Managing Climate Risk in Financial Institutions

With Ali Arab

Climate change is an environmental problem that requires economic solutions. As demonstrated by William D. Nordhaus, the 2018 Noble Prize laureate in Economic Sciences, “climate change is the ultimate challenge for the economics.” It can have significant business implications for corporations vulnerable to climate change, and therefore, requires special attention at a strategic level. Climate change is currently addressed under the umbrella of environmental, social and governance (ESG) activities by corporations including financial institutions. In recent years, we have witnessed a sustained rise in corporate-level awareness around the globe to address the risk posed by climate change — referred to as climate risk — to the stakeholders’ values through a wide range of ESG initiatives.

The World Economic Forum recently developed a set of metrics for consistent reporting of sustainable value creation across the organizations. At the same time, the regulators, international organizations, think tanks, and academic institutions, among others, have been actively developing a variety of regulations, standards, tools, and methodologies to facilitate the operationalization of the climate risk management at enterprise level. Among the earliest efforts, the Financial Stability Board took important steps by establishing Task Force on Climate-related Financial Disclosures (TCFD) to develop practical recommendations for climate disclosures to promote risk-informed investment, credit, and insurance underwriting decisions. Its goals are, to enable stakeholders to better understand the risk associated with concentrations of carbon-related assets in the financial system and its exposure to climate change. Most recently, the Basel Committee on Banking Supervision (BCBS) published a series of analytical reports that includes a set of recommendations and guiding principles to address the climate risk in financial institutions. At the same time, numerous other consultative documents have been published in various jurisdictions across the world. While these efforts are right steps in the right direction, we believe the industry is still far from standardizing the common practices for efficient operationalization of climate risk management in financial institutions. That is primarily due to the absence of a concerted effort within the industry to develop a broad consensus around “best practices” in managing the climate risk in financial institutions.

Climate risk is primarily transmitted through two different channels, i.e., physical risk, and transition risk. Physical risk emanates from the interactions of climate-related hazards with corporate assets resulting in financial losses. These losses primarily arise from the increasing frequency and intensity of climate-related events (e.g., storms, floods, heatwaves), and significant shifts in the existing climatological patterns and their consequences (e.g., ocean acidification, rising sea levels and changes in precipitation). Transition risk, however, is associated with the uncertain financial impacts that could result from transitioning into a low-carbon economy, including from policy changes, reputational risk, technological breakthroughs, and shifts in market sentiments, consumer preferences and social norms. The transition to a low-carbon economy has a direct impact to the fossil fuel industry, gasoline-fueled automobile manufacturers, and electric utilities, among others, leading to significant financial implications for their creditors and shareholders — including banks and financial services companies.

As the saying goes, “risk is an opportunity.” This business philosophy should hold for climate risk, as well. Financial institutions in general need to take stronger initiatives by playing a more proactive role in shaping the debates, regulations, and trends in the industry as they relate to the climate change. This requires a clear vision to develop a climate strategy to inform the internal decision-making processes and define their roles and responsibilities in climate change arena. That starts from operationalizing the climate risk management across the enterprise with a clear-cut understanding of its implications, and their position with respect to climate risk exposures in the financial markets. It needs a comprehensive understanding of the climate risk management not just limited to an ESG corporate initiative, but as a business problem that needs to be addressed with a holistic approach to identify, measure, and manage climate risk drivers that can impact their financial performance through prudential risks, such as credit, market, counterparty, operational, liquidity and funding risks.

In the absence of a well-thought-out climate strategy, a financial institution could lose their competitive advantage to their rivals in a medium- and long-term horizon by not taking the first-mover advantage and fast adaptation to the rapidly changing dynamics of the global financial markets. That strategy should involve a set of forward-looking tactical operations that integrates the climate risk management into the enterprise risk management architecture with a clear definition and ownership of climate-related activities across the organization. The success of a financial institution in this new era of finance, to a great extent will depend on the quality of their operational excellence in managing the climate risk across their organization, ceteris paribus. We believe that Chief Risk Officers (CROs) should play the most active role in operationalizing the climate risk management efforts in financial institutions. In our view, the integration of climate risk into the existing risk management framework of a financial institution involves three pillars, as follows: people, processes, and systems.

People, as the first pillar of climate risk strategy, involves the personnel with the required expertise and their ongoing efforts that starts from the inception of the strategy and continues as the processes and systems are being developed to operate during their entire lifecycles. This pillar requires strategic and tactical decisions in ramping up the development of the required human resources in various stages of climate strategy implementation. Due to its unique nature, climate risk management can pose a set of challenges to bring in people with diverse skillsets including various areas of climate science, financial risk, engineering technologies, and energy markets. Therefore, it requires strategic decisions on optimal level of insourcing, co-sourcing, and outsourcing of the human resources needed for both implementation and ongoing operations of the climate risk management activities across the enterprise. The goal is to strike a balance between short-term cost dynamics and long-term strategic advantages that can be attained from human capital development as a source of competitive advantage. The insourcing decisions should include holistic training programs for current staff, and a hiring strategy for new employees to fill the gaps in the corresponding lines of business, risk management, corporate audit, and leadership team.

Processes, as the second pillar of this strategy, involve an effective design of policies and procedures that are needed to integrate the climate risk into business decisions and operations across the enterprise. These policies and procedures should address four distinct priority areas at enterprise level, as follows: (i) the corporate strategy in addressing the impacts of both physical and transition risk in the existing and future assets and financial positions of the institution; (ii) the compliance framework for both voluntary and mandated climate risk regulations including stress testing components in the jurisdictions that the institution operates in; (iii) corporate strategy in monetizing the climate risk-related opportunities in the markets, including but not limited to trading the climate-related derivatives and other financial instruments; and (iv) the scope and scale of ESG activities as they relate to the climate risk management process which need to be addressed under an overarching umbrella of the firm’s enterprise risk management (ERM). The design of these policies and procedures should be done in consultation with the lines of business, and should be evaluated by internal or external auditors and independent evaluators by exercising a healthy dose of objective challenge. Once the policies and procedures for climate risk management framework is approved by the board of directors, implementation of the processes should ensure the operating effectiveness of the controls.

Systems, as the third pillar of this strategy, primarily involve three priority areas, as follows: (i) filling the data gap by development of in-house climate datasets and ensuring access to external proprietary data on climate risk exposures and scenarios; (ii) developing in-house methodologies and ensuring access to proprietary models to identify, measure, and manage credit, market, counterparty, operational, liquidity, insurance, and systemic risk in the market emanating from climate change; and (iii) securing the required software tools, and hardware infrastructure that are required for managing the climate risk operations. This pillar should be capable of supporting an integrated climate risk management framework to identify, measure, manage, and monitor the climate risk embedded in various functions across the organization.

Climate risk management is still an evolving practice in the financial industry. As this practice evolves, banks should consider assuming a climate fiduciary role for their retail and institutional client activities as we transition into this new era of low-carbon economy. That requires setting an ambitious, yet realistic institutional climate strategy with measurable outcomes in improving their business bottom line in short and medium terms and gaining strategic competitive advantage in the long term. Risk professionals should play a pivotal role in transformation of financial institutions to a resilient and climate-ready enterprise of the future envisioned in the Paris Agreement.