Climate Risk Management through Banking Imperatives
Published on : Jul-2023 Report Code : 10 Report Format : PDF
Climate change has become a critical threat of our times. In recent decades, the Earth's surface temperature has risen at a record pace, establishing risks for life, ecosystems and economies. Climate science states more warming is inevitable in the next decade, and possibly even after as well. In this ambiguous environmental situation, banks need to act on two fronts: both managing their financial exposures and help to fund a green agenda that will be crucial to mitigating the impact of global warming and climate change. Excellent management of climate risk is one imperative in both cases.
The physical threats of climate change are strong and omnipresent. Warming caused by greenhouse gasses could harm livability and workability — for example, by the rising likelihood of lethal heatwaves, global warming is predicted to threaten food systems, natural ecosystems, human assets and infrastructure. By 2030, the risk of a substantial reduction in grain yields — of 17% or more — and flood damage to capital stock will double.
Fatpos Global predicts that somewhere about one-third of the planet's land area would be affected due to climate change. Sectors that are anticipated to bear the brunt include oil and gas, real estate, automobile and transportation, power generation, and farming. Farmers facing various problems due to climate change and environmental issues are the most affected group. With global warming, increasing heat and changing temperatures affect their crop production productivity and fertility of the land, often altogether hampering the crop growth. With untimely storms and rains, the farms get affected or destroyed completely.
Source: World Bank
Government regulations increasingly demand that banks manage climate risk. Some have made a start but others also need to make policies and adopt strategies, build their skills and create structures for risk management. Growing environmental concern is fueling the demand for making greener investments. This will also force a transition towards a greener economy, and the goods and services produced for this reason have long-lasting worth. Sustainable finance goods, for example, sustainable investment funds and green bonds remain small, though increasing rapidly. An urgent need arises to extend the scope and depth of sustainable financial markets and creating the data and analytical systems underpin that. The urgency now is to act decisively and with conviction, so an important skill set in the years ahead will be efficient management of the climate risk.
According to Sabine Lautenschläger, a member of the European Central Bank's Executive Board, “it is important for banks to build forward-looking risk management strategies for climate change with a longer time horizon than that commonly used to assess 'traditional' risks. Banks need to have the assessment of climate risk concerning other financial risks”.
Banks are under increasing regulatory and commercial strain to safeguard against the effects of climate change and cooperate with the global agendas of sustainable development.
Banking regulators around the world, including the Federal Reserve, the European Central Bank and the Bank of England, now structuring new creactinglimate risk management regulations, plan to implement rigorous stress tests over the months. Most investors, to the changing preferences of their clients, already find environment, sustainability, and governance (ESG) variables in their investment decisions and channel funds to "green" entities. The Prudential Regulation Authority of the United Kingdom was among the first to bring out clear standards about governance, procedures, and risk management. These necessitate banks to recognize, measure, quantify and monitor climate risk exposure and to make sure that the technology and talent required are in place.
The Bank of England intends, among the forthcoming initiatives, to devote its 2021 Biennial Exploratory Scenario (BES) to the financial risks of climate change. The BES introduces criteria that would possibly push many organizations to broaden their capacities, including data collection on physical and transfer hazards, modelling methodologies, risk sizing, identifying business model challenges, and strengthening risk management. The European Banking Authority (EBA) is setting regulatory and supervisory criteria for economic, social and governance (ESG) risks and has released a multiannual action plan on sustainable finance. The EBA may include a blueprint for regional authorities like the U.S., Canada, and Hong Kong, which are all considering integrating climate risk into their supervisory structures.
The commercial imperatives for efficient management of climate risks are also rising. In a competitive environment where banks are often evaluated on their green credentials, designing sustainable financing packages and integrating climate factors into capital allocations, loan approvals, portfolio monitoring, and reporting make perfect sense. Some banks have already taken significant strategic decisions, building up sustainable finance, providing green lending incentives and mobilizing new capital for environmental programs. Most banks are already doing quite a bit to deal with climate change, including reducing their carbon footprint, funding low-carbon companies, supporting "Green Bonds" and making their sustainability initiatives clear.
“As of June 30, 2019, Renewable Energy & Energy Efficiency and Clean Transportation made up the largest portion in the Green Bond eligible projects portfolio. They comprise approximately 66% of all Green Bond commitments.” – World Bank
Source: World Bank
Renewable energies, plant refurbishments and innovative technology all need substantial funding amounts. Electrification of transport and automation of mobility as well as the transformation of energy production towards renewables such changes would reduce carbon emissions, capture and store greenhouse carbon gas and accelerate the fossil-fuel-free shift. Some banks have already taken steps by redefining their priorities to match their loan portfolios with the Paris Agreement's objectives.
Significant green investment opportunities include oil and gas, power generation, real estate, manufacturing, and agriculture. For example, in the United Kingdom, 30 million homes are projected to need significant investment if they are to become low-carbon, low-energy dwellings. In coal usage, manufacturing, carbon capture, aviation, petrochemicals, and transportation present opportunities for alternatives. For certain companies leaving oil and coal, banks play a role in helping them decreasing their level of risk in supply contracts or in providing organized funding options for power-purchase agreements. Substantial capital investment in renewables is expected in energy storage, mobility, and recycling.
Banks have generally represented climate change from a perspective of corporate social responsibility, rather than a risk-management agenda. Not only is there an urgent need for new, reliable structures and analytical approaches for banks to handle climate risk effectively, but also specific taxonomies and data standards need to be in place as well. Another major undertaking will be to gather and analyze appropriate data to help the study of climate change impacts across economies, industries and geographies, and the development of new quantitative models to stress check the effects of climate change on different activities, including lending.
Such improvements in risk management and governance to better prepare for climate risk will not occur overnight, but the good news is that efforts are underway to establish methods and techniques for evaluating the threats and opportunities associated with the transition to a low-carbon economy. But regulators should provide clear guidelines and encourage sharing of best practices across banks. International cooperation and coordination between regulators and the banking sector are a must for it to be truly successful.
The banking industry attempts to confront the world's complex climate risk challenges, and turn climate risk management into an autonomous and robust discipline such as credit risk or operational risk. Banks often lack the technical know-how needed to manage climate risk. They need to concentrate on obtaining them and gaining a strategic understanding of how physical and transformation risks in some locations or business sectors will impact their operations. For example, banks typically need "quants"—the experts needed to develop climate-focused counterparty or portfolio-level models. Hence, they need a budget for enhanced technology, data, and talent investments.
Boards, CEOs, and CROs are anticipated to play a critical role in providing leadership on climate risk management by putting climate risk at the top of the agenda and influencing their institutional responses in this respect. Constructively addressing climate risk also helps banks to meet customer requirements, who increasingly turn to them for advice and insights on the different impacts of climate risks on their financial and company profiles.
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