Future Risk - Why Climate Change Risk Is On Top Of The Regulatory Agenda
Climate change is a grave global issue that impacts us all. For too long, policy makers, businesses and consumers have turned a blind eye to the impact this is having on our world and we are now at a critical juncture where it can no longer be ignored. The growing risks posed by climate change, as evidence by the recent IPCC report, are systemic and pervasive, impacting every asset class, as well as the profitability and long term sustainability of some of the most resilient businesses.
Regardless of size, location, or sector, the transition and physical risks resulting from climate change could present a material threat to the value and creditworthiness of many businesses, with these risks emerging in many diverse ways such as, revenue headwinds, product redundancy, demand substitution and margin pressure due to increased cost of raw materials/green premium.
This presents both challenges and opportunities, and banks should care very much about this because it will require a fundamental revaluation of how balance sheets, income statements, and operating models of businesses are assessed by lenders, as borrowers' exposure to climate risk grows. Simply put, traditional methods of assessing borrowers based on ESG disclosures and CSR initiatives alone are no longer sufficient, as these do not measure companies based on the climate-related challenges they will have to overcome with a consistent framework.
There is a lack of expertise and understanding on climate risk across the banking industry at all levels of seniorityas the mix of skills, knowledge and experience required is new and complex
As a result, stakeholders from governments, central banks and regulators are increasingly focused on the implications of climate change as a key risk to the stability of banks and the financial system as a whole.
To give recent examples from this year, the Bank of England and the European Central Bank are running first-of-a-kind thematic stress tests of their banks' exposure to everything from freak weather events to transitional risks that their portfolios may face. Further more and from the outset the Biden admini stration has also made it clear that climate change would be high on its agenda.
In November last year, a couple of weeks after he became President elect, Biden appointed the first ever climate envoy, John Kerry. Then in May, he is sued an executive order for the Financial Stability Over sight Council(FSOC), instructing that a comprehensive government wide climate risk strategy be developed within 120 days to pinpoint and disclose climate related risks to government programs, assets and liabilities, highlighting a clear centralised coordination that will impact future regulation.
Turning to banks and the challenges and opportunities they're facing when it comes to climate change risk management, at OakNorth, we've identified several of these:
Data and Scenario analysis
Banks need very granular data to examine effects at the counter party and exposure level. This is because climate risks are highly uncertain and non-linear in their propagation and can affect multiple risk categories simul taneously. Banks therefore need to consider a broad range of scenarios and with sufficient granularity to enable them to adequately assess the risks of meeting their risk management objectives and wider climate change targets.
Predicting Future Risk Over Very Long Term Horizons
Historical loss experience cannot be used to estimate the future risks. For one thing, the scale of natural disasters can vary significantly an earthquake that scores 3.0 on the Richter Scale for example, has ten times the amplitude of one that scores 2.0, so will likely cause a lot more damage. Equally, the response from local government and emergency services to manage the consequences of events such as an earthquake may vary significantly from state to state. Climate risks are expected to materialise over a long term horizon, so regulators and boards will expect management teams to be able to model different scenarios based on this. This presents a challenge however, as banks are typically used to looking at potential risk over 9-12 quarters, not decades.
Reputation And Due Diligence
Public opinion is critical in terms of how a bank is perceived in its community, so senior management and boards need to look at the existing risks in their portfolio and what types of risks they're willing to take on in the future. Banks are expected to do significant due diligence on who they lend to and how they lend to them. Regulators want to see banks examining their entire portfolio to identify the most vulnerable borrowers with regards to climate change, and work with those borrowers sooner rather than later to reduce their long term risk. While this creates challenges, it also creates opportunities for banks to identify clients that will have to go through a transition period, and seeing how they can provide advice, funding, and services that may facilitate that transition.
There is uncertainty about the appropriate governance structures required for different sized firms, and the level of detail needed to meet disclosure standards effectively, given that proportionality is some thing regulators are still thinking through. Having said that, smaller banks tend to have more of limited geographic footprint, and therefore in certain geographic areas, it's going to be more important that sea levels are rising than it will be in other areas. This means banks need to know about both their geographic and sectoral exposures at a granular level.
Expertise And Corporate Governance
There is a lack of expertise and understanding on climate risk across the banking industry at all levels of seniority, as the mix of skills, knowledge and experience required is new and complex.
Looking ahead, climate change is an area where executive management and the board of directors at banks need to take a very active role in setting the direction of travel. Institutions are going to differ in terms of their strategy, client selection, and risk appetite, and there are significant challenges that need to be addressed. However, for banks that are willing to be proactive, climate change presents an opportunity to support customers through the transition to greener operations. This in turn, will create positive ripple effects across its stakeholders from investors to employees, customers to regulators.