Green RWA is a small but mighty association comprised of a handful of banking, finance and tech heavyweights who propose that a significant environmental change could be achieved if banks effectively measure their risk profiling and rebalance their climate risk capital.

Adrian Sargent, Green RWA treasurer and founder of ESG Treasury explains the association’s modus operandi outlined within its recent paper How banks can save the planet: “Financial services are at the heart of driving the change to a sustainable economy.

“This paper and the mathematical proposition that it illustrates is a call for collective intelligence and collaboration to drive the market to the right place.”

Sargent’s response to the Bank of England’s 2019 discussion paper on environmental stress tests underscores his belief that it is vital for banks to hold capital against climate risk, therefore requiring banks to undertake risk assessments across their operations.

The approach taken by Green RWA proposes the application of a capital charge for bank loans in line with the risk posed by the ‘transition’ risk and the ‘physical’ risk of the loan itself. In this way, banks would be obligated to look deeper into the impact the extension of their loans bear up and down the chain.

“The calculation which we have devised builds on existing regulation and calculations. It covers three key areas. The first step is to assess the risk as usual. Second, to assess the risk from transition to a green economy. For instance, where companies exist in environmentally unsustainable business sectors or will require significant investment to transition away from unsustainable practice. The third element is physical risk, such as exposure to flooding or other severe weather risks.

“We propose that firms take the traditional risk calculation, add on transition risk, add on physical risk, and we are presented with a new approach to risk weighting of assets.”

Sargent explains that by undertaking such a method, though certain capital holding requirements will increase while others decrease, there would overall be an overarching increase in the amount of capital that would be held.

The approach also works to reward banks if they are being proactive about their lending. For instance, if a firm seeking the loan is already performing carbon sequestration in their operations that that can be recognised in the calculation to the bank’s advantage.

Though seemingly a straightforward proposition at first instance, the methodology behind the proposal is dense and undergoing careful fine tuning. The modelling is currently being reviewed by the mathematician Professor Josselin Garnier, are intended to be of a standard such that they can be pulled through a bank’s existing data or modelling into their reporting.

When questioned why banks aren’t already adopting a free, accessible, (arguably) simple proposition on the whole, Sargent explains: “I’ve worked with banks for many years, and in my experience, they value guidance from the regulator given such a seismic shift the Bank of England have been vocal on this topic, without yet setting specific regulation, and this move along with a change in public interest is making a number be proactive which is encouraging.”

The model is entirely free and open source for interested parties to access, emphasising the association’s core objective of pushing this approach to drive discussion and collaboration around the issue.

“This is why we want our approach, this discussion, to be seen and adopted by regulators. The sooner that this dialogue becomes part of the regulators’ public discussions, the sooner banks will start paying attention. It will become a normalised requirement across financial services.”

But is it realistic to envision banks getting on board with humouring this seemingly altruistic endeavour?

“If we can get banks to start paying attention to this, look at their own portfolios and look at the detail, then they can make their own views. If this is not adopted by some banks, they may then assess the risks incorrectly and they may succeed or fail as a result.

“Those that do take serious note of this now and change who and how they behave will influence their customers to transition earlier as well. All evidence points to the idea that earlier transition equals a reduction in cost.”

Given this acceptance of such stark variation in approach to the impact of climate risk, would it be futile to attempt to enforce the Green RWA methodology in a standardised way?

“It’s a challenge,” argues Sargent, “which lies largely in the fact that there is no single source of climate change data which an institution can utilise that is prescribed across the board by a regulator.”

Sargent comments that the Bank of England says it is up to individual banks to choose which climate change data they wish to work against, providing the institution with a little more space to carry out sophisticated modelling on their own terms.

“That said, I do think that there is value in a consistent set of variables akin to the standardised approach to credit risk that ensures some level of relative weighting between different banks.”

Green RWA is currently completing their secondary paper expected to be released in late Q4 2020, which will include a refined Climate-Extended RWA model and advanced portfolio analysis, to provide banks with an initial evaluation of impact on capital.