Financial institutions still struggle with how to manage financial risks posed by climate change, but they continue to make strides in areas like governance and strategy around the climate change challenge, according to a new report published by the Global Association of Risk Professionals.
Twenty banks and seven other financial institutions comprising asset managers, insurers, and financial market infrastructure companies from across the globe were surveyed. These firms collectively hold about $20 trillion of assets on their balance sheets and manage assets of $12 trillion.
The survey was structured around the main themes for climate risk reporting that have been developed through the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD). The topics covered include governance and strategy around dealing with actual and potential climate-related risks; the risk management approach; metrics, targets, and limits used to assess and manage climate-related risks and opportunities; the use of scenario analysis to understand the risks; and disclosures of climate-related risks.
To understand better how financial institutions today are identifying climate-related risks and opportunities, the survey asked firms about their approach to climate risk management. Using terminology borrowed from the Bank of England, firms were asked to categorize themselves in one of three buckets:
- Responsible: An approach driven primarily by corporate social responsibility (CSR), focusing on reputational risks.
- Responsive: Climate change is viewed as a financial risk—albeit from a relatively narrow, short-term perspective.
- Strategic: A more comprehensive approach, taking a long-term view of the financial risks, with board engagement.
According to the survey, 55 percent of respondents described their approach to climate-related risks as strategic, complete with board oversight of climate-related risks and opportunities (80 percent) and a long-term view of financial risks. Moreover, most firms have more than one member of senior management responsible for climate risk, often at the C-suite level. Only a few firms view climate change as a financial risk through a short-term lens while just a handful describe their climate-risk approach as being driven mainly by reputational risk and CSR.
“On the surface, this is positive, as it indicated that firms are aspiring to improve their approach to climate risk management,” the report states. However, a deeper analysis finds a disconnect between firms’ own self-assessment and what they do in practice.
For example, half of the firms with little or no governance, strategy, disclosure, metrics, targets, limits, or scenario analysis described their approach as strategic. “On the other hand, a few of the firms with the most developed approach to climate-related risk management described themselves as responsible or responsive,” the report states.
“One possible explanation for this disconnect is that the firms have not yet done much tangible risk management of climate risks,” the report continues. “As firms undertake more work, their knowledge base will increase. They will become more aware of what they don’t know and become more modest and realistic in how they describe their capabilities.”
As it pertains to strategic objectives, 80 percent of firms said they have identified climate-related risks and opportunities, particularly within the next five years. Many have created new products—most commonly green bonds and other products positioned to facilitate the transition to a low-carbon economy.
Other firms have altered some of their existing products, with many adding restrictions on lending-to-coal projects and other projects with larger climate impacts. However, only 15 percent of firms felt their strategy was resilient to further climate change.
The extent to which firms use scenario analysis was also examined. “Given the range and timing of possible climate-related impacts, scenario analysis is an important and valuable tool firms may utilize in developing strategies that are prepared for climate changes,” stated the report.
However, according to the survey findings, scenario analysis is the least developed aspect of climate risk management, used by half of respondents. Moreover, these firms tend to use scenario analysis on an ad hoc basis, rather than as a regular part of a risk assessment, and only a few firms that regularly use scenario analysis leverage it to take any action.
Risk management practices
To gauge the extent of firms’ current climate risk-management capabilities, respondents were asked about the levels and nature of staff involved in climate risk management. The survey also explored the nature of regulatory oversight of climate risk.
According to the findings, few firms have a dedicated climate-related risk management function. If they do, these tend to be an environmental risk or corporate social responsibility team. Less than half of the firms have embedded the risk into their credit risk (or other day-to-day risk functions) while just a few firms have cross-discipline teams working on climate-related risks.
Metrics, targets, limits
Participants were asked about the use of metrics, targets, and limits within their climate-related risk management processes. The survey defined these terms as follows:
- Metric: A measure used to assess climate-related risks.
- Target: The outcome the organization aims to achieve.
- Limits: The worst outcome the organization is prepared to accept without taking corrective action.
“Setting metrics, targets, and limits for climate-related risks enables firms to understand these risks and incorporate them into their risk appetite statements,” the report states. According to the survey, two-thirds of respondent firms use metrics and targets. Fewer than half use limits, and more commonly for managing assets and liability risks, whereas metrics and targets are more commonly used for managing the firms’ own operations (e.g., measuring carbon emissions).
Where firms use metrics and limits for managing asset and liability risks, these are generally part of the firm’s risk management framework and are aligned with the firm’s strategy. “Targets are less likely to be part of the risk management framework, perhaps not surprisingly as they are more concerned with firms’ own operations,” the report stated. Targets are most commonly monitored at an annual frequency, whereas monitoring for limits is evenly spread between daily and annual frequency.
Finally, the GARP survey also set out to better understand the extent to which firms disclose their governance, strategy, and risk management practices, as well as the progress they are making to meet the recommendations set out in the TCFD. Two-thirds (18 respondents) disclosed the governance-related questions, although only half of these regarded the disclosures as compliant with the TCFD standards. Fewer firms disclose information on strategy and risk management. Across all categories, many firms said they are working to meet the TCFD standards in the future.
GARP Risk Institute Co-President Jo Paisley and Senior Vice President Maxine Nelson have issued a companion paper, “Climate Risk Management at Financial Firms: Challenges and Opportunities,” that provides an introductory guide on how financial institutions can better manage financial risks arising from climate change. “Given mounting regulatory scrutiny and the increased focus on disclosures,” the report concludes, “it is likely that firms will need to start paying greater attention to this area.”