Carbon and Climate Change: The emerging risks that banks must tackle now

The recent report revealing that the G7 banks' financed emissions exceed those of several member countries combined highlights the urgent need for comprehensive action to reduce carbon footprints within the financial sector. This report underscores the increasing recognition of carbon risks and climate risks as critical challenges for the banking industry. As extreme weather events continue to affect every continent and the world moves towards a lower-carbon economy, banks are working on two intertwined objectives: understanding the impact of climate change on their strategy and operations and helping customers and communities navigate the complex market dynamics that arise from these changes.

?The Merging of Carbon and Climate Risks

Climate change has emerged as the most significant risk for banks over the next five years, according to the 11th annual EY/IIF global bank risk management survey. Ninety-one per cent of Chief Risk Officers (CROs) identified climate change as their top concern, a sentiment 96% of their boards echoed. The banking industry is increasingly aware that climate risks, including both physical and transitional risks, must be integrated into their risk management frameworks.

Physical Risks: involve the direct impact of extreme weather events on the bank's physical assets, operations, and the broader economy. These risks include damage to bank branches and facilities and the creditworthiness of clients affected by climate change.

Transition Risks: relate to the changes required to move towards a low-carbon economy. These risks encompass the potential financial losses associated with the shift in market conditions, regulatory changes, and evolving stakeholder expectations.

Key Measures for Banks

To mitigate these risks, banks must adopt a multifaceted approach that includes the following measures:

1. Integrating Climate Risk into Lending Practices: Banks should incorporate climate risk assessments into their lending and investment decisions. This involves evaluating the environmental impact of funded projects and prioritizing low-carbon and sustainable initiatives.

2. Setting Emission Reduction Targets: Financial institutions need to establish clear and ambitious targets for reducing financed emissions. These targets should align with international climate goals, such as those outlined in the Paris Agreement, and be publicly disclosed to ensure accountability.

3. Enhancing Transparency and Reporting: Banks must adopt standardised carbon accounting methodologies, such as those from the Partnership for Carbon Accounting Financials (PCAF), to measure and report their indirect emissions (Scope 3). Improved data collection and transparency will enable more accurate assessments and drive better decision-making.

4. Investing in Green Finance: Increasing investments in renewable energy, energy efficiency projects, and other green technologies can significantly reduce the carbon intensity of bank portfolios. Banks should actively seek opportunities to finance environmentally sustainable projects.

5. Engaging with clients and stakeholders: Collaborating with clients to support their transition to low-carbon business models is crucial. Banks can offer incentives for sustainable practices and provide guidance on reducing emissions. Engaging with stakeholders, including investors and regulators, is also vital for creating a unified approach to sustainability.

Regulatory Actions

Regulators play a critical role in facilitating the banking sector's transition to a low-carbon economy. Key regulatory actions include:

1. Establishing Clear Guidelines and Standards: Regulators should develop and enforce guidelines for measuring and reporting financed emissions. Standardised frameworks will facilitate consistent and comparable data across the financial sector, enabling more effective monitoring and regulation.

2. Incorporating Climate Risk into Regulatory Frameworks: Regulatory bodies need to integrate climate-related risks into existing financial stability assessments. This includes revising the systemic risk buffer to address climate change’s systemic nature and incorporating climate science into stress testing scenarios.

3. Promoting Transparency and Accountability: Regulators should require banks to publicly disclose their carbon emission targets, progress, and methodologies. Enhanced transparency will enable stakeholders to hold financial institutions accountable for their environmental commitments.

4. Incentivizing Green Investments: Governments and regulatory bodies can introduce incentives for banks to increase their investments in sustainable projects. This could include tax benefits, subsidies, or preferential regulatory treatment for green finance activities.

5. Strengthening International Cooperation: Climate change is a global issue that requires coordinated efforts. International bodies like the G7, G20, Financial Stability Board, and the Basel Committee on Banking Supervision should work together to establish global standards and promote the greening of the financial system.

Challenges and the Role of CROs

Despite the significant opportunities in sustainable finance, banks face several challenges. Chief among these is the difficulty in assessing both physical and transition risks. Banks need to evaluate the impact of climate events on their physical infrastructure, staff, customers, and vendors, requiring an understanding of weather patterns, geography, and social factors. Additionally, transition risks necessitate a long-term view of the exposure to greenhouse gas emissions by sector and customer.

Lack of Standardised Models

The lack of a standardised industry model for embedding climate risk into risk management presents a significant challenge. As a result, only 26% of survey respondents quantitatively assess physical risks, while just 33% do so for transition risks. Industry bodies at a global level are still working on consolidating frameworks and standards, so banks must navigate a range of different methodologies in the short term. Risk leaders should collaborate closely with compliance colleagues to stay abreast of these evolving changes.

Having the right governance structures and processes in place can help. A dedicated management-level climate risk committee or an executive who reports directly to the CRO is ideal for ensuring the subject receives the attention and focus it requires. For smaller organizations, however, this may not be feasible, and the CRO will have to shoulder the burden. Working closely with ESG or sustainability leads ensures that climate risk is addressed in a coordinated manner across the organisation.

Skills Shortages

Another significant challenge facing banks and CROs is the lack of relevant skills. Climate change is identified as the third most important risk management skill needed over the next three years, behind cybersecurity and data science. However, executives with climate science and risk management expertise are scarce and in high demand across all industries. This shortage necessitates a strategic approach from banks.

The obvious solution is to train existing risk specialists in climate science or vice versa, but this is not a quick fix. Third-party support from external experts will probably be necessary to fill gaps in the meantime. Regulators and governments can play a pivotal role in addressing this skills shortage. They should fund and promote educational programs focused on climate risk and sustainable finance. Additionally, governments can create incentives for professionals to gain expertise in these areas, such as scholarships, grants, and tax benefits for relevant training programmes.

Conclusion

Banks have a once-in-a-generation opportunity to lead the transition to a more sustainable and climate-friendly economy. By implementing robust measures, collaborating with regulators, and overcoming challenges, banks can significantly reduce their environmental impact and contribute to a more sustainable future. The future of the banking industry depends on bold and immediate action to mitigate climate risks and embrace sustainable finance. With the right skills, governance, and regulatory support, banks can navigate these challenges and seize the opportunities the transition to a low-carbon economy presents.