Climate change risks are financial risks. Here's why forward-thinking banks are incorporating climate change risk into their enterprise risk management frameworks – and why you should, too.
By Peter Plochan, Principal Risk Solutions Manager at SAS
As discussions around climate change and its environmental impacts heat up, concerns mount over the related economic repercussions across various geographies and industries – including financial services, where cross-industry impacts ripple and threaten banks' future profitability.
Climate change's impacts on the water, energy, agriculture and manufacturing industries, for instance, already cost banks money. Consider farm loans that go unpaid due to poor crop yields caused by extreme weather. Or manufacturing debtors shutting down production due to unexpected water shortages or severe weather incidents. From a bank's perspective, each of these events adversely affect credit risk, lessening a bank's likelihood of collecting its debts.
The bottom line? Climate change is source of financial risks. Banks must consider the changing climate and its associated risks when reflecting on strategy and economic outlook.
Incorporating climate change into ERM
Scenario analysis and stress testing form the cornerstone of any robust enterprise risk management (ERM) framework. To truly understand the potential impact of climate change risks on their business and borrowers, banks must incorporate climate change into their future-forward analyses and decision making.
According to the PRMIA Institute's November 2019 briefing note, The Impact of Climate Risk on Financial Institutions, "Scenario Analysis needs to evolve: climate-based scenario analysis is much harder than anything currently done and will need new computational approaches, data and methodologies."
When considering how to incorporate climate change risk into their ERM framework, banks must assess both their:
- Loan/customer portfolio, where impacts of climate change can impair the financial stability of their borrowers (i.e., credit risk).
- Banking operations, where, for instance,their branches might be exposed to severe changes of weather, or they may be negatively affected by regulatory changes, etc. (i.e., operations, strategic or reputational risks).
Some of the world's leading banks have already caught on and are adapting their ERM frameworks to account for climate change. For example, Dutch multinational bank ING has established a climate change committee, chaired by its chief revenue officer, to address strategic climate-related risk. As part of its Terra approach, the bank tracks its borrowers' CO2 footprints and monitors their alignment to the bank's emission decrease goals, defined per industry.
Nordea, the leading financial services group in the Nordics, is another large bank that has taken action to measure and spotlight climate change, but for its retail banking customers. Nordea recently launched an individual carbon footprint calculator to help its customers understand the environmental impact of their everyday purchases. The tracker monitors and estimates customers' CO2 footprint to encourage more sustainable choices.
The key? Forward-looking ERM considers the impacts of these new risks on the bank's expected performance over the next three to five years. This entails examining how climate change risk drivers affect their credit risk, market risk and operational risk profiles.
Top of mind for banking regulators
While a few banks are already incorporating climate change risk factors into their strategies, most still have a long way to go. More promising, though, banking regulators and central banks are starting to pay close attention to climate change as a source of financial risk and recognize the imperative to embed climate change risks into banking ERM frameworks and processes.
The Central Banks and Supervisors Network for Greening the Financial System (NGFS), for example, formed in late 2017 and now includes about 70 central banks and regulators. As stated by NGFS chairman Frank Elderson:
"As long as the temperatures and sea levels continue to rise … central banks, supervisors and financial institutions will continue to raise the bar to address these risks and to green the financial system."
According to the NGFS framework, climate change may have system wide impacts on financial stability and/or adversely affect macroeconomic conditions. Banks and their portfolios are exposed to both:
- Physical impacts of climate change– economic costs and financial losses resulting from the increasing severity and frequency of extreme climate-change-related weather events and progressive climate shifts.
- Transition impacts of climate change– the process of adjusting to a low-carbon economy.
The core banking processes affected by the above are credit underwriting and, in particular,credit risk assessment and credit scoring.
Helping foster a greener financial system, the NGFS's call for action report provides six recommendations aimed at inspiring all central banks, supervisors and relevant stakeholders:
- Integrate climate-related risks into financial stability monitoring and micro-supervision:
- Assess climate-related financial risks in the financial system. Adopt key risk indicators to monitor climate-related risks and perform quantitative assessment of financial industry, including climate change risk-specific scenario analysis and their integration into macroeconomic forecasting and financial stability monitoring.
- Integrate climate-related risks into prudential supervision.Set supervisory expectations to provide guidance to financial firms and direct engagement with them to ensure climate-related risks are understood and discussed at board level, considered in risk management, and embedded into firms' strategy and risk management processes.
- Integrate sustainability factors into own-portfolio management. Related to portfolio management performed by central banks themselves on the portfolios under their own management (e.g., pensions funds, reserves).
- Bridge the data gaps. Encourage the appropriate public authorities to share relevant data to climate risk assessment and, whenever possible, make them publicly available.
- -6. Focus on building awareness and knowledge sharing.Establish internationally consistent climate and environment-related disclosures and building of a "green" taxonomy to factor all the above.
While these recommendations are not binding, it's reasonable to expect they will eventually be translated into requirements set – and actions taken – by local regulators and central banks and cascaded in some form to individual banks.
Beyond its core recommendations, the NGFS plans to provide additional guidance on how to incorporate climate change risk into ERM frameworks, including:
- A handbook on climate and environmental risk management outlining steps to better understand, measure and mitigate exposure to climate and environmental risks.
- Voluntary guidelines on scenario-based risk analysis, developing data-driven scenarios for use by central banks and supervisors in assessing climate-related risks.
Regulators are also getting quickly up to speed, determining how to capture the complexity of climate change risks in financial sector stress testing to ensure stability and support the transition to a greener economy. In the end, the joint effort of regulators, banks and public initiatives will drive the development of respective climate change risk assessment and monitoring methodologies.
In the UK for example, banks and insurers are already subject to a climate change stress-testing program facilitated by the Bank of England. Other regulators and jurisdictions plan to follow a similar approach.
A greener future
As the effects of climate change intensify, we will see more attention on the assessment of environmental and climate change risk – both at the individual bank's loan exposure level, portfolio level, and on the financial system as a whole. Initiatives set forth from organizations like NGFS will help provide a common understanding and benchmark.
While a few leaders are already taking action, most banks have yet to initiate a strategy that incorporates climate change risks into ERM frameworks and future outlooks. But now's the time! To better mitigate climate change-related losses, banks must implement more forward-looking ERM systems and processes. Those that think green will see green.