Managing climate risk financial risks and reflecting climate risk into capital frameworks

Julius Herfel, Head of Audit, BNY Mellon

Below is an insight into what can be expected from Julius’s session at Risk EMEA 2023.

The views and opinions expressed in this article are those of he thought leader as an individual, and are not attributed to CeFPro or any particular organization.

Why is it important for financial institutions to include climate risk within stress tests?

Stress tests are a powerful tool for financial institutions to understand the impact of climate change on their business, and test its resilience against possible adverse future states. Many institutions perform standalone climate stress tests, usually modeling one or several predicted concentration pathways. However, the trend is towards embedding climate related stresses into broader integrated stress tests. While the latter is better in understanding interdependencies and feedback loops, the different time horizons in which climate risk would materialize compared to other financial risks, provides a challenge in integrated stress tests. Regulators, such as the ECB and the PRA, are keen on understanding the results of these stress tests. In some instances they require their own stress tests to be performed, as it helps them understand the risk that climate change poses to financial stability.

It is worth mentioning that while regulators and most financial institutions have been focused on stress testing impacts on their financial parameters we also see the emergence of more and more alignment stress tests. I would classify these more as a scenario analysis type tool, but it is a powerful instrument for banks, investment managers and other institutional investors to help align their portfolio to a certain climate target or commitment.

How can financial organizations effectively quantify potential financial impacts of nature and biodiversity?

Organizations can achieve this with natural capital assessments or accounting. Natural capital can be thought of as the natural assets that support human well-being and economic activity. A natural capital assessment involves identifying, measuring, and valuing the benefits and services that ecosystems provide to humans. The general approach is to assign economic values to the benefits of the ecosystem using appropriate valuation methods, such as market-based approaches, cost-based approaches, or non-market valuation techniques.

Natural capital assessments have been used on national and supranational levels for a while, but more recently gained more application in private sector entities. Some challenges still remain, primarily the relative immaturity of available techniques and approaches, and that performing a natural capital assessment is complex and resource intensive as it requires interdisciplinary expertise and collaboration between ecologists, economists, social scientists, and other stakeholders.

Why should financial institutions incorporate EU taxonomy within loan processes?

The EU taxonomy provides a relatively clear and standardized classification system which defines environmentally sustainable economic activities. Incorporating the EU taxonomy in their loan process can help financial institutions better manage environmental and climate risks, for example, by reducing the risk of stranded assets, and ensure that their loan portfolio is aligned with their sustainability goals. It also helps financial institutions demonstrate their commitment to sustainability and enhance their reputation among clients and stakeholders. Through its standardization and transparency, investors benefit from the comparability and consistency the taxonomy provides.

Risk managers, however, should not forget that there is a political dimension to the taxonomy, for example, with regards to the treatment of nuclear energy. It is therefore important for loan officers and risk managers to provide an independent challenge complementing the taxonomy.

What are the benefits of transitioning balance sheets towards a low carbon economy?

As the world transitions to a low carbon economy, there will be a shift away from high-carbon assets such as fossil fuels, and financial institutions that are heavily invested in these assets could face significant losses. By transitioning their balance sheets towards low carbon assets, financial institutions can reduce their exposure to carbon risks and manage their portfolio more effectively. Regulatory bodies are starting to require financial institutions to align their balance sheets with the goals of the Paris Agreement and the transition to a low carbon economy.

Through this transition financial institutions can meet these regulatory requirements and avoid potential penalties or reputational damage. But there are also environmental and social benefits. For example, by investing in renewable energy and other low carbon assets, financial institutions can help reduce greenhouse gas emissions, improve air and water quality, and support sustainable development.

To evaluate the specific sources of carbon risk in the balance sheet, institutions first need to identify carbon risk factors, for example, market or technology factors, and asses their exposures to carbon risk. After this initial screening, institutions need to quantify the actual risk, for example, by using scenario analysis approaches, or specific risk or valuation models.

How can financial institutions effectively use data to measure and calculate capitalizations for climate risk?

Financial institutions require a vast amount of different types of data to understand the impact of a change in the climate and the resulting effects on their activities, and translate these into financial metrics and parameters. The Basel Committee on Banking Supervision (BCBS) defined three layers of data banks will need to assess climate financial risk:

  • Data describing physical and transition risk drivers such as forecasts of natural catastrophes
  • Data describing the vulnerability of exposures such as carbon sensitivity metrics, and financial exposure
  • Data which are usually traditional financial measures like projected cash flows or Probabilities of Default (PDs) and Loss Given Defaults (LGDs) adjusted by the effects of climate change.[i]

I think it is fair to say that data is one of the biggest – if not the biggest – challenge financial institutions face when managing climate financial risks. One reason for this is that banks have no history of collecting and using climate data. Fortunately, more specialized climate data providers enter the market regularly, but banks still need to build further expertise and experience in interpreting the information they provide. Another challenge risk managers and modelers face is that climate change is a gradual process that will materialize over several decades; traditional risk management considers much shorter time horizons. Meaningful metrics need to be able to address this discrepancy.

Other challenges I see is the volume of data points, complexity and interdependencies in these, data paucity in certain areas, and the lack of benchmarks. Therefore the challenge of climate data has to continue being the focus for risk managers.