Reuters

This article originally appeared on Thomson Reuters Regulatory Intelligence, 8 October 2019

Written by Vanessa Havard-Williams, Partner, Global Head of Environment, London

The UN Climate Summit in late September demonstrated that multinational corporations and financial institutions are mobilising to respond to climate change, even if many governments outside the EU are finding it harder to respond.

In the UK and Europe, policy makers have focused initially on using the financial markets as a lever to drive change in other sectors.

A suite of EU measures is intended over time to encourage the redirection of capital towards low carbon activities and to require large companies and asset owners to provide improved information on their climate related risks. In particular, the EU sustainable finance package will introduce new obligations for certain regulated entities (including funds, insurers, asset owners and asset managers) to disclose their approach to environmental, social and governance (ESG) risks. There are also governance and risk management requirements to fulfil with regard to ESG. More detailed obligations and disclosures will apply in relation to any financial products that are marketed as sustainable.

Enhancing banks' and insurers' approaches to managing thefinancial risks from climate change

Most EU measures will not come into effect for several years. However, 1500 UK regulated banks and insurers face a more immediate requirement. The Prudential Regulatory Authority or PRA published a supervisory statement earlier this year that requires banks and insurers to begin incorporating climate related financial risk into their governance and management processes. Any firm to whom the supervisory statement applies must submit an initial plan for doing so and revised senior management function forms to the PRA by 15 October 2019. Typically CROs are expected to take on this responsibility and the PRA has expressly discouraged creation of specialist silos to manage climate related risks – the hope and expectation is that regulated firms will manage these risks in an integrated way.

At its simplest, the supervisory statement will require banks to start considering their own portfolios, asset allocation and lending policies through an additional climate risk lens. There is the potential for impacts to capital requirements in the longer term. However, supervisory statements are inherently flexible instruments that set expectations, leaving it to firm and ultimately supervisory judgment to determine whether a firm meets those expectations. The climate change supervisory statement recognizes that the sector and its regulators all need to learn how to consider these issues and how best to manage them. Practice and regulatory expectations will develop and mature over the next few years. More detailed guidance is promised in due course, as the PRA develops its own thinking and leverages the best practice aspects of the various plans submitted to it.

The detail of the statement sets out the PRA’s expectations, some of which are easier than others to implement.

These fall into four categories:

 
1) Governance arrangements

There should be clear roles and responsibilities for managing the financial risks from climate change for the board and its subcommittees, and effective oversight of risk management and controls. This includes allocating responsibility for climate change risk to the relevant existing Senior Management Function and ensuring sufficient resources and expertise.

2) Risk management

Banks and insurers are expected to consider financial risks from climate change as part of their ordinary course risk management and to integrate them into existing risk management frameworks, in line with their board approved risk appetite. There is an expectation that firms will deploy a range of quantitative and qualitative tools to monitor their exposure to such risks.

These are likely to manifest as increased risks associated with existing activities such as underwriting, reserving, or credit. The underlying issues can best be split into two categories – physical risks (both acute, such as severe weather events, and chronic, such as rising sea temperature or acidification) and transition risks, such as those attributable to market and technology shifts, policy change or reputational issues. Liability or litigation is a third area of risk though it is more material for the insurance sector than for banks.

The difficulty for banks and insurers will lie in anticipating with any precision how or when these inherently complex climate related risks will translate into increased financial risks in their business. In particular the interaction of climate risks and financial exposures has the long term potential to create non linear and correlated outcomes but with very significant levels of uncertainty as to timing or precise results. Impacts within an immediate risk horizon may very well be immaterial from the perspective of bank or insurer resilience. The area of true skill may lie in timing, mapping and mitigating medium term risk.

3) Scenario analysis

Where proportionate, the PRA expects that banks and insurers will undertake scenario analysis to explore the resilience and vulnerabilities of their business model to a range of climate outcomes (e.g 2 degree increase, no regulatory intervention etc). In doing so they will need to consider the risks and opportunities typically associated with climate change for the sectors to which they are exposed. This process is expected to include both a short term assessment, within the firm’s existing business planning horizon, and a longer term assessment that contemplates different policy scenarios but which is based on current business model. This is an area of considerable complexity, requiring assumptions to be made, and drawing significantly on information about firm clients and their sectors. The PRA recognises that approaches to this aspect of the statement’s requirements will take time to evolve and mature. It will also pose challenges in the context of the reporting obligation.

4) Reporting

Banks and insurers already have reporting obligations in respect of material risks (under Pillar 3 obligations) and in their strategic report under the UK Companies Act. In addition, the supervisory statement asks firms to consider further disclosures, including how they have integrated climate related financial risks into existing governance and risk management, and the process by which they have determined whether they are material or principal risks. There is a strong indication that more granular reporting will be mandated for large asset owners and listed companies from 2022 (as announced in the UK’s Green Finance Strategy of July 2019). The PRA expresses the expectation that firm consider engaging with the principal soft law climate related disclosure framework, prepared by the international Taskforce for Climate Related Financial Disclosures, and that they encourage counterparties also to embrace greater disclosure.

This is a substantially new area for banks and will require the development of new thinking and new skillsets. It is already apparent that considerable care needs to be taken to articulate the assumptions and uncertainties inherent in any scenario analysis, and in any conversion of that analysis into projections of possible financial risks. Materiality is also likely to pose challenges. A possible physical or transition risk may be immaterial to a bank (because its own exposure to it is limited) and yet have significant social or environmental consequences on a region, locality or subsector.

These issues and how firms might deal with them will become clearer as banks and insurers engage with the statement. The PRA’s own views on good practice will develop not just through its review of initial plans but as it progresses its own thinking through other work streams (such as the Bank of England’s promised 2020 report of its own position under the TCFD framework) and the insurance company and bank stress tests. The climate financial risk forum set up jointly by the PRA and FCA also offers a route for banks and insurers to debate how best to resolve some the challenges that will inevitably flow from this step change in financial risk assessment. All these processes can be expected to result in further guidance the PRA on managing and reporting on climate related financial risks over the coming year. This is just the first step along a winding path.