Banks are the backbone of many industries, and if banks encounter problems, it will undoubtedly have an impact on the economy. In the past two to three years, central banks and regulatory authorities around the world have begun to require banks to conduct stress tests related to climate change in order to understand the impact of global warming on banking operations. So far, the European Central Bank (ECB) has conducted the most detailed tests, using both macro and micro analyses and providing forecasts of bad debt rates under different scenarios, such as short-term climate deterioration and long-term climate change.

The ECB emphasizes that the impact of global warming on the economy is exceptionally complex and that there are no previous data to reference. This test is just part of the learning process, and the ECB will not adjust the capital requirements for banks based on the test results.

Limited Estimated Impact

The impact of global warming on the quality of bank assets mainly includes two aspects. First, there is physical risk – the impact of crises caused by global warming, such as floods, rising sea levels, or wildfires, on bank customers or the bank’s own operations and assets. Second, there is transitional risk – the impact of policy changes or new technologies on borrowers’ repayment abilities. A typical example is the reduced carbon emissions and its impact on a company’s economic performance.

From the macro test conducted by the ECB, it can be seen that southern European countries have relatively higher physical risks. Nearly all commercial loans in Greek banks can be categorized as high physical risk, and the same goes for Cyprus, where the proportion is as high as 75%.

As for transitional risks, they are less related to geographical location. About 40% of commercial loans from banks within the European Union come from high carbon-emitting industries, with most of it coming from large banks. Because many high-emission loan projects come from large companies in industries such as oil, mining, or energy supply, small banks simply do not have the capacity to make such large loans.

As for how global warming affects the quality of bank loans, the micro test conducted by the ECB can be used as a reference. The test includes two scenarios: long-term climate change and short-term climate deterioration. Even under the assumption of the worst long-term climate change, bad debt rates only increase by roughly 0.2% per decade between 2040 and 2050. The ECB has not disclosed the impact of the increase in bad debt rates on bank profits. However, a rough estimate indicates an impact of only a low single-digit percentage on their annual profits, which is not too high. If there is a severe short-term climate deterioration, the test estimates a potential increase of 70 billion euros in bad debts. While this result is much higher than the losses caused by long-term climate change, it still seems to be less than one year’s profit for European banks and should not significantly erode bank capital.

Global Warming is Different from Past Natural Disasters

The Hong Kong Monetary Authority has also conducted similar tests. For instance, in the scenario of short-term climate deterioration, mortgage bad debts for residential properties would reach HKD 17.3 billion by 2050, a 25-fold increase from HKD 700 million in the fourth quarter of 2020. The profits of Hong Kong banks before making provisions for bad debts last year were approximately HKD 170 billion. From this, it can be seen that the impact of global warming on Hong Kong bank capital seems manageable at the moment.

The Federal Reserve Bank of New York (NY Fed) pointed out in a research report last year that natural disasters could even benefit the banking industry. This is because part of the cost of post-disaster reconstruction comes from bank loans. However, investors should be aware that global warming is not a one-time short-term disaster but a year-after-year, continuous, repeating, and worsening process. Therefore, it is believed to be fundamentally different in nature from past disasters.

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Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.

Would you take a guess on which one of the ESG elements professional investors value the most?

Before revealing the answer, there is a story we would like to share with you. It began with a visit to a mid-sized manufacturing company in Southeast Asia many years ago. Little did we know that the moment we set foot in the premise, it would be its lobby that had us flabbergasted.

The atrium was tall and wide, while the honeydew green marble slabs covering the floor were exquisitely juxtaposed with white marble, each tile waxed so finely that they reflected vaguely the marble wall behind the concierge counter. That wall could not have been the work of an amateur interior designer – every streak and vein of the metamorphic rock was an artwork of its own, with each of the backlit marble tile carefully mounted, leaving a small gap between them so that the soft lighting seeping out of the wall would accentuate the intricate patterns of the stones further.

The concierge counter in gold polish was equally magnificent. It’s around ten-feet-wide, with the front facing the main entrance designed with wave effects. Indeed, it sounded ostentatious, but, together with an orchid arrangement sitting on the counter, nothing looked out of place.

Adding an extra touch of luxury was the backlit ceiling: lights were diffused from the top, illuminating the entire lobby without overwhelming the eyes. In the center of it hung a tasteful chandelier, glistening softly and conveying the elegance of a six-star hotel.

The splendor of the lobby certainly made an impression on us, to say the least – it resembled more of a luxury hotel than a manufacturing company.

But first, back to the question about which one of the ESG elements carries the heaviest weight. In a 2017 poll by the CFA Institute, 67% of investors would integrate corporate governance (G) into the investment decision process, more than those who would consider environmental and social factors[1]. Naturally, stock prices are highly subject to the quality of corporate governance.

Many components make up what we now broadly call corporate governance, but in essence the following two criteria should be met: is capital being put to good use, and are minority shareholders being treated as fairly as those holding larger stakes.

In the example above about the manufacturer, should it really be splurging on fancy décor? Whose interests did those marble tiles serve? Had it been a private bank, it probably wouldn’t hurt to fuss over furnishing pieces and decorative lighting. They could well command confidence from clients, which would ultimately be good for business. But the customer base in question here is that of manufacturers, who would more likely fret over product quality and costs than whether the lobby floor has marble in it. In other words, what they would generate for the company’s investors was anything but tangible returns.

Now that we have looked at what responsible corporate finance means, we think that, in investors’ analysis of how well companies are upholding governance standards, they could also pay attention to whether bigger shareholders are cognizant of the interests of smaller ones. For example:

1. Should corporates be distributing dividends? We don’t think failing to do so reflects poor governance, rather, the crux of the issue lies more in the “why”. If business performance is robust with substantial potential for further growth, the decision to not distribute dividends may be justified, or encouraged even, provided that profits are being reinvested. Ultimately, such moves will support share prices.

If instead, the profits end up being hoarded or squandered in speculative stocks, without any plans to be reinvested, the lack of dividends will reflect poorly on the corporates’ governance quality. It shows an insufficient focus on creating value for minority shareholders. As such, we think analysts should exercise more caution towards valuing these companies.

2. Are corporates hiring reputable accounting firms to handle their financial records? It could be a red flag for analysts if turnover of auditors is high, or if there’s an apparent predilection for smaller accounting firms.

3. Are they entangled in convoluted business ties with their parent companies? The more complicated these dealings are, the easier their boards could potentially manipulate the financial records.

4. How are corporates’ shares classified? The Hong Kong Stock Exchange has relaxed the rules on weighted voting rights in a bid to attract Chinese tech companies to go public in the city, giving some companies’ senior management personnel disproportionate voting rights than allotted by the shares they hold. This could put minority shareholders at a disadvantage, so we think analysts should take due note of how share classes are structured as well.

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[1] Source: CFA Institute, as of Dec 2017

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Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.