Climate risk and the financial impact

As scientists continue to reinforce the severity of climate change, the potential disruption and financial implications have come to the forefront.

The bankruptcy of the major Californian utility PG&E, dubbed “the first climate-change bankruptcy” by The Wall Street Journal, is the most recent example. Banks cannot afford to ignore this global issue.

With the growing recognition of the financial stakes, rising external pressures, and upcoming regulations, how should banks and specifically their risk management teams manage climate risks?

Our paper, Climate Change: Managing a New Financial Risk, provides industry perspectives from a climate risk awareness survey we conducted in partnership with the International Association of Credit Portfolio Managers (IACPM), across 45 global financial institutions. We present how institutions can integrate climate considerations and opportunities into their financial risk management frameworks and provide guidance on implementing the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) recommendations.

KEY TAKEAWAY 1: Banks should treat climate risk as a financial risk, not just as a reputational one.

The impact of climate change will prompt substantial structural adjustments to the global economy. Such fundamental changes will inevitably impact the balance sheet and the operations of banks, leading to both risks and opportunities. While mortgage portfolios in coastal areas may be exposed to the physical impact of climate change through rising sea levels and flooding, massive amounts of capital and new financial products will be required to fund the transition and finance climate resilience, creating demand for bank services. Meanwhile, regulators are beginning to act, and investors, clients, and civil society are looking for actions, mitigation, adaptation, and transparency on the issue.

Historically, banks have approached climate change through the lens of Corporate Social Responsibility (CSR). With increasingly high financial stakes, growing external pressures, and new regulations, the pure CSR approach is no longer sufficient. Climate change has become a financial risk for banks and must be treated as such.

KEY TAKEAWAY 2: Banks should integrate climate considerations into financial risk management.

To effectively manage climate risks and protect banks from its potential impact, institutions need to integrate climate risk into their financial risk management frameworks, as described in the exhibit below.

RISK MANAGEMENT FRAMEWORK AND INTEGRATION CONSIDERATIONS

1RISK MEASUREMENT AND TOOLS

Integrating climate risk into the broader risk management framework requires an institution to understand and measure its potential exposures to climate change. Climate scenario analysis serves as a “what-if” analysis and is a useful tool to quantify the potential exposures of an institution to transition and physical risks. Many institutions are developing capabilities or plan to do so in the near future, often in response to the TCFD recommendations.
2RISK MITIGATION AND MONITORING

Many banks are including climate considerations into limits and sector exclusion policy—though these are largely for reputational risk management rather than credit risk management. These limits are often in the form of a ban or restrictions on specific sectors such as coal mining. Evidence of more advanced climate-related limit systems, for example based on total portfolio emissions or climate stressed losses, are limited.
3RISK BUSINESS APPLICATIONS (STRATEGIC PLANNING)

As with other risks, once quantified and well understood, the assessment of climate risks can inform key business applications, such as strategic planning. For instance, measurement of risks and expected losses under different climate scenarios will help inform views of potential downsides but must also be complemented with an assessment of revenue-generating opportunities for the bank.
4RISK ORGANIZATION & GOVERNANCE

Currently, initial efforts around the integration of climate considerations are driven by Sustainability and Environmental and Social Risk teams—often focusing on the potential negative impacts of projects and reputational issues. As the scope of climate expands beyond these purely reputational risks and is recognized as a financial risk, the responsibility for managing that risk should also shift. Expanding the responsibility and capabilities from Sustainability and Environmental and Social Risk teams to the financial risk management teams is a key step towards driving effective management of climate risk, as highlighted in our survey results. Strong board-level oversight and ownership is also critical for institutions to take a long-term, strategic, and firm-wide approach to climate risk.
5RISK APPETITE

The management of climate risk is a new exercise and will continue to evolve. Once better understood, the board of directors will need to determine the level of climate risk the institution is willing to accept.

CLIMATE RISK AWARENESS SURVEY

Below are select highlights from our survey in partnership with the IACPM, across 45 global financial institutions. The full results can be found in our paper, Climate Change: Managing a New Financial Risk.

Implementing the TCFD recommendations is a multi-year journey.

HOW LONG DO YOU EXPECT IT WILL TAKE FOR YOUR COMPANY TO IMPLEMENT THE
TCFD RECOMMENDATIONS (EXCLUDING ONGOING ACTIVITIES)?