Greening up the Banking ERM

Impact of Climate Change on banks

Over the last few years, the concerns and public discussions around environmental impact & climate change and the related social impacts have increased dramatically. This is a big uncertainty for the economy and thus it should be only natural that when banks are thinking about their strategy & economy outlook for the next 3-5 years, they should capture this as well in one way or another. If they do not, then they might miss important risk drivers.

And climate change is already costing banks money, and whether we talk about:

• farm loans that are not getting repaid due to poor crop yields caused by extreme dry weather
• a manufacturing debtor shutting down its water-heavy production due to unexpected water-shortage that is becoming more and more common
• a plastic producer losing lot of its business due the new anti-plastic regulations
• a debtor located / doing majority of its business in a geographic area that is being more regularly swamped by extreme weather events
• or a debtor receiving huge environmental fine from the authorities for its unclean production practices & waste pollution

the result is the same, the likelihood that the bank will see its money back is impacted.

“Climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks”

Source: NGFS : A call for action: Climate change as a source of financial risk

Some of the leading banks in the world area already taking serious actions, for example ING , the dutch leading bank has set up a climate change committee chaired by their CRO with the objective to address strategic climate-related risk. As part of its Terra initiative, the bank tracks the CO2 footprint of its borrowers and monitors their alignment with the respective C02 decrease pathway towards an emission decrease goal defined by ING per each industry.

Another example is Nordea, the leading banks in Nordics, which has rolled out individual carbon footprint tracker calculator for its customers which can now estimate and monitor their CO2 footprint as part of their digital banking.

Perspective of banking regulators

The banking regulators & central banks are starting to suddenly pay more attention to the role of climate change as source of financial risk.

The recently established network of 60+ central banks & regulators – The Network for Greening the Financial System (NGFS) openly recognized the need for the banking industry to act and embed the management of climate change risks into the banking ERM frameworks & processes.

“As long as the temperatures and sea levels continue to rise and with them the climate-related financial risks, central banks, supervisors and financial institutions will continue to raise the bar to address these risks and to green the financial system.”

Frank Elderson, chairman of the NGFS & Executive Director at Dutch Central Bank

This NGFS’s call to action report provides the recommendations below which are not binding but are aimed at inspiring all central banks and 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 micro-supervision. This recommendation covers two main areas:

•  Assessing climate-related financial risks in the financial system by adopting key risk indicators to monitor the climate related risks, perform quantitative assessment of financial industry including climate change risk specific scenario analysis and their integration into macroeconomic forecasting and financial stability monitoring.
• Integrating climate-related risks into prudential supervision by setting supervisory expectations to provide guidance to financial firms and direct engagement with them to ensure that climate-related risks are understood and discussed at board level, considered in risk management and embedded into firms’ strategy & risk management processes.

2) Integrating sustainability factors into own-portfolio management which relates to portfolio management performed by central banks themselves on the portfolios under their own management (e.g. pensions funds, reserves..)

3) Bridging the data gaps where building on the G20 GFSG/UNEP initiatives, the NGFS recommends that the appropriate public authorities share data of relevance to Climate Risk Assessment (CRA) and, whenever possible, make them publicly available.

4-6) focus on building awareness & knowledge sharing and establishing internationally consistent climate and environment-related disclosures and building of a “green” taxonomy to factor all the above.

While the above recommendations are not binding it is reasonable to expect that these will eventually be translated into the requirements set and actions taken by the local regulators & central banks and thus will be cascaded down to individual banks in some form as well. In particular, the recommendation nr. 1 together with any new green disclosures & taxonomy will have a direct impact on banks.

Concrete examples of regulatory actions can be found in the Action Plan to Sustainable Finance of EBA (European Banking Authority) which includes among other:

• As part of the regular risk assessment of EU 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 longer time horizon
• The EBA aims to develop a dedicated climate change stress test
• EBA will provide guidance to banks and supervisors regarding banks’ own stress testing where the qualitative and quantitative criteria to assess the impact of ESG risks under scenarios with different severities will be explored

Figure 1: Milestones for regulatory Mandate of EBA on sustainable finance

Source: EBA, Action plan on sustainable finance

Climate Change Risk Exposure Assessment

According to NGFS framework, climate change may result in physical and transition risks that can have system-wide impacts on financial stability and might adversely affect macroeconomic conditions. Thus, banks are exposed to:

• Physical impacts of Climate Change (Figure 2) include the economic costs and financial losses resulting from the increasing severity and frequency of extreme climate change-related weather events (such as heat waves, landslides, floods, wildfires and storms) as well as longer term progressive shifts of the climate (such as changes in precipitation & temperature, extreme weather variability, ocean acidification, and rising sea levels). 

Figure 2: Climate change Physical risks

Source: NGFS: Call to Action - Climate change as a source of financial risk 

• Transition impacts of Climate Change (Figure 3) relate to the process of adjustment towards a low-carbon economy. The process of reducing emissions is likely to have significant impact on all sectors of the economy affecting financial assets values. The 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 way.

Figure 3: Climate change Transition risks

Source: NGFS: Call to Action - Climate change as a source of financial risk 

The magnitude of how the Physical and Transitional risks will manifest themselves will depend on how orderly the transition process will be and how successful will be the measures taken to meet the climate targets (Figure 4 below).

Figure 4: Climate change impact matrix

Source: NGFS, Macroeconomic and financial stability –implication of climate change 

The core banking process impacted by the above is the credit underwriting process and in particular the credit risk assessment & credit scoring part. For more details you can have a look at this complementary blog of my colleague Naeem Siddiqi,

Incorporation of Climate Change into Enterprise Risk Management 

It is clear that banks have to start thinking seriously on how to incorporate climate change risk into their enterprise risk management framework. Banks have to assess their:

• Loan / customer portfolio, where the impacts above can impair the financial stability of their borrowers. In this case, the climate change risks would manifest as increased Credit Risk for the banks.
• Banking operations, where their branches might get more exposed to severe changes of weather (i.e. physical impact) or bank can be negatively impacted by change in regulations resulting for example in penalties for financing heavy polluting projects (i.e. transitional impact). In this case, the climate change risks would manifest themselves as operational, strategic or reputational risks for banks.

In particular the forward-looking ERM needs to consider the impacts of these news risk on the expected bank’s performance over the horizon of next 3-5 years. Rather than adding a new risk category under the strategic risk umbrella, banks need to think how these climate change 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:

• A handbook on climate and environmental risk management which would set out 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: where 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 & Stress Testing

Forward-looking scenario analysis and stress testing form the cornerstone of any robust Enterprise risk management framework. Therefore, to truly understand the potential impact of Climate Change Risks on their business & borrowers, banks have to incorporate climate change into their forward-looking analysis and decisioning. 

Scenario Analysis needs to evolve: climate-based scenario analysis is much harder than anything currently done and will need new computational approaches, data and methodologies.

Source: PRMIA, The Impact of Climate Risk on Financial Institutions

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

Recent example of such cooperation is the 2019 Insurance Stress Test conducted by the Bank Of England using 3 climate change scenarios each coming with predefined global temperature rise target and corresponding shocks to equity & bonds portfolio broken down per industry segment. These estimates come from cooperation with PACTA and are available also for public use via this simple PACTA assessment tool.

Figure 5: Impact of climate change scenario on bonds & equity

Source: PACTA, Stress Testing tool for BoE Insurance Stress Test

The way forward

There is an urgency for banks to incorporate climate change risks in to their ERM frameworks and strategic planning. Some banks are already active, but majority still has a long way to go. Initiatives like the ones of NGFS and PACTA help to provide a common understanding and will provide benchmark that banks can relate themselves to.

Thus, banks need to reflect all the above when they look now into the future and think about their strategy & product mix if they do not want to lose money & future customers.

One thing is sure thought, we will see much more attention going to the assessment of the Environmental & Climate Change risk both on the individual bank level and also on financial system level, considering both the current circumstances and also the potential future outlook & impact. All in all, the demand for green and more forward-looking ERM processes & systems at banks will likely increase significantly.