Climate Risk: Regulatory Framework Build Positioning

The impact of climate change on risk management has become a central point of discussion in today’s Financial Services business environment. Firms have come to the realization that they must assess and monitor the potential impact climate change can have on their business operations and portfolios. Firms must therefore re-evaluate their risk frameworks to incorporate these additional components and face increasing scrutiny from investors and regulators in this domain.

In 2015, the Task Force on Climate-Related Financial Disclosures (TCFD) was established by the Financial Stability Board (FSB) to assess potential opportunities and methods for assessing climate-related financial risks. Through its annual reports and recommendations, the TCFD has been working towards improving and increasing reporting on climate change financial risk, laying the foundation for climate change financial risk disclosure best practices. 

In 2017, the Network for Greening the Financial System (NGFS) was established by central bank members to promote green finance and provide uniform recommendations for the role of central banks on climate change initiatives. Central Banks across Europe have joined the NGFS in order to gain climate change financial risk experts' recommendations. The NGFS began releasing yearly reports as of 2019 outlining best practices for environmentally friendly financial procedures. The NGFS organization has promoted TCFD recommendations for disclosures as central bank standard practices. 

The European Union and the United Kingdom have already laid the foundations for stress testing and disclosure requirements related to climate-change risks, while the United States regulators have recently initiated discussions and inquiries in relation to climate-change risks. Firms should be making the best use of this period before US-based regulations are fully established in order to assess their exposure to climate change risks and evaluate their functional and technical readiness.

“Increasing awareness of climate change and its impacts has been resulting in growing regulatory focus globally to protect against potential systemic risks.”

Over the past two years, European Central Banks have made positive progress as they have laid out plans for stress testing in accordance with NGFS. Through these stress testing exercises, regulators will assess the resilience of financial services firms under various scenarios, analyzing how a firm’s assets and operations react under different conditions and climate change paths e.g., implementation of carbon taxes, increase in the cost of raw materials, increase in severe weather events, etcetera. The ability to “stress test” bank operations and assets n relation to climate change is crucial in order to gain a more comprehensive understanding of the bank and the overall financial system’s current and potential exposure to climate change risk. The first round of United Kingdom climate change risk stress testing is underway as of June 2021 with the 2021 Biennial Exploration Scenario (BES). The BES includes self-imposed scenario analysis to understand a firm’s exposure to climate-related risks, measure the exposures that come from these risks and define mitigation strategies to manage identified vulnerabilities. The findings of this stress test are expected to be published in May 2022 and will help lay the foundation for future exercises and a more permanent framework. Many European central banks are monitoring the BES closely in order to implement their own near-term stress test exercises. European central banks hope to make climate change disclosures mandatory for the 2021 fiscal year in accordance with TCFD recommendations.

“We have seen recent progress from US financial regulators to acknowledge the systemic financial risks of climate change. Regulators have started to indicate their intention to integrate climate change into their mandate and are starting to build up their own internal capacity. Despite these advances, most U.S. federal and state financial regulators have yet to act on the climate crisis and lag far behind their global counterparts.”

Over the past year, the United States has pivoted with a more pronounced focus on climate change. The Biden Administration is working to establish a regulatory framework for assessing financial risks linked to climate change, and to establish best practices for financial service firms to develop climate change risk mitigation approaches. In April 2021, Treasury Secretary Janet Yellen committed to an agenda to impose a “regulatory climate risk framework” through “bold and urgent actions.” This commitment implies the normalization of disclosures on financial risks related to climate change as key climate financial risk indicators and tools are established.

Last October, the New York Department of Financial Services (NYDFS) released a letter to advocate for preparatory actions and disclosures in anticipation of the looming regulatory framework. In December of 2020, the US Federal Reserve (FED) joined the NGFS. Later in July 2021, the Office of the Comptroller of Currency (OCC) also joined the NGFS. Membership to the NGFS cemented the commitment of the United States to make an impact on sustainability, green finance and climate-related financial risks in both the near and long-term future.

In January 2021, The United States rejoined the Paris Agreement in order to make climate change risk a top priority as the nation attempts to realign with global standards and decrease its ecological footprint. To coincide with the rejoining of the Paris Agreement, the FED appointed a team in January 2021 to focus on climate change risk. FED Chairman Jerome Powell has mentioned that the FED is considering the introduction of climate stress tests, separate from the existing bank stress tests, to evaluate lenders' responses to climate-related shocks to the financial system.

On May 20th, 2021, President Biden signed an executive order titled “Climate-Related Financial Risk” in order to establish guidelines for accurate disclosure of climate-related financial risk. The executive order laid the priorities of the government. Within the next 180 days, the Financial Stability Oversight Council (FSOC) will release a report with recommendations on how government agencies and regulators intend to limit climate change-related financial risks and how these principles will be implemented into regulations. This report will establish a regulatory framework over both a short-term and long-term horizon as well as outline best practices highlighted by real-world organizations’ risk mitigation examples.

Recent TCFD guidance on risk management and disclosures set out recommendations for financial firms as to how to approach climate change risk. Firms are advised to embed climate change risk management into their governance structure. This might require a shift in culture, which can be built through training or internal debate. To be successful this transformation has to be inclusive: senior management, modeling teams, product and business teams, support teams all have a part to play in this discussion. Ultimately, clear roles and responsibilities will need to be defined and relevant subcommittees established in order to align the firm’s overall business strategies and risk appetite with climate change risks.

Climate-related financial disclosures will be required to provide transparency to regulators and the market on risks associated with the impact of climate change on operations and asset value. Financial service firms should begin to prepare with simple disclosures and add complexity over time as uniform metrics and standards become available.

The use of modeling and scenario analysis will be critical to identify and understand exposures to climate change impacts, policy change and technological disruption. Using an agile approach, financial service firms can quickly start developing such capabilities by leveraging existing stress testing tools. It is important to keep in mind that no backtesting is possible with climate risk modeling. The focus should therefore be on the general trend of the stress testing (i.e., ensuring that outcomes are sorted according to the scenario magnitude and classification) rather than very specific results.

As market expectations, regulatory requirements and industry best practices continue to evolve, financial service firms should ensure that they do not work in a silo. Discussions with clients, peers, data and solution providers, insurers and other risk transfer partners are essentials to keep up to date. As part of their preparation, financial service firms should establish an office in charge of the periodic watch.

In summary, rather than a complete overhaul of their risk management processes it is advisable to implement a multi-phased program that builds on existing capabilities.  Through an adaptable program that is fit to purpose, firms can more systematically achieve a comprehensive model to rapidly support adapt, append aspects of climate change for financial risks to their current framework, and develop their capabilities through a self-reinforcing learning process.