Climate Risk and the Role of the Finance Sector

Climate change is the most urgent threat facing the world. It affects us all. The imminent risks are spelt out in detail in the recent IPCC Report, which was headlined around the world as “Code Red for Humanity.” The subsequent COP26 conference in Glasgow has seen world leaders agree on certain measures designed to reduce emissions and take concrete steps towards the decarbonisation of the world economy, including agreement on halting and even reversing deforestation. 

The responsibility of business
The crisis demands that we all as individuals change our behaviour, and remedial actions like recycling, reducing our use of water, and flying and driving less are important. However, it is industry and business that are positioned to take the most effective mitigating action. Businesses have to manage changing regulations, evolving consumer preferences and new technologies as they strive to reach carbon neutrality.

Significant impact can be achieved by changes in the role played by finance. The goals of COP26 recognise the importance of action by the finance sector, with this stated objective: “Financial institutions must play their part, and we need work towards unleashing the trillions in private and public sector finance required to secure global net zero.”

The funds involved are indeed huge. ESG (environmental, social, and governance) assets surpassed US$40 trillion globally in 2020 and may hit $53 trillion by 2025. Many organisations have been slow to react to the crisis, but now regulators are stepping in, supported by shareholder pressure, to change the way business is financed. Many providers of project and trade finance are setting standards for sustainability in their loan instruments. Physical and transition risk will also be priced into financing, making “green finance” a major factor. 

Climate risk is also becoming an important component of the risk analysis and stress testing that banks must undertake. The Basel Committee on Banking Supervision has published papers on climate-related risk that will serve as a “conceptual foundation” as the committee seeks to incorporate climate risk into the Basel regulatory framework.

The reports cover climate-related risk drivers and note that traditional risk categories used by banks—such as credit risk, market risk, liquidity risk, and others—can be used to capture climate risk.

The impact of climate risk on financial institutions and systems
Physical and transition risks will have a significant impact on the financial system. There is a growing focus on potential risks from climate change affecting financial stability.

Numerous international initiatives by public and private sector bodies are underway to address climate risk. The International Sustainability Standards Board (ISSB) has been established to focus on climate-related reporting.

Financial Stability Authorities globally are also working on strategies to protect the stability of the financial system from climate risk. In Asia Pacific, regulators in Australia, Singapore and Hong Kong have announced guidelines on climate change stress testing and scenario analysis, and Japan’s FSA is collecting stress testing results from mega banks. New Zealand has introduced a law requiring players in the financial sector to reveal the impact of climate change. 

In the past, many institutions have treated climate risk as part of their corporate social responsibility (CSR) agenda with a focus on reputational impacts and a relatively narrow, short-term perspective on financial risks. Now institutions plan to shift to a more comprehensive approach, embedding climate risk in their risk management frameworks and taking a long-term view of financial risks.

Institutions are at different stages in the journey to integrate climate risk into enterprise risk management. According to a survey by the Global Association of Risk Professionals (GARP), about 33% of institutions introduced climate risk into their business more than five years ago, and 24% just during the last year. About 70% of the respondents use scenario analysis, mainly on an ad-hoc basis.

The need for data and analytics to drive action on climate change
The lack of data to identify and measure climate risk is one of the main challenges faced by institutions. Even where data such as CO2 emissions of a counterparty is available, companies must work out how the data impacts financial performance.

Institutions must proactively build up their data infrastructure to collect the information necessary to conduct climate risk assessments. This includes the use of proxies and estimates as an intermediate step. Loan origination can be a critical opportunity to collect climate-related data. The accumulated data must of course feed an analytics methodology, which in turn is conditioned by data availability.

The financial sector is expected to play a key role in financing the transition to a greener and more sustainable economy, and there are three ways in which FSI organisations can incorporate climate risk into their business activities. 

First is portfolio alignment. This approach looks directly at the ultimate goal of global efforts on climate change and explicitly defines the portfolio changes that would be required to align with the Paris agreement 2 °C scenario.
The second is the risk framework method - a risk-based adjustment which enables institutions to manage their risks internally and allocate their portfolios in the most risk-effective way, taking into account climate risk.

Thirdly, institutions can follow the exposure method, whereby they assess individual counterparties and individual exposures. This approach directly evaluates the performance of an exposure in terms of its climate risk attributes. It provides institutions and investors with a tool to better understand their individual counterparties and the performance of their existing or potential portfolios before making an investment decision.    

The self-assessment model 
GARP has proposed a model for assessing the maturity of an institution’s climate risk management, which also helps prioritise areas for future improvement. 

Elements of the model include governance - assessing the role the board plays in overseeing climate-related issues, as well as how senior management measures and manage those issues.

It also calls for institutions to undertake strategic assessment of the impact of climate risk and opportunities on the organization’s business, strategy, and financial planning. 

Risk management in this model assesses how institutions identify, assess and manage climate risk and how these processes are being integrated into their overall risk management framework. 

The model calls for the assessment of the granular use of metrics used to assess climate risk, as well as the targets the organization aims to achieve and the limits, that is, the worst outcome the organization is prepared to accept without taking corrective action). 

Institutions must look at their current use of scenario analysis for assessing climate risk and actions taken as a result of these analyses, and finally, they must assess whether they are disclosing all the information above and the progress they are making to meet the Task Force on Climate-related Financial Disclosures (TCFD) recommendations. 

Taking effective action on climate change is a math, engineering, and human behavioural problem of unprecedented scale and complexity that will require analytically driven decisioning on an equally unprecedented scale to protect the environment, save lives and make our world a better, safer place. It is an opportunity for curious and relentless problem solvers and for innovation fuelled by data and analytics.

The impact on the financial sector of steps taken to mitigate climate change is huge, and in turn the impact on industry and business of a finance sector that is driven by environmental concerns will be critical to global efforts to save our planet.