Directory Image
This website uses cookies to improve user experience. By using our website you consent to all cookies in accordance with our Privacy Policy.

Early Movers Set the Tone as Banks Plan for Climate Change Regulations

Author: Maria Butler
by Maria Butler
Posted: Mar 17, 2022

The financial community widely accepts that there will be rules and reporting expectations around climate change. In most jurisdictions, these are still in development or ‘Out for Comment’ stages, but banks can see what is likely by learning from early movers in the space.

The UK developed a set of guidelines in 2019, through its Prudential Regulatory Authority (PRA) and Financial Conduct Authority (FCA). The basis for this guidance was for an enhanced focused governance and risk management specifically around climate change, and the financial risks it creates for banks that lie outside the traditional risk management processes and reporting.

Guidance from the PRA calls for banks to implement tools, both quantitative and qualitative, and to utilize these to monitor the risks continuously. There must be specific reporting on the concentration of risks within the loan book, along with contingency plans to reduce the concentrations. Reporting of such risks should be sufficient for senior management and the board to understand climate-related risks and be in a position to fully appreciate how they align with the existing risk appetite of the firm.

The most expedient form of climate analysis recommended is scenario-based, and financial institutions are asked to use these pathways to explore the firm’s vulnerabilities and resilience to them. As material risks, these would be included within the Pillar 3 Capital Requirements Regulation (CRR), as well as the Solvency 3 reporting.

Scenarios are the keystone for this risk management exercise. Climate change scenarios have specific taxonomies and include ‘Transition’ aspects, which deal with the policies and economic changes made to combat climate change. Physical scenarios must also be considered to measure the impact on bank assets from experienced environmental changes due to climate change that is already locked into the atmosphere.

Scenarios must be defined with short- (under 10 years), mid- (15 to 30 years), and long-term (80 years) timeframes in mind, and include multiple routes to the specified warming targets. The data required for these scenarios is complex and incomplete, as the science itself is still developing.

That said, data does exist and is being refined regularly. The bodies involved in data creation include:

  • The Intergovernmental Panel on Climate Change (IPCC), is a collective of scientists and climate change experts who plot potential pathways to specified global warming outcomes.

  • The Net Greening of Financial System (NGFS) takes these pathways and puts costs against them in terms of GDP. The NGFS are experts in finance, either ex-central bankers or economists.

  • The International Energy Agency (IEA), further breaks down this analysis and attributes the costs to specific industrial sectors. Furthermore, the IEA tracks each industry’s progress towards the required regulatory standards and outcomes needed for the pathway to be followed.

Additionally, banks determine whether the pathways will be followed in ‘orderly’ ways, which implies a well-planned transition, or in a ‘disorderly’ manner, implying a late start with sudden policy changes.

The outcomes of these scenarios will be extremely important for banks to understand their risk profiles over the coming decade(s). They will also provide much-needed visibility into potential credit and liquidity issues they may face as the world fights against, and adapts to, climate change.

Rate this Article
Leave a Comment
Author Thumbnail
I Agree:
Comment 
Pictures
Author: Maria Butler

Maria Butler

Member since: Dec 21, 2021
Published articles: 17

Related Articles