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Understanding climate-related financial risks

Climate change is the most significant geopolitical risk to emerge in the past year, motivating banks around the globe to track and manage their exposure to what is now being referred to as ‘green swan’ risks. 
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Understanding climate-related financial risks

The physical risks of a changing climate and the transition risks of adjusting to a low-carbon and more environmentally sustainable economy will become “increasingly material” for banks in the coming years, Frank Elderson, vice-chair of the supervisory board and member of the executive board of the European Central Bank (ECB), told a conference in Frankfurt in April.

For this reason, the ECB is undertaking a stress test to assess the impact of climate-related risks on the European banking sector over a 30-year horizon. This entails the ECB mapping projections of climate patterns and expected climate developments to the location of firms’ physical assets, and estimating the impact that severe climate events would have on those assets and, consequently, on banks’ portfolios. Together with other central banks, the ECB is developing joint climate stress-test scenarios.

The ECB has also asked banks to assess themselves against the supervisory expectations outlined in its ‘Guide on climate-related and environmental risks’, issued in November 2020. Banks are expected to draw up action plans for aligning their practices to the expectations. More than 112 institutions, representing 99% of total assets under the ECB’s direct supervision, have submitted self-assessments and are finalising their action plans.

It is important to embed goals to be achieved over a longer period of time into the overall ESG strategic programme

Andreas Bohn, McKinsey

The ECB is assessing their responses, and Mr Elderson said: “Where we see that banks are not managing their exposures to climate-related risks in an adequate manner, we can and will draw on the full supervisory toolkit at our disposal to correct that situation, just as we do for any other material risk.” He added that ECB Banking Supervision has identified climate change as a key risk driver for the European banking sector.

Banks are still in the early stages of incorporating climate change into their risk frameworks, and risk identification and risk limits around climate-related goals do not yet feature in their risk management processes. This needs to change, Mr Elderson said at the conference, and euro-area banks must “drastically improve their capacity to manage climate-related and environmental risks and start acknowledging how these risks can drive others, including credit, market, operational and liquidity risks”.

The stress test will help the ECB to catalogue the “resilience of banks’ balance sheets to risks coming from climate change”, he said. “Importantly, this exercise will push banks to strengthen the climate dimension of their risk management toolbox. Finally, the exercise will also dramatically increase the availability of data and shed light on our supervisory reporting needs around these types of risks. Given our current lack of data, this will greatly help us in charting the course forward.”

Global moves

Supervisory authorities in Australia, Brazil, Canada, France, Hong Kong and Singapore have also conducted, or are scheduled to conduct, climate-related stress tests. In June, the UK’s Bank of England (BoE) launched a climate-related stress test as part of its biennial exploratory scenario testing. Seven of the largest banks and building societies, five large life insurers and six large general insurers were invited to take part, together with 10 selected Lloyd’s of London managing agents.

UK banks are “well advanced” in preparing for climate stress tests and meeting supervisory expectations for financial risk management related to climate change, according to research by German rating agency Scope Ratings. “The focus on climate, and environmental social and governance (ESG) more broadly, is increasing but it is not always clear what is material and relevant from a credit investor’s perspective,” says Pauline Lambert, executive director in Scope’s financial institutions team. “Ideally, we would be able to assess the nature and magnitude of the climate-related risks to which banks are exposed. However, disclosures are still evolving, and making direct comparisons between banks remains challenging.”

One of the desired outcomes of the UK stress test is to evaluate the size of participants’ financial exposures. Like the ECB, the BoE has stated that the exercise will not be used to set capital requirements, but Ms Lambert says depending on the materiality of the risks, “we believe this is likely to impact capital requirements in the future”.

Large UK banks have been making disclosures in line with the Financial Stability Board’s Taskforce on Climate-related Financial Disclosures framework, which was designed to improve and increase reporting of climate-related financial information. Scope Ratings says there is “relatively good” detail from UK banks about the management of climate-related risks and the work that is being done to evaluate exposures under different climate scenarios. Drawing conclusions about the impact on loan books, however, is still not feasible, it adds.

Success metrics

At the treasury level, success of an ESG programme would be first defined as being able to issue suitable financing instruments, says Dr Andreas Bohn, partner at McKinsey’s Frankfurt office. Second, a programme should obtain meaningful external recognition and rating for achievements that can be realised in a short timeframe.

“It is important to embed goals to be achieved over a longer period of time into the overall ESG strategic programme of the company,” says Mr Bohn. “This means that goals and strategy are transparent; furthermore, [that] expectations from regulators, investors and relevant rating agencies are understood and embedded in the overall strategic ESG programme.”

When it comes to treasury activities, he says, a first step should be issuing ESG-compliant financial instruments, such as inaugural bonds and notes that can be associated with and linked to ESG-compliant assets. This should be supported by respective opinion providers and rating agencies, he adds. “In the medium and long term, it is important to align the issuance programme and investment policy of the treasury department with a coherent overall ESG strategy of the company. The overall ESG issuance strategy should be embedded in a holistic framework of governance, risk and performance metrics and reporting.”

Ambrose Shannon, lead of Accenture’s chief financial officer (CFO) practice in the UK, says technology and sustainability need to be factored into financial institutions’ day-to-day operations. “Our research has shown that the remit for ESG in banks and corporates falls to the CFO, and by extension, the treasurer.”

In Accenture’s CFO study of 1300 senior finance leaders from around the globe, carried out between April and June 2020, 68% of respondents said their department “takes ultimate responsibility” for ESG performance within their enterprise.

The study says: “CFOs play a critical role in addressing some of the most pressing societal and environmental challenges of our time. They can do that through more consistent ESG disclosures; for example, CFOs are embracing their role as growth catalyst by disclosing and ‘optimising’ stakeholder outcomes in these areas. Leading by example, CFOs can ensure that ESG performance metrics are embedded in financial planning and analysis, leveraging digital tech to activate ESG priorities at speed.”

Vinod Jain, senior analyst in Aite Group’s institutional securities and investments team, agrees that treasury as a group has an important role in ESG governance and the contribution to the overall corporate goal. “Treasury also connects with the outside world and there’s added pressure to demonstrate how a financial institution has complied with ESG strategies. Everything is being looked at through the ESG angle,” he says.

Mr Shannon refers to the ‘three Rs’ of ESG: risk, regulation and return. “On risk, treasurers should ask ‘what is the risk to my business, portfolio and lending book?’ The risks for banks are more pertinent when they are writing a mortgage that will be on their books for the next 30 years. There are also risks that arise from carbon pricing, asset stock valuations and lending.”

A problem in dealing with regulation, he says, is that there are five to six global ESG standards setters and several industry standards setters. “Banks can self-select standards that they will make disclosures on but in general, these aren’t prioritised in annual reports, for example.” The International Accounting Standards Board is looking to engage and formalise metrics, a move Mr Shannon says could result in a “shift in behaviour”.

Finally, if banks make the right decisions, there is a huge potential uplift in terms of return. “Banks can create new, tailored products in the ESG space that will drive returns,” he says.

Financing transition

A bank treasury has three potential roles in ESG: to incentivise, optimise and achieve internal ESG, according to Leonardo Orlando, an executive in Accenture’s finance and risk practice. “Bank treasuries can create the funding structures for the changes required at corporates to achieve net-zero carbon. Funding and capital allocation to ESG-compliant corporates will become a competitive advantage for financial institutions.”

Loans and funding strategies can also help to optimise corporates’ ESG strategies, adds Mr Orlando. By creating green bonds and green asset-backed securities, bank treasuries can help even small companies to access the capital markets for funding for ESG projects. “Internally, the digitisation of treasury transactions can play a big role in a bank’s own efforts in achieving ESG. Treasury is also the first line of defence against social factors such as money laundering and bribery. There are many different lenses through which there is applicability of ESG in bank treasuries.”

There are challenges in integrating ESG into treasury operations, however. Mr Bohn says ESG considerations are becoming increasingly important for institutional and private investors and “may even represent an investment constraint”. ESG ratings are playing a large role. “Hence it is important to have a plan of increasing ESG-compliant bond issuances. Furthermore, the efforts to increase a climate-neutral asset composition have been stepped up by both regulators and banks themselves. One of the latest examples is the Net Zero Banking Alliance (NZBA) of 43 founding banks. Treasurers can support this by structuring their invested securities accordingly.”

Across the supply chain, there’s a desire to be consistent on ESG, both internally and externally

Paul Sinthunont, Aite Group

The industry-led and UN-convened NZBA now numbers 45 banks from 23 countries with over $28tn in assets. The members are committed to aligning their lending and investment portfolios with net-zero carbon emissions by 2050.

Launched on April 21, the alliance aims to reinforce, accelerate and support the implementation of decarbonisation strategies, providing an internationally coherent framework and guidelines in which to operate, supported by peer-learning from pioneering banks. It recognises the vital role of banks in supporting the global transition of the real economy to net-zero emissions.

Among the commitments the NZBA banks have made is to transition the operational and attributable greenhouse gas emissions from their lending and investment portfolios to align with pathways to net zero by 2050 or sooner. Within 18 months of joining, banks will set targets for 2030 (or sooner) and a 2050 target, with intermediate targets set every five years from 2030 onwards.

Priorities and targets

Banks’ initial 2030 targets will focus on priority sectors where they can have the most significant impact – that is, the most greenhouse gas-intensive sectors in their portfolios – with further sector targets to be set within 36 months. NZBA members will annually publish absolute emissions and emissions intensity in line with best practice and, within a year of setting targets, disclose progress against a board-level reviewed transition strategy for proposed actions and climate-related sectoral policies.

Mr Bohn says that since ESG and climate risk targets often can only be achieved over a longer period, it is important to define ambitions clearly and have a viable strategy that is transparent to external stakeholders and employees. “The composition of assets and funding sources needs to be aligned over time and external stakeholders need to grant sufficient time. At the same time, the company can focus on what can be implemented in the short term, such as issuance and rating of the first relevant ESG-compliant bonds.”

Paul Sinthunont, a senior analyst at Aite Group, says there is increasing pressure on financial institutions to change the way they run their businesses. “Across the supply chain, there’s a desire to be consistent on ESG, both internally and externally. Firms managing money can help to steer the direction of the companies with capital. There is an expectation that a partner will have the same approach as you. ESG compliance will become an accepted standard, and any financial institution or company not embracing it will not win much business.”

Accenture’s Mr Shannon says the great energy and enthusiasm for the ESG agenda in wider society means banks and businesses are being challenged on their commitment to net-zero carbon emissions. “Financial institutions face questions about what they are financing and how they are plotting their own transitions to net zero carbon. It is early days in some respects for ESG, but everyone is on the road. It is complex – banks cannot stop funding certain supply chains and switch into others, because everything is interconnected. However, with consistent standards and dedicated defined policies, financial institutions will be able to invest in areas that are aligned with where society is moving.”

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