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Managing Climate Change Risks: Key Actions for Financial Institutions

“Every company, investor, & bank that screens new & existing investments for climate risk is simply being pragmatic” - Jim Yong Kim (Former President, World Bank)

As per Prudential Regulation Authority (PRA) findings from a 2018 survey of UK banking sector, even as 70% of the banks acknowledged that climate change present financial risks, only 10% had taken a long-term view of such risks. In fact, 30% of the lenders considered climate change purely as a corporate social responsibility (CSR) issue and one that has insignificant relevance to their firm’s business strategy or operations.

In an earlier article, entitled “Why financial institutions must heed the climate change risks?”, I had posited on why it is the need of the hour for financial institutions (FIs) to heed to and act urgently on their climate change risks management. In this article, I would like to share my views on the key actions for FIs in this regard.  

In my view, for effective management of the climate change risks, FIs should focus on the following aspects:

 

1) Risk integration: For FIs, climate change risks, in effect, are prudential risks – and which are strongly aligned with their credit & operational risks. Hence, FIs should treat the climate change risks as financial risk – rather than continuing with their current approach of regarding it as purely reputational risk. Further, these institutions should work towards integrating climate risks considerations into their financial risk management (FRM) framework - and put in place the required processes and systems to effectively recognize, measure, manage & report their climate risks exposures. In fact, it is desirable that FIs include such material exposures in their Internal Capital Adequacy Assessment Process (ICAAP).

Climate risk factors should also be integrated into the FIs’ conventional borrower & deal-level financial analysis and their underwriting & credit review processes. Further, it should be ensured that, in due course, the FI’s existing risk rating models are adjusted to account for borrower’s climate change risks. Additionally, FIs should actively strive to grasp the possible impacts of physical & transition risks of climate change on their customers, counterparties and the businesses they invest in.

 

2) Scenario analysis: Two businesses with the same traditional risk ratings may perform very differently in certain climate change scenario. For example, real estate prices would become vulnerable in scenarios of extreme storms or rising sea levels. Similarly, there can be potential for loan impairment in high-carbon sectors. Hence, to effectively integrate climate risks into their FRM framework, FIs need to leverage robust scenario analysis tools and techniques.

Both physical & transition risks scenarios need to be considered. Physical risk scenarios can include, for example, temperature pattern changes and heat stress, wildfires, droughts and water shortage, extreme precipitation, floods, rising sea level, and hurricanes/typhoons/cyclones. Transition risk scenarios can include, for instance, policy changes (such as emissions limits, higher carbon prices, subsidizing of low-carbon solutions), technological changes (e.g. cost-reduction and advancements in low-carbon technologies) and changes in consumer preference (e.g. increased adoption of low-carbon services & goods).

FIs should keep in mind that climate risk scenarios analysis differ from their traditional scenario analysis approaches. For example, unlike the 3- to 5-year time horizon that FIs typically use in their conventional scenario analysis, the climate risk scenarios require longer time horizon. FIs should therefore focus on enhancing their current stress testing tools and scenario analysis frameworks to accommodate the climate risk scenarios requirements.

 

3) Strategy: FIs need to embrace a long-term firm-wide approach and strategically focus on the following dimensions vis-à-vis climate risks:

A) Risk management: For example – a) proactively assessing the business impacts of future policy changes and technological evolution, b) aligning portfolios with the climate risks management targets,  c) reducing/forgoing business dealings in risky geographies, sectors and asset classes (such as new coal mining projects, loans for diesel vehicles, mortgages on properties that don’t meet the new energy efficiency standards etc.), d) lending to low-carbon businesses and incentivizing adoption of less carbon-intensive technologies (e.g. providing lower lending rates to borrowers who surpass the sustainability targets), e) enabling advanced limit systems (e.g. based on total portfolio emissions), and f) periodic stress-testing for assessing financial resilience against climate risks.

B) Opportunities exploitation: For example – a) proactive identification & assessment of revenue-generating opportunities (e.g. financing of renewable energy projects or development of new technologies that help in carbon footprint reduction), b) providing retail customers with solutions that nudge them towards responsible choices (e.g. green mortgages, loans for energy efficiency retrofits), and c) sustainable investment (e.g. green bonds).

C) Technology and data: For example – a) advanced spatial risk modeling and analysis tools, b) analytics and AI-based solutions for evaluating the climate risks in the borrower’s value chain,  c) implementation of common taxonomies and data standards, d) automated sourcing of relevant data for impacts analysis of climate risks across geographies, sectors and markets, and e) system for capturing relevant external macro- & micro-level industry- and borrower-level data (such as collateral location for mortgages, supply chain info, cost of reserves for gas & oil corporations etc.) for the credit review and underwriting processes.

D) Central bank related: Central banks should actively focus, for example, on a) making due modifications to their monetary policy & refinancing frameworks – to accommodate for the unfavorable impact of climate change on productivity, health, infrastructure, inflation volatility, uncertainty etc., and b) integrating sustainability concerns into portfolio (pension funds, own funds, international reserves etc.) investment decisions.

 

4) Collaboration: To help effectively addressing the climate risks at a broader level, FIs need to proactively coordinate/cooperate at a global level with all the concerned stakeholders – including with legislators, governments, regulators, central banks, National Competent Authorities (NCAs), borrowers, and insurance industry. Additionally, institutions should engage with cross-disciplinary subject matter experts such as environmental scientists, energy economists, climate & economic research community, and the concerned academics. Also, ensuring internal collaboration across their various business units is important.

Such collaborative endeavors would, for example – a) help regulators & central banks to effectively integrate specific risk management activities (such as stress testing) into their supervisory activities, b) aid in defining clear requirements for sector/corporate risk rating agencies (vis-a-vis carbon risk), c) allow central banks to better understand how climate issues affect their collateral policy, d) provide FIs with deep insights vis-à-vis their assets’ sustainability, e) enable FIs to optimally incorporate climate risks within their ICAAP, e) encourage sharing of best practices, and f) support development of sustainable finance standards & flexible taxonomy for climate-change related financial products.

 

5) Governance: FIs should work on gaining adequate board-level engagement & accountability; and on ensuring appropriate senior management ownership vis-à-vis climate risks management. Further, the monitoring & management of these climate risks need to be integrated into the FI’s supervision approach. CEO and CRO should play pivotal leadership role in this regard.

FIs may want to institute a dedicated function to oversee their firm-wide climate risks management. An internal cross-functional working group, comprising adequate skills and expertise, can also be formed - this would help an FI’s various business units to work collaboratively in identifying & assessing climate risks. However, ultimate responsibility of managing the climate risks should reside with firm’s FRM function.

 

6) Disclosure: FIs should work on providing timely & adequate climate risks related disclosures – both internally and to the regulators & other external stakeholders (as needed). This would, apart from helping FIs in effectively understanding & managing their own climate risks, would also offer market actors & policymakers with useful insights – e.g. for capital allocation, facilitating transition to green economy etc. Also, it would help supervisors & central banks in performing comprehensive stress testing.

FIs can consider leveraging, as appropriate, the Task Force on Climate-related Financial Disclosures (TCFD) framework. TCFD has been working on developing voluntary, consistent climate risk disclosures for businesses.

Further, FIs should encourage their borrowers – across sectors – to provide detailed disclosure on their carbon footprints. This would help FIs in evaluating own loan portfolio risks; and may also provide them insights on sustainability-related new business opportunities with their borrowers.

Gradually, the regulators too should mandate adequate and standardized disclosures from all concerned stakeholders – this would help enhance the accuracy & completeness of disclosures and improve comparability of climate risk exposures across businesses.

 

Actions by FIs: Few examples…

In September 2019, the UN & leading banks had launched the Principles for Responsible Banking - 130 banks together holding USD 47 trillion in assets signed up. Through the Principles, banks have pledged to strategically align their businesses with the Paris Agreement on climate change & the Sustainable Development goals.

So far, over 50 FIs - including HSBC, ING Group, Credit Agricole, Societe Generale, and AXA Group have publicly committed to setting science-based targets to reduce their greenhouse gas (GHG) emissions in conformance with the Paris Agreement.  

In 2019, Citigroup Inc. had instituted a working group to assimilate the climate change issues in its risk management controls. Further, in November 2019, it published its 1st climate report in accordance with the TCFD guidelines. Citigroup has also teamed up with many other large banks to create pilot models to evaluate how the various climate change scenarios may affect the loan portfolios’ performance.

People’s Bank of China (PBOC), China’s central bank, has undertaken numerous steps to encourage green financial development. It has been incorporating green finance into its macro-prudential assessment system - including providing positive incentives for commercial banks in China to enhance their green deposits and stock of green credit.

In 2019, DNB, the central bank of the Netherlands, became the 1st central bank to endorse the UN-supported Principles for Responsible Investment (PRI) committing itself to integrating six ESG principles in its investment practices.

In December 2017, at the Paris “One Planet Summit”, 8 central banks & supervisors had founded a Network of Central Banks & Supervisors for Greening the Financial System (NGFS). Since then, NGFS has expanded to 42 Members & 8 Observers strong, representing five continents. NGFS’ purpose is to help bolster the global response needed to fulfil the Paris Agreement goals & to augment the associated role of financial system to handle the risks and mobilize capital for low-carbon & green investments.

 

Conclusion

With each passing year, the adverse outcome of climate change is becoming more and more pronounced. Resultantly, the need for significant structural adjustments to the global economy has become imminent and the financial stakes involved are very high.

Clearly, FIs cannot remain untouched with this change. Inaction, therefore, is no longer an option for them! FIs need to act decisively & urgently in managing their climate change risks and should also look forward to capitalizing on the associated opportunities.  

Managing Climate Change Risks - Key Actions For FIs
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Comments: (1)

Richard Peers
Richard Peers - ResponsibleRisk Ltd - London 20 May, 2020, 09:181 like 1 like

Thanks Anjani great information

Anjani Kumar

Anjani Kumar

Principal Consultant - FS Risk & Compliance

Infosys Limited

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15 Dec 2011

Location

Pune

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Financial Risk Management

This network brings together professionals involved in the oversight and management of their company's financial risks and exposures as well as solution vendors, in order to discuss risk issues including interest rate risk, foreign exchange risk and commodity price risk, among others.


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