5 Principles for Banks to Manage Climate Change Risks

June 15, 2020 by Stefanini

As we navigate climate change, banks are tasked with responding. Find out five ways banks can manage climate change risks!

In recent decades, the surface temperature of the Earth has risen at a record place, threatening life, economies, and ecosystems. And if that news isn’t worrisome enough, climate science warns us that further warming is unavoidable over the next decade and likely the one after it as well.

As we navigate this uncertain environment, banks are tasked with responding on two fronts: they need to manage their own financial exposures while also helping to finance a green agenda, which will be critical to lessen the effect of global warming. In both cases, a necessary mindset to have is excellent climate-risk management.

According to McKinsey, January 2020 was the warmest January ever recorded. As temperatures continue to rise, it is especially important that banks manage relevant risks and opportunities in an efficient manner. In that same token, regulation increasingly requires banks to manage climate risk. Though some have started, even more still must formulate strategies, build their capabilities, and create risk-management frameworks. To make climate-risk management an essential skillset in the coming years, banks need to act decisively now.

Photo by Micheile Henderson on Unsplash

Regulatory and Commercial Pressures are Increasing

To align with the global sustainability agenda and protect themselves from the impact of climate change, banks are under rising regulatory and commercial pressure. Now formalizing new rules for climate-risk management, banking regulators globally intend to roll out demanding stress tests in the months ahead. Responding to their clients’ shifting attitudes, many investors already consider environmental, sustainability, and governance (ESG) factors in their investment decisions and are channeling funds to “green companies.”

Commercial imperatives for better climate-risk management are also on the rise. As banks are in a competitive environment where they are judged on their green credentials, it is only natural to develop sustainable-finance offerings and to incorporate climate factors into capital allocations, portfolio monitoring, reporting and loan approvals. Some banks have already made significant strategic decisions by offering discounts for green lending, mobilizing new capital for environmental initiatives, and ramping up sustainable finance. 

This increased engagement reflects the reality that climate-risk timelines closely align with bank risk profiles. There are material risks on a ten-year horizon – which is not far beyond the average maturity of loan books – and transitions risks are already coming to maturity, forcing banks to do things like write off stranded assets. Meanwhile, climate factors are being incorporated into ratings agencies’ assessments. For instance, amid a high volume of activity in the energy sector, Standard & Poor’s saw the ratings impact of environmental and climate factors increase by 140 percent over two years.

As climate risk seeps into almost every commercial context, two challenges stand out as drivers of engagement in the short and medium terms.

1)      Protecting the balance sheet from uncertainty 

Corporates will become increasingly vulnerable to value erosion that could undermine their credit status as physical and transition risks materialize. Risks might manifest themselves in effects like land redundancy, coastal real-estate losses, and forced adaptation of sites or closure. These could have direct and indirect negative impact on banks, including uncertain residual values, an increase in stranded assets, and the potential loss of reputation if banks are not perceived as supporting their customers effectively.  McKinsey’s analysis of portfolios at 46 European banks showed that around 15 percent of them carry increased risk from climate change. The relevant exposure is directed mostly toward industries like electricity, gas, water, mining, construction, and transportation that have high transition risks.

2)      Financing a green agenda 

Adaptive technologies, renewable energy, and refurbishing plants all require large amounts of financing. These improvements will accelerate the transition away from fossil fuels, cut carbon emissions, and capture and store atmospheric carbon. Some banks have already begun to act by redefining their goals to align their loan portfolios with the aims of the Paris Agreement. Agriculture, automotive, power generation, real estate and oil and gas present significant green-investment opportunities. For example, in the United Kingdom, 30 million homes will require sizable expenditure if they are to become low-energy, low-carbon dwellings. In renewables, significant capital investment is needed in recycling, mobility and energy storage. In energy, opportunities are present in transport, petrochemicals, aviation, carbon capture, refining and alternatives. As clients say good bye to coal and oil, banks play a part in helping them reduce their level of risk in supply contracts or in creating structured finance solutions for power-purchase agreements.

Key Actions for Financial Institutions

1)      Risk integration

For financial institutions, climate change risks are prudential risks, which are aligned with their operational and credit risks. Therefore, banks, credit unions, and other institutions should treat the climate change risks as financial risk. They should also work toward integrating climate risks considerations into their financial risk management framework, putting in place the necessary systems and processes to effectively recognize, measure, manage and report their climate risks exposures. Indeed, financial institutions should even include such material exposures in their Internal Capital Adequacy Assessment Process (ICAAP). In addition, climate risk factors should be implemented within financial institutions’ conventional borrower and deal-level financial analysis and their underwriting and credit review processes. Further, it should be assured that their existing risk rating models are adjusted to account for borrower’s climate change risks. Finally, financial institutions should actively strive to grasp the possible impacts of physical and transition risks of climate change on their counterparties, customers and the businesses they invest in.

2)      Governance 

Banks, credit unions, and other financial institutions should work on gaining adequate board-level accountability and engagement while also ensuring appropriate senior management ownership in regard to climate risks management. Further, the management and monitoring of these climate risks need to be integrated into their supervision approach. The CEO and CRO should play pivotal leadership role here. Institutions should also institute a dedicated function to oversee their firm-wide climate risks management. An internal cross-functional working group, comprising adequate expertise and skills, can also be formed - this would help various business units to work collaboratively in assessing climate risks. However, the ultimate responsibility of managing the climate risks should reside within the firm’s FRM function.

3)      Tailor credit and business strategy 

Climate considerations should be deeply embedded in risk frameworks and capital-allocation processes. Many institutions have decided not to serve certain sectors or companies or have enacted emissions thresholds for financing. Boards should regularly identify potential threats to strategic plans and business models.

4)      Scenario analysis 

In certain climate change scenarios, two businesses with the same traditional risk ratings may perform very differently. To effectively integrate climate risks into their FRM framework, institutions need to leverage strong scenario analysis techniques and tools. Both transition and physical risks scenarios need to be considered. Institutions should remember that climate risk scenarios analysis differ from their traditional scenario analysis approaches. They should therefore focus on enhancing their current stress testing tools and scenario analysis frameworks to accommodate the climate risk scenarios requirements.

5)      Strategy 

Institutions need to embrace a long-term firm-wide approach and strategically focus on the following dimensions when it comes to climate risks:

a.       Risk management: For example – a) aligning portfolios with the climate risks management targets, b) proactively assessing the business impacts of technological revolution and future policy changes,  c) reducing/not doing business dealings in risky geographies, sectors and asset classes d) enabling advanced limit systems, e) lending to low-carbon businesses and incentivizing adoption of less carbon-intensive technologies,  and f) periodic stress-testing for assessing financial resilience against climate risks.

b.       Opportunities exploitation: For example – a) sustainable investment, b) giving retail customers solutions that lead them toward responsible, sustainable choices, and c) proactive assessment of revenue-generating opportunities.

c.       Data and technology: For example – a) advanced spatial risk modeling and analysis tools, b) AI-based solutions and analytics solutions for evaluating the climate risks in the borrower’s value chain,  c) implementation of data standards and common taxonomies, d) automated sourcing of relevant data for impacts analysis of climate risks across markets, geographies, and sectors, and e) system for capturing relevant external macro- and micro-level industry- and borrower-level data for the credit review and underwriting processes.

d.       Central bank related: Central banks should focus, for example, on a) making due modifications to their refinancing frameworks and monetary policy – to accommodate for the unfavorable impact of climate change on productivity, health, infrastructure, inflation volatility, uncertainty etc., and b) integrating sustainability concerns into portfolio investment decisions.

Three Steps to Reach for Risk Maturity

It is important to remain pragmatic when considering how to incorporate climate-change considerations into risk-management activities. The climate issue is a highly sensitive one. Stakeholders want action and banks are feeling the pressure to respond. Rather than rushing their response, the best strategy is comprehensive, adequate preparation: a bank can create a value-focused road map setting out an agenda fitted to its circumstances and taking into account both the regulatory and physical status quo. Once the road map is enacted, banks should adopt a standardized approach to implementation by ensuring that investments are tied to areas of business value by meeting external expectations, facilitating finance, and offering downside protection.

To develop a comprehensive approach to risk management, McKinsey pinpoints three key steps that can be reached in four to six months.

1)      Define your strategic ambition

Competent climate-risk management should be based on a committed strategy. Individual banks must be sure about how they want to act and identify the industry sectors and client segments where they can add the most value. They should also put into place governance frameworks for climate risk—frameworks that include the use of dedicated senior personnel, as well as a minimum standard for reporting up and down the business.

2)      Build the foundations

As quickly as they can, banks should pinpoint the tools, processes, and methodologies they will need to effectively manage climate risk. This involves ingraining climate factors into credit and risk framework. Stress tests and scenario analyses will be pillars of supervisory frameworks and should be considered necessary capabilities. Outcomes should be hardwired into disclosure and reporting frameworks. Finally, like most sectors, banking does not yet have the climate-risk resources it needs. The industry must therefore accumulate skills and buy or build relevant analytics, IT, and data.

3)      Construct a climate-risk-management framework

Banks must aim to embed climate-risk factors into decision making across their front- and back-office activities and for both nonfinancial and financial risks. A significant hurdle will be data, which is needed to understand the fundamentals of climate change as well as the impact it will have on activities like client-relationship management, pricing, and credit risk. However, a dearth of data should not become a barrier to getting started. Banks should measure – as far as possible – climate exposures at a number of levels, including by portfolio, subportfolio, and even transaction. This will enable the creation of detailed reports of specific situations where necessary and heat maps. In corporate banking, this kind of measurement and reporting might support individual companies’ climate-adjusted credit scorecards. Banks may then assign specific risk limits. In fact, some banks have already moved to integrate these types of approaches into their loan books.

Banks play a crucial role in economic development that now includes managing the transition and physical risks of climate change. The task is complex, and the models and assumptions needed to align the business with climate priorities will inevitably be refined over time. Yet, as the climate continues to change, banks will need to have these types of priorities at the forefront.

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