How Climate Change is Reshaping Financial Risk Management
Risk management is a structured approach that involves identifying, evaluating, and addressing potential risks to minimize the impact of uncertain events. Financial institutions and non-financial businesses have long used these strategies. Traditionally, risk management focuses on areas like credit, market, liquidity, and operational risks. However, with the growing concerns around climate change, a new category of risk, known as climate risk management, has emerged. Climate risk involves proactively identifying, assessing, and mitigating the effects of climate change on a business’s operations or a financial institution’s portfolio. It addresses both physical risks, like sudden extreme events (hurricanes, floods) or gradual changes (rising sea levels) that harm infrastructure and productivity. Transition risks occur during shifts to a low-carbon economy, involving policy changes, technological shifts, market dynamics, and reputational concerns.
Climate risks can also spread through multiple channels, including market, credit, and operational risks, ultimately impacting the stability of firms and the financial system. Understanding the interconnections is crucial for effectively managing climate-related vulnerabilities. Below is explanation of how climate risk affects other risk.
Market Risk: Climate events, like extreme weather, and transition risks, such as regulatory changes or shifts to a low-carbon economy, can lead to price volatility in markets, affecting asset values and investment portfolios.
Credit Risk: Businesses exposed to climate risks may struggle to meet financial obligations, increasing the likelihood of default. Industries with heavy reliance on fossil fuels or vulnerable to physical risks face higher credit risk.
Liquidity Risk: Physical disruptions from climate change can hinder cash flow, reducing liquidity. Transition risks, like the shift to green technologies, may also leave financial institutions holding illiquid assets, impacting their ability to meet obligations.
Operational Risk: Climate change can damage infrastructure or disrupt operations, increasing operational failures. Transitioning to green practices or complying with new regulations may also create operational challenges for businesses and financial institutions.
The banking sector plays a crucial role in the broader economy by controlling the money supply, which, in turn, impacts industrial production and the balance of supply and demand. To minimize the environmental harm caused by industrial activities, it is essential to regulate banking operations. Banks are responsible for providing loans to businesses and corporations, as well as investing in various assets. By regulating these activities, financial support can be directed toward sustainable and environmentally conscious practices within industries, encouraging investment in business models that prioritize eco-friendly and greener products.
Furthermore, climate risks—both physical and transitional—extend beyond the direct impact on assets or firms. These risks can propagate throughout the financial system, affecting key sectors and potentially causing broader economic instability. For instance, the physical effects of climate change, such as extreme weather events, and policies aimed at reducing emissions can influence the balance sheets of corporations and the portfolios of financial institutions. Given these challenges, risk managers in the banking sector must consider the wider implications of climate risks when making lending and investment decisions. This is essential to ensure that their portfolios remain resilient in the face of climate-related disruptions and contribute to the transition toward a more sustainable economy.
To address climate-related risks effectively, central banks and financial supervisors are incorporating climate change considerations into micro prudential and macroprudential supervision frameworks. Micro prudential supervision ensures the financial soundness of individual institutions, such as banks and insurers, by identifying and mitigating climate-related risks like property damage, operational disruptions, income losses, and declining asset values. These risks often manifest at the microeconomic level, affecting households and businesses. On the other hand, Macroprudential supervision focuses on safeguarding the stability of the broader financial system. At the macroeconomic level, climate risks can influence the economy through price volatility, productivity shifts, socioeconomic changes, and labour market disruptions, which can propagate as systemic financial risks. This dual-layered supervisory approach is critical in addressing climate-induced vulnerabilities in the financial sector.
Further micro prudential supervision, regulators like the Bank of England (BoE), European Central Bank (ECB), and others have outlined expectations for governance, risk management, scenario analysis, and disclosure. Governance frameworks require senior managers and boards to actively manage climate risks. Risk management often employs tools like stress testing and scenario analysis, while disclosures align with the Task Force on Climate-Related Financial Disclosures (TCFD) standards, which are increasingly becoming mandatory in countries like the UK and New Zealand.
Stress tests, a key tool in both micro- and macroprudential frameworks, simulate financial institutions' responses to climate shocks using various scenarios and time horizons. Other proposed macroprudential measures include carbon countercyclical capital buffers, which increase capital requirements during carbon-intensive credit booms, and exposure limits to reduce reliance on carbon-heavy assets. Some central banks, like Sweden's Riksbank, are applying these principles to their own portfolios by excluding investments with significant climate footprints.
Efforts by global bodies like the Network for Greening the Financial System (NGFS) are promoting best practices and harmonizing climate-related prudential policies across jurisdictions, despite national differences in mandates and tools. These measures collectively aim to mitigate financial instability and promote sustainability in the face of climate risks.
To assess and measure climate risks, banks can adopt the frameworks and methodologies outlined by the Task Force on Climate-related Financial Disclosures (TCFD). The TCFD highlights physical risks (acute events like extreme weather and chronic changes like rising sea levels) and transition risks (policy/legal changes, technological advancements, market shifts, and reputational challenges). Banks should evaluate these risks systematically through the following approaches:
Key features of these methodologies include their universal applicability, requirement for inclusion in financial filings, focus on forward-looking financial impacts, and emphasis on risks and opportunities related to transitioning to a low-carbon economy.
In addition to the above, the introduction of green taxonomies, which provide frameworks to assess and classify investments based on their environmental sustainability, have been proposed as an effective solution to address this issue. These taxonomies offer a consistent way to determine whether an investment is "green," thereby improving comparability across investment products. This, in turn, helps reduce the burden of assessing the environmental impact of individual investments. By making it clearer what constitutes a green investment, taxonomies help mitigate greenwashing and ensure that investments are genuinely contributing to positive environmental outcomes.
For instance, the EU taxonomy includes provisions that aim to prevent investments from causing significant harm to the environment, ensuring that the activities labelled as "green" indeed contribute to sustainable outcomes. This approach is designed to be a common framework across jurisdictions, helping to clarify the environmental impacts of various corporate activities. If applied correctly, these frameworks could play a crucial role in greening portfolios and loan books by making it easier to identify and track investments and loans that align with sustainability goals.
However, despite the intuitive appeal of green taxonomies, they face significant challenges. Assessing the environmental sustainability of every type of economic activity is complex, and applying these assessments consistently across all companies and industries is a daunting task. The evolving nature of climate science and the diverse approaches to sustainability in different sectors further complicate the process. This inconsistency may lead to difficulties in fully implementing green taxonomies, limiting their effectiveness in driving broad change across the financial system.
By incorporating comprehensive climate risk assessments and utilizing tools like green taxonomies, banks can help direct capital toward environmentally sustainable projects while mitigating potential climate-related financial risks. However, it remains essential to overcome the complexities of consistent application and ensure that regulatory frameworks continue to evolve as our understanding of climate risks grows.
Below is an example of best practices adopted by Regulatory Authority, Banks and Financial institute.
1. The Bank of England (BoE), as the UK’s central bank and financial regulator, has integrated climate-related risks across its core responsibilities: micro prudential policy, macroprudential policy, and monetary policy. This integration reflects the growing recognition of climate change as a systemic financial risk.
· Climate Integration Background: The BoE began addressing climate risks following the 2015 "Tragedy of the Horizon" speech by then-Governor Mark Carney. He highlighted the long-term systemic risks posed by climate change, which often fall outside traditional investment horizons. These include physical risks, transition risks, and litigation risks. Recognizing these threats, the UK government in 2021 expanded the BoE’s mandate to include supporting environmental goals and facilitating the country’s transition to a net-zero economy by 2050.
· Micro prudential Measures: The BoE introduced guidelines emphasizing governance, risk management, scenario analysis, and disclosure. It expects firms to allocate responsibility for climate risks to senior executives and ensure board-level oversight. Financial institutions must incorporate climate-related risks in their capital adequacy assessments and strategic planning while aligning disclosures with frameworks like the TCFD recommendations.
· Macroprudential Measures: To manage systemic risks, the BoE employs stress testing. Since 2021, it has conducted the Biennial Exploratory Scenario (BES), which examines the financial system's resilience under various climate policy scenarios. This builds on earlier tests, such as the 2019 insurance sector stress test incorporating climate risks.
· Monetary Measures: The integration of climate considerations into monetary policy remains nascent. The BoE has assessed climate risks in its corporate bond holdings under quantitative easing. With its updated mandate, the BoE is expected to align its asset purchases with climate goals, promoting greener investment practices.
Through these measures, the BoE is addressing both firm-level and system-wide climate risks to enhance financial stability and support the transition to a sustainable economy.
2. ING has been a leader in integrating climate change risk into its risk-governance framework, ensuring that climate-related risks are fully accounted for in its overall risk management strategy. The bank’s annual reports and Climate Risk Reports detail its current integration efforts, emphasizing its commitment to addressing environmental challenges.
· Governance Structure: ING employs a two-tiered board system, typical of many continental European banks, where climate risk oversight is embedded at both the supervisory and management levels. The supervisory board has a risk committee responsible for overseeing climate risks, while at the management board level, the Chief Risk Officer (CRO) holds the responsibility for ensuring climate risk is integrated into decision-making processes.
· Credit Risk Management: From a credit risk perspective, ING addresses climate risk within its Global Credit & Trading Policy Committee (GCTP) and the Global Credit Committee-Transaction Approval (GCC-TA). These committees, which include the CRO, CFO, and Head of Wholesale Banking, play a pivotal role in assessing and managing the climate risks that could affect the bank’s credit portfolio. By involving top management, ING ensures that climate considerations are factored into major decisions, particularly those related to lending and credit risks.
· Three Lines of Defence Model: ING describes its risk management approach using the "three lines of defence" model. This structure ensures clear accountability for managing climate risks across the organization:
a) First Line of Defence: The front office staff, including relationship managers and deal principals, take responsibility for identifying potential climate-related risks in transactions. Their role involves actively assessing the environmental impacts of deals before they are finalized.
b) Second Line of Defence: Local and regional risk committees, along with regional risk managers, form the second line. They are responsible for overseeing the risk assessment process and ensuring that any identified risks are managed effectively. This layer provides more specialized, localized expertise on climate risks across different markets.
c) Third Line of Defence: The final line consists of internal audits. These audits provide independent assurance that the bank’s risk management processes, including those related to climate risks, are functioning properly and complying with internal policies and external regulations.
By incorporating climate risk into every level of its risk management structure, ING demonstrates a holistic approach to integrating sustainability into its financial operations. This model helps the bank manage the emerging risks associated with climate change, ensuring that they remain aware of and prepared for the evolving regulatory landscape and environmental impacts. This integration is crucial in preparing for potential future risks while also meeting growing expectations from stakeholders for responsible environmental practices in the financial sector.
4. McKinsey highlights an example of a global banking group that incorporated climate risk into its counterparty risk assessment. The bank uses an annual scorecard system to evaluate 2,500 counterparties based on their industry and geographic presence. Adjustments are made for factors such as emissions intensity and fossil fuel dependency (transition risk) and exposure to physical hazards (physical risk). This approach effectively distinguishes climate risk exposure within sectors. For instance, in the utility’s portfolio, electricity providers and multi-utilities ranked higher in risk compared to regulated networks.
Exhibit from "Banking imperatives for managing climate risk", June 2020, McKinsey & Company, www.mckinsey. Com
References
www.mckinsey. com
As climate change accelerates, its impact on financial markets is becoming undeniable. 🌡️ Traditional risk management frameworks must now account for climate risks—both physical (extreme weather, rising sea levels) and transition-related (policy shifts, market dynamics).