Climate risk: the new kid on the block in risk management
- Climate change has a major impact on financial institutions;
- Climate risk is not a ‘stand-alone’ risk but embedded in both financial and non-financial risks;
- Data, disclosure and reporting of climate-related information are major challenges.
Recently, several institutions, such as the European Central Bank and the European Banking Authority, once again highlighted the high priority of climate risk governance for financial institutions. With different focus areas arising, banks need to change their risk management framework in the years ahead. What are the main reasons to take climate risk into account? Which priorities will be put in place? Most importantly: what will be the impact for the financial sector? The challenges are numerous, especially in terms of data, disclosure, reporting and implementation in the general risk appetite framework. Gwen De Bruyn and Antonio Liviello discuss how climate risk will affect the financial sector.
Increased attention from regulatory bodies and national authorities
Financial institutions are not only responsible for their investments but are also held accountable for the societal impact of their investments and their strategic decisions. It’s their duty to take into account the impact of their business on the environment and the society as a whole. Possible failure to respect this duty poses a risk, not only for their legal security and performance, but also for their reputation. Therefore, an increasing number of institutions are recognizing the importance of Environmental, Social and Governance (ESG) criteria.
“Financial institutions are held accountable for the societal impact of their investments and their strategic decisions. It’s their duty to take into account the impact of their business on the environment and the society as a whole.”
Moreover, companies need to understand which impact climate change can have on a physical level but also on a transitional level; ‘physical’ meaning the physical impacts on operations and ‘transitional’ the transition to a low-carbon economy. To counter these physical and transition risks, authorities have begun to build resilience and reduce exposure. Two examples:
- National governments agreed to strengthen the global response to the threat of climate change in the Paris Agreement of 2016. Since it was adopted, the interest in both the micro- and macroprudential implications of climate change has grown substantially;
- In 2016, the European Systemic Risk Board (ESRB) issued a report stating that economies must reduce their carbon intensity for carbon emissions, implying a shift away from fossil-fuel based energy and its related physical capital. According to the ESRB, the system risk could happen in three ways: (1) macroeconomic impact of changes in energy use, (2) revaluation of carbon-intensive assets and (3) rise in the incidence of natural catastrophes.
Recommendations to control the impact of climate risks
As climate change presents serious risks to the global economy, the financial markets and financial system need clear and high-quality information on the impact of climate change. This includes for example the risks coming from rising temperatures, sea levels, climate-related policy by governments and the emergence of new technologies in our continuously changing world. The Financial Stability Board (FSB) created the Task Force on Climate-related Financial Disclosures (TCFD) to improve and increase reporting of climate-related financial information.
In this regard, the TCFD finalized its recommendations on financial climate risk disclosures. It aims at improving investors’ and corporates’ understanding of the impact of climate risks and reducing the risk of a systemic financial shock to the economy due to climate change. The TCFD formulated its recommendations around four core elements: Governance, Strategy, Risk Management, and Metrics and Targets.
"Disclosure is even more important than how companies invest for the future. They must be accountable to investors and corporates."
1. Governance: creating clear insights into responsibilities and reporting processes
Investors, lenders and other users of climate-related financial disclosures are interested in understanding the role a board plays in managing climate-related issues. Such information supports evaluations of whether climate-related issues receive appropriate board and management attention.
Therefore, the TCFD advises companies to describe the board’s oversight of climate-related risks and opportunities. To do this, they can list the processes and frequency by which the board is informed about climate-related issues, and whether the board committee considers those during risk management board meetings. Last but not least, the company might disclose how the board monitors and oversees progress goals and targets for addressing climate-related issues.
Secondly, the company should describe the management’s role in assessing and managing climate-related risks and opportunities. This involves assigning climate-related responsibilities to management-level committees, whether these last report to the board, and whether those responsibilities include assessing and/or managing climate-related risks issues. The organization and the reporting processes should be described, as well as how the management monitors climate-related issues.
2. Strategy: considering climate risk when establishing strategies
To form expectations about future performance, the organization should first disclose climate-related risks and opportunities it has identified over the short- medium and long term. This while taking into consideration the useful life of the organization’s assets and the fact that climate-related issues often manifest themselves over the medium and longer terms. In addition, the company should describe the specific climate-related issues for each time horizon that could have a material financial impact on the organization and which processes are used to determine them.
Secondly, the company needs to describe the impact of climate-related risks on the organization’s businesses, strategy and financial planning. They should assess how climate-related issues serve as an input to their financial planning process, the time period used and how these risks and opportunities are prioritized. This also corresponds to an overview of the interdependencies among the factors that affect their ability to create value over time.
Lastly, the company should describe the resilience of the organization’s strategy with different climate-related scenarios, including a discussion of strategies affected by climate-related risks and strategies that might have to change to address such potential risks.
3. Risk Management: describing processes to manage climate risk
Risk management information supports users of climate-related financial disclosures in evaluating the organization’s overall risk profile and risk management activities. For investors, this information refers to an understanding of the way an organization’s climate-related risks are identified, assessed and managed and whether those processes are integrated into existing risk management processes.
Financial institutions should describe their risk management processes including how they make decisions to mitigate, transfer, accept or control those risks. Some reasons to do this include:
- Identifying and assessing climate-related risks. An important aspect of describing these processes is how organizations determine the relative significance of climate-related risk in relation to other risks. They should consider existing and emerging regulatory requirements related to climate change as well as other relevant factors.
- Prioritizing climate-related risks, including how materiality determinations are made within their organizations.
Finally, they should make clear how their processes for identifying, assessing, and managing these risks are integrated into their overall risk management.
4. Metrics and Targets: to measure is to know
Disclosure of Metrics and Targets allows investors and other stakeholders to better assess the organization’s potential risk-adjusted returns and ability to meet financial obligations. They also provide a basis upon which investors can compare organizations within a sector or industry.
Financial institutions should provide the key metrics used to measure and manage climate-related risks and opportunities. They need to consider including metrics on climate-related risks associated with water, energy, land use, and waste management where relevant and applicable. Moreover, companies should consider describing whether and how related performance metrics are incorporated into remuneration policies. In addition, companies should provide a description of the methodologies used to calculate or estimate the metrics.
Next to this, regulators oblige organizations to describe their key climate-related targets such as GHG (Greenhouse Gas) emissions, water usage and energy usage, in line with anticipated regulatory requirements, market constraints or other goals. The targets need to be precisely defined on different levels, such as whether the target is absolute or intensity based, the time frames over which they apply, the base year from which progress is measured and the key performance indicators used to assess progress against targets.
"At TriFinance, we consider climate risk as one of the main risks financial institutions will be facing in the coming years."
Rising challenges and opportunities
In our opinion, disclosure and reporting is often not yet well developed or implemented. This is due to the fact that climate change is a long-term phenomenon and a lot more complex than the traditional business risks. Risk management teams are often struggling with the uncertainty of the long-term aspects, the qualitative data which is more difficult to collect and analyze, and a general methodology that is missing.
Most of the companies that report on climate risk use different frameworks: the Global Reporting Initiative (GRI), the Sustainable Development Goals (SDG), and the TCFD recommendations among others. With the rising availability and complexity of data, the need for standardized and harmonized climate risk metrics and disclosures is higher than ever before.
Better disclosures and reporting will increase the gained insights and possible ways to improve the incorporation and management of climate risks. That will in turn lead to a better incorporation of climate change in the strategy and day-to-day business.
In general, we believe that climate risk management is still in its infancy. Financial institutions are at different maturity levels in their approaches. A lot of them have already developed a board-level or management-level governance, and many have climate risk incorporated into the business strategy. In contrast, they often lack standardized data and a widespread integration of scenario analysis which is taking into account different climate risks. The ones already using the scenario analysis often miss the direct link to risk management actions.
In our opinion, the risk appetite framework should be enhanced to include the impact on several risk factors. Examples among others are
- insurance risk (i.e. higher insurance pay-outs and underpricing of new products);
- market risk (i.e. repricing risk and decreasing collateral values);
- credit risk (i.e. impact of downgrades);
- liquidity risk (i.e. lower illiquidity of new instruments);
- and operational risk (i.e. impact on reputation risk and business continuity).
We see climate risk as one of the main risks for the coming years. Therefore, financial institutions will have to speed up the incorporation of the climate risk factor into their risk management framework. They will need to work out, together with the regulatory authorities, possibilities to standardize their approaches, scenario analyses, reporting, and disclosures. We believe that this integration of climate risk will require the deployment of considerable resources, and thus we want to act as a key partner to assist the financial institutions in taking on this challenge.
About the authors
Gwen De Bruyn
After finishing his Master in Finance and Risk Management at KU Leuven, Gwen De Bruyn started his professional career at TriFinance. Gwen worked on several finance projects at three major clients within the Belgian financial sector and is currently working as Financial Business Analyst at one of Belgium’s largest insurance companies. As a member of TriFinance’s Risk Management & Compliance Practice, he performs a market watch and regulatory follow-up on Solvency II, Business Continuity, Recovery and Resolution Planning and Climate Risk/ESG.
Graduated in Applied Economics at the Catholic University of Louvain (UCL), Antonio Liviello joined Candriam Investor Group as Client Reporting Officer. During two years, he helped in the delivery of institutional mandates reporting and was the single point of contact for all italian mandates. He also passed a certification from the Executive Asset Management Program at Vlerick and studied Socially Responsible Investing courses given by the Candriam Academy. Since his start in TriFinance, Antonio has collaborated with TriFinance’s Risk Management & Compliance Practice on Climate Risk subjects such as Disclosure and Reporting.