Complying with climate risk framework standards for streamlined processes

Financial institutions worldwide are actively studying ways they can integrate climate risk management into their more traditional risk frameworks

Conscious that climate change affects all sectors of the economy, financial institutions are realising the significant impact this will have on their customers and, ultimately, their own profit margins. In addition, there is a greater appreciation of how their own activities can influence the evolution of climate change.

During a Risk.net webinar, Complying with climate risk framework standards for streamlined processes, panellists analysed the nascent climate regulatory framework, the issues that financial firms face in assessing the types of risk climate change poses and the opportunities it presents, as well as potential ways forward.

The road to net zero

Debate in the financial industry has long moved beyond merely installing solar panels on the roofs of its offices. Today, the more than 500 financial institution members of the Glasgow Financial Alliance for Net Zero have gone as far as committing to fully decarbonise their portfolios by 2050, including decarbonising their own day-to-day operations and those of their financial interests and investments.   

While reducing carbon dioxide emissions to zero will be incredibly difficult to achieve, climate change should not be seen as just another risk parameter, but rather as an opportunity to invest in the decarbonisation of the global economy, said Peter Plochan, Emea principal risk management adviser at SAS.

“The whole climate change movement is bigger than just regulation; it’s bigger than just risk. The increasing attention on decarbonisation is very important and should be seen as positive – as an opportunity coming from climate change. As the chief executive of BlackRock says, ‘decarbonisation is the greatest investment opportunity of our lifetime’.”

How banks respond to the climate change challenge is therefore critical, Plochan pointed out. But, whether they view decarbonisation as a compliance exercise or as an investment opportunity, banks have a dire need for forward-looking analytics that can help them understand the choices they are confronted with.

“There are a lot of strategies banks can choose to become net zero,” said Plochan. “However, each of them will have a different risk and return profile. The challenge now is how can banks identify the optimal strategy to get them to net zero by 2050, help them manage risk along the way and make some profit.”

Channelling capital to technology and data

The optimal strategy will undoubtedly involve the adoption of new technologies, new sources of data and new processes to manage that data. While financial institutions will obviously be consumers of data and technology, they will also have the responsibility of channelling capital to the firms that are developing these new technologies and new data management processes.

“It’s no secret, however, that most green capital right now is often being directed to very large, publicly listed borrowers,” said Li Sun Leong, head of ESG at AIA Singapore. “But it’s unlikely that the innovation we need is going to come from these established firms.”

“Many of the best ideas come from start-ups,” she said, “but they don’t find it easy to access the type of capital they need to get things moving faster. As such, financial institutions need to quantify the long-term risk of not investing in real innovation sooner.”

To this end, Plochan reminded webinar attendees that much of the technology necessary to achieve net zero as a society has yet to be invented, and that financial firms have a fundamental responsibility and opportunity to invest in and fund the technologies that will facilitate decarbonisation in the future.

Adding a caveat to the technology debate, Alexander Pui, executive manager, climate scenario analytics at Commonwealth Bank, said that “while the best technology certainly helps, it’s important to have the right people running it. Upscaling is incredibly important. The best technology will help with transparency, process and speed, but it will also need the right people in the driving seat.”

As well as financing technology to reduce carbon emissions, financial institutions must upscale their own technology stacks to handle large swathes of unstructured and complex data to feed the complicated models necessary to make the decisions that address climate change.

“That will put pressure on financial institutions’ underlying infrastructure,” pointed out Plochan. “Banks that have legacy solutions in place will realise these are no longer up to the task. We thus see climate change becoming a trigger for modernisation in banks.”

As banks grapple with warehousing ever larger quantities of data, they will also need efficient management processes that can generate meaningful insight from this data. Building decarbonisation models and strategies with different scenarios 30 years into the future is no simple feat. Plochan said that financial institutions could benefit significantly from artificial intelligence and machine learning models to combine traditional data with unstructured data.

As climate change is not an exact science, a certain degree of humility will also be required from those that design these climate change models, he highlighted. They will need to accept that their model might not be the best one out there, and that others with equally defensible techniques – but with very different results – could be as relevant for their organisation.      

“The question is: how do we translate these models into day-to-day business decisions?” said Plochan. “We don’t want banks to have a climate risk environment that is disconnected from business as usual. They need to be integrated closely together so that, when a new model is built and put into production, it can be used in the online loan application process, with credit risk factors adjusted accordingly. They will also need to be very flexible and prepared to make changes in light of new data methodologies that come to light.”

In practical terms, however, Pui reminded webinar attendees that carbon emissions shouldn’t be seen as a linear path towards a specific emissions target by a certain date. “The reality is, as recent geopolitical events have shown, at times there may be a slight uptick in emissions followed by a sharper dip later. As such, the cumulative nature of emissions is important. But, more importantly, firms should not forget to explore the range of possibilities and build buffers where possible because the science, scenarios and timelines are all moving goalposts, and it is often hard to know where we are and where we need to be.”

Public sector commitment

When asked which climate change risk is the most challenging to assess, webinar attendees voted transition risk (72.8%) the most difficult, followed by physical risk (14.6%) and then greenhouse gases (10.7%). As transitioning towards net zero at a societal level is contingent on government or regulatory initiatives, Leong pondered whether the results pointed to the perception that governments are less predictable than the physical wrath of nature.

“Of course, it’s hard to tell,” she said. “A lot of financial institutions have already started dealing with transition risk and some here in Asia have even started on physical risk. Transition risk may seem much harder to assess than physical risk because that’s what a lot of us are dealing with at the moment.”

That perception may be because climate-related initiatives worldwide remain largely non-binding and therefore seem less definite. The most notable of these initiatives include the Task Force on Climate-related Financial Disclosures and the Network for Greening the Financial System, which were created to help firms with guidance, recommendations and best practices in assessing and disclosing climate change risks.

Some regulators – such as the Monetary Authority of Singapore – issue guidance that is more comprehensive than international guidelines, but remains non-binding, while others – such as the European Union – intend to make corporate sustainability reporting mandatory for all firms listed on regulated markets. And, within its supervisory capacity, the European Central Bank performs regular climate risk stress-test assessments of all European banks under its purview.

“It’s becoming increasingly clear from regulatory assessment activities and scenario analysis that the scenario of an orderly transition to net zero as quickly as possible is the path we want to go down to ensure we keep temperature increases within manageable levels. The requirement for that is quick action by governments, which is why we need to prepare ourselves for net-zero initiatives to become less voluntary and more mandatory,” said Plochan.

This implies, Leong pointed out, that disclosures and reporting will eventually make their way into a firms’ general financial reporting.

“In the end, if governments – and the public sector in general – provide unwavering policy and commitment to climate change, there would likewise be more confidence from the private sector in committing capital of all different forms,” commented Pui.

Confidence in the future

Despite the challenges financial firms face in integrating climate change into their risk frameworks, the panellists were optimistic about the future. The industry has already taken the challenge in its stride, with banks joining industry alliances to share data, exchange information and benchmarks.

“We’re moving to a stage where there is better-informed management, increased training, more advanced technology, better data quantity and quality, and greater synergy between the growing number of functions involved in supporting climate-related work,” said Leong.

“I expect we will see a big uptake in sustainable finance and truly green products appearing everywhere,” concluded Plochan.

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