[Music]
hello all
this is Spina Binelli a partner in
Baringa
us talking to you from new york today
the topic for today is to focus
on how to take climate change
goals and targets that have been set
by your institution and translate that
into
action and change in behaviour I'm glad
to say I'm here today with two of our
senior leads
from our climate change practice James
Belmont
and Dara McDavid both are coming with
over 25 years
experience in the industry um James from
a corporate finance and risk perspective
and Dara from a front office
perspective they're going to give us a
balanced view
in regards to how this change will
impact
the first and second lines of defence
within your organization
um so I'm super excited about this
conversation today
um and look forward to a balanced
conversation
and from from uh about both James and
Dara
so with that being said um I'll
hand over to James and and ask the
question
what have you seen from a corporate
perspective
in regards to how organizations are
taking their
commitments and translating that into
action so uh banks have been
subject to external constraints on their
balance sheets and their p
l's for as long as they've existed
um associated with leverage they've had
cost income ratio targets
and they've had to achieve uh certain
returns on equity
and they will typically use some of
three tools
to trans transmit those
external constraints uh through to the
businesses
they've got limit frameworks they can
use um
capital attribution and transfer pricing
uh so limits if I'm somebody in the
organization and you're
limiting me that's a little bit daunting
so
explain to me how that works so
mechanically this is actually probably
the easiest thing to do
it's a slightly lazy option uh but but
there are plenty of limit frameworks
within banks
if a bank has already expressed
externally a target or a commitment
to harvest financed emissions by 2030
for example
then it could simply translate that into
internal limits that it applies to the
businesses
it is quite crude but it is mechanically
relatively easy to do
and Dara if you're sitting in the front
office
what what would that mean to you how
would how would that impact you
and the way in which the front office
would would behave
well look there's a lot of respect for
limits ultimately it's uh you know a
serious offence if you break the limit
so they're effective in other words if
the organization is just trying to
uh not have more carbon than x then
obviously allocating limits is an
effective tool to do that
I guess I guess from my perspective um
what tends to happen is if you think
about
this whole sphere it's a new
constraint and the organization clearly
isn't optimal in terms of it's not
managing that constraint to date you may
we're going to move on going forward
what tends to happen is you you allocate
the limits to people who've got
you know the the carbon let's say in
this case um so your starting point is
not
even trying to be the optimal one it's
kind of its way where you are which is
by definition not the optimal position
to be in so it's fairly blunt as far as
i'm concerned and there's no
efficiency to it there's no sort of
trading to it so the front of us
guy you know in reality we we we
arbitrage markets for a living let's say
we're certainly going to just
work out the limits could be used up
reasonably quickly we're going to try
and fill our boots
in the first quarter of the year
regardless how much money or you know
whether the relative return is higher
because I've got carbon or anything else
it's just a question of well there's a
limit i may as well use it
and i want to use it before someone else
uses it so that's kind of the response
that you get
yeah i mean James it sounds like a quite
a blunt
instrument uh to use it you mentioned
two other areas that capital allocation
be
been another what would be the the
benefits of
of using that approach um instead
yeah well as Dara says limits are pretty
crude and they don't incentivise
efficient use of the balance sheet they
just incent
in fact they probably incentivise
inefficient use as people fill their
boots in
in Darren's language um and so
you know as a second line guy I don't
much like limits either when a limit
becomes binding
it's sort of an admission that the other
incentives you have in your armoury have
failed
capital attribution on the other hand
rations out balance sheets
um in a way that potentially promotes
more efficient use of
of the constraints so if you think of a
bank already for example having
constraints on its rwas and its leverage
they might already be
um allocating out or attributing out
capital in the performance reporting
on a basis of some combination of rwas
and leverage
um you could extend that and attribute
out the capital
on the basis of some combination of
rwa's leverage
and financed emissions or whatever your
chosen
metric of um of greenness
is that is a that is definitely an
option
and our from from a front office
perspective um
looking at it from a capital uh lens
you know how would that be different or
would there be different behaviours that
that which
that would create in a positive way well
i think at the sort of the
um probably the death code level it it
works and so far as definitely
typically understand you know if you
communicate to them what good look good
looks like in terms of what a good
business looks like and how they should
contribute to the division
in terms of you know what extra return
they should expect on let's say carbon
or whatever
I think you know that's a
useful tool it's basically what it's
done is it basically takes some of the
burden away from the other constraints
like leverage and rwa and attributes it
to carbon
so ironically you actually may end up
with um you know you may be easy to do
trades with
without carbon obviously because you're
getting a lower hurdle return so
so that's arguably a positive and
i think that's
you know that's not an accident that's
deliberate in so far as you want to be
allocating capital to inverted commas
things that
are green or at least not brown and
thereby don't have
that negative carbon footprint so so
from my perspective
you know you haven't taken money away
from me you've basically just said we
expect certain things if you're going to
use carbon expect more return it's
logical
so yeah I mean I like it i guess the
critical thing is
again we're starting from an unknown
position therefore
using those tools getting it right so
you actually get the right number at the
end in terms of what your finance
commissions are whatever else you're
targeting
is uh you know is a
decent exercise to try and optimize one
of the things that
steers me away from uh a capital
attribution one of the things I don't
much like as a second line sort of
person
in here is the idea that by attributing
a greater share of capital to
um my sustainability commitment so I've
diluted
the rwa incentives that I had in place
or the leverage incentives that I had in
place so I'm having to trade off
which balance sheet constraints I really
uh transmit to the businesses because
I've only got a fixed amount of capital
I can
attribute out yeah and James
because the industry and the regulator
hasn't come out yet
with clear guidelines um in regard to
capital allocation and expectations
is is there challenges in then
implementing that across the
organization because
you know the mandate um doesn't exist
or are there other options for for
organizations to consider
well the other option is transfer
pricing so
banks will already transfer price the
funding that they provide when they
extend
the loan uh they transfer price on the
basis of the cost of
funding the loan and
you could quite conceivably transfer
price the
cost of carbon an internal cost of
carbon to your
to your front office um you might aim to
do that
in a way that was zero sum so you might
set the internal cost of carbon in a way
that meant that
net net your businesses on average
um had had a zero transfer price
but having a transfer pricing mechanism
gives you a lever which
if you if you wanted to you could pull
as hardly as
as hard as you needed in order to create
the incentives
to steer the balance sheet towards your
your external commitment so transfer
pricing
has some appeal to me from that
perspective
daryl what would that mean to the front
office it feels like a very fluid
um approach a little bit more less
constrained than
the limits and allocations and how do
you see the front office
embracing that method well I mean if
it's a
cost it generally goes down poorly um
because obviously it makes you look like
you've made less revenue and I think
um where where that cost is real in
other words let's say like like in cva
where you've actually got a cost of
credit i can go and take credit without
doing any deals
so it's a real thing and it represents
expected loss it's real
um likewise if my cost of credit is cost
of carbon is real
and it's something that the bank
actually needs to hedge by buying car
and credit their offsets etc than I have
then it's then then it should absolutely
be pushed down onto the desk
the issue is if it isn't real it's just
a lever to steer me towards a certain
thing
what then happens is you've effectively
created a cost which doesn't
which I've got which doesn't reflect the
cost of the business
and when you do that that's that's
actually really impactful because what
you've done is you've changed
the way I behave so you know there could
be situations where
the bank's making let's say 80 base
points running and we think that's
that's great
um but because the cost of carbon takes
away let's say 40 basis points of that
um I'm going to only see 40 and I've
still got risks for this
to this transaction so the bank thinks
it's a good trade releases the risk
because it's making 80 but me is the
person who's deciding whether to go
ahead and trade or not
i'm only seeing let's say 40 basis
points fat and it will therefore change
my decision as to
whether to do that deal or not so that's
the impact that's the sort of the major
difference between let's say the rate of
return and you know
greenhouse of arrays or whatever is
effectively just doing the same thing as
you just
you have actually taken the roe and
you've turned it into a
hurdle rate of return on or cost of
carbon if you like
um but here we've got a hard cost um it
will change my behaviour and it won't
therefore i think get the optimization
that do you desire
it sounds to me like there's uh some
some great pros and cons to
all of the options and potentially over
time a healthy tension that needs to
uh it needs to occur and we're
considering
um each of them from a corporate
perspective versus
versus a frontline perspective James is
there any
um experience that you could talk to in
regard to what you're seeing at clients
as to
you know what way they're looking across
these three dimensions
or others um whether that be hybrid or
or a single approach to this yeah I'd
say a couple of things
firstly you definitely don't want to do
transfer pricing and capital attribution
you'd simply be double counting and
creating unnecessary complexity having
both of those incentive mechanisms
but you might quite conceivably have one
of those
with some limits as a backstop that you
hope never to use
the other thing I think is that's going
to become clear is
banks are making these external
commitments
right now many of them before having
actually determined
internally how they're going to to
deliver on those
decarbonization commitments and
it would be quite possible quite
unsurprising if in a few years time
approaching a commitment they realize
that the external politics or the
technology change
that that is in the real economy just
hasn't been sufficient
to enable them to get particularly close
to their targets or their front office
haven't
haven't changed their their origination
enough to
to enable the bank to meet its targets
and so i think you'll start to find the
emergence of what I would call
contingency contingency emissions plans
a bit like a contingency funding plan
where you
pre-agree um or a recovery plan where
you
pre-agree and in a certain situation
what's the menu of options of actions
that your businesses could
potentially take to um deliver on
those targets what are the financial
trade-offs associated with taking those
transactions
and how what's the lead time associated
with those transact
those um those actions
and having that in your armory
up front before it becomes a real live
commercial issue I think is going to be
important for banks to enable them to
steer through to these targets um
in in the coming years I mean that
resonates with me as somebody
who has a healthy risk paranoia
having a contingency plan um you know
because the future
in this area is unknown um seems like a
great idea Dara from a front office
perspective
um you know recognizing some of this new
change coming down the line but it's not
new
um to people do you see the front office
already taking action
uh in this space ahead of um you know
some of these frameworks being
implemented
well I think that you know it's really a
mixed bag I think anywhere
again you've got a new constraint coming
in you you should take a hard long look
at your portfolio of investments and
whatever best would be project finance
or trading and say well you know which
of these
are the metrics going to change on
because again if if
let's say 200 base points was a good
with a good trade it's pretty
intensely looking to decarbonize and
then suddenly you've got
you know a loan to a um
elongated loan to a coal-fired power
station
then you can expect that to reprice if
you so so
if you if you leave it on the books fine
you don't take a loss but then
you know the opportunity cost is that
you could have done a new deal if you
wanted to or not that you would but to
a coalified power station let's say
and got a much higher return so so that
sort of concept of cleaning the decks
if you're getting ahead of the game
anticipating change I think is a really
powerful one
um and likewise you know what good looks
like is people looking for opportunities
to
you know do I chase after the green
you know you can imagine everyone rushes
the door to do green financing for
example in order to be seen to be um
uh you know adhering to that management
action uh obviously that can drive down
returns of those things which is
ultimately what we want right we want
the cost of financing of things which
will change the climate to be to be
lowered
but if you think that's going to become
more and more of a constraint then that
price is going to go down and down and
down and you want to do that early
and so again cleaning the decks
anticipating that and then potentially
taking from the lazy would be I would
say
you know the intelligent thing to do so
i suppose a few key takeaways that I
took from this conversation change is
coming um
in this um you know it really is now
about how to take action
there's a number of ways to do that um
that will
drive different um behaviours and
outcomes and
uh organizations have to look at it from
a balanced
and approach perspective so they get the
right outcomes front to back
in the organization um I love james's
point in regards to
have a contingency plan um you know
that there's something that you can fall
back on and then Dara's closing point
there
and in regard to the front office
getting ahead
um and and starting to look at their
portfolio now
as opposed to waiting for those um
actions or constraints and to come down
the line
I think there's lots more that we can
talk on this topic in regards to
the the detail of how you put processes
and
technology in place to support this we
won't have time today
but maybe we'll add that to our next
part of the series
with that being said we'll sign off
from this baringa podcast um and
closely thank you thank you
thanks everyone
you
