Climate risk is financial risk

The changing climate represents a rapidly growing risk and opportunity for financial institutions globally. To be prepared, financial institutions must start planning a response to climate change today to mitigate future adverse scenarios and to avoid being left behind.

Impacts related to a changing climate and climate action failure were described as the greatest long-term global risks by the World Economic Forum in 2020.^[1] While leaders from 184 nations pledged in 2015 through the Paris Agreement to take nationally determined actions to keep the rise of the global temperature “well below” an increase of 2°C above pre-industrial levels^[2], and G20 leaders pledged in October 2021 to limit increases to 1.5°C, global temperatures have continued to rise. The Nationally Defined Contributions (NDCs) currently committed to by countries are insufficient to achieve the Paris Agreement goals, even with recent progress at the 2021 United Nations Climate Change Conference (COP26). The Intergovernmental Panel on Climate Change (IPCC) calculates that emissions must be halved by 2030 to achieve carbon neutrality by 2050, which has further increased recognition of the need for an international economic transformation to mitigate and adapt to climate change.

With the amount of funding required to drive that economic transformation and meet the goals of the Paris Agreement far exceeding the scope of traditional development finance (and with public financing only able to provide a portion of the requisite capital), the involvement —and transformation — of the global financial sector will be essential.

While finance designated for green purposes has exponentially grown in recent years, it is clear that simply scaling up green finance volumes will be insufficient in and of itself to address the changing climate, and systemic change in the financial sector will be required. Financial institutions will need to not only mobilise and deliver significant increases in climate-related finance, but also to fully integrate climate risks and opportunities into their institution strategies and operations. The topic of climate must move to being a key aspect of a financial institution’s governance, strategy, business operations, risk management, and reporting/evaluation.

Fortunately, there is growing recognition globally at both regulators and leading financial institutions that climate risk is financial risk, while climate change mitigation and adaptation investments also represent a significant economic opportunity, potentially leading to innovation, technological development, and overall growth.^[3] However, although regulators, funders, customers, are increasingly prompting financial institutions to take action to embed climate considerations into their strategies and structures, a recent climate pulse survey by EBRD completed by 134 financial institutions found that many institutions are constrained by a lack of awareness, skills, internal capacities, standard approaches, and available tools.^[4] As a result, many financial institutions struggle to identify the most fitting and effective means to become more resilient to climate change and respond to the changing climate.

What is climate risk?

While most organisations, including financial institutions, recognise that impacts of climate change will have damaging economic and social (as well as environmental) consequences, the unique nature of climate change makes it challenging to accurately quantify or precisely assess impacts, in part due to an inability to rely on historical (time series) data. As a result, “many organisations incorrectly perceive the implications of climate change to be long term and, therefore, not necessarily relevant to decisions made today.”^[5]

Climate risks are typically categorised into two major categories: physical and transition.

Physical risks arise from the physical impacts of climate change and can be: a) event-driven (acute) such as extreme events (hurricanes, floods), or b) related to longer-term shifts (chronic) in weather patterns (sustained temperature rises, rising sea levels).

Transition risks, on the other hand, are those risks related to the transition to a lower-carbon economy and may include policy and legal risks, technology risks, market risks, and reputational risks for financial institutions.

As highlighted by the Basel Committee on Banking Supervision (BCBS), climate risk — whether physical or transition — is not a “separate risk” but in fact manifests itself in the other risks with which financial institutions are very familiar: credit risk, market risk, liquidity risk, and operational risk. BCBS identifies numerous macro- and micro-economic transmission channels, or causal chains, explaining how climate risk drivers give rise to financial risks that impact financial institutions directly or indirectly through counterparties, assets, or economies.^[6]

^{Figure 1: Core financial risks affected by climate-related risks}

Source: IPC, adapted from Basel Committee on Banking Supervision 2021, Climate-related risk drivers and their transmission channels.  

TCFD: what is it and what does it mean for FIs?

Recognising the lack of decision-useful, climate-related information available in financial markets, the Financial Stability Board (FSB) of the G20 established the industry-led Task Force on Climate-related Financial Disclosures (TCFD) in 2015 to design a set of voluntary and standardised recommendations for disclosure to aid financial market participants in understanding climate-related risks.

The TCFD issued its Recommendations of the Task Force on Climate-related Financial Disclosures document in 2017, and the framework and approach described within the document for describing and disclosing on climate risk has become the gold standard globally. The TCFD has additionally provided general and sector-specific practical guidance on implementing climate-related disclosure requirements, through a guidance document entitled Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures, which was most recently updated in 2021.

While the TCFD Recommendations remain voluntary, regulators and investors globally are increasingly incorporating elements of the TCFD Recommendations into their regulations, policies, and due diligence/assessment processes. As a result, it is critical that financial institutions increase their awareness of the Recommendations, regardless of the current status of incorporation into their national regulatory frameworks.

The TCFD structured its disclosure-related recommendations around four thematic areas related to the operations of each organisation:

• Governance – the organisation’s governance around climate-related risks and opportunities
• Strategy – the actual and potential impacts of climate-related risks and opportunities on the organisation’s business, strategy, and financial planning
• Risk Management – the processes used by the organisation to identify, assess, and manage climate-related risks
• Metrics and Targets – the metrics and targets used to assess and manage relevant climate-related risks and opportunities

Under each of the above thematic areas, TCFD provides recommended disclosures for an organisation, as may be seen in Figure 2, taken from the TCFD Recommendations document.

In addition, TCFD has provided additional supplemental guidance for specific financial sector groups, including banks, insurance companies, asset owners, and asset managers.

TCFD also provides high-level guidance to organisations on how to engage in scenario analysis, identifying and assessing the potential implications of a range of plausible future states under the conditions of uncertainty provided by a changing climate — all with the goal of identifying potential exposures to climate-related risks.

Figure 2: TCFD Recommendations and Supporting Recommended Disclosures

Source: TCFD 2021, Implementing the Recommendations of the Task Force on Climate-related Financial Disclosures, pp. 15.

A changing climate also provides opportunities – for those ahead of the curve

A changing climate also provides new opportunities for forward-looking and early-moving financial institutions. In exploring internal operations, as well as potential markets for financing, financial institutions can explore a variety of opportunities related to resource efficiency (e.g., energy efficiency, water efficiency, material efficiency etc.); energy generation (e.g., renewable energy); low-emission products or goods; new markets; resilience development; etc.

Financial institutions not exploring such opportunities run the risk of missing out on first-mover advantages, and financial institutions not developing capacities around climate risk management run the risk of being stuck with riskier (or more opaque) portfolios — along with higher costs in the future to adapt to regulatory changes.

[1] https://www.weforum.org/agenda/2020/01/top-global-risks-report-climate-change-cyberattacks-economic-political/

[2] Ideally below 1.5 C

[3] The recent establishment of the Glasgow Financial Alliance for Net Zero (GFANZ) at COP26 further underscores the increasing focus on climate matters at FIs.

[4] EBRD 2021. Readiness of the Financial Sector for the Impacts of Climate Change.

[5] TCFD 2017. Recommendations of the Task Force on Climate-related Financial Disclosures. pp. ii.

[6] Basel Committee on Banking Supervision 2021. Climate-related risk drivers and their transmission channels.