Step 1 Set the function of the impact of changes in environmental protection standards on financial indicators of firms： C=f ， where C indicates the change in a firm’s cost and f denotes environmental protection standards. For thermal power companies, the annual power generated was estimated according to prime operating revenue and on-grid power tariffs, while the increase in the amount of prime operating cost was then calculated based on the increased cost per kilowatt*hour under the stress scenarios. For cement producers, the prime operating costs under the stress scenarios were calculated by prime operating costs and the percentage increases.
Step 2 Calculate main indicators for balance sheet and income statement according to changes in prime operating costs and financial statement articulation.
When applying stress on the financial position of a sample firm, we paid attention primarily to two indicators in the income statement: revenue and cost of goods sold (COGS).
Correspondingly, other accounts in the income statement would also change, thus affecting profit and retained earnings in the balance sheet.
We assumed △ B = percentage of cost change, △ P = percentage of price change, and △ Q = percentage of quantity change. After accounting for changes in cost, price and quantity we arrived at revenue, COGS and profit from the equations below:
△ R=(1+ △ P)(1+ △ Q) － 1
△ COGS=(1+ △ B)(1+ △ Q) － 1
△ Profit= △ R －△ COGS
Here △ R= revenue change in percentage, △ COGS= COGS change in percentage, △ Profit=
profit change in percentage.
1) Income statement under stress conditions
The prime operating revenue and income in the income statement were directly impacted and adjusted accordingly.
Environmental Stress-Testing on Banks’ Credit Risks
2) Balance sheet under stress conditions
A decrease in net profit in the income statement leads to decrease of the owner’s equity in the balance sheet. We adjusted the current assets and liabilities according to the cash flow cycle while maintaining other assumptions.
Similar changes in the income statements can have different impact on the balance sheets of different borrowers. We translated the impact into a reduction in retained earnings on the balance sheet, with the understanding that no general rules were applicable to all borrowers.
One limitation of such a simple approach is that it does not account for individual companies’
adjustments to their own financing structures responding to the decline in revenue. As well, cash flow cycle may deteriorate under stress conditions. However, given that cash flow cycle has no significant weighting in the customer credit rating model, we believed that results based on this simplified approach were sufficient to deduce a credit rating migration matrix.
Step 3 Input above financial indicators into the corresponding score sheets. At ICBC, different corporate customer credit ratings and evaluation models were applied to thermal power and cement companies. The evaluation model consisted of quantitative and qualitative evaluations.
To be prudent, we assumed that scores on qualitative and quantitative evaluations declined by the same proportion.
From the change in a firm’s evaluation score we obtained the change in its credit rating, which through relationship mapping allowed us to estimate the change in PD. Raising the environmental protection standards for firms would cause their profits to decline, reducing their solvency and causing declining credit standings and rising PDs.
Step 4 Construct credit rating transition matrices for the industries that the companies were in by summarizing changes in credit ratings of firms; further analyze changes in loan quality in related industries based on the relationship between the PD and the NPL ratio.
Main findings of stress-testing and policy recommendations Thermal power firms
Stricter environmental protection standards will impose great cost pressure on the thermal power industry, but the industry will maintain stable given steady economic growth and rising demand for electricity as China furthers industrialization. Enhanced environmental protection standards will nonetheless have major structural impact on the thermal power industry.
Policy recommendations
• Maintain existing AAA customers while continuing to attract high-quality customers from the five major power companies.
• Pay attention to the impact of changes in environmental protection policies on the financial cost and credit risk of firms with AA+ ratings and below, especially corporate customers that may be degraded to BBB+ or below.
• Recognize opportunities to grant loans to firms with energy-saving and emission- reduction plans.
• Recognize new upstream and downstream segments resulted from environmental technologies, such as solid waste treatment.
• Strictly prevent thermal power firms violating environmental protection laws and regulations from obtaining funding.
Cement industry
The cement industry will by and large enter a slow-growth stage under pressure to reduce capacity. Raised environmental protection standards will impose obvious financial pressure.
Policy recommendations
• Guard against risks faced by small and medium-sized cement firms as they adapt to the green economy.
• Keep track of possible credit risks from industry capacity reduction.
• Select companies strong on desulfurization, denitration and dust removal and help them expand given growth potential.
• Monitor mergers, acquisitions and reorganizations in the industry and improve bank’s customer quality by seizing appropriate environmental improvement opportunities.
• Use ICBC’s financial portfolio products to focus on the development of the industrial solid waste market and lend more support to cement co-treatment projects.
• Grant loans to firms well-positioned in the green transformation of the cement industry, support companies with the potential to go global.
Further development of environmental stress-testing
In our research, the first problem was data availability and accuracy, so relevant ministries and commissions are advised to implement requirement on companies for mandatory disclosures of environmental data. Our research group is strengthening cooperation with the Ministry of Environmental Protection in a bid to improve the accuracy of estimates for the internalization of environmental cost.
As ICBC sets high standard for high-polluting and high-energy-consuming industries to access its business, the customers selected for this stress-testing were mainly large and medium- sized companies, which likely produced above-average results. These test results therefore are more indicative of ICBC customers and do not reflect the entire industry. The quality of the stress-testing would have been much improved if data representing the whole industry had been obtained.
These stress-testing targeted thermal power and cement industries. We plan to cover other polluting industries including iron and steel, nonferrous metals, chemical and paper. The methods will be enhanced to include prices, regions and climate change, with the goal to yield quantitative results. For example, stress-testing concerning the impact of environmental factors on the credit risks of commercial banks will be conducted from the perspective of pricing (carbon trading), the sustainable rating (ESG) for firms will be explored, and the feasibility of incorporating environmental factors into the bank customer credit rating system will be considered to help research and develop an “ICBC Green Index”, prioritizing loans to and investment in green firms and fields.
5 Conclusion and recommendations
Environmental risks have become an important factor impacting the daily operations of commercial banks, therefore environmental stress-testing should be incorporated into bank credit risk rating systems and processes. This will improve the ability of the banking sector to
Environmental Stress-Testing on Banks’ Credit Risks
identify environmental risks and the customers most able to contribute to sustainable development, thereby enhancing the ability of the banking system to continuously support the green economy, while also becoming resilient to environmental risks itself. In our opinion, stress-testing the impact of environmental factors is important for commercial banks for the following four reasons: first, stress-testing can help precisely estimate and quantify the impact of more extreme environmental factors on a bank’s credit risks, improving the capacity of a bank’s environmental risk management processes; second, environmental risk factors can be included in the customer credit rating system, enabling environmental risk measurement to form a basis for the pricing of credit products; third, stress-testing leads to rational arrangement of bank loans and investment portfolios, thus actively promote the adjustment of credit and investment structures; fourth, stress-testing could be taken as a reference point for banks and regulators in their future considerations of environmental factors and risks.
ICBC has stayed at the forefront exploring the impact of environmental risks through stress-testing analysis. The following are the highlights of our stress-stress-testing:
• The scenarios constructed by ICBC accounted for many complex factors with a series of policies and standards formulated or due to be released.
• A number of aspects of the environmental stress-testing methodology developed by ICBC may be innovative in China or globally, such as the transmission mechanism from environment protection policies to firm impacts to bank impacts, the formulation of scenarios despite the complexity faced and the forecasting methodology based on ICBC’s big data.
• ICBC started the stress test on a single industry and gradually extended to multiple industries, an innovative and practical approach to developing the research methodology.
• Both first-round and corresponding feedback effects were accounted for. For example, in stress-testing thermal power companies, the impact from changes in the on-grid power tariffs was considered; for the cement industry, the study discussed subsequent improvement measures that firms could take in response to environmental protection policies, including co-treatment operations
• The approach of expanding coverage from one to many factors and from one to many industries created a path for the banking industry to intensify its capabilities on stress-testing.
We believe the construction of this market-oriented mechanism can greatly help reduce the impact of economic development on the environment. To improve the efficacy of this method, we make the following recommendations:
• The authorities should actively and collaboratively promote research on fiscal policy, financial policy and industrial policy and develop a whole set of policy support systems for the internalization of environmental costs.
• Emissions standards should be tightened with strict supervision and implementation, additional pollutant discharge taxes should be collected from polluting firms, and companies should be encouraged to make green investments and upgrade technologies through tax reductions, discounts, government procurement.
• Voluntary agreements and tradable permits should be introduced to establish a well-running carbon trading market.
• Special re-lending policy for “environmental protection fields “should be formulated, along with positive development of green bonds and green insurance, to reduce the operating cost of firms through a market-oriented approach supporting green investment.
• Intermediary service system should be actively cultivated, and policies on the open and transparent disclosure of environmental information should be enacted.
• Policy and market signals should both aim to enhance the value of preserving natural resources and reduce the value of carbon intensive investments to spur the transformations of the industrial structures and companies toward a green economy.