Climate risk at the heart of the regulatory agenda beyond 2020.

Article co-écrit avec Nicolas de Jenlis, Directeur Deloitte Développement Durable et Asli Oncel, consultante Risk Advisory.

Climate change is perceived to generate the most significant risks to the global economy¹ and its complexity poses tremendous challenges to identify, quantify and monitor its material impacts. The uncertainty related to the impact of different climate trajectories obliges the society to make informed and strategic decisions today to change the pathway of tomorrow. A transformation is required towards a sustainable future aligned with Nationally Determined Contributions(NDCs) and the first step to do so is to understand the nature of climate risks to quantify its impact. In the era of transition to low-carbon economy, climate change has become a major long-term threat for financial stability and therefore financial institutions have a big role to play.

Climate risks can have an impact on economies through two main channels:

• Physical risks arising from extreme meteorological and climatological events;
• Transition risks arising from the transition to a low-carbon economy.

Regulators are investing in climate risk assessment

 Regulators have started prioritizing climate risk assessment. European Central Bank (ECB), the French Prudential Supervision and Resolution Authority (ACPR), the Prudential Regulation Authority (PRA), many more central banks and authorities have recently published reports to guide financial institutions in measuring the impact of climate change. The main objective is to become a starting point to measure the resilience of the economy and accelerate the implementation process of mandatory exercises. On the international level, cooperation is established through the Network for Greening the Financial System (NGFS), a union of more than 70 central banks and supervisors to analyze the transmission channels of climate-related risks, to develop and share best practices.

The NGFS has published multiple reports to show the current state of financial institutions and to provide guidance in scenario assessment.  Moreover, the NGFS shared technical documentation on climate scenarios which intends to provide a common framework by incorporating certain Intergovernmental Panel on Climate Change (IPCC) scenarios under different temperature pathways and combining them with Nationally Determined Contributions. The reports conclude that there are still issues regarding the framework for minimum capital requirements (Pillar 1). First, a fundamental work needs to be done to better understand the systemic risk transmissions channels and then the climate-related potential loss should be assessed by leveraging on existing risk assessment methods such as stress testing. The NGFS will continue to refine scenarios and publish more guides to improve methodologies and to minimize uncertainty related to climate risk assessment.

 By leveraging from the NGFS scenarios, the ACPR has initiated a pilot study on climate risk assessment to encourage banks to embed climate risk assessment in strategic planning and provided a scenario-related methodology for 55 sectors in 4 main geographic bricks (France, Europe, the United States of America and the Rest of the World). Banque de France, the central bank of France, also published a working paper which demonstrates the technical modeling behind the exercise with a focus on transition risks. One of the objectives of the pilot exercise is to explore limitations and help financial institutions overcome challenges related to climate risk assessment. Financial institutions will submit results between October and December 2020 and the results will be published in April 2021 after reconciliation.

Following all the national momentum generated by central banks worldwide, in May 2020, the ECB has published a guide on climate-related and environmental risks which provides recommendations on areas related to climate risk management including effective governance, its inclusion of risk management and its proper disclosure. The objective is twofold: to set ECB expectations on governance and risk management of climate and environment-related risks while increasing market transparency by enhancing climate-related and environmental disclosures.

13 recommendations cover the following domains:

Business model and strategy
Identification, assessment and monitoring of the current and forward-looking impact of climate-related and environmental factors on the business environment to make informed decisions

Governance and Risk Appetite
Embedding climate risks in their governance and risk appetite frameworks, while adequately involving all relevant functions. Reporting to the management to ensure proper management and robust governance

Risk Management
Integration of climate-related and environmental risks into Credit, operational, market and liquidity risk management, as well as into the ICAAP, including risk quantification using scenario analysis and stress testing.

Climate-related Disclosure
Disclosing climate-related information which will improve institutions’ and investors’ understanding of the financial implications of climate change.

ECB Guide Takeaway – The current practices of financial institutions are not adequate for climate risk assessment

The ECB has acknowledged that the climate risks will materialize in the near term, therefore financial institutions should have an exhaustive understanding of climate risks to have the competency to perform short, medium and long-term climate impact assessments. To properly determine systemic risk impacts, institutions should consider up-to-date scientific insights and the monitoring of policies. Strong governance needs to be established by leveraging from internal and external experts in order to define and improve the environmental strategy. Strategies to tackle climate risks (which include planning, budgeting, risk-taking limits, capital etc.) have to be properly documented, integrated into risk management methods (e.g. leveraging current risk identification process and vulnerability assessment, RAF, ICAAP, stress testing) and key metrics need to be disclosed. To do so, new capabilities related to the identification and quantification of climate risks have to be developed. Better climate-related disclosure allows more constructive dialogue with stakeholders, in particular investors and shareholders. At the systemic level, market discipline will help to reorient capital towards sustainable investment. The guide integrates the recommendations of the Task-Force on Climate-related Financial Disclosures (TCFD) and methodologies, definitions and criteria related to figures, metrics and targets that are expected to be disclosed transparently. Public consultation for the guide ends on the 25^th of September 2020 and its implementation is immediate.

Regulatory convergence around climate risk assessment only validates its necessity

As reinforced by NGFS member central banks, national supervisory authorities and the ECB, the integration of climate risk requires an exhaustive understanding of the nature of these risks and its transmissions channels. Therefore, financial institutions should first perform a preliminary analysis to assess the current state of institutions’ high-at-risk exposures and analyze the gap regarding supervisory expectations to be fully aligned and ready for the low-carbon transition.