Responsible Banking – Three Ways to Strategize Climate Change Risk

People around the world are witnessing how climate change can devastate our planet. Scientists continue to sound the alarm that, climate change is the greatest threat to human health in recorded history. As climate crisis is rising governments & agencies around the world are working to advance policies that reduce carbon pollution, support clean energy technologies, prepare for the effects of climate change, and curb deforestation.

For example, The Basel Committee on Banking Supervision last year in 2021, issued a public consultation on principles for the effective management and supervision of climate-related financial risks. This follows the publication of a series of analytical reports earlier this year (source - link). In another initiative, the industry-led, United Nations-convened Net-Zero Banking Alliance representing over 40% of global banking assets was formed, which are committed to aligning their lending and investment portfolios with net-zero emissions by 2050 (source - link). In another example, The Financial Action Task Force (FATF) published a report highlighting money laundering relates to environmental crimes are among the most profitable proceeds, generates around USD 110 to 281 billion annually (source - link).

Also, Federal Reserve of the Unites States published Climate Change and Financial Stability notes (source - link) as per which, financial regulators, international organizations, market participants and others have directed significant attention in recent years towards developing an understanding of the implications of climate change for the financial sector and financial stability. Climate change-related financial risks pose both micro- and macroprudential concerns. Hence, it is critical to understanding how risks arising from climate change may affect financial stability and connects this discussion to the financial stability monitoring framework described in the Federal Reserve's Financial Stability Reports.

Impacts & Key Consideration Areas

Financial services industry is exposed to climate change through macroeconomic and microeconomic transmission channels that arise from two distinct types of risk drivers: physical and transition climate risk drivers.

The traditional risk categories used by financial institutions and reflected in the Basel Framework can be used to capture climate-related financial risks comprised of credit risk, liquidity risk, operational risk, and reputational risk categories. Additionally, several Financial Institutions sometime referred as “green bank”, pursue to reduce energy costs for ratepayers, stimulate private sector investment and economic activity, and expedite the transition to a low-carbon economy. The impacts of physical and transition risks can vary according to geography, market segment and financial system development. For example, climate-risk exposures vary according to the geographic location of an institutions and its exposures based on different weather patterns, natural environments, political systems, and consumer sentiment.

Below are three key impacts physical & transition risk areas in relates to changing climate change setting.

1. Climate Change Risk – Risk profile of commercial customers is changing significatenly under the paradigm of climate change. High emission industries which are generally capital intensive may no longer be favoured by the lenders given the complexity involved in the transitions to net zero targets. Lenders must consider new ways to identify, measure, stress test and mitigate the risk introduced by climate change and transition risk.
2. Managing Profitability & Margin – Transition from current environment to more climate friendly will lead to major adjustment by all market segments and industries. This transition is unpredictable and can lead to profitability for financial institutions. This uncertainty needs to be managed carefully otherwise can lead to multiple chocks to lenders and financial system as whole. Like any other crisis, climate risk related migration risk may also offer opportunities to early movers.
3. Financial Crime & Compliance – States or institutions in Europe and North America which is not considered naturally rich or “source countries”, have not factored financial crime risks like money laundering from environmental crimes in their assessments, this is a big gap. Also, criminals rely on specialized networks to move the goods and facilitate the financial flows. These networks are leveraged as cash couriers or networks of front and shell companies to move funds. More importantly, environmental crime can be integrated with broader criminal network engaged in diverse criminal activities such as human trafficking, drug trafficking, corruption, and tax evasion. Therefore, the financial flows generated by environmental crime would be integrated within the larger criminal network or legit businesses, making it very hard to detect.

 Managing Physical and Transition Risks

Businesses including FIs have a responsibility to reduce their contribution climate change. Here’s three ways they can effectively management physical and transition risks relates to climate change.

1. Effective Data Acquisition & Management – Data management is key to address the challenges emerging from climate change risk. Given the uncertainty involved, lenders have to have a robust data management and data governance capability to ensure that they have figure on the pulse as the transition is taking place. This data management capabilities has to ensure data is consistent across the organization and also extend to data attributes not being captured today. 
2. Agile Analytics & Scenario Management – In order for institutions to assess climate change risk it is critical to have an agile scenario analysis program, which can be leveraged to produce right output and analytics. Ability to access the internal and external data and understand the impact of changing scenarios is key to organization ability to adapt and react accordingly. Once assessed, institution can approach impacted industries with positive mindset to create new expansion opportunities.
3. Suspicious Activities Monitoring & Reporting – Moving on to financial crime compliance, use of web of shell and front companies is commonly exploited in environmental crimes. Therefore, it is critical that institution correlate internal data for customers and other involved parties with external company registry data to uncover hidden highly organized networks and actual beneficiary owners. Following entity resolution, monitoring should consider the whole network of related parties and associated risk indicators including external risks like negative news and high-risk lists. Basically, enhancing the monitoring to typology based rather than just single risk indicator. Generally, institutions have limited oversight over the activity, therefore it is key to combine contextual information (both internal and external) while investigating flagged cases. Internal data should contain resolved entity profile, earlier activities and company registry including recently provided import/export activity. And external data should contain negative media scan, high risk lists including sanctions, politically exposed persons (PEP), and ultimate beneficiary owners (UBO) data.

Path to Responsible Banking

 As of now, there is limited research and accompanying data that explore how climate-related risks influence the traditional risks faced by institutions. With increasing focus and as pointed in last UN Climate Change Conference (COP 26) goals (source - link), very soon countries need to manage the increasing impacts of climate change on their citizens’ lives, and to achieve our climate goals, every company, every financial institution, every bank, insurer, and investor will need to change. As time progresses, a better understanding of climate risk drivers and their impact on institutions' exposures across all risk types would be gained from further research by a broader community, hopefully tacking climate crisis and safer planet for all humans.