Climate Change: Evolution and Impact on Financial Risk Management

GRI's Jo Paisley on climate risk, the role of regulators, the complexities of scenario analysis and the importance of getting started.

Friday, August 9, 2019

By Robert Sales


The presidential nominee of the European Commission recently endorsed the idea of creating a European bank focused on climate change, and the European Union is trying to figure out how to eliminate greenhouse gas emissions by 2050. What's more, as part of a green finance push, the U.K. is considering rules that force companies to disclose their climate-related risks.


All of this follows on the heels of comprehensive climate risk regulatory guidance issued by both the Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD) and the Prudential Regulation Authority. Clearly, the transition to a low-carbon economy is coming, but how are financial institutions responding to these significant developments?

Though climate risk management in financial services is still in its early stages, progress is being made. Just a few years ago, financial institutions mainly treated climate risk as a reputational risk, assigning it to their environmental, social and governance (ESG) units. Today, in contrast, most firms see it as a financial risk and are taking steps to embed it into their existing risk management frameworks.

Earlier this year, to gauge how mature financial institutions are in their approach to climate risk management, the GARP Risk Institute (GRI) conducted a global, cross-sectoral survey of banks, asset managers, insurers and financial market infrastructure companies. The results showed that headway is being made in areas like governance (80% of respondents had board oversight of climate risk), strategy and risk management, but more complex aspects of climate risk - like scenario analysis - are lagging behind.

Climate risk is a transverse risk

In a recent interview with Mike Barber (see full video, above), a partner in Deloitte's U.K. sustainability services group, GRI co-president Jo Paisley said the survey clearly showed that firms have different levels of maturity. “Some firms were doing an awful lot and had really thought about [climate risk] and had embedded it in their day-to-day operations,” she said. “Others, frankly, had not started and were really looking for help.” This video interview was first published on Deloitte U.K.'s dedicated climate change website.

Climate risk, she elaborated, is a transverse risk - i.e., a “risk that will manifest itself in existing risk types,” including credit risk and operational risk. If a bank is lending to a company that is impacted by either the transition to a low-carbon economy or by physical events (e.g., hurricanes) that can inflict property damage, its credit risk profile is going to change, Paisley noted. If, on the other hand, its internal operations are affected by, say, floods or wildfires, its operational risk levels will rise.

Since climate risk is a transverse risk, firms do not have to create separate risk frameworks to address climate change. Rather, it can just be embedded into firms' existing frameworks. (For a more comprehensive perspective on how firms are weaving climate risk into their risk management frameworks, read the survey companion paper, “Challenges and Opportunities.”)

To advance their climate risk management programs, Paisley advises firms to create cross-disciplinary working groups with representatives from, among other units, risk, strategy, finance, legal, CSR and human resources. “Any institution that is serious about this [is] going to have to bring everybody together, because no one will have all of the answers,” she said. “That's one of the benefits of this, actually. … It can be a little uncomfortable, but you'll get a much better outcome if you do bring all of these perspectives together.”

Scenario Analysis Challenges and Regulatory Optimism

The least developed aspect of climate risk management is scenario analysis. Only 50% of respondents in the climate risk survey said they currently use scenario analysis, which includes scenarios selection and modeling. Paisley said that one of the biggest challenges with climate risk scenario analysis is trying to get people to “wrap their heads around” scenarios that are 20 years out.

At the beginning of scenario analysis, a firm must determine the risks that are currently on its balance sheet, and then look to the future to determine how its balance sheet and P&L will evolve. Asking the right questions, particularly about data, is an integral part of the process. “Have you got the right data? Do you really understand how to measure, if you like, the greenness of your portfolio today? Even that's a challenge. And then you try to work out, well, what's a sensible scenario for us to run? Then the fun really starts,” said Paisley.

One of the keys to success, she elaborated, is simply getting started with climate risk management. Initially, Paisley said, firms might not realize that this is not a tick-box exercise, and that embedding climate risk into their existing risk management frameworks could, in fact, take between three and five years.

“I think the best message is, don't let 'the best' be the enemy of the good. You won't get this right completely,” Paisley said. “You have to get your governance right, you have to get the right people around the table. You have to start on that journey and start having conversations, and you will get better.”

The role of regulation

Regulators, of course, will also play a pivotal role in helping firm hurdle climate risk management obstacles. On the regulatory front, Paisley points to the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) as a reason for optimism. The NGFS, a coalition of central banks aimed at financing the transition to a low-carbon economy and managing climate risks, has grown from eight members in 2017 to 42 (including the Bank of England, the European Central Bank and the Hong Kong Monetary Authority) today.

Paisley, who worked as the global head of stress testing at HSBC before joining GRI, said that climate risk supervisors can learn valuable lessons from stress testing regulation. Part of the reason that stress tests are a huge challenge for global firms is because different regulators around the world have varied stress testing requirements. That's a pitfall that the climate risk community might be able to avoid with the help of NGFS.

“I really hope that climate risk scenario analysis doesn't go the same way [as stress testing], with different regulatory approaches, because this is truly a global problem. You need to be able to look across different regulators, and they need to work together, because we're under time pressure here,” Paisley said. “We need to make this transition happen, and what we don't want to occur is for this to become a compliance exercise. I'm hopeful that [NGFS], in particular, will really help drive coordination and harmonization.”


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