Climate risk and the role of the finance sector

SHUANG TAO

Principal Solutions Architect, SAS Risk & Finance Advisory

SHUANG TAO

Climate risk and the role of the finance sector

Climate change is the most urgent threat facing the world. It affects us all. The imminent risks are spelt out in detail in the recent IPCC Report, which was headlined around the world as “Code Red for Humanity.” The subsequent COP26 conference in Glasgow has seen world leaders agree on certain measures designed to reduce emissions and take concrete steps towards the decarbonisation of the world economy, including agreement on halting and even reversing deforestation.

The responsibility of business

The crisis demands that we all as individuals change our behaviour, and remedial actions like recycling, reducing our use of water, and flying and driving less are important. However, it is industry and business that are positioned to take the most effective mitigating action. Businesses have to manage changing regulations, evolving consumer preferences and new technologies as they strive to reach carbon neutrality.

Significant impact can be achieved by changes in the role played by finance. The goals of COP26 recognise the importance of action by the finance sector, with this stated objective: “Financial institutions must play their part, and we need work towards unleashing the trillions in private and public sector finance required to secure global net zero.”

The funds involved are indeed huge. ESG (environmental, social, and governance) assets surpassed US$40 trillion globally in 2020 and may hit $53 trillion by 2025. Many organisations have been slow to react to the crisis, but now regulators are stepping in, supported by shareholder pressure, to change the way business is financed. Many providers of project and trade finance are setting standards for sustainability in their loan instruments. Physical and transition risk will also be priced into financing, making “green finance” a major factor.

Climate risk is also becoming an important component of the risk analysis and stress testing that banks must undertake. The Basel Committee on Banking Supervision has published papers on climaterelated risk that will serve as a “conceptual foundation” as the committee seeks to incorporate climate risk into the Basel regulatory framework.

The reports cover climate-related risk drivers and note that traditional risk categories used by banks— such as credit risk, market risk, liquidity risk, and others—can be used to capture climate risk.

and systems

Physical and transition risks will have a significant impact on the financial system. There is a growing focus on potential risks from climate change affecting financial stability.

Numerous international initiatives by public and private sector bodies are underway to address climate risk. The International Sustainability Standards Board (ISSB) has been established to focus on climate-related reporting.

Financial Stability Authorities globally are also working on strategies to protect the stability of the financial system from climate risk. In Asia Pacific, regulators in Australia, Singapore and Hong Kong have announced guidelines on climate change stress testing and scenario analysis, and Japan’s FSA is collecting stress testing results from mega banks. New Zealand has introduced a law requiring players in the financial sector to reveal the impact of climate change.

In the past, many institutions have treated climate risk as part of their corporate social responsibility (CSR) agenda with a focus on reputational impacts and a relatively narrow, short-term perspective on financial risks. Now institutions plan to shift to a more comprehensive approach, embedding climate risk in their risk management frameworks and taking a longterm view of financial risks.

Institutions are at different stages in the journey to integrate climate risk into enterprise risk management. According to a survey by the Global Association of Risk Professionals (GARP), about 33% of institutions introduced climate risk into their business more than five years ago, and 24% just during the last year.

The need for data and analytics to drive action

The financial sector is expected to play a key role in financing the transition to a greener and more sustainable economy. There are three ways in which FSI organisations can incorporate climate risk into their business activities.

First is portfolio alignment, which looks directly at the ultimate goal of global efforts on climate change and explicitly defines the portfolio changes that would be required to align with the Paris agreement 2°C scenario. Second is the risk framework method, a risk-based adjustment that enables institutions to manage risks internally and allocate their portfolios in the most riskeffective way, taking into account climate risk. Third is the exposure method, which directly evaluates the performance of an exposure in terms of its climate risk attributes.