Climate Change and the Future of Risk Management in Banks

Posted on 9/16/21 11:19 AM

Climate change is a cross-cutting phenomenon, because our entire economy has previously depended on assumptions of operating within a stable climate. Unstable conditions yield increasing frequency of extreme events — as seen with 2021’s Texas cold snap and the recent West Coast heatwave — that prove costly and deadly. 

In a speech prepared for the 2021 IIF U.S. Climate Finance Summit, the U.S. Federal Reserve’s governor Governor Lael Brainard emphasized the importance of climate risk management for financial institutions: 

“Financial institutions that do not put in place frameworks to measure, monitor, and manage climate-related risks could face outsized losses on climate-sensitive assets caused by environmental shifts, by a disorderly transition to a low-carbon economy, or by a combination of both. 

Conversely, robust risk management, scenario analysis, and forward planning can help ensure financial institutions are resilient to climate-related risks and well-positioned to support the transition to a more sustainable economy.”

This blog post examines how banks can define climate financial risk, the capabilities financial institutions need to conduct strong scenario planning, and ways for banks to seize climate-related opportunities.

 

What is climate financial risk and how can banks assess it?

Climate financial risks and opportunities are the potential economic costs and gains associated with climate change. 

Physical risks, relating to direct changes in the environment, and transition risks, relating to shifts in policy, technology, and consumer behavior in response to climate change, need to be assessed and managed. 

Banks can use traditional strategies for managing these risks, like measuring the risk through means of credit, market, liquidity, reputational, and operational risks. Establishing a reliable basis for these measurements, however, requires tackling the complex “wicked strategy problem of our time” through scenario analysis.    

Scenario analysis is a key recommendation by the Task Force on Climate-Related Financial Disclosures (TCFD), an independent organization established by the Financial Stability Board in 2015 to improve the transparency of climate-related impacts on the financial system. 

 

Why scenario analysis is challenging for banks

Scenario analysis isn’t a new approach to long-term strategy planning, but climate scenario analysis presents a few challenges because it has complex, wide-reaching impacts. 

As an exploratory exercise, it differs from stress testing in a number of ways. It includes more variables for the sake of comparison and it includes probabilistic variance for different timespans. Ideally, stress testing and scenario analysis can be used together for a more robust climate banking strategy. 

Climate scenario analysis is still an emerging field, which brings with it its own challenges, including:

  • Scenario analysis norms that are still emerging: Few banks have already published their climate risk disclosures using scenario analysis. However, the scenario approaches of several central government banks are starting to come forward. The Bank of England recently announced its execution of scenario analysis with an anticipated publication date of 2022. The Bank of England’s approach draws from the technical guidance on scenario analysis published by The Network for Greening the Financial System. 
  • A lack of actionable data: Critics say the usefulness of scenario analysis is limited due to its inability to make exact predictions, and its future projection time period doesn’t give enough granularity for banks to act on. As more data emerges, however, predictive models relying on historical analysis will continue to improve. Collecting high quality, reliable data is one of the significant technical demands associated with climate risk assessment in banking. 

How can banks build the capacity to manage climate risks?

Incorporating climate risk management into the banking culture starts with gap analysis to understand how well the bank is positioned to undergo scenario analysis aligned with TCFD recommendations. This process enables them to review their governance, human resources, documentation, and technical capabilities for performing a scenario analysis. 

Banks lacking experience with scenario analysis may feel overwhelmed by a seemingly open-ended exercise in risk assessment. This is why it’s important for banks to work with experienced technical teams capable of processing and translating the large amounts of data needed to prepare effective climate risk reports. 

The various lenses banks should incorporate into effective scenario analysis include:

  • Physical and transition risk assessment in financial terms - Banks should be able to leverage models and visualizations of financially quantified physical risks and opportunities.
  • Short-, medium-, and long-time span - 10-20, 20-30, and 80-90 year assessment time spans enable both short- and long-term planning. 
  • A range of warming scenarios - Ideal reference points to contrast are the RCP 8.5 and RCP4.5 warming scenarios. The high emissions “hothouse earth” scenario associated with tipping points and runaway temperature extremes presents numerous physical risks, while lower RCP scenarios entail significant transitional risks.
  • Micro and macro integration of risk - Assessing climate risk from the asset level to the portfolio level enables improved prioritization for strategic improvements.

The Climate Service’s Climanomics® platform provides these capabilities and more, enabling financial institutions, asset managers, Fortune 500 companies and other leading organizations to analyze risks to their businesses associated with extreme weather and climate change, and plan accordingly.

Related: Check out this case study of a consortium of large, international pension funds with more than $1 trillion under management working with The Climate Service to analyze asset and portfolio-level physical climate risks.

 

How Banks Can Approach Climate-Related Opportunities

Soon, most corporations will likely undergo scenario analysis on their own. Banks need to take the lead in this transition, because they play a crucial role in the financial system, and they are well-positioned to incorporate climate financial risks into their strategies. 

For banks to build the capacity to undergo scenario analysis at the asset- and portfolio-levels, keys to success will include:

  • Building out their technical capacities;
  • Reorienting economic investments toward greener funding opportunities;
  • Navigating rapidly evolving asset-level risks; and 
  • Leveraging climate risk analytics to build out the proper systems for climate risk management.  

Financial institutions require high-quality data for assessing and acting upon climate risk within their portfolios, particularly as many global leaders request voluntary or mandatory TCFD reporting by financial institutions. A shift from short-term planning to long-term future climate risk projections will help bridge the complex challenges of climate risk management. 

Learn how The Climate Service can help banks and financial institutions elevate their climate risk management strategies today.

Topics: Banks, Risk Management in Banks, Financial Institutions, Risk Management in Banking, Climate Risk

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