical risk or the risk of extreme weather events leading to impairment of assets or collateral. The two will be in constant interaction as nations attempt to drastically reduce emissions while preparing for irreversible changes in climate patterns. But, as the case of Rabobank shows, transition risk has an additional element of political uncertainty that makes it inherently fickle to model.

After all, it is one thing to set climate goals, but quite another to implement them, with all the trade-offs that entails. Rabobank did not contest the nitrogen emission reduction targets themselves, which it endorsed. On the contrary, uncertainty about how local governments will implement national legislation is what prompted the bank to precautionarily label the entire dairy portfolio as at risk.

It is not difficult to see the same concerns emerging on a much broader transnational level. For example, each government in the European Union will have to chart its own course towards agreed bloc-level goals. Would a multinational lender apply higher provisioning overlays to portfolios in countries where political gridlock makes net-zero goals more difficult to achieve?

Of course, political considerations already inform the ratings assigned by credit rating agencies, which are then incorporated into banks’ loan loss models. But a small dairy farm in the Dutch countryside is not a rated business. The only way to assess its climate risk profile is through a detailed review of its business, which is on top of a bank’s operating costs.

Governments around the world have yet to clearly define the details of net-zero emissions 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 measures like Rabobank’s could become a regular part of banks’ risk management.