A ship finance deal today has access to more climate information than at any point in the industry’s history. Fuel consumption, annual emissions, CII ratings, ETS or FuelEU payments and penalties are all data points that sit alongside the financial information. The Poseidon Principles brings together leading ship financiers who assess their portfolios against decarbonisation curves in line with IMO’s ambitions. Class societies, research groups and think tanks are producing vessel-level emissions models that are increasingly nuanced to enable risk monitoring. Based on publicly available information, it can be inferred that this data currently sits alongside deal decisions and contributes (largely) qualitatively.
The next step is integrating this data into credit decisions, with approaches where risk is appropriately priced. Supervisory direction points the same way. Measures like the ECB’s climate factor are early signals. And a transitioning sector needs its financiers able to price what they are financing. Paul Taylor of Société Générale, chair of the Poseidon Principles, wrote in a LinkedIn post: “Integrating compliance, geopolitics and emissions into credit decisions is no longer optional; it’s essential.”
There is no established method for this integration. Banks may choose various risk management actions such as client engagement, tailoring specific covenants, provisioning at sector or portfolio level, hedging, insurance or other de-risking measures. Pricing transition risk is a potential transaction-level tool that builds on information banks are already collecting, and can support institution-level approaches.
What follows is the outline of one pricing approach.
Respecting the role played by bank capital
Bank finance is designed to provide low-risk capital for established, bankable business cases. Any transition risk pricing mechanism that works well should respect this boundary, which is key to financial stability objectives. It should make visible the risk that may be accumulating on the books, as well as the risk potentially embedded in transactions to which new capital is being allocated. The approach outlined here works within existing capital rules, and does not depend on regulatory relief on green lending.
Price risk where it arises or accumulates
Some risks are attached to a borrower, their demonstrated transition behaviour or the resulting decarbonisation trajectory. These can impact the entity’s financial position and map to the credit rating. Considerations attached to a vessel map to the collateral valuation.
Breaking down the transmission channels of the risk drivers across the value chain, and understanding which numbers they move, can mitigate double counting a specific risk (both at borrower and asset level), and allow for a comprehensive analysis.
A net adjustment
After adjustments at asset and borrower levels, a well-positioned deal earns a net negative adjustment on price; an exposed one carries a net positive add-on. A one-way factor would serve only as a screen; a two-way adjustment differentiates risk. Because the net adjustment factor is essentially composed of asset- and borrower-level components, the underlying risk drivers also stay visible. A bank can run such an adjustment in shadow to quantify and internally benchmark its own portfolio and position, before implementing it on live transactions.
Fit to a bank’s chosen decarbonisation trajectory
A pricing adjustment factor structured this way does not assert a decarbonisation trajectory of its own. It can fit a bank’s chosen pathway and risk appetite, at the portfolio and institutional levels. Two institutions can run the same structure against different trajectories (with assumptions on aspects like fuel availability or sector growth) and reach different, equally defensible answers. The transition risk adjustment can then quantitatively inform the credit judgement that banks already exercise.
Independent of transition timing
Recent European Commission (JRC) modelling of transition risk finds that the fire sale it models could unfold in the very short term, because the trigger is expectations of the transition rather than its actual progress. Shipping has lived through similar systemic dynamics before, though not triggered by climate factors.
The JRC paper proposes that an additional capital buffer of 0.9% of risk-weighted assets on average would be sufficient to protect the European banking system. The authors note that such a buffer might be only temporary, until banks’ balance sheets become green enough. This would enable institutions to survive a systemic event. Transforming portfolios over time requires different deals being originated and financed, and those are shaped by terms and pricing.
Strider Carbon is developing and detailing this framework further. For institutions looking to implement similar measures, we would welcome the opportunity to work through use cases for specific segments or portfolios.