The Evolution of Climate Risk Management in Financial Services
Though climate risk management is still in its early stages, financial institutions are making progress in areas like governance and strategy. While firms are taking steps to embed climate risk into their existing risk management frameworks, there is still much work to be done - particularly in scenario analysis.
Friday, June 28, 2019
By Jo Paisley and Maxine Nelson
The treatment of climate risk at financial institutions has changed significantly over the past five years. Whereas it used to be viewed mostly as a reputational risk that could be addressed through the environmental, social and governance (ESG) agenda, climate change is now seen by many firms as a financial risk that needs to be integrated into existing risk management frameworks.
To provide a benchmark for how mature firms are in their approach to climate risk management, in the first quarter of 2019, GARP undertook a global, cross-sectoral survey. Our sample covered 20 banks and seven other financial institutions (comprising asset managers, insurers and financial market infrastructure companies) from across the globe.
The survey was structured around the main themes for climate risk reporting that have been developed through the Financial Stability Board's Task Force on Climate-related Financial Disclosures. The topics covered included governance and strategy; risk management; metrics, targets and limits; scenario analysis; and disclosures.
Board-level governance is practiced at the majority of firms. Most firms (roughly 80%) have board oversight of climate-related risks and opportunities. Two-thirds of board members have seen papers on climate risk, which was introduced as a topic more than five years ago at roughly half of the firms. Senior managers (including C-suite level executives) are typically responsible for managing climate risk.
Though climate risk management is still in its infancy, firms are mostly taking a comprehensive approach. A majority of firms (55%) said they are taking a strategic (comprehensive) approach to climate risk - complete with board oversight and a long-term view of financial risks. Moreover, 95% of firms aim to have a strategic approach in the future. Only a few firms view climate change as a financial risk through a short-term lens, while just a handful describe their climate-risk approach as being driven mainly by reputational risk/corporate social responsibility (CSR).
Self-assessment is inconsistent. There is a disconnect between how firms perceive their climate risk management approach and what they actually do. Half of the firms with little or no governance describe themselves as taking a strategic approach to climate risk, while a few of the firms with strong governance describe their approaches as either CSR or financial risk driven.
Current business strategies are not resilient enough to protect against future change, but climate risk does present opportunities. Only a handful of firms (15%) believe their current strategy is resilient to further climate change. However, 80% of firms have identified climate-related risks and opportunities. Moreover, 60% have introduced new products in response to climate-related risks and 40% have changed existing products.
Scenario analysis is the least developed aspect of climate risk management. Whereas around two-thirds of firms use metrics and targets, only 50% of firms currently use scenario analysis for climate risk management. Moreover, it is used mainly on an ad hoc basis (rather than for regular risk assessment), and only a few firms that regularly use scenario analysis actually leverage it to take actions.
Climate risk is a 'transverse' risk - that is, not a risk in its own right but one that will manifest itself through existing risk channels.
If you know nothing about climate change, it is time to start learning. Indeed, it is imperative for financial institutions to figure out how climate risk can be embedded into existing risk management frameworks. This difficult task is addressed in our companion piece, Challenges and Opportunities, which also provides a useful overview on climate change itself and paints a detailed picture of the evolving regulatory landscape.
As a starting point, from a practical point of view, firms need to establish board-level governance and the appropriate senior management ownership. Developing an internal cross-disciplinary working group can also help bring together different parts of the business to begin identification and assessment of climate-related risks. It is preferable for this to be led by the business or the risk management function, rather than the corporate social responsibility team.
Firms that have yet to start considering the financial risks arising from climate change should be aware that as global temperatures rise, increases in physical risks from weather-related events will inevitably change the risk profile of a financial institution's balance sheet. Furthermore, the risks to the firm will increase if policy, business or societal pressures demand a faster transition to a low-carbon environment.
Distinguishing physical and transition risks can be helpful in identifying the channels of impact. Moreover, prioritizing asset classes, geographies and sectors that are high risk can improve focus on the most material areas of concern.
Developing in-house expertise on scenarios is also important, not only for risk management but also for disclosure. In summary, while we have seen some progress, much work is still to be done before climate risk management becomes embedded in day-to-day operations.
Jo Paisley, Co-President, GARP Risk Institute, served as the Global Head of Stress Testing at HSBC from 2015-17, and as a stress testing advisor at two other UK banks. As the Director of the Supervisory Risk Specialists Division at the Prudential Regulation Authority, she was also intimately involved in the design and execution of the UK's first concurrent stress test in 2014.
Maxine Nelson, Senior Vice President, GARP Risk Institute, is a leader in risk, capital and regulation. In her career, she has held several senior roles where she was responsible for global capital planning and risk modelling at banks. She also previously worked at a UK regulator, where she was responsible for counterparty credit risk during the last financial crisis.