Risk and exposure assessment must come first

Article originally published in The Intermediary February 2024 – page 77

The run-up to a general election is always fraught with the uncertainty born of opposing (and often unrealistic) political pledges – most of which will never see the light of day when it comes to implementation. This year is unlikely to be different, making planning rather harder than it might be.

Barely four months ago, Rishi Sunak pushed back net zero deadlines that would have seen private landlords have to invest significantly in energy efficiency upgrades. Owner occupiers were also given more of a reprieve on replacing gas boilers, heating systems and off grid oil and gas fuelled residential heating systems.

Sunak was at pains to point out the decision to delay was not to do with the UK’s commitment to cutting carbon emissions, but rather that it was a recognition that individuals could not be expected to foot the bill, especially after two years of consumer price inflation scaling double digits and the financial shock inflicted by the base rate rising from 0.1 per cent to over 5 per cent. Whether Labour would reverse the u-turn is neither clear, nor really relevant.

What matters for the industry, lenders, brokers and borrowers is how this uncertainty affects practical lending decisions, and that boils down to risk assessment – both current and future.

Notwithstanding the government’s pull back from specific net zero compliance dates, lenders are now beginning to start specific projects and departments to conduct more work on Category 15 Scope 3 emissions.

The GHG (greenhouse gas) Protocol defines category 15 emissions as: “Scope 3 emissions associated with the reporting company’s investments in the reporting year, not already included in scope 1 or scope 2. “This category is applicable to investors (i.e., companies that make an investment with the objective of making a profit) and companies that provide financial services.” According to the UN Environment Programme Finance Initiative, around 97 per cent of a financial institution’s GHG emissions are situated in scope 3, by virtue of being associated with financing, investment and underwriting activities.

Regulatory expectation

The challenge in quantifying this risk exposure is immense. The regulatory expectation that firms do is unequivocal. The UN Environment Programme finance initiative says: “Financial institutions should examine the scope 1, 2, and 3 of their investee companies. “It is important to note that one investee company’s scope 2 is likely to be another investee company’s scope 3 (an oil and gas company’s sold products, purchased by an aviation company, to both of which an investor or bank may provide financing), and scope 3 data has traditionally been relatively unreliable.”

This is going to be key for lenders this year. The implications for lenders’ balance sheet risk, capital adequacy requirements and governance disclosures are significant.

In December, UK Finance published its response to the Department for Energy Security and Net Zero’s Scope 3 Emissions in the UK Reporting Landscape consultation. In it, UK Finance admitted: “Scope 3 reporting remains a challenge across the economy, particularly in terms of the data challenges for financial services firms which have complex financed emissions chains.

“There should be a recognition in any future UK Scope 3 disclosure rules that reporting will be carried out on a best-endeavours basis and will improve as capacity and capability increase. “There should be a recognition that banks will obtain data from a range of sources, including International Sustainability Standards Board 2 direct company disclosures and syndicated databases, and that the use of assumptions and proxy data should be permitted for estimating Scope 3 emissions where primary data is not readily available.

“Measurement standards are still evolving and approaches to estimating emissions for all sectors are not available. This means that disclosures will require judgments related to methodologies and initially may lack consistency amongst firms.”

For lenders, the challenge is clear. Risk and exposure assessment must come first, but there must also be a clear understanding of the specific elements judged and how, from many different sources, these are used to support disclosures. Ultimately, this – and other corollary regulation to protect consumer outcomes – will shape origination strategies and have ramifications for the entire value chain.

Uunderstanding the environmental risk of mortgage books is a critical component in the valuation of securitised mortgage assets and assessment of risk capital requirements. Robust granular understanding of the property upon which loans are secured will be essential in addressing the global and local regulatory drive to net zero.

We will continue to invest heavily in delivering systems and data solutions that facilitate that, so lenders have the information they need to meet these expectations, but also to support the right decision making for their businesses.