Posted: 23 Jan. 2020 7 min. read

Financial risks stemming from climate change: “Challenging the degree of resilience into a constantly changing environment”

During the last years, climate change and its consequences to the global economy have become more transparent. Hence, financial regulators are trying to mitigate the negative impacts, by setting out a framework for a transition to a greener economy. Climate change is not an issue that will arise difficulties in the future, it is happening now and constitutes a main issue for the financial, among any other sector. A number of EU initiatives put climate change at the forefront of the financial regulatory agenda, and it is clear that the regulators will continue to hold an active lead. Banks and other financial institutions must effectively collaborate with regulators to focus on the financial risk that arises from climate change. Trying to adapt and transit their business models to a low-carbon economy may affect the business models and creditworthiness of the companies to which they are exposed to, as Banks need to re-design their governance, policies, and processes.

The timeline below shows the developments on the regulatory framework across Europe being established mainly over the last five years:

Figure 1: Timeline loan origination and monitoring guidelines/ credit underwriting exercise.
Figure 1: The Governmental and Regulatory framework.

In responding to the financial risks from climate change, banks and insurers should be aware of the key regulatory proposals and expectations.

A strategic approach for managing the financial risks from climate change

On 15 April 2019, the PRA (Prudential Regulation Authority) published a Policy Statement setting out not only the expectations as a firm’s responses to manage financial risks arise from climate change, but also a strategic approach in order for those to be properly and effectively addressed. Taking into consideration the existing supervisory framework, the 4 key themes firms should be considered are the following:

Figure 1: Timeline loan origination and monitoring guidelines/ credit underwriting exercise.

1.    Governance:

o   Board-level engagement and accountability.

o   Integration with business strategy and risk appetite framework.

o   Evidence of how the firm monitors and manages financial risks arise from climate change (long-term view).

o   Ownership by the relevant Senior Management Function (SMF).

o   Inclusion of the sustainable finance metrics in the Group’s strategic plans.

o   Provision of adequate resources, skills and expertise, including of sustainability training to manage financial risks from climate change.

2.    Risk Management:

o   Identification of material exposures to physical and transition risks.

o   Development of sustainability risk policies covering specific sectors/ customers.

o   Measurement of short-term and long-term risks.

o   Models enhanced to include climate-related risks in credit decision-making process.

o   Reporting & Management Information (MI) to drive board and senior management to discuss, challenge, and take decisions relating to the firm’s management of the financial risks from climate change.

3.    Scenario Analysis:

o   Inform strategic planning (short- and long-term) and determine the impact of the financial risks from climate change on their overall risk profile and business strategy.

o   Address a range of outcomes relating to different transition paths to a low-carbon economy.

o   Determine material exposures and the impact on the ICAAP.

o   Impact on the solvency and liquidity profile and realistic, credible management actions.

4.    Disclosure:

o   Relevance within existing material and principal risks disclosures.

o   Consider whether further disclosures are necessary to enhance transparency on their approach to managing the financial risks from climate change.

o   Develop and maintain an appropriate approach to disclosure of the financial risks from climate change.

o   Disclosure of integration into existing governance and risk management process.

o   Consider engaging with the TCFD (‘Taskforce on Climate-related Financial Disclosures’ published recommendations in June 2017) framework and other initiatives in developing their approach to climate-related financial disclosures.

Implementing the “best practice”, as identified by NGFS

Figure 2: Recommendations regarding the actions that central banks and supervisors can execute and the way that policymakers can facilitate this implementation.

On the 17 April, the NGFS (Network for Greening the Financial System) published a report, namely “A call for action: Climate change as a source of financial risk”, trying to aware central banks and supervisors about the climate change and the related financial risks and help them comprehend that the financial system is resilient to these risks. It is noteworthy to be mentioned that, recommendations n°1 to 4 are aimed at inspiring central banks and supervisors, while recommendations n°5 and 6 are focused in actions that can be taken by policymakers to facilitate the work of central banks and supervisors. The six recommendations clearly stated in that report, are the following:

🗸 Integrating climate-related risks into financial stability monitoring and micro-supervision:

Banks and other financial institutions must effectively collaborate with supervisors in order to assess both qualitatively and quantitatively the impacts of physical and transition risks, and adopt appropriate key metrics indicators to monitor these risks. Climate‑related risk analysis should be conducted to size the risk exposure across the financial system, using a consistent and comparable set of data‑driven scenarios. The NGFS outlines the importance of regulators including climate‑related risks on their prudential supervisory agenda, to ensure they receive the attention (i.e. identification, analysis, management, reporting of climate-related risks) they require at the highest level within firms. Thus, supervisory expectations have been set to provide guidance to financial institutions. 

🗸 Integrating sustainability factors into own-portfolio management:

Central banks are encouraged to embrace the impact of climate change on their own operations, including publicly disclosing their approach to managing these risks. Consideration should be given to how central banks will adapt their investment strategies to include environmental, social and governance (ESG) aspects into their portfolios. One of the next steps the NGFS will take is to study the interaction between climate change and central banks’ legal mandates to promote green finance via monetary policy frameworks.

🗸 Bridging the data gaps:

One of the biggest challenges firms face is the availability of data. The NGFS recommends authorities to share data on climate risk assessments, publicly available in a data repository where possible, in an attempt to bridge data gaps. The NGFS has identified definite benefits to setting up a joint working group with interested parties as another avenue to bridging existing data gaps.

🗸 Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing:

The NGFS encourages central banks and other financial institutions to collaborate with the supervisors (work together with peers and wider stakeholders) to understand the risks and opportunities posed by climate‑related financial risk, thereby identifying the impact on their future business models.

🗸 Achieving robust and internationally consistent climate and environment-related disclosures:

The NGFS highlights the importance of developing and implementing a robust and internationally consistent climate and environmental disclosure framework. All companies issuing public debt or equity as well as financial sector institutions are encouraged to disclose in line with the TCFD recommendations. This will ensure comparability across firms, which will be invaluable to regulators and investors. In addition, policymakers and supervisors are exhorted to consider the actions they can take to encourage wider adoption of the TCFD recommendations and the development of an internationally consistent environmental disclosure framework.

🗸 Supporting the development of a taxonomy of economic activities:

Policymakers are encouraged to collaborate with relevant stakeholders with a view to developing a common taxonomy; this will enhance transparency and comparability across the industry and foster the transition to a low-carbon economy. A common taxonomy should be forward‑looking and take into account the changing technological and economic landscape, as well as international developments. It should be made publicly available and firms should be encourage to use it in their management of climate‑related risk

Despite these recommendations are not mandatory, adopting by regulators will initiate firms to comprehend more efficiently the financial risks arise from climate change.

How climate considerations affect Banks?

In consideration of the financial stakes and rising external pressures, it is clear that banks can no longer ignore the financial risks associated with climate change. Treating climate risk as a financial risk requires adopting a comprehensive, firm-wide approach to the issue, with active engagement from all levels of the firm, up to the board of directors. Banks will need to integrate climate considerations into their financial risk management frameworks. The effective management of climate risk requires integration across multiple elements of a firm’s risk management framework.

Figure 3: Risk management framework and integration of climate considerations.

Financial institutions will need to reorganize/ re-design their RMF (Risk Management Framework) in order for a climate-risk approach to be followed, in accordance with the existing risk assessment methodology. Starting from the review of the existing risk approach, Banks should be able to understand the used risk analysis framework, including the identification of portfolio segmentation and the risk segmentation and categorization. Following the same pattern, identification of internal data and resources is necessary, as this approach would require a large amount of data, gathering both banking portfolio data and external data regarding economic and climatic forecasts. Finally, one other significant step is to design a dashboard for decision making. Taking this into consideration, the new applied approach must meet the following attributes:

o    comparable with existing approaches,

o    transparent enough,

o    appropriate granularity, and

o    able to link impacts to risks.

What are the financial risks stemming from climate change?

In addition to operational and market risks, climate change can lead to increased credit risks for banks, and therefore they should treat climate risk as a financial risk. However, in order for financial institutions to be able to assess the risk regarding the stability of the financial system, it is essential first to distinguish the different types of climate-related risks:

Physical risk:

A physical risk is the climate risk resulting from extreme events due to climate change. When speaking about physical risk, both acute and chronic events are included. A physical risk example for the banking sector would be increased observed default rates, and credit losses due to extreme weather events where as for climate change-related sectors (e.g. tourism) increased frequency of extreme events will lead to damage to infrastructure and changing seasonal demand.

Transition risk:

A transition risk is the climate risk resulting from mitigation challenges as societies decarbonize. To stimulate a low- carbon transition, governments will need to take actions which will naturally impact the economics of borrowers. A transition risk example would be associated to GHG emission reduction policies such as carbon taxation, constraints on consumption. Another example is risk arising from policies aimed at changes in land-use and farming practices.

 Liability risk:

A liability risk refers to a customer or company seeking compensation for losses they may have suffered as a result of the physical or transitional risk related to climate change. A liability risk example would be an investor claiming back against a business which makes a loss due to climate-related events. Liability risks are closely related to disclosure level of climate-related financial risks. If investors presume lack of disclosure, they can and will make a claim against the business.

Trying to get a better understanding of these types of risk, different examples and their potential impacts for both physical and transitional risk are presented in Figures 4 and 5.

Figure 4: Example of potential impacts of increased physical risk on banks.
Figure 4: Example of potential impacts of increased physical risk on banks.
Figure 5: Example of potential impacts of increased transitional risk on banks.

Left unmitigated, physical risks and transition risks can be devastating for the world economy. Therefore regulators, governments, central banks and supervisors, financial market participants, firms and even households must follow a credible and forward-looking policy path.

Physical impacts are not just risks for the future and they are already impacting the economy and financial system today. Estimates suggest that in the absence of action to reduce emissions, the physical impact of climate change on the global economy in the second half of the century will be substantial. There have been fewer attempts to quantify the physical risks to financial stability rather than for the economy as a whole, but again losses are likely to be significant. 

Feedback loops between the financial system and the macro-economy could further exacerbate these impacts and risks. Currently, physical impact models for both the economy and financial stability are partial.

Figure 6: From physical risk to financial stability risks (Source: NGFS 2019 report).

The scale of the economic and financial transformation related to this transition is significant, bringing both risks and opportunities for the economy and the financial system.

Intuitively, the economic costs of the transition would stem from a disruptive transition and the need to switch to – initially more expensive – low-carbon technologies in some sectors, for instance, aviation or cement and steel production. Nevertheless, the estimated costs are likely to be small compared to the costs of no climate action. In addition, these cost estimates are not universally accepted and some argue that the economic costs of the transition to a low-carbon economy would be offset by a positive “green growth” effect. 

Figure 7: From transition risk to financial stability risks (Source: NGFS 2019 report).

Implications for Credit Risk Modelling

⮞Probability of Default (PD)

As it can be easily observed, credit risk models may also require re-development and/or re-calibration in order to be climate - change inclusive. Among other measures, many credit rating agencies have already introduced specific criteria (i.e. ESG criteria and relevant scorecards) in their creditworthiness assessment. A shift in the probability of default distributions should be expected, as borrowers will be exposed to physical, transition and liability risks caused from climate change. 

Figure 8: A schematic view of the impact on Probability of Default (PD).

⮞Loss Given Default (LGD)

Environmental risks will also impact Loss given Default (LGD) values since the calculation of LGD is highly associated with the value of the collateral against the value of the loan. As collateral value is expected to depreciated over time (because physical or transitional risks), LTVs are estimated to be increased resulting to higher losses.

Figure 9: Impact of climate-related risks to LGD models.
Figure 9: Impact of climate-related risks to LGD models.

⮞ Concentration risk

Sector and single-name concentrations must be adjusted for physical and transition risks. The main challenge will be to get a better handle on portfolio concentrations to inform business re-allocation and determine implications for capital adequacy.

Figure 10: A schematic view of the impact on concentration risk.
Figure 10: A schematic view of the impact on concentration risk.

⮞ Stress Testing

Stress testing will prove challenging not only for Banks, but also for insurers and asset managers. Several risk drivers need to be brought together under a single scenario. The main challenge will be to identify any additional costs of doing business and impact on income streams and determine if asset re-valuations require any funding or solvency implications. 

Figure 11: Stress test simulation carried out by DNB, trying to study the impact on financial institution’s assets ahead of a transition to a low carbon economy. (Source: 2018, DNB, Occasional Studies, vol. 16-7.)
Figure 11: Stress test simulation carried out by DNB, trying to study the impact on financial institution’s assets ahead of a transition to a low carbon economy. (Source: 2018, DNB, Occasional Studies, vol. 16-7.)

Concluding remarks

Climate change requires the re-assessment of the way we eat, dress, travel and make business. In order to cope successfully with this enormous change Financial Institutions should not only increase their level of awareness regarding financial risks stemming from climate change but also adjust their risk management systems by taking into account these types of risks. It is all about testing the degree of flexibility and adherence into this constantly changing environment in order to be able to ensure future resilience and sustainability of their business models. 

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Alithia Diakatos

Alithia Diakatos

Partner | Risk Advisory

Alithia is Equity Partner and Risk Advisory Leader at Deloitte Greece and over the years she has offered numerous clients her valuable experience on various risk advisory projects in different industries. She focuses on assisting clients in the following areas: IT & Specialized Assurance, Internal Controls System, Accounting & Reporting, Internal Audit, Digital /AI Controls/Algorithms, Cyber, Crisis & Resilience, Strategy & Brand, Sustainability, Regulatory & Compliance, Financial Risk Management, Financial Crime and Corporate Governance.

Spyridon Bisisidis

Spyridon Bisisidis

Principal

Spyridon has extensive professional experience of over 10 years in the Financial Services sector which includes a significant number of consulting and advisory projects across all three lines of defense plus statutory audit. Recent experience as team leader includes large scale advisory projects in the context of IFRS 9 implementation at A-IRB Banks in Greece and abroad, participation at statutory audits of systemically important financial institutions as impairment methodologies subject matter expert, IRB and IFRS 9 credit risk models development and validation as well as Management Consulting Projects focusing on regulatory and strategic issues.