Addressing Climate Risk in Financial Institutions

Over the recent years, the financial community has increasingly recognized that climate change represents a source of financial risk. Since the Lehman Brothers’ crisis, financial institutions have reviewed their risks analysis methodologies and metrics. Driven by regulatory requirements, banks and insurance companies have focused their efforts on measuring and limiting credit/ liquidity/ market/ reputation risks. In 10 years, financial institutions (FIs) have successfully transformed their operations, increased their capital reserves, created liquidity buffers and set new standards for allocating risk capital. Today, the regulatory pressure has finally decreased on these issues.  However, a new area is emerging as a focus for governments and regulators: climate change and the measurement of climate-related risks.

What are the financial impacts of climate-related risks?

The financial impacts of climate-related risks can be divided into three types:

  1. Physical risks: associated with the physical effects of climate change, and caused by the increased frequency of extreme weather events
  2. Transition risks: associated with public authorities measures to transform into a low-carbon economy
  3. Liability risks: associated with the damages a legal person would be required to pay in case it is deemed to be responsible for the consequences of global warming

 

Based on this climate risks classification, serveral regulators have chosen to develop the management of climate-risks by FIs is by enforcing disclosure requirements. The idea is that communication will lead to transformation.

In France, the law “Loi sur la transition énergétique pour la croissance verte” adopted in August 2015 requires financial institutions and listed companies to publish annually an assessment of their financial risks related to climate change as well as their targets for a transition to a low carbon model. In addition, investors have to communicate on the ESG sides of their investment policies and their efforts towards ecologic and energy transition.

Currently, the Bank de France and the ACPR are both leading projects to bring French FIs to the latest standards. At the European level, central banks are working together to determine new climate risk management methodologies, scenario analysis and sustainability initiatives reviews. In the coming years, climate risk self-assessment requirements are likely to be part of every European bank supervisory review. Overall, regulators are following the Task Force on Climate-related Financial Disclosures (TCFD) recommendations, which lists specific reporting requirements.

For FIs, producing qualitative information on climaterelated risks will take years. While complying to TCFD’s recommendations may still seems too costly for many institutions, starting early is an opportunity to capture new business. In any cases, adaptation will be necessary as most governments /regulators are currently translating TCFD’s recommendations into national laws/rules.

 

Achievements since 2015

Globally, significant progress has been made since 2015 in climate risk identification and communication. Banking and Insurance groups have been early adopters of climate-risks disclosures. For its 2019 report, the TCFD’s 2019 analysed 104 banks, 147 insurance companies as well as companies from other industries. Results demonstrated that banking is the leading industry for publication of recommended disclosures.  As highlighted in the below chart, the progression margin remains high for banks. Insurance companies, lagging behind banks, have to catch-up.

Action plans for the coming years

Leading institutions have already ignited their transformation towards climate friendlier business models.

Amongst the French banks, Credit Agricole stands out as a leader. The banking group has adopted this June a new climate strategy built on three pillars to reshuffle the group investment mix towards green finance.

Once delivered, this roadmap will bring Credit Agricole to high standards, helping the group meet objectives set by the Paris Agreement and the TCFD.

Looking at FIs over the world and their application of reporting requirements: it appears that many still have to build the reportings. Those who already report often have to improve the quality/ accuracy of reporting. FIs financial disclosure still lacks:

  • Clarity on the potential financial impact of climate change on their businesses
  • Resilience assessment of their strategies to respond to climate-related risks
  • Operational adaptation of business strategies at business lines levels

These challenges are open and will have to be tackled in the coming years. Institutions quickly adapting their model will be able to seize new opportunities, while those lagging risk losing revenues and be disregarded by long-term investors.

 

Sources:

Credit Agricole Group Press Release (13.06.2019) « Credit Agricole adopts a new climate strategy »

ECB Supervision newsletter (15.05.2019) « Interview with Frank Elderson, Member of the Supervisory Board of the ECB »

Banque de France (06.2019): Financial Stability Review. Greening the financial system

Direction Générale du Trésor: L’évaluation des risques liés au changement climatique dans le secteur bancaire