The impact of climate change on banks

Physical impacts of climate change, such as extreme weather, can have a system-wide impact on financial stability

Over the past few years, concern and public discussion around environmental damage and climate change – and their social impacts – have increased dramatically. Peter Plochan, principal risk management advisor at SAS, discusses some key ideas to allow companies to perform a self-assessment of their maturity in climate risk management

Peter Plochan, SAS

Much is made of the future implications of climate change, but the truth is that it is already costing banks money. Changes to the environment have incurred costs on banks’ returns on investment in broad range of scenarios, including:

• Farm loans not being repaid due to poor crop yields caused by extremely dry weather
• Manufacturing debtors shutting down water-heavy productions because of unexpected water shortages, which are becoming increasingly common
• Plastic producers losing significant amounts of business due to new legislation on plastic pollution
• Debtors based in regions that are regularly overwhelmed by extreme weather events
• Debtors receiving huge environmental fines from authorities for unclean production practices and waste pollution.

The banking regulators’ perspective 

Banking regulators and central banks are suddenly beginning to pay more attention to the role of climate change as source of financial risk.

The recently established network of more than 60 central banks and regulators – the Network for Greening the Financial System (NGFS) – recognises the need for the banking industry to act and embed the management of climate change risks into its enterprise risk management (ERM) frameworks and processes.

An NGFS report, A call for action – Climate change as a source of financial risk, provides the following recommendations, which – although not binding – are aimed at inspiring all central banks, supervisors and relevant stakeholders to take the necessary measures to foster a greener financial system: 

1. Integrating climate-related risks into financial stability monitoring and microsupervision. This recommendation covers two main areas:

• Assessing climate-related financial risks in the financial system by adopting key risk indicators to monitor climate risks; performing quantitative assessments of the financial industry, including climate risk-specific scenario analysis and their integration into macroeconomic forecasting; and financial stability monitoring.
• Integrating climate risks into prudential supervision by setting supervisory expectations. This provides guidance to financial firms and directly engages with them to ensure climate risks are understood and discussed at the board level, considered in risk management and embedded into firms’ strategies and risk management processes.

2. Integrating sustainability factors into own-portfolio management, which is portfolio management performed by central banks themselves on the portfolios under their own management, such as pensions funds and reserves.

3. Bridging data gaps and building on the Group of 20’s Green Finance Study Group and UN Environment Programme initiatives. The NGFS recommends the appropriate public authorities share data that is relevant to the assessment of climate risk and, whenever possible, make it publicly available.

4. Focus on building awareness, sharing knowledge, establishing internationally consistent climate and environment-related disclosures, and building a green taxonomy to accommodate this.

While these recommendations are not binding, it is reasonable to expect them to eventually be translated into requirements, and for actions to be undertaken by local regulators and central banks. They will thus trickle down to individual banks in some form. In particular, the first recommendation, alongside any new green disclosures and taxonomy, will have a direct impact on banks.

Examples of regulatory actions include the European Banking Authority’s (EBA’s) Action plan on sustainable finance, which notes:

• As part of the regular risk assessment of European Union banks, a sensitivity analysis for climate risks could be undertaken in the second half of 2020 for a sample of volunteering banks. The exercise would focus on transitional risks and a longer time horizon.
• The EBA aims to develop a dedicated climate change stress test.
• The EBA will provide guidance to banks and supervisors regarding banks’ own stress-testing where the qualitative and quantitative criteria to assess the impact of environmental, social and governance risks under scenarios with different severities will be explored.

Climate change risk exposure assessment

According to the NGFS framework, climate change may result in physical and transition risks that can have system-wide impacts on financial stability and may adversely affect macroeconomic conditions. In this situation, banks would be exposed to:

• Physical impacts of climate change. These include the financial losses that result from increasingly severe and frequent extreme climate change-related weather events – such as heatwaves, landslides, floods, wildfires and storms – and longer-term progressive shifts of the climate, such as changes in precipitation and temperature, extreme weather variability, ocean acidification and rising sea levels. 
• Transition impacts of climate change. These relate to the process of transitioning to a low-carbon economy. Reducing emissions is likely to have a significant impact on all sectors of the economy that affect the value of financial assets. Potential risks to the financial system from the transition are greatest in scenarios where the redirection of capital and policy measures – such as the introduction of a carbon tax – occur in an unexpected or otherwise disorderly manner.

The magnitude of how physical and transitional risks will manifest will depend on how orderly the transition process and how successful the measures taken to meet climate-related targets will be.

Incorporating climate change into ERM 

It is clear banks must seriously consider how to incorporate climate risk into their ERM frameworks. Banks should assess their:

• Loan/customer portfolios. The aforementioned impacts can impair the financial stability of borrowers. In this case, climate risks would manifest as increased credit risk for the banks.
• Banking operations. Branches may be more exposed to severe changes in weather (physical impact) or banks can be negatively impacted by changes in regulations, resulting, for example, in penalties for financing heavy polluting projects (transitional impact). In this case, climate risks would manifest as operational, strategic or reputational risks for banks.

In particular, forward-looking ERM must consider the impacts of this new risk on the bank’s expected performance over the next three to five years. Rather than adding a new risk category under the strategic risk umbrella, banks must consider how these climate risk drivers impact their credit risk, market risk and operational risk profiles.

The NGFS initiative is planning to provide additional guidance in this area, namely through:

• A handbook on climate and environmental risk management that would set out the steps to be taken by supervisors and financial institutions to better understand, measure and mitigate exposures to climate and environmental risks.
• Voluntary guidelines on scenario-based risk analysis. The NGFS is working to develop data-driven scenarios for use by central banks and supervisors in assessing climate-related risks.

Climate change scenario analysis and stress-testing

Forward-looking scenario analysis and stress-testing form the cornerstone of any robust ERM framework. Therefore, to truly understand the potential impact of climate risks on their businesses and borrowers, banks must incorporate climate change into their forward-looking analysis and decisioning.

Regulators are also quickly getting up to speed and are thinking of how to capture the complexity of climate risks in the stress-testing of the financial sector to ensure its stability, and support the transition to a greener economy. In the end, the collaborative effort of regulators, banks and public initiatives such as the Paris Agreement Capital Transition Assessment (Pacta) will be driving the development of respective climate change risk assessment and monitoring methodologies.

A recent example of such co‑operation is the Insurance stress test 2019, conducted by the Bank of England (BoE) using three climate change scenarios, each with predefined global temperature rise targets and corresponding shocks to equity and bonds portfolios broken down per industry segment. These estimates incorporate co‑operation with Pacta and are available for public use through Pacta’s assessment tool.

The way forward

There is urgency for banks to incorporate climate risks into their ERM frameworks and strategic planning. Some banks are already active, but the majority still have a long way to go. Initiatives such as those of NGFS and Pacta help promote a common understanding and will provide a benchmark banks can relate to.

Banks must reflect all of the aforementioned when looking to the future and considering strategy and product mixes to prevent the loss of custom and capital.

What is certain, however, is that there will be a much greater focus on the assessment of environmental and climate risk both on an individual bank level and on a financial system level, considering both the current circumstances and the potential future outlook and impact. Overall, demand for green and more forward-looking ERM processes and systems at banks is likely to significantly increase.

 

Climate risk – Special report 2020
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