Climate Change Risk Management in Banks: The Next Paradigm 9783110757910, 9783110757958, 9783110757972

Table of contents :
Advance Praise for Climate Change Risk Management in Banks: The Next Paradigm
Acknowledgments
Preface
Design and Structure of the Book
Opening Notes
Contents
Part 1: Brief Overview of Risk Management
The Big Picture
Chapter 1 An Overview of Risk and Risk Management in Banks
Chapter 2 The Different Flavors of Risk that Banks Work With
Part 2: The What, Why and Who of Climate Change Risks
Practitioner’s Note – Moorad Choudhry
Chapter 3 ESG and Climate Change as Relevant for Banks
Chapter 4 Climate-related Financial Risks for Banks
Chapter 5 Importance of Understanding and Acting on Climate Change
Chapter 6 Challenges for Banks in the Climate Change Risk Management Space
Chapter 7 Players of the Climate Change Risk Landscape
Part 3: The “How” of Managing Climate Change Risks – Building Blocks
Practitioner’s Note
Chapter 8 Building Blocks – The Big Picture
Chapter 9 Principles for Effective Management of Climate-related Financial Risks
Chapter 10 Risk Appetite Statement (RAS)
Chapter 11 Climate-related Risk Data
Chapter 12 Identification, Assessment and Measurement of Climate-related Financial Risks
Chapter 13 Scenario Analysis and Stress Testing
Chapter 14 Risk Mitigation, Control, and Monitoring Process
Chapter 15 Disclosures and Reporting Requirements
Chapter 16 Operating Model for Climate Change Risk Management at Banks: Some Pointers
Part 4: A Glimpse into the Complex Universe of Multilayered, Interlinked Climate Change Risks
Practitioner’s Note
Chapter 17 Interlinks – The Big Picture
Chapter 18 Interlinks with Financial and Non-financial Risks of Banks
Chapter 19 Capital and Climate Change Risks – the Links
Part 5: Going Forward
Practitioner’s Note
Chapter 20 Going Forward
Closing Notes
Bibliography
List of Abbreviations
List of Figures
List of Tables
About the Author
About the Series Editor
Index

Citation preview

Saloni P. Ramakrishna Climate Change Risk Management in Banks

The Moorad Choudhry Global Banking Series

Series Editor Moorad Choudhry

Saloni P. Ramakrishna

Climate Change Risk Management in Banks The Next Paradigm

The views, thoughts and opinions expressed in this book represent those of the author in her individual private capacities, and should not in any way be attributed to any employing institution, or to the author as director, representative, officer, or employee of any affiliated institution. While every attempt is made to ensure accuracy, the author or the publisher will not accept any liability for any errors or omissions herein. This book does not constitute investment advice and its contents should not be construed as such. Any opinion expressed does not constitute a recommendation for action to any reader. The contents should not be considered as a recommendation to deal in any financial market or instrument and the author, the publisher, the editor, any named entity, affiliated body or academic institution will not accept liability for the impact of any actions arising from a reading of any material in this book. Most of the references and quotes are from publicly available sources. Thanks to the regulators and global organizations, these documents can be accessed free of charge from their respective websites. Given that climate change risk is an evolving discipline, since publication different FAQs and clarifications would have been and will be published. For updated information please check the official websites of the referred content. For ease of reference the year of publication of each document referred has been given in the Bibliography.

ISBN 978-3-11-075791-0 e-ISBN (PDF) 978-3-11-075795-8 e-ISBN (EPUB) 978-3-11-075797-2 ISSN 2627-8847 Library of Congress Control Number: 2023941373 Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available on the internet at http://dnb.dnb.de. © 2024 Walter de Gruyter GmbH, Berlin/Boston Cover image: Nikada/E+/Getty Images Typesetting: Integra Software Services Pvt. Ltd. Printing and binding: CPI books GmbH, Leck www.degruyter.com

Advance Praise for Climate Change Risk Management in Banks: The Next Paradigm Ms. Saloni Ramakrishna has a long and deep experience in supporting financial institutions to enhance and adapt their risk management to rapidly changing external environments. With this background, she is well-positioned to write about the practitioner’s guide on designing, developing, and implementing the practical methodology of climate-related risk management. Through her book, Climate Change Risk Management in Banks: The Next Paradigm she has shared with us the essential framework required for establishing a proper climate-related risk management function. I believe her work will be a milestone in the literature on banks’ climate-related risk management. Tsuyoshi Oyama, Author; CEO, RAF Laboratory Co. Ltd.; earlier Partner, Deloitte Touche Tahmatsue; and Former Director-General of the Financial System and Bank Examination Department, Bank of Japan Ms. Saloni Ramakrishna, an acknowledged finance and risk professional, in her inimitable style, explores the various aspects of climate change risk that banks face and its risk management in a strikingly lucid manner. The book, Climate Change Risk Management in Banks: The Next Paradigm, with the body of work it encapsulates, is a worthy addition to the literature of the emerging discipline of climate-related financial risk management. A special mention needs to be made of the extra mile she goes to detail the different building blocks that will create a robust foundation and scalable framework for managing climate change risk. With this, she has moved the climate risk management dialogue beyond financial rhetoric to an actionable business proposition. Marc Irubétagoyena, Director of BNP Paribas; Global Head of Stress Testing and Financial Synthesis and Group Risk Board executive With her extensive and real-world experience as a financial services industry practitioner in the risk and data management space, Ms. Saloni Ramakrishna covers the various aspects of climate-related financial risks in her signature style of simple and straightforward narrative. The book, Climate Change Risk Management in Banks: The Next Paradigm, is a unique combination of real world challenges, concepts and a practical framework rolled into one. Possible ways of managing this new risk universe are covered in a succinct yet comprehensive manner. A shout-out for her focus on “the complex universe of interlinks,” which is where most of the industry’s challenges will be. Sridhar Aiyangar, Group Head, Balance Sheet and Liquidity Management, Bank ABC In the book, Climate Change Risk Management in Banks: The Next Paradigm, Ms. Saloni Ramakrishna, with her practitioner’s wisdom and industry experience, opens the book with an overview of risk and the flavors of risk that banks deal with. As she so rightly points out, at a fundamental level, all financial risks have a common set of https://doi.org/10.1515/9783110757958-202

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Advance Praise for Climate Change Risk Management in Banks: The Next Paradigm

principles. Having laid that foundation, she goes on to fluently discuss practical handling of climate-related financial risks, a nuanced and complex subject. She brings great value to this critical but young and evolving subject through a rare blend of curated content and strategic intent with real world issues and a practical approach. Dr. Sankarshan Basu, Author; Dean of AMSOM; Professor, Indian Institute of Management, Bangalore; Ph.D. from and taught at the London School of Economics and Political Science (LSE) Through her book, Climate Change Risk Management in Banks: The Next Paradigm, Ms. Saloni Ramakrishna brings to bear her vast hands-on practitioner’s experience of advising and implementing projects for global clients, on how technology weaved intrinsically into complex risk management frameworks is a huge value multiplier. Her emphasis on the role and relevance of a well thought out, appropriately designed “Climate Information Architecture” as the bedrock of creating and perpetuating an active climate change risk management program, is spot on. Jason Wynne, Group Vice President, Oracle Financial Services Global Business Unit; Previously Risk Technology Head of Australia & New Zealand Banking Group Limited, Australia

To my mother, Pisipati Suguna Murthi The indomitable spirit, who taught me the essence of “joie de vivre” by living it every day of her life.

Acknowledgments Men argue. Nature acts. –Voltaire

The greatest benefit of authoring a book is the immense learning it affords the author. The journey of authoring this book has taken me through a rich canvas of myriad sources and experiences. From researching industry challenges and practices, to perusing content from authentic sources – regulators and global organizations that are shaping the narrative, exploring operational constructs across the life cycle of climate change risk and its management used by successful practitioners as well as drawing from my real-world experiences. All together this has been one of the most significant kaleidoscopic journey. I have many to thank for insights gained and the intricacies understood. My foremost gratitude is to “Mother Nature.” This book is one of the ways I am paying homage to climate and environment with an acknowledgment of the enormity of responsibility placed on each of us to preserve nature, so it can continue to protect and nurture humanity. A big shout out and thank you to my partner Ramakrishna Gullapalli, my rock, my strength, who made this book possible, in every conceivable way. Gratitude to my father, Sh. Pisipati Sri Ramachandra Murthi, my guru; my mother, Pisipati Suguna Murthi, to whom this book is dedicated; and Sameer Kumar Pisipati, my elder brother. Bless Sravani, the inexhaustible fountain of energy, Srikar, the boundless powerhouse, Sudhir the epicenter of positivity and all the young ones of the family, my collective source of joy and creativity. Thanks are due to Seetha, for being there always!! This book happened because of Professor Moorad Choudhary, a prolific author. Our common ground is our passion for the banking industry. It was his suggestion that I author a book for the Global Banking series which he is the editor of. His infectious enthusiasm is the genesis of this journey. Thank you, Professor, for motivating me to embark on this arduous but fulfilling path. Senior practitioners and thought leaders, Dr. Sankarshan Basu, Professor Moorad Choudhary, Tsuyoshi Oyama, Marc Irubétagoyena and Sridhar Aiyangar, have readily agreed to bring to bear their distilled wisdom and hands on experiences to add to the industry narrative of the budding climate change risk discipline, through their “Practitioner’s Notes,” which prefix the five parts of the book. These notes have enriched its content manifold. A big thank you to each of them for their positive collaboration. A special note of appreciation and thanks to the regulators and global organizations who are working through the multilayered and multithreaded complex universe of climate change and its risk management, sharing their guidance and best practices, as they navigate through the gigantic standardization exercises. It is from this well thought out and well laid out landscape of material that I have drawn nuggets to string together concise, consumable curated content. Thanks is also due to them for readily and gra-

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ciously permitting usage of their references, perspectives, definitions and nuances that will shape the tone, timber, and direction of the young but challenging discipline. My understanding of the deep, involved, and interlinked climate change risk management has been enriched manifold through the many discussions on the discipline with banking professionals, regulators, consultants, IT professionals, financial services industry association members and many other stakeholders, who have all added to my learning canvas with their unique perspectives. Thanks to each one of them. With great joy, I place on record my acknowledgment of the creative, facilitative ethos and environment my organization, Oracle Financial Services and my colleagues provide, that promotes a spirit of excellence. My thanks to publishers De Gruyter, with a special call out to Stefan Giesen, the perfect gentleman, because of whom the proposal experience was so positive. Thanks is due to Jaya Dalal, the editor, whose serenity, I marvel at. Thanks to the entire editorial team of De Gruyter. Many thanks to all of you, dear readers, and fellow professionals, for being part of this journey. Saloni P. Ramakrishna

Preface Water water everywhere – Nor any drop to drink. –Samuel Taylor Coleridge, The Rime of Ancient Mariner

In hindsight, it seems that the great poet S.T. Coleridge, almost two centuries ago, tried to warn us about the impending climatic catastrophe if we did not steer the mythical “ship” to safety!! The reality today is that, while two-thirds of the earth is covered by water, only 3% of it is drinkable with that percentage fast depleting. Water stress and water crisis are only two facets of the fallout of casual and irresponsible handling of climate related issues. The broader landscape across various aspects of everyday life, that could be impacted negatively, due to adverse climate change, is immense. No one can remain impervious to the risks humanity faces if urgent remedial steps are not taken to protect the environment in its current fragile state. As a citizen of the world, I am deeply connected to and concerned with all aspects of climate change. When I thought of penning my next book, “climate and its risk management” was naturally the theme I chose. There were two challenges to execute this thought. One, the scope of the subject of ESG1 and sustainability finance, both in terms of width and depth is too vast to encapsulate in one book, even if it is focused on one sector, the financial services. The second, as a published author2 in risk management space, I have experienced firsthand the focus, clarity and rigor required to take a foundational yet comprehensive approach that stakeholders can relate to and use as a guidepost. Acknowledgement of these challenges led to the two definitional themes that shaped the scope of the book. The focus on climate change, and its risk management in banks. The canvas and the contours of the landscape created in this book are an amalgamation of real world experience, across the globe, of working with data, risk and finance functions of financial services firms both as a banker myself as well as a consultant. An experience that is continuously enriched through conversations, experiences gained and shared with global organizations by working on the ground issues with Industry Leaders. As a practitioner in the financial services industry, I can visualize the crucial role banks can play in positively influencing the climate change risk management narrative while ensuring strong and sustainable growth for themselves. The combination of understanding the urgency of taking action in climate change risk management and my field of experience in execution of complex projects in data and risk management has led to the genesis of this book. The decision and its follow through have taken me on an invaluable learning and sharing journey that is encapsulated in the following pages.

 Environmental, Social and Governance.  Saloni P. Ramakrishna, Enterprise Compliance Risk Management – An Essential Toolkit for Banks and Financial Services, Wiley Corporate F&A (2015). https://doi.org/10.1515/9783110757958-204

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Adding depth and practical hands-on wisdom, five industry practitioners, each an acknowledged expert in their area of operations, and working on climate change risk management in their distinct way, have contributed to the content and narration through the “Practitioner’s Notes,” a unique feature of this book. These notes prefix each of the five parts. The book is aimed at all the stakeholders of the financial services, particularly the banking industry – practicing bankers, banking associations, regulators, consultants, system integrators and analysts. It will be of use to educational institutions that have financial services and/or risk management and climate change in their curriculum. It will also be relevant to other players like banking colleges, risk management associations, and banking associations/industry bodies as for all others who are interested in understanding the role and impact of financial services firms on climate risk and vice versa, like governments and their policy makers as well as world organizations. Written in simple text, it is aimed at creating the much-needed literary asset for both the stakeholders of the financial services industry as well as academia. Climate change risk management in banks as a distinct discipline is in a very nascent stage. The impact of adverse changes of climate on the socioeconomic canvas has been and is debated fiercely. However, the potential sizeable negative effect on the financial services industry itself and the need for a possible organized method to counter it, both for its own well-being and for the environment at large, is little understood, much less documented. This book centers on these critical aspects. The varied facets of climate risk management right from risk sources all the way to regulatory approach are the focus of this work. It presents, in simple articulate style, an orderly and systematic approach. The attempt is to separate “the wheat from the chaff,” and reduce the surround noise so the fundamentals are understood and focused on for positive action. It encapsulates curated content, as relevant to climate change risk, from regulators and global organizations. This knowledge not only protects businesses from negative impacts but also give the much-needed competitive advantage that goes a long way in value creation, preservation, and growth. Saloni P. Ramakrishna

Design and Structure of the Book The secret of getting ahead is getting started –Mark Twain

The three principal objectives of this book are: – To create curated content from a sea of information on the subject so it becomes consumable and actionable. – To be the “go to book” for practitioners of financial services firms, particularly banks, to understand, contextualize and operationalize a stable construct for their climate risk management framework. – To be part of the narrative and direction of this nascent discipline by providing foundational reference literature. This book presents a possible path to managing “climate change risk” effectively so it is handled holistically. Multiple aspects of the subject and their interlinks are delved into including the connections with other risk areas. The text offers varied and detailed insights into specific risk aspects of vital importance to bankers through an operational framework which will give the industry the much-needed edge in understanding and managing it. The book is presented in five parts, prefixed by “Opening Notes,” and suffixed by “Closing Notes.” Each part, prefixed by a “Practitioner’s Note,” has a brief abstract of the themes covered in the chapters within it. Part 1 – Context setting: Brief overview of risk management – The first part provides a bird’s eye view of “risk” and its management in financial services. Content here is referred to in subsequent sections to compare and contrast with climate change risks. Part 2 – The what, why and who of climate-related financial risks – This part sets out the core aspects and looks at the impact of adverse climate changes, its primary risk drivers, transmission channels, amplifiers and related themes. Part 3 – The how part – This part seeks to provide the building blocks and a functional toolkit for navigating the climate risk universe providing an operational and actionable framework. This part highlights the critical components and functional constructs required for creating an effective climate change risk management structure in banks. Part 4 – A glimpse into the complex universe of multilayered climate-related financial risks – Multiple facets of the subject, their interrelationships, risk spillovers, the second order impacts and how these are deeply intertwined with both the financial world as well as real economy are explored.

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Part 5 – Going forward – In this part, the stated roadmaps of regulators, important global organizations such as TCFD, NGFS, ISSB, etc. and banks are looked at briefly. Each of these, both individually, and in combination, will shape the narrative going forward. The Closing Notes section encapsulates my views on what could help shape this young subject to its potential of being able to build and sustain a healthy future not just for banks and the economy but also the larger ecosystem.

Opening Notes The best time to plant a tree was 20 years ago. The second-best time is today. –Chinese Proverb

I always wondered (and still do) if “climate risk” is a misnomer – shouldn’t it be “Ecosystem @ Risk”!! Unless some constructive and urgent action is taken to address, reduce and rectify the negative impact from all of us individually and collectively, inclusive of all organizations, there would be enormous financial and economic fallout, not to mention the irreparable loss to humanity. If there is a subject that has captured attention across the globe, it is climate change. The pandemic was like a wakeup call to shake us awake from our slow-paced response to something that is and should be an immediate concern. Fact is, managing climate change positively is central to a “sustainable future” for ALL. The economy, climate and environment are deeply interlinked – each affects the other in many ways. A quick example to illustrate the interlink between environment, global economy and climate change is a data point from Bank of England that I came across -The floods in Thailand in 2011 resulted in over $45 billion of economic losses. More positively, at the other side of the globe, the mangrove forests in Mexico provide storm protection and give support for fisheries and eco-tourism. These benefits have been estimated at $70 billion in financial terms. These numbers, one in a multitude of such data points, set the context for the financial implications of both sides of the coin – inaction and action. Climate risk, while deeply linked to the wider conversations on climate change, is a distinct and critical subset of the broader umbrella themes of climate change and environment. The larger discussions are shaped by global dialogue and intergovernmental summits, considering diverse aspects both of mitigation and adaptation strategies. The understanding and analysis of climate risk, on the other hand, is shaped largely by financial regulators and global organizations like TCFD, NGFS, ISSB, GHGP, PCAF and other related private sector institutions. Understanding the impact of physical and transition hazards/drivers, exposures and vulnerabilities, and how they impact individuals, households, corporates, financial institutions that lend and invest in them, their financial outcomes, impacting different sectors, geographies and individuals differently, is the focus of the risk lens. This book looks at climate change risk management from the lens of financial Services firms in general and banks in particular. It covers themes like relevance of climate change risk to banks, its impact and how to manage it in a way that it can create a win-win situation for all stakeholders including the environment and society. The many dimensions and nuances added due to the exponential increase in the complexity of the financial world on one side, and the possible catastrophic impact of adverse climate changes on economies on the other, have brought the need for serious dialogue and documentation on “climate change risk management” to center-stage.

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Dubbed as the next big thing and the new frontier in the risk management world for banks, no risk area has been as challenging and hazy as managing climate risk, a subject that demands to be treated as a focused discipline. The challenge stems from the fact that it is an evolving, layered, intricate, interconnected and nuanced canvas. The ability to see it in its totality for capturing its essence and at the same time to be able to zero in on the relevant specifics of the scope to create an actionable framework is an art, craft, and science, all rolled into one. As an Industry practitioner with hands-on experience for over three decades in risk and finance space from “all sides of the table” of financial services industry, I have learnt that the best way to manage risk is through a structured proactive approach. The narrative and presentation of the book is simple, straight forward and structured by design. As I acknowledge in my books, the narration style is influenced by guiding principles ingrained in me by my father and my mentors. – “To understand or explain a subject, look for answers to 3 ‘W’s, the What, the Why and the Who, that will give you the rationale, context, and the impact. The ‘H’, the How part, provides answers to establishing a practical set of doable constructs that provides answers to the required approach, framework, sequence etc.” This insight from my father stands me in good stead both as a professional and as an author. – The art of narration is its simplicity and straight forwardness – because “all fundamentals are simple and straightforward and do not need the garb of jargon to claim their rightful place” – a profound sense of wisdom one of my mentors instilled in me. The narration, therefore, is simple and straight forward, de-jargonizing and demystifying the subject (to the extent possible), presenting it in a consumable, actionable and “to the point” form. – The primary objective of literature is to “elevate the debate, energize the dialogue, and go from what it is to what it can be. That is how growth and progress happen.” This was the dictum of another one of my mentors. The effort is, therefore, to elevate the current tactical context of climate risk to its rightful strategic ability of becoming a powerful competitive weapon for organizations, enhancing the overall wellbeing of the system and aid in creating a sustainable future. The objective is to rise from accepting to actioning in the real world. The goal of regulators and organizations is a systemic and systematic integration of climate risk management into the business and strategic fabric of the organization. Being a young and evolving discipline, the rule book on climate risk management, if anything, is and will be an iterative process for some time to come, but a well thought out foundation will go a long way in optimizing capital, costs, time, and human resources while trying to arrest further deterioration of the climate. All stakeholders, right from regulators to the risk managers at their desks in individual firms are learning along the way. This book adds to shaping that budding narrative.

Contents Acknowledgments Preface

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Design and Structure of the Book Opening Notes

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Part 1: Brief Overview of Risk Management The Big Picture

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Practitioner’s Note – Dr. Sankarshan Basu

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Chapter 1 An Overview of Risk and Risk Management in Banks Chapter 2 The Different Flavors of Risk that Banks Work With

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Part 2: The What, Why and Who of Climate Change Risks Practitioner’s Note – Moorad Choudhry

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Chapter 3 ESG and Climate Change as Relevant for Banks Chapter 4 Climate-related Financial Risks for Banks

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Chapter 5 Importance of Understanding and Acting on Climate Change

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Chapter 6 Challenges for Banks in the Climate Change Risk Management Space Chapter 7 Players of the Climate Change Risk Landscape

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Part 3: The “How” of Managing Climate Change Risks – Building Blocks Practitioner’s Note – Marc Irubétagoyena Chapter 8 Building Blocks – The Big Picture

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Chapter 9 Principles for Effective Management of Climate-related Financial Risks Chapter 10 Risk Appetite Statement (RAS) Chapter 11 Climate-related Risk Data

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Chapter 12 Identification, Assessment and Measurement of Climate-related Financial Risks 117 Chapter 13 Scenario Analysis and Stress Testing

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Chapter 14 Risk Mitigation, Control, and Monitoring Process Chapter 15 Disclosures and Reporting Requirements

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Chapter 16 Operating Model for Climate Change Risk Management at Banks: Some Pointers 208

Part 4: A Glimpse into the Complex Universe of Multilayered, Interlinked Climate Change Risks Practitioner’s Note – Sridhar Aiyangar Chapter 17 Interlinks – The Big Picture

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Chapter 18 Interlinks with Financial and Non-financial Risks of Banks Chapter 19 Capital and Climate Change Risks – the Links

Part 5: Going Forward Practitioner’s Note – Tsuyoshi Oyama Chapter 20 Going Forward Closing Notes Bibliography

257 275 281

List of Abbreviations List of Figures List of Tables About the Author

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291 293 295

About the Series Editor Index

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The Big Picture A business without risk is a risky business.

Banking is like any other business in many ways and yet distinctly different from others. It has the same sustainability, growth, and profitability objectives. Where it differs is in its role as a core vehicle of the economic activity of its ecosystem, due to its part in financial intermediation. That role is central to how all stakeholders view, interact, and define boundaries to banks and other financial industry firms which are some of the most regulated industries, given their critical role in the economic landscape of not only countries and regions, but also the entire globe in this connected universe. In the response to climate changes, there is a dual expectation from the financial services firms. On the one hand to reduce significantly their contribution to the erosion of the climate, and on the other to help their customers transit to more sustainable operations. All this is expected while ensuring that their business sustains and grows, hedging the financial risks that are posed by adverse climatic changes. Written through the lens of banking, the focus of this book is to explore “climate change risk management of banks.” It is important to set the context to that conversation, to get a foundational insight as well as appreciation of “risk” and its management frameworks in banks. This introductory part sets out the bird’s eye view of risk and its canvas as well as its management fundamentals. Risk is an inherent part of every business, geography, and by extension every enterprise. It presents both threat and opportunity. Acceptance of risk, its outcomes/costs, and planning out the optimal approach to manage it for the benefit of the enterprise is the goal. Risk management is the process of objectively identifying the potential of both downside and upside of business transactions, optimizing the upside while monitoring and mitigating the downside. Enterprises take calculated risks to optimize returns by making it an ally, as risk taking is core to value creation. Risk as a concept is simple and complex at the same time. Understanding “risk” at its core is simple – it is the contextual nuances that add the layers of complexity. Risk has always been associated with “the possibility of loss,” the downside. The loss itself could be any of the following – financial, physical, or reputational, each with dire consequences. Rarely, if at all, is the “upside” of risk spoken of. This is not surprising given that the usage and association of the term has almost always been in the context of negative impacts. However, ignoring the possibility of a positive outcome is blindsided, because this negates the very essence of calculated risk-taking for value creation. Yet one does not hear a CXO say that the organization stands the risk of making “gains.” But a good risk management system needs to be designed to give a view of the potential both ways (downside and upside). Risk presents a mixture of a potential significant down-

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side and/or a potential of upside. There lies the complexity of grasping the concept and its nuances. Understanding and planning for the upcoming diaspora of risks to “ride the wave” to create value for the firm is the focus of businesses. The problem is that not all risks and all impacts can be visualized and planned upfront. The coronavirus pandemic of 2019 forward is a case in pointer. There will be surprises, some nasty ones. It is at these times that the resilience of the organization and its risk management is put to the test. Geopolitical risks, natural disasters, and sustainability initiatives will make new and challenging demands on banks. The bottom line is that risks are dynamic in nature and their management needs to be planned as such with built-in flexibility. Risk stems from different sources having different outcomes. This is evaluated and approached as banks manage different flavors of risk like, credit, market, liquidity, operational, and reputational risk, to name a few material categories. While each of these require their specialized evaluation, controls, and action, the fact remains that there is no “standalone” risk – each of them is intertwined and impact one another. As an example, pandemic risk (the new kid on the block), which some banks have categorized as strategic risk, dotted its link not only to credit risk, owing to the potential of default or delayed repayments, but also to cybersecurity risks (technology risks), as digitization and remote working were becoming the norm. Two other themes need a mention here. The first is capital and related buffers that banks hold, which in principle, is both the shareholder’s stake (shareholder’s skin in the game) and also the cushion to take the blow from losses. The other aspect of importance is the return both on equity and investment because banking, like what was said earlier, is a business with sustainable growth objectives. Therefore, it is critical to have a healthy risk-return relationship. The ability to price risk correctly is critical for sustainable growth of banks. However, the multiple low-cost options for various services brought to the fore by digitization, technology, and fintechs in the financial services industry has resulted in lowering costs for customers but increasing the risks for banks. This has also resulted in challenging the ability of banks to price risks realistically. Banks, therefore, need to have a proactive risk pricing and management capability and a speedier response to market opportunities. All of these become more complex and pronounced in the climate change risk space, which will be explored through the different sections of the book.

Practitioner’s Note Core Risk Management Fundamentals are Common Across Risk Classes

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Practitioner’s Note Core Risk Management Fundamentals are Common Across Risk Classes Dr. Sankarshan Basu Risk in the strict sense of the word is defined as “the effect of uncertainty in outcomes of an event.” If the outcome of all events were always certain and known there would be no risk element at all. It is due to the fact that there is intrinsic uncertainty in the outcome that leads to the existence of risk. In that sense, risk is inherent in every facet of life, of both individuals and organizations. As Walter Wriston, the former chairman of Citicorp had put it: “All of life is management of risk, not its elimination.” The field of risk management is synonymous to “decision making” and forms a part of the disciplines of statistics, operations research, economics, finance, psychology as well as management. Exposure to risk is a given. The effort is to try and manage the risk so that it stays “in control.” The skill is to try and manage it effectively. For banks, risk management is at the core of their business. Banks can be classified into one of three groups in terms of their risk taking (risk bearing) ability: a. Risk Averse: This is the set of organizations that do not want to take any risk on themselves and at all times try to minimize the risk that they bear. In practice, existence of such organizations is difficult. More so if they want to be a going and growing firm. b. Risk Neutral: This group is indifferent to the risk that they bear – they do not make any extra efforts to either reduce or increase the risk that they bear. This stance is not possible for commercial banks. c. Risk Seeker: This category seeks to take on and actively manage risks. They believe in the adage “High Risk, High Returns” and want to take on risk in pursuit of higher returns. Banks, as vehicles of economy, while typically avoiding uncontrollable risks, would like to ride the tide of manageable risks to optimize returns. In that context banks are seekers of “feasible” risks. Risk management in the financial context is the fact that an unexpected negative outcome leads to a financial loss and the entire concept of financial risk management and by extension a bank’s risk management is based on how to measure the expected financial loss and manage that level of loss. Given the fact that risk will exist and is an integral part of organizations, the philosophy of risk management lies in the three principles of: 1. Identification of the sources or causes of risk. 2. Accurate measurement of the risks to which one is exposed to.

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Part 1: Brief Overview of Risk Management

Trying and controlling the risk to the extent feasible and possible such that the risk is within the ability to bear it.

Ms. Saloni Ramakrishna expertly and succinctly reiterates these principles in this book, bringing to fore the foundational reality that risk and value are two sides of the same coin, provided they are identified, measured and managed well. Risk in general can be classified into two categories: business risk and nonbusiness risk. Business risks can be described as those type of risks which the organizations willingly and knowingly undertake with the intention of creating increased competitive advantage and value for all the stakeholders. These are risks which could be attempted to be minimized by the organization by proper decision making, good controls, and can be treated as a core competency of the business enterprise. For banks, the business risks take on different flavors of risks which are clubbed into two broad categories: financial and non-financial risks. The former encompasses the traditional risk categories of credit, market, liquidity and operational risks and the non-financial risks broadly cover legal, reputational, regulatory, and strategic risks. Though, as Ms. Saloni Ramakrishna, a financial services practitioner of repute, so aptly points out, there is nothing like non-financial risk in the medium to long term, from an impact on balance sheet perspective. The classification is more on the objective measurability of these risks as well as the timing of impact. Non-business risks on the other hand are those risks that are external to the organization but it is nonetheless exposed to. For example, risks resulting from fundamental shifts in the economy, political environment or events could be treated as these kinds of risk. Organizations rarely have any control over these types of risks and they are very difficult to manage. Only a marginal benefit may be obtained by diversification, though not in all situations. Climate change risks fall into this bucket. Ms. Saloni Ramakrishna, in a simple and relatable way, brings to fore the complexity of climate change risks, which stem from uncertain climate paths, influencing and influenced by real economy, policy decisions and impact the financials of banks. As a practitioner of risk management, I have seen that across time, while different risk classes have been segregated to bring focus on the nuances of that specific risk class, the fundamentals of risk, risk management and risk optimization are and will remain the same. Manageable risk-taking for sustainable growth is a must. Realistic risk identification, objective risk measurement (to the extent possible and feasible) and effective as well as implementable controls are what differentiates successful organizations from the non-successful ones. Climate change risks too, will need these foundational aspects woven into banks’ enterprise risk frameworks as they understand and incorporate climate-related nuances to that framework.

Practitioner’s Note Core Risk Management Fundamentals are Common Across Risk Classes

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Dr. Sankarshan Basu, an alumni of IIT Kharagpur and London School of Economics and Political Science (LSE), UK, is a Dean at Amrut Mody School of Management, Ahmedabad University, and has been a professor of Finance and Accounting at the Indian Institute of Management Bangalore (IIM Bangalore). Dr. Basu a published author, an educator of repute and has been a teaching faculty at London School of Economics and Political Science, Heriot Watt University, Edinburgh, U.K. and a Visiting Professor at University of Twente, Netherlands, Gothenburg University, Sweden, ESCP, Paris, CFVG, Ho Chi Min City and Hanoi, Vietnam and Asian Institute of Technology, Bangkok. He is an acknowledged authority on risk management and is a member of many risk management committees.

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Part 1: Brief Overview of Risk Management

Section Abstract The two chapters in this part explore the core and nuances of the “risk,” its different flavors and its management, particularly in the context of banks. The objective is to lay out only the important foundational aspects which can then be compared and contrasted with climate change risk. As understanding of the financial impact of climate change starts to take center stage with sustainability, resilience, and organizational agility demanding attention; first an understanding and then a refresh/reset of programs and practices will follow. The next two chapters set the context for that conversation, and they are explored for that purpose, rather than a detailed thesis on the below topics.

Chapter Abstracts –

–

Chapter 1 explores, at the top level, definitions, construct, purpose of risk, and its management, as risk and value are two sides of the same coin. The purpose is to touch on the fundamentals that hold true across time and across risk categories. This chapter will be cross-referenced when we discuss concepts of climate change risk. Chapter 2 briefly looks at the different flavours of risks, the important ones, that banks work with. The idea is to emphasise that there is truly no standalone risk – each category impacts the other. The overall health of the organization is in creating a positive collaboration and correlation across the various categories. Some of the risk categories discussed here and their links with climate change risk will be explored in subsequent chapters.

Chapter 1 An Overview of Risk and Risk Management in Banks Opportunity and risk come in pairs. –Bangambiki Habyarimana, The Great Pearl of Wisdom

“Risk” in its broadest sense is the probability of winning or losing something of value. Good management of this core element of business is to optimize the wins and arrest the losses to manageable levels. It is because of this fine balance that this discipline is an art, craft, and science rolled into one: an art required to visualize something that is not apparent, a craft/skill to spot the risks in time, and science that facilitates objective measurement and management.

Risk Risk is a business reality and affects almost every decision the business takes. The only choice that businesses have is whether to take it or not. If the former, then this involves putting in appropriate controls for an optimized outcome. Risk occurs when there is hazard, exposure and vulnerability at the same time. Understanding “risk” is foundational to its “management.” Risk as a term is used in multiple contexts, with the most used the likelihood of quantifiable loss. There are a couple of interesting horizontal definitions/explanations I came across that are simple yet interesting and illustrative at the same time. The first brings out the contours of risk (and a smile as well) detailed as five sub-themes: – Risk = an unwanted event which may or may not occur – Risk = the cause of an unwanted event which may or may not occur – Risk = the probability of an unwanted event which may or may not occur – Risk = the statistical expectation value of an unwanted event which may or may not occur – Risk = the fact that a decision is made under conditions of known probabilities (“decision under risk” as opposed to “decision under uncertainty”)1 The definition lucidly brings to fore a couple of critical aspects of risk (in addition to others). The first is the possibility of an unwanted event happening and the second is the preparedness for that possibility that aids decision-making in the event of risk. The other quote that I like, explains the distinction between risk and uncertainty, “To preserve the distinction . . . between the measurable uncertainty and an immea Sven Ove Hansson, “Risk,” The Stanford Encyclopedia of Philosophy (Spring 2014 Edition), ed. Edward N. Zalta, http://plato.stanford.edu/archives/spr2014/entries/risk/. https://doi.org/10.1515/9783110757958-002

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Chapter 1 An Overview of Risk and Risk Management in Banks

surable one we may use the term “risk” to designate the former and the term “uncertainty” for the latter.”2 This one highlights “measurability.” These two bring together the core facets of risk, that of identifying the vulnerable events and the ability of quantifying them. Typically risk and its definitions are associated with loss, with the exception to this rule being the ISO definition of risk, as the “effect of uncertainty on objectives.”3 In this definition, uncertainties include events (which may or may not happen) and uncertainties caused by ambiguity or a lack of information. It also includes both negative and positive impacts on objectives. This definition broadens the scope and impact of “risk’ to include both sides of the likelihood. This is a realistic definition as it acknowledges the fact that risks may result in either gain or loss. Interestingly, risk can result from action or inaction, the latter resulting in opportunity loss. Table 1.1 looks at the primary terms used and their dictionary definitions. Important to understand that these are horizontal definitions not contextualized to how banks use them. However, they serve the vital function of setting the right appreciation of the terms. Table 1.1: Primary risk vocabulary and their dictionary meaning. The Primary Terms

Dictionary Definition (Merriam Webster)

Risk

Possibility of loss or injury

Uncertainty

Something that is uncertain (uncertain defined as not clearly identified or defined)

Hazard

A source of danger

Exposure

An amount at risk

Vulnerability

Open to attack or damage

Likelihood

The chance that something will happen

Probability

The chance that a given event will happen

Source – Merriam Webster Dictionary.

Some nuances: – An important fact to keep in mind is that hazard by itself does not lead to risk with negative impact unless there is exposure at the same time to that hazard. Both hazard and exposure need to occur simultaneously for loss to happen. The magnitude of loss is dependant on the firm/location specific vulnerability.

 Frank Knight, Risk Uncertainty and Profit (1921).  The ISO 31000 (2009)/ISO Guide 73 (2002).

Risk

–

–

–

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Perception of risk is different at different levels of management, defined by the scope of their operations – what seems high at an instrument level will be different from when viewed at a portfolio level, where diversification comes into play. Risk management is everyone’s business, not just of those designated as such. That is because every business decision has a risk component. Each role and function has a responsibility and accountability in the overall risk management of the organization. The challenge and the success depend on spelling out of the clear boundary definition for each group. Risk is a combination of the probability of an event happening and its outcome/ result that could be negative, positive, or different from the expected.

Some of the terms appear to be similar or synonymous but a closer examination reveals the differences and these are fundamental to interpretation of the nuances of the subject and provides the required insights to appreciate the contours of risk. Each of the themes below have been the subject of a great amount of discussion, debate, research, and the resultant literature. Given that the objective here is to set a foundational understanding, the distinction has been presented in simple terms in Table 1.2 for this to be appreciated. Table 1.2: The principal distinction between common terms that are mistaken as synonyms. The Terms

The Distinction

Risk vs. Uncertainty “The concept of risk is distinct from uncertainty. The former relates to that which can be predicted, measured, or quantified whereas the latter relate to “unknown unknowns” and “known unknowables” where outcomes and probability distributions cannot be meaningfully defined.” The main point here is that risks can and should be measured while uncertainty cannot. Hazard vs. Risk

An important distinction is that while risk is a potential of downside (or upside), hazard is the possible source of loss. Another important difference is that while risk could lead to loss or gain, the outcome of hazard is always harmful.

Risk vs. Vulnerability

While risk is the possibility of loss (or gain in some cases) vulnerability is organization specific. Two organizations exposed to similar risk with potential downside and exposure may not suffer the same quantum of loss due to their differing vulnerability level.

Likelihood vs. Probability

Probability is associated with possible results; likelihood is associated with hypothesis. Probability is usually expressed as a numerical value – a proportion that ranges from  to  or as a percentage ranging from % to %. Likelihood, on the other hand, is typically expressed as a scale – low, medium, high, very high, etc.

 Sanjeev Sanyal, Principal Economic Adviser, Risk Vs Uncertainty: Supervision, Governance & Skinin-the-Game – Discussion Paper No. 1/2020-DEA Feb 2020.

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Chapter 1 An Overview of Risk and Risk Management in Banks

Innovation and opportunity go hand in hand with risk because optimizing the positive outcome of a risk taken is dependent on an intelligent approach to managing the context presented. This is where a well-structured risk management ecosystem comes into play.

Risk Management This part begins with two quotes from regulators’ documents that capture the essence of risk management in banks and financial institutions from a structure and process perspective: Financial institutions are in the business of risk management and hence are incentivised to develop sophisticated risk management systems. The basic components of a risk management system are identifying the risks the entity is exposed to, assessing their magnitude, monitoring them, controlling, or mitigating them using a variety of procedures, and setting aside capital for potential losses (including expected and unexpected losses).5 Risk management . . . encompasses the process of identifying risks to the bank, measuring exposures to those risks (where possible), ensuring that an effective capital planning and monitoring programme is in place . . . 6

The first one clearly states that financial institutions are “in the business of risk management” – that of taking risks and managing them. When confronted with risk that would impact their books (Balance Sheet and/or P&L Statements) organizations have, broadly, three options: – – –

Risk avoidance (a non-option for going concerns though definitely a situational option) Risk Transfer or risk hedging. Risk acceptance – of risks that fall within a clearly stated risk appetite with proactive and executable controls that will help mitigate the downside.

Every going concern has or is expected to put in place a robust risk management framework. The basis of a sound framework is its ability to take “controllable” risks which can be measured/quantified with assignable probabilities of potential upside and the significant downside. Risk management is simple in terms of its objective – managing risks an organization faces in a way that negative impact is minimized and positive impact is optimized. The word “optimized” is consciously used as opposed to “maximized,” as every opportunity has a cost, and it is the ability to achieve balance that ensures growth.

 Reserve Bank of India – Guidance note on management of Operational risk, https://m.rbi.org.in/up load/notification/pdfs/66813.pdf.  Basel committee on banking supervision, principles for sound management of Operational Risk (June 2011).

Risk Management

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Purpose of risk management is to provide input for businesses to make informed decisions. It does not exist in isolation – for its own sake – much like technology – it is a business enabler – a powerful one. The litmus test is its ability to create higher value for the organization. That is possible only through positive collaboration between risk managers and business leaders of the organization. At an abstract level, risk management fundamentals are fairly universal – as an example, Carnegie Mellon University’s Enterprise Risk Management framework7 is shown in Figure 1.1. The blocks and the flow, at the top level, are similar across industries and organizations. Where they start to differ is in detail which needs to be contextualized to the concerned industry – in our case the banking industry.

Risk Reporting & Monitoring

Risk Consciousness & Organizational Resiliency Risk Appetite

Process Improvement & Training

Risk Identification & Prioritization

Carnegie Mellon University Enterprise Risk Management Business Continuity Planning & Exercises Emergency Preparedness & Response

Risk Assessment & Analysis

Risk Treatment & Mitigation

Figure 1.1: Carnegie Mellon University’s Enterprise Risk Management framework. Source: Image provided courtesy of Carnegie Mellon University.

Simply put, risk management is the construct that enables organizations to identify, assess, and control risks that affect their capital and revenue. Risks could stem from multiple sources that are both financial and/or non-financial, internal or external, and natural disasters – the list is long. The ability to examine the link between risks taken and the impact they have on the strategic objectives of the organization is core

 Carnegie Mellon University Risk Operations – Enterprise Risk Management, Defining Enterprise Risk Management (ERM), https://www.cmu.edu/risk-operations/erm-framework/index.html.

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Chapter 1 An Overview of Risk and Risk Management in Banks

to the program. Like I said earlier, the objective of risk management is not to eliminate risks but to manage them in a way that they preserve and grow organizational value by enabling management to make informed decisions. Risk avoidance is not an option as it is part of and affects every action of the firm. It is much bigger than mere risk transfer and risk hedging. The successful firms have learnt or are learning to have the right balance between the upside and the downside realistically. Figure 1.2 captures the basic tenet of desirable and undesirable risks.

Desirable risk

Undesirable risk

Healthy upside

Sizeable downside

Limited manageable downside

Uncertain/ limited upside

Figure 1.2: Desirable versus undesirable risk.

The above is idealistic. The real-life situations lie somewhere in-between, and actions taken depend on the risk appetite, control systems, and potential size of the impact on the books of the bank. There needs to be a structured approach by design. The underlying canvas has multiple currents and cross currents, effect and counter effects, and interdependencies that are challenging. The effort is as much to manage negative risk (avoid, transfer, hedge, control, etc.) as it is to spot and leverage positive risks that add value or, on the other hand, affect the capital or P&L of the organization if not taken. Risk management is the function of making choices by the organization amongst the alternatives, based on their risk appetite, to pursue courses of action of measurable and controllable losses (or gain) in its pursuit of value. It is about prioritizing and acting based on reliable information to enable better decisions, thus ensuring sustainable growth. The three foundational aspects of the flow are: –

– –

Evaluation process: – To establish with reasonable certainty the potential of upside or downside – normally a logical and methodical activity. – Ensuring that the required controls are in place to counter or reduce the negative impact if risks are accepted. Decision Process: – Management decisions, based on the above, to accept or reject the risk Execution Process: – Execution of the decisions – Monitoring the outcomes and speedy course correction if and when required

Figure 1.3 captures the material components of the risk management process of a bank.

Risk Management

15

Risk Information System

Identification

Assessment

Monitoring &

Communication Channels

Likelihood &

Mitigation

Probability

Communication Channels

Risk Appetite & Acceptance if

Risk Tolerance Quantification

Aligned with

Impact – Exposure @

Corporate

Risk

Objectives Controls & Their Effectiveness

Risk Information System

Figure 1.3: Connected continuum of risk management processes.

The centerpiece to a good risk management flow is putting in place a robust risk information management system (RIMS) that communicates costs, risks, controls in place, and the benefits in a quick, simple, transparent, and relatable way. Accurate and timely availability of information is at the heart of an effective RIMS. A good RIMS is the oil that lubricates and ensures smooth operation of the risk function and is crucial to its success. The practical choice needs to be “appropriate technology” as opposed to “latest technology.” The appropriateness is determined by the size of the organization, their major and material risk categories, and the geographies of operations. In short, the internal and external realities of the organization. The challenge of risk management is to keep it simple and usable. While the program must consider the full range of risks it faces, it will make sense to keep “material” risks as the focus, as opposed to all risks. It is advisable to have an overall approach, governance, and business ethics-based ground rules as applicable across the spectrum. For the identified material risks, the entire gamut starting from risk appetite, identification, assessment, measurement, mitigation, and controls that are relevant to that risk category need to be clearly spelled out, communicated and tracked. The non-material risks can be managed through good governance and ground rules referred above.

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Chapter 1 An Overview of Risk and Risk Management in Banks

A mention needs to be made of the human aspect here – different individuals perceive the same risk differently, both in terms of understanding the risk concerned and its impact. Therein lies the creeping in of subjectivity. The judgement/decision of which risks to exploit or avoid is normally based on the risk manager and decision maker’s understanding of the organization’s ability to manage the risk in terms of the quality of information, resources, dexterity, nimbleness, controls, and speed of response. The other aspect that needs to be kept in perspective is the perception competitors hold of the risk and opportunity in question, as not all market participants react to the same risk in a similar way. Each player’s attempt will be to optimize the situation presented to the best advantage of the organization and therein lies the importance of a good risk management construct. While subjectivity can never be completely done away with (even in the AI, ML world – at least not while the machine is learning), it is important to create a referenceable, usable, accessible corporate memory on risk management. Well-defined, articulated, documented, and communicated organizational constructs are critical for effective risk management (a kind of detailed risk inventory) – that is created to reinforce corporate memory. However, a fundamental reality is that the quality and effectiveness will be as good as the people who are tasked with that function, hence building a positive risk management culture is at the core of a sound system. Positive risk culture, a well-documented umbrella approach, robust governance constructs, strong RIMS, and sound ground rules are critical because all risks may not give enough upfront warning, impacting organizations in multiple ways, from monetary costs to reputational challenges to extreme cases of closure. Unlike Brexit, where the different players planned for the eventuality, the recent pandemic and the Geopolitical spurts did not give enough turnaround time. There would be novel risks too, like the climate change risk and its impact on the financials of the organization. In such situations, it is the umbrella approach that provides the initial starting point while more context specific management approaches are worked out. The reason risk management constructs are challenging is that they not only need to look at the standard risk drivers but also evaluate the impact of factors like business model, strategy, growth plans, market/s that the firm operates in, etc., on those drivers. Risk models need to be cognizant of these factors and build in their impact as risk does not exist in a vacuum. As mentioned earlier in the chapter, the vulnerability to the same risk in the same market could be different for different organizations based on their internal factors including controls in place. Extreme events like war, terrorism, climate change (the focus of this book) affect all organizations. What differs is the degree of impact.

Risk Management

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From a standards and frameworks perspective, ISO 310008 and COSO9 frameworks for enterprise risk management are good references. A good summary of the weaknesses that need to be taken care of while designing a risk management system has been nicely summarized by Paul Hopkins as follows: Failure to adequately manage the risks faced by an organization can be caused by inadequate risk recognition, insufficient analysis of significant risks and failure to identify suitable risk response activities, failure to set a risk management strategy and to communicate that strategy and the associated responsibilities may result in inadequate management of risks. Risk management procedures or protocols may be flawed, such that these protocols may actually be incapable of delivering the required outcomes.10

Success factors of risk management – the big-ticket items – include: – – – – – –

Dynamic, well-articulated risk appetite and risk tolerance framework Clearly documented, communicated, and actively followed policies and procedures Positive risk management culture Effective, relevant, flexible, and tested technology – Risk Information Management System (RIMS) Efficient and transparent governance framework Constructive collaboration between the risk management team and business team while maintaining the independence of each

At the end of the day, the measure of a good risk management construct is the ability it provides the decision makers to decide which risks to sidestep, which to passthrough, and which to take on for value creation. Progressive organizations have this as an important evaluation criterion of their risk managers. In the ultimate analysis, some risk will be passed through to the investors, some will be hedged or insured, and some actively pursued. The wisdom is really in making the right choices at the right time.

 ISO 31000: 2018 – Risk management, Guidelines, https://www.iso.org/obp/ui/#iso:std:iso:31000: ed-2:v1:en.  COSO Enterprise Risk Management Integrating with Strategy and Performance Executive Summary, https://www.coso.org/Documents/2017-COSO-ERM-Integrating-with-Strategy-and-Performance-Execu tive-Summary.pdf.  Paul Hopkin, Fundamentals of Risk Management 4th Edition – Understanding, evaluating and implementing effective risk Management. Institute of Risk Management, Kogan Page (2017).

Chapter 2 The Different Flavors of Risk that Banks Work With If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky business. –Gary Cohn

The fabric of risk is woven together with multiple threads in complex patterns, some by design and others by default or accident. Oftentimes, there is also the ignorance or plain carelessness of the weavers (stakeholders), either internal or external. For understanding purposes, it is good to look at the different risks, the major ones, in slightly more detail. This chapter will focus on five major categories of risk that have direct bearing on the financial impact of climate change risks on banks. Each of the major risk categories mentioned in this chapter has an extensive amount of literature focused on every detail of the subject, both from an academic perspective as well as application oriented. The objective of this chapter is to provide a bird’s eye view of the different risk categories, with the intention to explore the interlinks with and impact on climate change risk in later chapters. Figure 2.1 lists the Risk Categories at the top level as a start point. It is important to mention, however, that there is nothing like “non-financial risk” in the long run as all risk categories will have financial implications, either on the balance sheet or the profit and loss statement of the organization sooner or later. The only major differences are the timing, when the organization will take a hit (if not controlled), and whether the impact can be measured upfront, reasonably and objectively. Nonfinancial risks are more difficult to measure. Figure 2.2 looks at risk classification at slightly more detail, giving examples of financial and non-financial risks.

Financial risks

The risks that arise from its financial intermediation operations. By their nature, these risks are quantifiable like credit, market, and liquidity

Non –financial risks

The risks that arise from its operations, Internal factors, strategies, and other risks not bracketed as financial risks

Risk categories

Figure 2.1: Risk categories. https://doi.org/10.1515/9783110757958-003

Chapter 2 The Different Flavors of Risk that Banks Work With

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Risk types

Financial

Non-financial

Others …

Operational

Strategic

Reputational

People & processes related

Technology related

Liquidity & Credit risks

Market risks

interest rate risks

Customers related

Figure 2.2: Major risk types banks work with.

Another view of segmenting risks of the bank is provided by regulators who are concerned with the capital adequacy and relative buffers that the organization should keep to cover its risk profile. This view is captured in Figure 2.3. The classification seems to be largely centered on two aspects – the measurability and the potential of hit on capital. For Pillar 1 components, regulators articulate capital to be set aside, their quantification methods, and algorithms. This set is seen as more “objective,” more “measurable,” more “predictable,” and having a higher impact on capital. Pillar 2 risks, on the other hand, are more difficult to “quantify” from a capital perspective. The assessment of adequacy of capital to cover these risks are left to the individual banks, subject to the overall guidance and supervision of regulators.

Capital management view of risks (per regulators) Pillar 1 Risks Credit Market Operational (Minimum regulatory capital to align with potential economic loss.)

Figure 2.3: Pillar 1 and Pillar 2 risks.

Pillar 2 Risks (Internal Capital Adequacy Assessment Process – ICAAP) Liquidity, Concentration, Reputational, Strategic, Legal and other Material risks (To gauge additional capital that might be required to cover all material risks that banks carry)

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Chapter 2 The Different Flavors of Risk that Banks Work With

It is interesting to note that operational risk is classified under the Pillar 1 category for capital adequacy purposes, but under non-financial risks from a typical risk categories classification. In the case of liquidity risk the reverse is true – Pillar 2 for capital adequacy and financial risk from a traditional perspective. The real insight is that while classifications are based on the objective, all risks at the root will impact banks, if not managed well. Figure 2.4 captures a slightly different view1 of risks, highlighting the operational risk sub-types in some detail.

Analytical and Policy Risk IT Systems Risk

Human Resources Risk

Operational Control Risk

Bank Operational Risk

Project Risk

Business Disruption Risk

Bank Analytical & Policy Risk

Liquidity Risk

Bank Financial Risk

Compliance and Business Practice Risk

Credit Risk

Market Risk

Security Risk

Legal Risk

Figure 2.4: The different contours of operational risk. Risk categorisation Model

Financial risks have been the focus of banks for decades in a regulated world and for centuries as part of businesses. The big blocks here are credit risk (the possibility that borrowers and counterparties may not honor agreed terms), market risk (the possibility that value of market instruments they hold will fluctuate adversely), and liquidity risk (potential inability of the bank to meet its maturing obligations to its depositors and counterparties). It is the non-financial risk categories (NFR) that are adding to the ever-expanding canvas of the risk universe. As this book goes into publication, the landscape of NFR is captured in Figure 2.5 with each of the categories having multiple sub-types and constantly evolving. The reason why NFR is a critical area, be it ongoing compliance failures,

 BIS, Chapter 8, Management of Non-Financial Risks, https://www.bis.org/publ/othp04_8.pdf.

Credit Risk

21

operational challenges or the more recent pandemic related or the upcoming climate change/ESG risks, is that they often have only downside if not managed well and the downside will be substantial. It is not just about the financial loss through fines and compensations, etc., but also the collateral damage of reputation loss, not to mention personal consequences for senior role holders. The interlinks between risk categories and each impacting the other is a given, but in NFRs these are more pronounced. What is of concern, in recent times, is the acceleration of intertwining of financial and non-financial risk, with a negative multiplier effect.

Traditional

Strategic risks Reputation risk Operational risks: people, processes, IT, etc., related Legal risk Compliance risk Conduct risk Model risk

More recent areas

Pandemic, natural disasters Climate change/ESG risks Digital disruption Cyber risk Third party risk Data breaches/privacy Others…

Non-financial risks

Figure 2.5: Representative non-financial risks.

Having set the broader canvas of risk categories and risk types, we now move to take a quick and high-level view of the material risks that banks carry in their books, especially the ones that have significant interlinks with climate change risks.

Credit Risk This is the biggest category of risks on the bank’s books. It is the potential that the bank’s borrower or counter party defaults on honoring agreed terms of repayment: “Credit risk or default risk involves inability or unwillingness of a customer or counter party to meet commitments in relation to lending, trading, hedging, settlement and other financial transactions.”2 As financial intermediaries, banks accept deposits and lend, with lending, usually, being the biggest chunk of their balance sheet

 Reserve Bank of India, Risk Management Systems in Banks, https://rbidocs.rbi.org.in/rdocs/notifica tion/PDFs/9492.pdf.

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Chapter 2 The Different Flavors of Risk that Banks Work With

and as such one of its big concerns. While capital and its buffers support to some extent in occasional cases of losses (defaults), they cannot be a substitute to well managed credit risk. The risk of non-recovery of funds (both principal and interest) in a timely fashion due to the default of its customers or counter parties will severely impair the ability to honor its obligations, a situation a bank cannot afford. Having been a banker myself, I remember during our initial training days having it ingrained into us that the worst nightmare a bank can have is a “run” on it. A run on the bank happens when depositors lose confidence on the bank and want to withdraw “everything” they hold with the bank. This could happen due to a combination of uncontrollable credit risk and insufficiency of immediate liquidity (liquidity risk). Inadequate or faulty processes (operational risk) could add to the milieu, as witnessed during the 2007–08 financial crisis. The real capital banks hold is the trust of their customers. An unmanaged credit risk may lead to losing that trust, which is why it is one of the most important risks to be managed well. Credit risk exists both at portfolio level and at individual borrower level, not to mention interbank transactions, trade financing, and derivatives. It can come in various shapes, the most common being default risk. The other forms can be concentration risk, downgrade risk, and the like. Some happen across their on-balance sheet businesses like mortgages, credit cards, term loans, and securities under their investment portfolio while others happen across their off-balance sheet businesses like guarantees, derivatives, etc. Some add country risk into the mix, while some bracket it under market risk, though most prefer to look at it as a separate risk category altogether.

Market Risk “Market risk is defined as the risk of losses arising from movements in market prices. The risks subject to market risk capital requirements include but are not limited to – Default risk, interest rate risk, credit spread risk, equity risk, foreign exchange (FX) risk and commodities risk for trading book instruments; and – FX risk and commodities risk for banking book instruments.”3 All market participants face market risk, a systematic risk that cannot be eliminated through diversification, and hence all of them look for optimal hedging mechanisms. Essentially, market risk is the risk caused by changes in markets that it operates in and is a measure of the various factors affecting the performance of financial markets they operate in. The risk stems from adverse movement of prices of financial instruments. This can come from adverse directional change of stock prices, commodity prices, interest rates, exchange rates or non-directional change in the form of volatility

 Definitions and application of market risk, BCBS MAR 11 (version effective January 1, 2023).

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23

risks. The sub-types of market risk that confront banks are, largely, equity risk, commodity risk, forex risk, and interest rate risk. An interesting trivia on interest rate is that “for over 300 years, the official interest rate has been positive (more than zero). The earliest rate we have on record was 6% in 1694. Since then, the official interest rate has ranged from 17% (in November 1979) to 0.1% (in March 2020).”4 This range from 17% to 0.1% gives a glimpse into the volatility and impact the periodic changes will have on the portfolio of a bank. This is data from one regulator; multiply it by the many regulators and their stance on interest rates, some of whom have implemented negative interest rates at points in time (e.g., Japan, Denmark, Sweden, Switzerland, etc.). Market risk a global bank is exposed to, as it operates under multiple interest rate scenarios across multiple geographies simultaneously, can well be appreciated. The interest rate is only one of the factors: add to it the volatility of the other factors like forex rates, commodity prices, and equity prices, all constantly in a state of flux both within a given market and across markets. The resultant is the canvas of many moving parts, a kaleidoscope with images changing by the minute, that banks need to deal to manage their market risk. This explains why it is a highly sophisticated area both from the information systems and technology as well as the people that support the function.

Liquidity Risk This is the risk associated with the bank’s inability to meet its obligations, in a timely manner, at viable cost, which it is forced to do through distress borrowing at high costs. Liquidity is the bloodline of a bank – it enables asset growth and meeting of obligations, both cash and collateral, at acceptable costs. The risk typically arises because of funding long term assets with short term liabilities, from a maturity mismatch between its assets and liability profile with over reliance on short term sources of funds. It stems from illiquid assets in the bank’s books too. The two components of liquidity risk are funding liquidity risk and market liquidity risk: “Funding liquidity risk is the risk that a firm will not be able to meet its current and future cash flow and collateral needs, both expected and unexpected, without materially affecting its daily operations or overall financial condition.”5

 Bank of England, Knowledge Bank, https://www.bankofengland.co.uk/knowledgebank/what-are-neg ative-interest–rates.  Federal Reserve Bank of San Francisco FRBSF Economic Letter, 2008–33, October 24, 2008, https:// www.frbsf.org/wp-content/uploads/sites/4/el2008-33.pdf.

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Chapter 2 The Different Flavors of Risk that Banks Work With

“Market liquidity risk relates to the inability of trading at a fair price with immediacy. It is the systematic, non-diversifiable component of liquidity risk.”6 Insufficient buyers against sell orders and insufficient sellers against buy orders exacerbate the situation in a liquidity challenged position. Central bank liquidity is an important factor in providing sufficient liquidity to balance the demand and supply. There is constant flow across funding liquidity, market liquidity, and central bank liquidity.

Operational Risk “Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk but excludes strategic and reputational risks.”7 While losses from any risk category can be high, operational risk losses can be catastrophic both financially as well as reputationally. The combined impact on business is, to say the least, very high. These are the risks that emanate from “how” day to day operations are conducted, as opposed to “what” businesses a firm is focused on (which are covered by financial risks like credit, market, and liquidity risks). Most of the risk drivers under this category are specific to a given organization and its operating model, hence “unsystematic” to a large extent, except events like natural disasters and acts of terrorism which are external in nature. Every organization faces operational risks triggered by both internal and external factors that could be due to mistakes (willful or otherwise), breaches of policies and procedures, work disruptions, or damages. Examples of internal causes can be through their people, processes, technology, etc. The external causes can be natural disasters, terrorist activities, third party partners, etc. Internal and external frauds, litigations and legal risks due to faulty processes, damage to assets due to disasters, and business disruptions due to system failures are some other examples.

Reputational Risk Reputational risk is the threat of negative perception or actual hit on the reputation and standing of an organization, either directly through the actions of the organization and/or its employees or indirectly through connected parties. Brand value is indicative of the reputation an organization enjoys. While reputation risk can stem

 Kleopatra Nikolaou, Liquidity (Risk) Concepts, Definitions and Interactions European Central Bank – Working Paper Series – NO 1008/February 2009.  BCBS 195, Principles for the Sound Management of Operational Risk (June 2011).

Interpretation Risk

25

from actual actions of the bank, at times it could happen due to negative publicity (true or otherwise) or employee fraud that they have perpetuated, taking advantage of loopholes in processes or lax governance structures. While the actual act in the latter case falls within operational risk realm, the perception of dishonesty impacts the credibility of the organization and therefore its reputation. This could result in the bank’s inability to raise capital or borrowings on favorable terms, a simple illustration of how the apparently different risk categories are intrinsically interconnected.

Interpretation Risk A special mention needs to be made of an important but less spoken of risk, which I call, “the Interpretation risk.” This “is the risk of likely differing interpretations of ambiguous, untested or elaborate laws, regulations and standards.”8 While this is extremely relevant in the compliance risk space, it is equally or perhaps more relevant in climate change risk space as this area has a double challenge in terms of there being multiple elaborate standards, disclosure requirements, policy guidelines, etc. on the one hand and the subject itself being new and evolving on the other. When I first used the term, “Interpretational Risk,” in the context of compliance risk, my banker friends said this perhaps is the biggest category risk they face because a lot of material is subject to interpretation. This is equally or more relevant in the climate change risk space, and therein lies the need for global standards which will be discussed across the book but more specifically in Parts three and five. In summary, banks face risks that go beyond their customer portfolios (deposits and loans) and beyond rising or falling markets. As we move forward, data breaches, pandemic risk, climate change risk and its financial impact on the organization, and geopolitical risks will add to the milieu of risks. A reality check is that no matter how vigilant the risk management function of a bank is, it is not possible to foresee or plan for every contingency. It is here that scenarios and stress designing help, where bankers try and visualize black swan events. Even then, the expectation that they can foresee every situation is remote, as it is outside of their experience or visualization capability. It is for this reason that a sound governance construct and fundamental risk management principles and processes need to form the bedrock of the enterprise risk management constructs of the bank, so they form the first level safety net. Events/situations that have the potential of disrupting business, either exploding on the horizon suddenly or stealthily coming in, will happen periodically. These, while arising in one risk type, will also impact other risk types. The more risk types that get impacted, the higher the magnitude of loss for a given bank. If this situation

 Saloni P. Ramakrishna, Enterprise Compliance Risk Management – An Essential Toolkit for Banks and Financial Services (2015), Wiley.

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Chapter 2 The Different Flavors of Risk that Banks Work With

of multiple risk types simultaneously impacted affects multiple banks and market players at the same time, it will lead to a contagion effect, a condition both banks and regulators dread as the consequences of such a state would be dire. It is for this reason that the understanding of not just the individual risk types but also their interlinks is required for efficient risk management. The interlinks of the risk categories and types mentioned in this chapter with climate change risk will be discussed in Part 4 of the book, which is focused on the multilayered interlinked climate related financial risks.

Part 2: The What, Why and Who of Climate Change Risks

Practitioner’s Note Climate Change Risk and Bank Lending Moorad Choudhry

Climate change, left unchecked, will lead to irreversible harm for generations to come. . . . If the previous decade was marked by a “call to action,” then this coming decade must answer it. . . . . And the financial sector should be instrumental in driving that change. –Sarah Breeden, Executive Director, Supervision, Bank of England, July 2020

As was noted at the “COP27” summit in November 2022, irrespective of the industry one is concerned with, there is no doubt that the impact of climate change, in actuality and in potentiality, is being felt strongly. And although the banking sector per se does not generate significant climate change-related output, unlike (say) the hydrocarbons, farming, energy or construction industries, the fact that banks finance businesses in these areas means that they will be, as Ms Breeden suggested, at the forefront of change. That the planet is experiencing climate change is, whilst not acknowledged universally, borne out by any number of relevant statistics. For example, – The 2010s was the hottest decade since records began in 1880 – 2020 tied with 2016 as the warmest year ever recorded – The last seven years have been the seven hottest in terms of global average temperatures – January 2020 was the warmest January on record (Source: NASA, McKinsey) What does the urgency on action to stem the pace of climate change mean for banks? As Ms. Saloni Ramakrishna cogently articulates in Part 2 of the book, it is important for banks to understand and act on climate change risks as there would be implications for banks’ strategy and lending policy, amongst others. The possibility that regulatory requirements governing bank lending may be changed to incentivise behaviors is very much on the anvil. Up to now, guidance from regulatory authorities has focused, essentially, on balance sheet management issues, and the impact on banks’ loan portfolios of the physical risks and transition risks associated with climate change. For example, one of the earliest pieces of supervisory ruling was the UK PRA’s SS3/19. This requires UK banks to implement policies addressing their approach to managing the balance sheet impact of climate change, and to incorporate this into their risk management frameworks. In fact, climate change risks, as Ms. Saloni Ramakrishna lays out coherently across the book, are multi-layered, interconnected and manifest through traditional risk types of banks as well as have capital implications, which is why it would be perfectly sensible for a bank to consider the impact on all its existing risks, and manage this accordingly, even without regulator expectation. https://doi.org/10.1515/9783110757958-004

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Part 2: The What, Why and Who of Climate Change Risks

Table P.1 shows those areas of existing bank risk types that may be affected by the physical and transition risks of climate change; addressing these would simply be good risk management practice. Table P.1: Climate-change related impact on banking risk types. Risk Register

Physical Risk

Transition Risk

Credit

Collateral value depreciation, uninsurable collateral; Customer business viability; Customer loss of income

Adaptation costs too high to bear; Competition from new/disruptive businesses

Market

Market shocks and liquidity crises in response to a specific climate catastrophe; Repricing for new information causing disruption

Changes in policies impact unexpected repricing; Higher volatility in specific asset categories, sectors, specific names or regions.

Operational

Disruption to operations and the supply chain; damage to firm’s own property assets; property assets uninsurable; Increased cost base (insurance, energy, etc.)

Supply chain disruption and rd-party risk; Higher operational risk costs

Liquidity Money markets funding shock due to and Funding catastrophe event

Reduction in funding sources to firms lacking or seen to lack strong “ESG” image

Reputational Poor disclosure of material risks

Negative image or guilt by association; not delivering on stated ESG and climate risk related goals

Strategic

SMCR liability; Losses from physical impacts leading to material capital loss

Business model obsolescence due to change in consumer behaviour and/or societal preferences

Legal

Foreseeable, material risks not disclosed

Legal challenge and court cases charged with contributing to climate change; Inability to adapt to new laws in sufficient time

Conduct

Conflicts of interest arising due to different types of customers and perceived best interests of the bank

Presenting misleading or false information on climate risk related issues; incentive scheme for “green” products leading to negative unintended consequences

Regulatory

Inadequate or inaccurate climate risk disclosures on past or current actions and events

P Capital add-on due to non-compliance or inadequacy of compliance; Fines due to non-compliance

Practitioner’s Note Climate Change Risk and Bank Lending

31

Whilst regulatory guidance in a number of jurisdictions implies, to a certain extent, that the climate-related policies of a bank’s corporate customers should be taken into account, there is no explicit requirement to adjust lending policy to reflect the fact that some sectors contribute more to climate change than others. It is reasonably straightforward (using statistics published by UN agencies) to identify those sectors that generate the greatest carbon output. The burning of fossil fuels (coal, petroleum, natural gas) creates the greatest such output; beyond that the evidence points to industrial processes such as cement production, transportation and land use for agriculture being in the “top three.” Hence, a bank that was lending into these sectors may consider to what extent it continues to do so in the long term; should it, for example, insist that customers produce detailed plans demonstrating their commitment to net zero by 2030? At present, there is still leeway for banks to lend to whoever they wish, provided they are able to manage the result risk in line with regulatory requirements. From bank capital perspective, whoever one lends to, the capital requirement associated with a loan follows international standardized guidance, and is based on a customer’s credit rating. (Put simply, the “risk weighting” applied to a loan, which drives its regulatory capital requirement, ranges from 0% to 100%, or exceptionally 150%, based on the borrower’s credit quality. The absolute minimum capital ratio for any bank is 10.5%. For a loan of £100m therefore, risk weighted at 100%, the capital required would be £100 x 1.0 x 0.105 = £10.5m.) But this requirement may be about to change. In August 2022, the EU Parliament put forward a proposed change to bank capital regulation, in Draft Report PE731.818v01-00, that suggested new risk weights for certain types of lending. On page 164, the report states: 3. Exposures related to existing fossil fuel resources, as referred to in paragraph 1 of this Article, shall be assigned a risk weight of 150% 4. Exposures related to new fossil fuel resources, as referred to in paragraph 2 of this Article, shall be assigned a risk weight of 1250%

The “justification,” stated on the same page is, . . . it would be appropriate to propose that a bank that continues to finance fossil fuels should bear the full risk. This is not to prohibit its financing, but rather to ensure that when a bank makes a new investment in fossil fuels, the cost of capital reflects the risks those energies represent for both climate and financial stability. If adopted into EU law, this would remove the core principle of international regulatory guidance that states credit risk capital is a function of the credit risk of the borrower. Instead, irrespective of the customer credit quality, lending to this specific sector would become prohibitively expensive for a bank. Taking the simple example from above, the capital required for a £100m loan to a new customer in the “fossil fuels” sector would rise from £10.5m to £131.25m.

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Part 2: The What, Why and Who of Climate Change Risks

Clearly, this will stop EU-domiciled banks from lending to this particular customer franchise. This may have a beneficial effect on global climate change. But the question is, would it? Limiting this change to EU banks only would simply drive customers to borrow from non-EU banks. We should also expect that lending from the non-bank sector would take up some slack. It appears that the ECB and the EBA realise this. In a “The Supervision Blog” post on November 4, 2022, both bodies noted, We are very concerned that in the ongoing legislative discussions in the EU Council and the European Parliament on the EU banking package, numerous calls have been made to deviate from the international standards. . . . At stake here are the reputation, the competitiveness and, ultimately, the funding costs of the EU banking sector.

Climate change is a global phenomenon, and action to mitigate its deleterious effects will only have value if undertaken globally. Measures that seek to limit climate change that are focused on one part of the globe may actually have negative unintended consequences. Ideally a standardized approach to bank lending into the hydrocarbons sectors would be adopted worldwide, with hopefully beneficial results. For now, we’ll need to wait and see what happens with this particular piece of proposed EU legislation. Prof Moorad Choudhry

Professor Moorad Choudhry, a celebrated author, is a non-executive director at Recognise Bank Limited in London, a non-executive director at the Loughborough Building Society and a non-executive director at Wandle Housing Association. He is Honorary Professor at University of Kent Business School. He was a Treasurer, Corporate Banking Division at The Royal Bank of Scotland. He began his career at the London Stock Exchange. Moorad is a Fellow of the Chartered Institute for Securities & Investment, a Fellow of the London Institute of Banking and Finance, a Fellow of the Global Association of Risk Professionals, a Fellow of the Institute of Directors and a Freeman of The Worshipful Company of International Bankers.

Chapter Abstracts

33

Section Abstract Objective – to introduce the reader to the climate change landscape as relevant to banks. This section sets out the core of climate-related financial risks for banks. It looks at impact of adverse climate changes, its primary risk drivers, transition paths, transmission channels, amplifiers and related issues. While acknowledging the challenges banks face in this space, it creates a compelling case as to why it is important and relevant and why it makes immense business sense to understand as well as act quickly on the climate change risk initiatives. It goes on to present the different players in the space.

Chapter Abstracts Chapter 3 introduces the fundamentals of Environmental, Social and Governance (ESG) themes and climate change from a banker’s lens. ESG, at the top level, is a vast subject. It impacts every business and every individual in multiple ways. The objective here is to get a bird’s eye view of ESG concepts, understand climate as a nested idea in the “Environment” part of ESG and at the same time know that neither “E” nor “C “ are discrete standalone concepts but impact and are impacted by each other as well as with the social and governance aspects of ESG. The intent is to bring in an appreciation of these fundamentals as relevant to the banking sector. Chapter 4 explores climate-related financial risks that banks are exposed to and the need for them to appreciate the nuances of the subject to be able to manage it. The undisputable fact is that climate change is a financial risk and needs to be managed as such. The themes explored here are the risk drivers, transmission channels, and amplifiers that are material to understanding the contours of climate change risk. Chapter 5 focuses on the importance of why understanding, assimilating, strategizing, and acting on the potential of negative financial impact of adverse climate change is critical for banks. It is not just because of the increased, intensive, and intrusive attention of regulators and policy makers. The fact that it is no longer a mere rhetorical exercise, but an existential one is fast dawning on the industry. Banks will be most impacted by climate change and so will the other participants of the financial services industry – insurers and asset managers – though in diverse ways due to their differing types of businesses. Chapter 6 brings to fore the multiple threads of challenges that banks face as they embark on the climate change risk management journey. Challenges are both on the conceptual side as well as on the operational side. On the conceptual side, standardi-

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Part 2: The What, Why and Who of Climate Change Risks

zation across the spectrum, starting from taxonomy all the way to disclosure requirements is very much a work in progress. On the operational side, the Basel Committee on Banking Supervision (BCBS), in its document d502, April 2020, points to some of the important operational challenges in assessing climate-related financial risks such as data availability, methodological challenges, and difficulties in mapping of transmission channels – topics explored in this chapter. Chapter 7 briefly looks at the important stakeholders in the climate change space as relevant to banks. There are multiple stakeholders that affect and get affected by climate change. Stakeholders cover the entire ecosystem – spanning governments/policy makers, regulators, financial service industry participants, global associations, corporates, rating agencies, data providers, research teams, individuals, and householders et al. All of these will collectively shape the climate change risk narrative, its direction and pace.

Chapter 3 ESG and Climate Change as Relevant for Banks The most difficult thing is the decision to act, the rest is merely tenacity. Amelia Earhart

“ESG factors are environmental, social or governance matters that may have a positive or negative impact on the financial performance or solvency of an entity, sovereign or individual.”1

Environmental

ESG

Social

Governance

• Climate Change • Natural Resources Management • Environmental Impact

• Workforce & Human Capital • Suppliers and Customers • Society & Communities

• Board Quality • Management Incentives • Stakeholder rights

Figure 3.1: High level representation of ESG.

Environmental, social, and governance concepts, herein after referred as ESG, paint a huge canvas, encompassing multiple themes and multiple stakeholders (Figure 3.1). Simply put, it impacts every business and every individual in a myriad of ways and hence it is a subject of concern for all. ESG and economic health were always linked, influencing each other, but never were they highlighted so strongly or visibly and with such resolve. Depletion of natural capital through climate change is a reality – it

 EBA Report, On Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, EBA/REP/2021/18. https://doi.org/10.1515/9783110757958-005

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Chapter 3 ESG and Climate Change as Relevant for Banks

always has been – what has changed now is the urgency. The reason for this urgency is the stark reality of the potentially huge negative impacts. It is important to understand that ESG cannot be understood or treated as three discreet themes. They are deeply interwoven, with each impacting the other both positively and negatively. Whatever the cause, the result will translate into negative economic and human impact. The following data point highlights the size of the problem: “Globally, the past six years are the warmest six on record, and 2020 was the warmest in Europe. The number of disasters caused by natural hazards are rising, resulting in $210 billion of damages in 2020.”2 This is one sample data point amongst a multitude of others that unequivocally highlight global warming. Sustainability, as a subject of active discussion, started from 2010, though the term itself was around since 2005. It was the 2015 Paris climate protection agreement with 195 countries/territories as signatories which brought the subject to greater attention. The 2015 Paris agreement needs a mention as the point of inflection – the outcome (amongst others) was three broad themes and goals: – – –

To keep global temperatures below 2 degrees Celsius (above preindustrial levels) while striving to go down to 1.5 degrees Celsius To strengthen the ability of countries to adapt to climate change while developing low greenhouse gas emission capability, both through newer technologies as well as their adaptation To make finance flows consistent with the above objectives – banks have a direct role to play here

Regulators, policymakers, and global organizations have created a laser focus on initiatives required for addressing the subject of ESG since then. The ESG principles are also intricately connected to the 2030 sustainable development goals (SDG) of the United Nations. The three themes of ESG are so intertwined that it will not be possible to classify any issue only as E, S or G – they would, however, originate from or impact one aspect principally, and then spread/impact the other two, which is why ESG is multi-layered with interwoven intricacies. For understanding purposes, the three components of ESG can be separately explained, but the three themes are nested in one another. An appreciation of these themes both individually as well as in relation to one another will be critical. This is true for banks along with other economic vehicles like insurance firms, capital markets, investors, etc.

 Climate change and central banking. Keynote speech by Ms Christine Lagarde, President of the European Central Bank, at the ILF conference on Green Banking and Green Central Banking, Frankfurt am Main, January 25, 2021.

Environmental Aspect

37

Environmental Aspect

Climate Change

E Environmental

• Carbon emissions • Extreme weather patterns • Transition arcs

Natural Resources Management

Environmental Impact

• Biodiversity • Water management • Deforestation

• Energy use and conservation • Air quality • Waste management

Figure 3.2: Environmental concepts.

This theme (Figure 3.2) focuses on contribution, by businesses, to climate change through greenhouse gas emission, energy efficiency, and waste managed/discharged. The resources are drawn from the environment and its consequences. Environmental consideration covers broadly adverse climate change, pollution, negative impact on biodiversity, over or misuse of resources both living (human, animals, sea life, plants, etc.) and natural (water, air, and land). It is about conservation (or the opposite) of nature and the ecosystem. S & P Global rightly points out that, “The “E” takes into account a company’s utilization of natural resources and the effect of their operations on the environment, both in their direct operations and across their supply chains. Companies that neglect to consider the effects of their policies and practices on the environment may be exposed to higher levels of financial risk. Climate change adds an extra layer of environmental risk.”3

 Understanding the “E” in ESG, S&P global, 23 Oct 2019, https://www.spglobal.com/en/research-in sights/articles/understanding-the-e-in-esg

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Chapter 3 ESG and Climate Change as Relevant for Banks

Social Aspect

Workplace

S Social

• Diversity & Inclusion • Pay parity • Workers’ rights & working conditions

Suppliers and Customers

Societies & Communities

• Data privacy & security • Fair pricing & dealing • Customer rights

• Human rights • Community relations • Health & Safety

Figure 3.3: Social concepts.

This theme (Figure 3.3) focuses on quality of relationships fostered between various stake holders (employees, customers, third parties’ suppliers/consumers/partners), both at community level (human rights violation, discrimination, etc.) and employee/ individual level (health and safety issues, child labor, various hues of discrimination/ harassment, etc.) as well as welfare related issues. It is a social license where businesses work in alignment with local communities. This is about the welfare and wellbeing of people and their relationships.

Governance Aspect This theme (Figure 3.4) focuses on practices, guiding principles, and good governance constructs that business is expected to adopt. Corporate governance across all operations covers arresting of fraud, money laundering, unfair practices, bribery, corruption, misleading communication, etc. A good and clear governance construct will help balance the interests of various stakeholders including the ecosystem businesses operate in. The focus under this theme is about following standards and business ethics

Climate Change

Board Quality

G Governance

• Board independence • Diverse skills and background • Board effectiveness

Management Incentives

Stakeholder Rights

39

• Pay & performance alignment • Accountability & transparency • Business ethics

• Accessibility to information • Accountability to stakeholders • Stakeholders’ ability to question and act

Figure 3.4: Governance concepts.

across the spectrum of stake holders. Good governance makes good business sense. Responsible business governance, risk reduction, and value creation are all connected. Banks are aware that good governance and management policies result in an increase of shareholder trust, customer confidence, and brand value. The risks that these three themes could cause are referred to as ESG risks, which could strongly affect banks’ books (balance sheet, P & L) as well as their liquidity: “ESG risks are the risks of any negative financial impact on the institution stemming from the current or prospective impacts of ESG factors on its counterparties or invested assets.”4 ESG risks can, therefore, be understood as the negative materialization of ESG factors through counterparties and assets as well as banks’ own operations.

Climate Change Climate change “C” sits nested in the E of ESG broadly speaking. The key issue under climate change is that environment is its core. Climate change, while more pronounced under the “E” part, is in many ways the central pillar of ESG. However, an important  EBA Report on Management and Supervision of ESG risks for Credit Institutions and Investment Firms, EBA/REP/2021/18.

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Chapter 3 ESG and Climate Change as Relevant for Banks

caveat is that ESG is not synonymous with climate change – they are deeply interconnected but not the same, more so for banks, as climate events can impact both the physical assets as well as the repayment capacity of counter-parties, thus impacting their recovery efforts. Climate change is understood as referring to long term shifts in climatic patterns, be it temperature, rainfall, or the like. Most times these were natural phenomenon through changes in solar cycle. But more recently (from 1800), human activities have been the main drivers of climate change,5 to the detriment of the environment and all within its envelope through an increase in greenhouse gas emissions. What have banks got to do with greenhouse gases? They could be financing organizations that contribute to the increase in greenhouse gas emissions. They lubricate the wheels of businesses through the financing they provide. The financial risk banks therefore face, either directly through their exposure or the exposure of their clients, is huge, as can be imagined. The notion that the impacts of climate change are only long term has been summarily shattered and replaced with an uncertain time horizon, starting from immediate to exceptionally long term. Risks Report 2022 of WEF, summarizing the risk perception, highlights that “Extreme weather” and “climate action failure” are among the top five short term risks to the world, but the five most menacing long-term threats are all environmental. “Climate action failure,” “extreme weather” and “biodiversity loss” also rank as the three most potentially severe risks for the next decade.”6 The idea that climate change related risks are long term risks, is not real. They occur across all terms – immediate, short, medium, and long term. In addition, the affect will be felt across different risk categories simultaneously and that is the crux of the problem. The bank’s exposure to the uncertainties as well as their influence on the possible outcomes is immense. Conversation here is the relevance, applicability, and influence of adverse climate change on financial services, particularly banks. Mitigating negative effects of climate change is an economic concern in addition to its being an environmental one as it exposes both the bank and its customers to the entire risk spectrum – both financial and non-financial. A conscious effort towards reducing factors that impact climate change adversely could take the form of net zero commitment and delivering that commitment of reducing emissions both by itself as well as its customers, suppliers, partners, etc., a stupendous task to say the least. Many banks have committed to “net zero” goals both for their own operations and for the businesses they finance. Net zero targets mean that there will be a balance between the quantum of greenhouse gas emissions generated and those removed from the ecosystem.

 Climate change widespread, rapid, and intensifying, IPCC, August 9, 2021.  World Economic Forum, The Global Risks Report 2022, 17th Edition, Insight Report.

Climate Change

41

When banks say they will be net zero by 2030 for their operations, they need to put in place a carbon offsetting strategy. Contribution to sustainability initiatives by finding eco-friendly solutions and saving of depleting natural resources like energy water, etc., will be tracked and measured through reduction in carbon/GHG emissions, better energy/fuel management, reduction in consumption of natural resources, compliance with regulations through disclosures, and regulatory reporting. That climate change and bank’s response to it will impact all facets of its own operations and policies is a given. It is also acknowledged that they have a crucial role in proactively aligning their strategy, operations, and activities towards supporting transition of both its operations and customer businesses to a greener economy – therein lies the challenge. Exploding of climate change risk and the broader ESG (Environmental, Social and Governance) on the banking horizon affect banks’ business models and strategy. Banks will need to look at the resilience of their business models to climate change and its financial impact on their books. Aligning businesses with plans of managing climate change risks like physical, transition, and liability risks, for both their operations and customer businesses they finance is non-trivial. Harmonizing the bank’s sustainability and growth goals, while mitigating negative financial impact of adverse climate change, all while correctly spotting and converting opportunities that the “new normal’ will throw up, requires agility of a different level. Climate change impacted adversely by, but not limited to, carbon and greenhouse gas emissions, climate change vulnerability, organizational carbon footprint, pollution of land, air, and water is what will manifest itself as financial risk for banks, which is the focus of this book. The other side of the coin is the business opportunities that this shift in sensibilities creates for banks to fund and lend. These would be clean and green technologies, ecofriendly buildings, smart cities, and alternate energy sources, to name a few. ESG and climate change will be at the forefront of the banking narrative and way forward in the coming years and hence core themes to weave into their plans and business models.

Chapter 4 Climate-related Financial Risks for Banks Risk comes from not knowing what you’re doing. –Warren Buffet

The statement that “Climate change is one of the defining challenges of this decade” (NGFS)1 is spot on. The focus of this chapter is the distinct aspects of climate change risk as relevant to banks and the impact they can have on the bank’s books if not understood and managed well. Climate-related financial risks are the next frontier for banks. The paragraphs to come, are a curated content of the various definitions/descriptions that have been given and elaborated by some of the regulators and narrative shaping global organizations. –

–

–

“Climate -related risks referred to financial risks posed by the exposure of financial institutions to physical or transition risks caused by or related to climate change.”2 Network for Greening Financial System (NGFS), “Climate-related risks are the financial risks posed by the exposure of institutions to counterparties that may potentially contribute to or be affected by climate change.”3 European Banking Authority (EBA). In this definition, the focus is on how the counterparties will impact the financial institutions. The Bank for International Settlements has two related definitions in two of its documents on the subject: – “Climate-related financial risks refer to the set of potential risks that may result from climate change and that could potentially impact the safety and soundness of individual financial institutions and have broader financial stability implications for the banking system.”4 – “Climate-related financial risks – The potential risks that may arise from climate change or from efforts to mitigate climate change, their related impacts and their economic and financial consequences.”5

An interesting point to note in the latter definition is highlighting the fact that “mitigating climate change” could lead to financial risk. A point that the Deputy Governor of Reserve Bank of India reiterated is that “Climate-related financial risk refers to the risk assessment based on analysis of the likelihoods, consequences, and responses to

 NGFS Scenario Portal, https://www.ngfs.net/ngfs-scenarios-portal/  Network for Greening the Financial System, Progress report on the Guide for Supervisors, October 2021, https://www.ngfs.net/sites/default/files/progress_report_on_the_guide_for_supervisors_0.pdf  EBA Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, EBA/REP/2021/18.  Basel committee on banking supervision, Climate-related financial risks: a survey on current initiatives, April 2020.  Basel committee on banking supervision, Climate-related risk drivers and their transmission channels, April 2021. https://doi.org/10.1515/9783110757958-006

Chapter 4 Climate-related Financial Risks for Banks

43

the impact of climate change. Thus, Climate-related financial risks may arise not just from climate change but also from efforts to mitigate these changes.”6 Important to note is that, while the core of the definition remains the same, there are slight variations and as per NGFS survey findings reported in October 21, “Results from the survey indicate that less than half of respondents use either the same definition as the one provided in the NGFS Guide (18%) or adopted international standards and definitions issued by leading institutions and organizations such as the European Union (EU) (24%) that are broadly aligned with that of the NGFS Guide. Very few respondents (6%) crafted their own definitions, while most respondents (52%) reported that there is no formal definition for climate-related risks yet, although work is underway to assess them.”7 This survey brings to fore the fact that a “uniform” definition of climate-related financial risks is still in the making, though at the core it is agreed that adverse climate change or its mitigation is a financial risk both for the banks and their counterparties. Global warming and climate change are real. Banks are exposed to financial risks emanating from climate changes which at first instance may appear to be macroeconomic in nature, which is not true. The impact will be through both micro and macroeconomic transmission channels arising out of the physical and transition risk drivers (the avenues through which adverse climate factors can lead to negative impacts, both financial and non-financial). Climate change and thereby its risks are global in nature, with potential of simultaneous crystallization across multiple sectors, markets, and jurisdictions. At the same time, their intensity/severity could differ significantly across economies. The nature of climate change risk impacts all market segments and businesses either directly or through their ecosystem of suppliers or customers. Physical risks arise as either a direct consequence of adverse changes of climate or indirect consequences. Transition risks, on the other hand, arise from transition to climate positive initiatives. Each of these are discussed in some detail later in this chapter. The complexity of climate change induced financial risks is that they very quickly become transboundary, trans-sector risk transmission and attack multiple risk categories simultaneously. It is the potential of climate triggered systemic risks that regulators are concerned about. Knowledge and understanding of the multiple causal pathways and their impact across geographies, sectors, and time is still very nascent at this stage. Regulators need to and are taking the lead in these aspects as the potential of systemic risk stems from this interconnectedness. Systemic risks flow and surge through interrelated, mutually impacting, and amplifying stems through contagion. The financial crisis of 2007–2009 is a compelling case in pointer.  Keynote Address by Shri. M. Rajeshwar Rao, Deputy Governor, Reserve Bank of India, Thursday, September 16, 2021 at the CAFRAL Virtual Conference on Green and Sustainable Finance.  Network for Greening the Financial System, Technical Document Progress report on the Guide for Supervisors, October 2021.

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Chapter 4 Climate-related Financial Risks for Banks

Climate change risks tend to be non-linear, subject to considerable ambiguities and tail-risk. The challenge lies in the fact that “their crystallization may result in sharp increases in the correlation of risk premia across different assets, and could be amplified by the interaction of different financial sectors or through feedback loops with the real economy.”8 The connectedness and mutual triggering of risk quickly cascades from the financial system to the real economy and vice-versa. This theme is captured lucidly by the IMF’s F&D in an article on climate change, titled appropriately as “The Economics of Climate” (Figure 4.1). Physical Risks (Extreme weather events and gradual changes in climate)

Economy

Business disruption

Lower property and corporate asset value

Financial System

Market losses (equities, bonds, commodities)

Asset destruction

Transition Risks (Policy, technology, consumer preferences)

Migration

Lower household wealth

Credit losses (residential and corporate loans)

Reconstruction /replacement

Lower corporate profits, more litigation

Underwriting losses

Lower value Increase in prices of stranded energy with assets dislocations Lower growth and productivity affecting financial conditions

Negative feedback from tighter financial conditions

Operational risk (including liability risk)

Figure 4.1: The Economics of Climate. Source: Adapted from the IMF, F&D climate change, central banks, and financial risk, December 2019.

The financial impact of climate change can take the shape of financial and/or nonfinancial risks and sometimes both sets simultaneously. Banks are exposed both to the direct impact and the derivative impact of adverse climate change or an attempt to mitigate it, which crystalizes most times under the existing catalog of risks. Climate change risks have both direct and indirect pathways that flow through not just weather patterns but also societal response to them, which is why climate is only one of the influencers of risk transmission devices. Getting to the next level of detail, climate-related financial risks (Figure 4.2) manifest as three broad categories of financial risk or climate related risk drivers: – – –

Physical risk Transition risk Liabilities risk

 Financial Stability Board, The Availability of Data with Which to Monitor and Assess ClimateRelated Risks to Financial Stability, July 7, 2021.

Physical Risks

45

Available material talks of the first two risk drivers in some detail, while the third liabilities risk is not discussed much due to two reasons. The first is that most fold it into reputational risk, regulatory risk, or legal risk. The second reason is that it is too early in the curve, with very few experiences in this sub-category. Acute events Chronic cyclical events Physical risks

Stealth stealers/gradual erosion

Policy changes

Climate change risk drivers

Technological changes Transition risks

Changes in investor/ customer preferences

Law suits Liability risks

Reputational challenges Regulatory/Governmental sanctions

Figure 4.2: Climate change risk drivers.

Physical Risks The Financial Stability Board (FSB) defines physical risk as “the possibility that the economic costs of the increasing severity and frequency of climate-change related extreme weather events, as well as more gradual changes in climate, might erode the value of financial assets and/or increase liabilities.”9 Basel describes physical risk as economic costs and financial losses resulting from the increasing severity and frequency of: – –

–

extreme climate change-related weather events (or extreme weather events) such as heatwaves, landslides, floods, wildfires, and storms (i.e., acute physical risks); longer-term gradual shifts of the climate such as changes in precipitation, extreme weather variability, ocean acidification, and rising sea levels and average temperatures (i.e., chronic physical risks or chronic risks); and indirect effects of climate change such as loss of ecosystem services (e.g., desertification, water shortage, degradation of soil quality or marine ecology).10

 Financial Stability Board, The Implications of Climate Change for Financial Stability, November 23, 2020.  Basel Committee on Banking Supervision, Climate-related risk drivers and their transmission channels, April 2021.

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Chapter 4 Climate-related Financial Risks for Banks

The coalition of financial reform and environmental groups goes into more detail in describing the scope of the two risk drivers: Physical risk: bank balance sheets and operations may have risk exposure to physical damage or decreased productivity from climate change. – – –

Damages may result from increased frequency, intensity, and duration of adverse climate changes Real estate, tourism, insurance, carbon-intensive energy and power, and agricultural/food/forestry assets may have particular exposures. Banks may also suffer losses because they or their borrowers are: – dependent on infrastructure that is vulnerable to increasing climate risk (e.g., the power grid, telecommunications, water utilities); and – subject to supply chain disruptions.11

The Deputy Governor of Reserve Bank of India highlights that climate risks can impact financial sector through “physical risks which mean economic costs and financial losses resulting from the increasing severity and frequency of extreme weather events and long-term climate change.”12 The increase indicates a higher “velocity” of both the occurrences and the impact on banks. EBA’s description of physical risks refers to “The risks of any negative financial impact on the institution stemming from the current or prospective impacts of the physical effects of environmental factors on its counterparties or invested assets.”13 The Financial Stability Board, in its report on supervisory approaches to climaterelated risk, summarizes A physical risk definition that includes both acute and chronic risks: Definitions of physical risks generally included a recognition of both acute and chronic risks. Acute risks are noted as more severe weather events, such as floods, hurricanes, and droughts. Chronic risks are often described by examples of sea-level rise, reduced farmland productivity, and changes in precipitation patterns. One authority (Hong Kong Monetary Authority (HKMA)) cited those disruptions in global supply chains could be part of the physical risks that financial institutions account for.14

HKMA’s inclusion of disruptions to global supply chains, as part of damages/losses through physical risk drivers, is very insightful and brings to bear the over-arching reach of the negative impact adverse climate change is likely to have on financial realities.

 Coalition of financial reform and environmental groups, with American for Financial Reform Education Fund Recommendations for Supervisory Guidance from Bank Regulators, September 2021.  Keynote Address by Shri. M. Rajeshwar Rao, Deputy Governor, Reserve Bank of India, Thursday, September 16, 2021 at the CAFRAL Virtual Conference on Green and Sustainable Finance.  EBA Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, EBA/REP/2021/18.  Financial Stability Board, Supervisory and Regulatory Approaches to Climate-related Risks, Interim Report April 29, 2022.

Physical Risks

Acute Events

Physical Risks

• Earthquakes • Tsunamis • Floods

Chronic/ Cyclical Events

Stealth Stealers

47

• Hurricanes • Cyclones • Forest Fires

• Rising Temperatures • Rising Sea Levels • Rising Pollution Levels

Figure 4.3: The three classes of physical risks.

Physical risk (Figure 4.3) includes weather risks, risks of exposure to severe, sudden, or gradual erosion weather events. Direct financial impact, in the form of erosion of financial assets or collaterals held by the bank, is because of an increase in the frequency and intensity of changes in weather patterns in immediate, short/medium/long term or is indirect through changes in the ecosystem. It could manifest through any of the three routes: chronic route (hurricanes, drought, ocean acidification, wildfires, etc.); acute route (tsunamis, floods, earthquakes); or stealthily (sea level rise, temperature rise), leading to human, livestock, and property damage. It is important to note that intensity of impact of physical risk varies based on the geographic location. These could result in direct immediate loss or reduction of value of the property. The other big byproduct of physical risk is the potential of transmission risk as a response. Simply put, physical risk is the risk posed to property, assets, collateral, resources, or operations by adverse climate change. The loss, when physical risks hit, will be so huge that it could expose banks to losses that are larger than their capital cushions. Losses result from changes in: a) physical capital because of destruction of infrastructure, and other physical assets; and b) human capital through displacement, negative impact on health, and such. All of this create ambiguity regarding future demand. The challenge has been that climate events are becoming more frequent and more severe. Both the velocity and the intensity are increasing at a faster pace that is or will result in negative financial impact (Table 4.1). This might increase non-linearity and become increasingly correlated over time, negatively affecting the value of financial assets

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Chapter 4 Climate-related Financial Risks for Banks

Table 4.1: Impact of Physical risks on traditional risk categories.

Physical Risk Increased frequency and severity of weather events

Credit Risk Damage to collaterals for Bank loans

Credit Impact Higher loan to value and loss given default (LGD) due to reduced collateral value, leading to higher capital requirements

Market Risk Physical damage and a perception of heightened risk that can affect the market value of investments

Market Loss Mark to Market (MTM) Investment and/or Trading Loss

Operational Risk Physical damage to premises; Outage of critical services or functions

Operational Loss Losses due to physical damage and/or outages Potential Reputational damage

Source: Adapted from Office of the Superintendent of Financial Institutions, Canada., Climate Risk Management guideline document, No B – 15 March 2023.

that impact both credit and market risks simultaneously as well as manifest as operational challenges.

Transition Risk FSB asserts Transition risks relate “to the process of adjustment towards a low-carbon economy. Whilst such an adjustment may be a necessary part of the global economy’s response to climate change, shifts in policies designed to mitigate and adapt to climate change could affect the value of financial assets and liabilities.”15 Basel describes transition risk as the “risks related to the process of adjustment towards a low-carbon economy.” Its description of the transition risk drivers is “climaterelated changes that could generate, increase, or reduce transition risks. They include changes in – – –

public sector (generally government) policies, legislation, and regulation, changes in technology and changes in market and customer sentiment,

each of which has the potential to generate, accelerate, slow, or disrupt the transition towards a low-carbon economy.”16

 Financial Stability Board, The Implications of Climate Change for Financial Stability, 23 November 2020.  BIS Climate-related risk drivers and their transmission channels (April 2021).

Transition Risk

49

Coalition of financial reform and environmental groups describes Transition risk as one where “banks may suffer losses as economies shift to become less carbon intensive and more climate resilient.”17 –

As renewable energy and other zero-carbon technologies become increasingly affordable and reliable, and new international agreements, governmental policies, corporate commitments, and investor and public demands accelerate adoption of these technologies, banks with significant fossil fuel assets are at risk of rapid asset value deflation while fossil fuel borrowers increasingly default on their loans”18

EBA’s definition of transition risk is “The risks of any negative financial impact on the institution stemming from the current or prospective impacts of the transition to an environmentally sustainable economy on its counterparties or invested assets.”19 The Financial Stability Board (FSB), in its report on Supervisory approaches to climate-related risk, summarizes “A transition risk definition that includes technological developments, behavior or social change, and policy changes: Definitions of transition risk primarily refer to three types of risk drivers. One driver is technological developments that would make less environmentally friendly technology obsolete. Another driver is behavior or social change, where consumers and investors demand more environmentally sustainable products and services. Lastly, legislation or governmental policy changes intended to shift to a lower-carbon economy, such as carbon taxes or pricing mechanisms, are another source of risk.”20 Simply put, transition risk (Figure 4.4) is the impact of economic adjustment of the ecosystem towards the low-carbon economy. Structural changes, reallocation of investments will affect both the industries/firms either currently producing or using fossil fuel and banks that have financed these activities. Transition risk could emanate from government policies, new regulations, technological advances, investor sentiments/ preferences and customer choices leading to business disruptions, consumption patterns change as well as funds availability to different sectors/industries. As the demand for ethical business practices tuned to environment protection grows louder, individuals, businesses, and banks need to protect themselves against stranded assets – a house, a piece of land, equipment, a factory whose value has dropped substantially. The energy industry and the mining sector are examples of sectors that are at the forefront of transition and as such are highly vulnerable to transition risks.

 Coalition of financial reform and environmental groups, with American for Financial Reform Education Fund Recommendations for Supervisory Guidance from Bank Regulators, September 2021.  Coalition of financial reform and environmental groups, with American for Financial Reform Education Fund Recommendations for Supervisory Guidance from Bank Regulators, September 2021.  EBA Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, EBA/REP/2021/18.  Financial Stability Board, Supervisory and Regulatory Approaches to Climate-related Risks, Interim Report, April 29, 2022.

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Chapter 4 Climate-related Financial Risks for Banks

Policy Changes

Transition Risks

Technological changes

Behavioral or Social Changes

• Disclosure requirements • Incentive structures • Tax structures

• Obsolescence of earlier, non environmentally aligned technologies • Evolution of new Greener Technologies

• Investor sentiments • Customer preferences • Market preferences

Figure 4.4: The classes of transition risks that stem from, broadly, three classes of transition responses.

Transition risks impact the assets side due to the possibility that the business models of counterparties are not built around the economics of low carbon objectives. Uncertain and uneven financial impacts will result due to the rapid shifts from the entrenched brown economy to the green economy vision. It is in the interest of all stake holders to plan and execute orderly transition as otherwise the result would be losses, not just financial but also the undermining of the financial system. A firm’s vulnerability to transition risk is difficult to assess as the impact can come from anywhere across their operational ecosystem viz. their suppliers, their own operations as well as that of their customers. Transitional risk, therefore, is the risk that bank is exposed to, both as itself and its counterparties transition to low carbon and sustainable economy (Table 4.2). Expectation is that transition risk could start to affect borrowers in the medium term in the form of cleaner energy requirements (particularly vehicle segment) and sustainable building standards (mortgages and property loans), etc.

Liability Risk

51

Table 4.2: Impact of transition risks on traditional risk categories. Credit Risk GHG intensive borrowers face higher costs of doing business and/or Lower revenues reducing profitability

Credit Impact Increased probability of default due to pressures on the borrower and LGD due to stranded assets, which could lead to higher capital requirement for the FRFI

Market Risk Unexpected valuation change in debt and equity securities issued by impacted firms

Market Loss Investment and/or Trading Losses linked to securities issued by impacted firms

Transition Risk Increased regulation related to GHG -intensive Industries Liquidity Risk An institution with a Liquidity impact Potential challenges GHG intensive portfolio may rolling over debt or raising capital experience diminished demand for its funding instruments in wholesale debt markets as its assets become more illiquid ✶ FRFI – Canadian federally regulated financial institution

Liability Risk The Board of the FRFI may not be seen as fulfilling its legal obligations and appropriately accounting for and managing its climate-related risks

Legal Impact Possible legal action against the FRFI Board Potential Reputational damage to FRFI

Source: Adapted from Office of the Superintendent of Financial Institutions Canada, Climate Risk Management guideline document, No B – 15 March 2023.

Liability Risk Liability risks might arise when parties are held liable for losses related to environmental damage that may have been caused by their actions or omissions. Liability risks could be a result of inability to comply with requirements/disclosures, both regulatory and otherwise. Liability risks are largely for insurance firms. But potential of legal risks for banks are also a reality which might arise from mis-leading or misrepresentation of products and services. There could also be potential economic loss where the bank’s counterparties face regulatory sanctions, lawsuits, or reputational challenges if they fail to curb carbon emissions, oil, or caustic wastage discharge, etc. Interestingly, Basel does not call out liability risk specifically, like it does with physical and transition risks. For now, it says that “banks may also be exposed to an increasing legal and regulatory compliance risk as well as litigation and liability costs associated with climate-sensitive investments and businesses. Furthermore, climate-related lawsuits could target corporations, as well as banks, for past environmental conduct whilst seek-

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Chapter 4 Climate-related Financial Risks for Banks

ing to direct future behavior. For example, climatic changes caused prolonged droughts in California that increased the risk of fires from the operations of PG&E. The company estimated the cost of settlements to claimants in excess of $13 billion.”21 This would have had a serious impact on PG&E’s bankers. EBA,, groups liability risks with legal risks: “Legal risks – also referred to as liability risks or litigation risks – are sometimes considered either physical or transition risks. They could, however, also be considered a separate risk category as they may not only arise from climate-related and other environmental risks but also from social and governance risks.”22 The Financial Stability Board, in its report on supervisory approaches to climaterelated risk, summarizes a definition of liability risk: liability risk associated with physical and transition risks, such as potential financial losses stemming directly or indirectly from legal claims, were also included in definitions. Liability risk can result from manifestations of physical and transition risks. Some national authorities have accounted for liability risk within their definitions of either physical or transition risks, while others have established separate definitions for liability risk as an additional risk. Others have accounted for liability risk more broadly as ESG factors. However, liability risk might materialize independently from transition risks and far in advance from the materialization of both transition and physical risks. Litigation cases have been increasing over the past few years and tend to be costly for financial institutions. Having a clear definition of liability risk, whether as a separate definition of risk or a subset of physical and transition risk, could increase the consistency in how such risk is identified and assessed. It could also enhance the governance of climate-related risks within financial institutions by encouraging the involvement of legal and compliance departments.23

Two critical takeaways from FSB’s observation, from a bank’s point of view, are a) The timing of materialization of liability risk could be, as rightly pointed out, earlier than the materialization of physical or transition risks. b) The need to proactively involve the legal and compliance team as part of control and mitigation of loss through the potential crystallization of liability risk. The risks from physical and transition risk are visible. It is the liability risks (Figure 4.5), while invisible till they surface, that will materialize hard and fast. This could be either directly on the bank or through customers in the form of credit risk – a case in point for the latter is PG&E, that has been drubbed as the first climate risk bankruptcy,24

 BIS Climate-related risk drivers and their transmission channels (April 2021).  EBA Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, EBA/REP/2021/18.  Financial Stability Board, Supervisory and Regulatory Approaches to Climate-related Risks, Interim Report, April 29, 2022.  The Wall Street Journal, PG&E: The First Climate-Change Bankruptcy, Probably Not the Last, January 18, 2019.

Impact of Interplay Between the Three Risk Drivers of Climate Change

53

Law Suits

Liability Risks

Regulatory/ Governmental sanctions

Reputational Challenges

Figure 4.5: Liability risk that stems from the response of stakeholders to improper execution of climate change initiatives.

probably not the last, as titled by Wall Street Journal. The California based company, estimated to be in billions of dollars in liabilities and subject to 750 lawsuits from wildfires potentially caused by its power lines. The fall, as per the market view, has been fast and steep. Liability risk, in simple terms, is the potential loss due to the possibility of any stakeholder claiming compensation, due to losses suffered either as a result of physical or transition risk or lack/insufficiency of or misleading disclosures of the climate change related risks either from the bank or its customers.

Impact of Interplay Between the Three Risk Drivers of Climate Change As rightly pointed out by the Financial Stability Board, in its report on Supervisory approaches to climate-related risk,25 “The interplay between physical, transition and liability risks across the financial system is not explicitly captured in existing defini-

 Financial Stability Board, Supervisory and Regulatory Approaches to Climate-related Risks, Interim Report, April 29, 2022.

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Chapter 4 Climate-related Financial Risks for Banks

tions.” Their suggestion is “the definition of transition risk could refer to how the increased frequency and severity of physical risk may create additional pressure on policymakers to take mitigating actions, resulting in increased probability that transition risk could manifest alongside physical risk. The definition of physical risk could also refer to how a delayed climate policy response associated with transition risk may aggravate physical risk.” While the definitions are within the realm of regulators and policymakers, the reality is that the interplay is involved and multithreaded. As mentioned by FSB, each class of risk driver can accelerate the other to the detriment of businesses and banks (or decelerate, if planned well). Physical and transition risk materialize as financial risks, both as first order direct risks and potentially second order effects or spillover effects. Both types of climate risk, physical and transition, result in risk for banks, both financial and nonfinancial. Again, for understanding purposes they are seen as financial and non- financial risks – In reality there is no “non-financial” risk for banks. In the ultimate analysis, every one of them will result into economic loss and that is a fact. “It is the combined realization of physical and transition risks, and the highly unpredictable knock-on effects they will generate, that constitute a ‘green swan’ event or series of events.”26 A green swan event is “a climate event that is outside the normal range of expected events. Green swans are different from black swans because there is some certainty that climate change risks will one day materialize.”27 Green swan events will be discussed in some detail in the chapter on scenario analysis and stress testing, but for now the reference here is to highlight the fact that the interplay of the two risk drivers could have a snowballing effect. Understanding and documenting clear discernable patterns of interplay is at a very nascent stage. However, banks need to be conscious of and provide for this tango in their loan assessment and pricing. An example of how both physical and transition risks can play on bank portfolios: Property loans (housing, mortgage, and the like) In the sphere of physical risks, acute events might result in causing immediate loss or destruction of collateral and, in the case of chronic events, the loss could result from the potential of depleting asset value. Transition risk could manifest itself through faster depletion of collateral value as demand for new age energy efficient and environment friendly housing grows exponentially. A combination event could be a situation where an existing property is vulnerable to a chronic event, and in parallel a new property, built on sustainability principles, with features that mitigate the negative effects of the chronic events is available as an alternative. The vulnerable property and their bank, because of the interplay of the risks, is likely to be subject to steep losses. The portfolio, therefore, could be hit by either risk drivers individually or together, the loss due to the latter being more severe.

 Patrick Bolton, Marcin Kacperczyk, Harrison Hong and Xavier Vives, Resilience of the Financial System to Natural Disasters, IESE Business School, University of Navarra, Centre for Economic Policy Research (2021).  Macmillan dictionary.

Transmission Channels

55

Transmission Channels Understanding transmission channels and amplifiers is central to understanding climate change risk. Transmission channels are the paths through which banks are affected by adverse climate change, either directly or indirectly. European Banking Authority (EBA) describes transmission channels as “The causal chains that explain how these risk drivers impact institutions through their counterparties and invested assets.”28 Basel describes transmission channels as “The causal chains that explain how climate risk drivers give rise to financial risks that impact banks directly or indirectly through their counterparties, the assets they hold and the economy in which they operate.”29 Financial risk and the impact on the bank’s exposures due to adverse climate change can be transmitted by the system through both micro and macroeconomic channels that arise from physical and transition risk drivers. Microeconomic channels impact the bank directly either by negative consequences to their counterparties or to banks themselves (their operations or the assets they hold). Basel’s description of micro transmission channel is as follows: Mechanism through which climate risk drivers affect banks’ individual counterparties, potentially resulting in climate-related financial risk to banks and to the financial system. This includes the direct effects on banks themselves, arising from impacts on their operations and their ability to fund themselves. Microeconomic transmission channels also capture the indirect effects on name-specific financial assets held by banks (e.g., bonds, single name CDS and equities).30 “Macroeconomic transmission channels are the mechanisms by which climate risk drivers affect macroeconomic factors, such as labor productivity and economic growth, and how these, in turn, may have an impact on banks through an effect on the economy in which banks operate. Macroeconomic transmission channels also capture the effects on macroeconomic market variables such as risk-free interest rates, inflation, commodities, and foreign exchange rates.”31 Risk transmission through the macroeconomic channels is indirect, in the form of the impact on the macro-economic variables in the economy they operate in (like interest rates, inflation rates, forex rates, etc.).

Both these transmission channels through climate risk drivers (physical or transition) affect banks as financial risks (credit, market, liquidity) and/or as non-financial risks (operational, reputational, legal, or regulatory). The impact is, most often, direct and observable. –

Credit risk – effect on counterparties. Climate change risk drivers impact both retail and corporate segments as they could negatively affect the economic health of individuals,

 EBA Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, EBA/REP/2021/18.  BIS Climate-related risk drivers and their transmission channels (April 2021).  Ibid.  Ibid.

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Chapter 4 Climate-related Financial Risks for Banks

– –

–

householders, SME/commercial segments, corporates and even sovereigns, and therefore their ability to repay or service debt. Equally concerning would be the fact that the value of the collateral or asset could fall, affecting banks’ ability to recover their dues. Transition risk drivers may impact the financials of counterparties through higher operating expenses, stranded assets, and reduced ability to sell goods due to altered customer sentiments. Market risk – affects market volatility and potential price shocks. The negative impact could be stock prices which would result in sizeable portfolio losses. Liquidity risk – affects bank’s ability to raise funds, liquidate assets at fair value or through customers both in terms of demand during natural disasters and inability to recover from them. All of these will severely impact the economics of the bank and their ability to meet their obligations/liabilities when they become due. Operational risk – affects both regular and crisis time operations. There could be impact to physical assets due to natural disasters impacting connectivity, communications, and disaster recovery efforts. Equally important is the likelihood of the increase in legal and regulatory risks associated with miscommunication about climate sensitive investments or initiatives.

What is of major concern for banks is that climate risk drivers could simultaneously impact multiple risk categories through both macro and micro economic transmission channels. It influences financial and non-financial risk outcomes, given the complex cause and effect associations it creates across the entire risk canvas. A special mention here about three factors that play a crucial role in the likelihood and severity of impact.

Geographical Heterogeneity An important characteristic of climate-related financial risks is the locational impact on the severity and timing of the loss impact. This is because climate pathways affect different geographies differently and at different points in time. Therefore, geographical heterogeneity is an important risk factor. –

–

–

Risk drivers – banks operating in high-risk geographies will be hit harder in terms of higher financial risks from physical risk events. The same applies to the impact of transition risk, which could manifest itself at differing levels based on government, policymakers’ initiatives, and technological advancements that affect businesses. Economic and market composition – the primary economic activities which are pursued in respective geographies and how they are impacted by either physical or transition risk drivers will determine the severity. Example geographies that are predominant agro-economies will be more affected by natural disasters like cyclones. Similar will be the impact of transition risk on geographies that have traditionally been oil, coal, and gas centric economies. Maturity of financial systems – the third factor that will have a say on how and by how much the financial impact will be is the maturity of the financial markets, the regulations, and the policies of individual geographies.

Mitigants

57

Amplifiers The adverse financial impact can be amplified through interaction and interdependencies between climate risk drivers. The more of these interdependencies there are, the higher the risk of amplification. – –

Financial system amplifiers – the response behavior of financial systems and their interaction with the real economy will have an impact Multiple channels – this is the greater amplifier where banks are concerned, since the possibility of physical and transition risks manifesting themselves through multiple transmission channels magnifying macro-financial risks of the area/s in which the bank operates

Mitigants When carefully planned and executed, mitigants can reduce or offset the negative financial impact. To this end, objectively analyzing the potential of risk will enable banks to plan reduction of their sensitivity to physical risks as well as an orderly transition to sustainable economy. This is where mitigants come into play and reduce the amplification effect. – –

–

Pre-emptive actions – business model orientation and business thrust into well researched sustainable initiatives and diversifying portfolios will be actions in a positive direction Risk transfer measures – like planning for appropriate insurance cover, either by the bank or giving pricing advantage to counter parties that have a well-defined and comprehensive insurance cover for their business. Hedging opportunities and maturity of capital markets provide avenues for creating mitigants that would soften the negative financial impact.

Climate-related financial risks are, as can be seen from the aforesaid discussion, complex, interrelated, and intertwined inexorably within themselves as well as with real economy. What complicates the canvas is that the cause and effects are still being discovered.

Chapter 5 Importance of Understanding and Acting on Climate Change Climate change is one of the greatest challenges faced by mankind this century. –Christine Lagarde

This is because climate change will affect all businesses and individuals in multiple ways. Banks are one of the core participants of the direction climate change initiatives take as they can both influence and be influenced by climate change. Adverse changes impact the entire balance sheet of banks, more particularly on its lending and asset class allocation policies. The writing on the wall is loud and clear, that the entire ecosystem will undergo massive change due to the wave of climate change management. The process may be painful, especially the transition. It is important to appreciate that climate change has two dimensions for banks, as banks are both impacted and in turn impact climate change risks, being active and influencing members of climate action. Banks and investor communities play an all-important role in protecting climate changes from worsening further as they are the principal fund providers for projects both big and small. They fuel consumption, spending, and creation of assets. They have the power to lead the way forward by facilitating businesses towards a sustainable future. Long-term viability and growth are the issues at stake for banks going forward. Simply put, sustainability is staying ahead on the opportunity curve while minimizing long term risks. Banks have an opportunity to be part of the solution to the vexing adverse climate change problem. They have some experience in the role – they have been part of “the solution” for the challenge posed by Covid-19 and came out quite successful. For banks, sustainability is no longer a “nice to support” activity; it is increasingly becoming an economic imperative as almost all sectors are affected by adverse climate change. Big banks, globally, have committed to net-zero by 2030 for their own operations and 2050 for net zero emissions aligned portfolios. While commitments have been made, the path and milestones are being worked out as stakeholders will require actionable trajectories. Climate change risk has such fluidity about it that it is quite challenging for banks to get a grip on it, hence it is critical for them to look at plausible scenarios and have some possible responses planned out to minimize the risk. Banks are in the business of managing financial risks. Head to toe climate change risk is financial risk. Banks are exposed to adverse climate change or its mitigation via both macro and micro economic transmission channels through physical and transition risk drivers, as discussed in Chapter four. Committing to net zero is a neceshttps://doi.org/10.1515/9783110757958-007

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sity for banks as responsible corporate citizens and as one of the most regulated organizations, subject to regulatory and policy directives. Banks need to plan net zero actions for their own operations as well as facilitate their customers’ transition. The bank’s climate impact is looked at not just from the bank’s operations but also counterparty emission data. Adverse climate change directly impact the financials of a bank through any or all the following forms – credit, market, liquidity, operational, reputational/strategic, and regulatory risk. A strong caveat here is that there are specific nuances of climate change risk which can affect multiple risk categories simultaneously. Earlier banks were responsible for their actions (both the organization and its staff) but now with climate risk they are part responsible for and become partners in their customer’s transition journey. The positive aspect is that, if done right, this will be at the core of their growth strategy. Appreciation of risks and opportunities both in the short term and long term that climate change presents are the starting point. Inaction or slow action are not options. They can hurt banks in the medium to long term both in terms of write-offs or being saddled with stranded assets. The World Economic Forum’s Global Risks Perception Survey 2021–22 points to the fact that climate change related issues occupy the top three spots. In relation to the top risks on a global scale over the next 10 years, as a response to the survey question “Identify the most severe risks on a global scale over the next 10 Years,” the top three themes identified were 1. 2. 3.

Climate action failure Extreme weather Biodiversity loss

If not focused on in a timely and proactive manner, this may become an existential question. This is because it is important both from the risks and opportunities sides. It is not that financial risk due to climate change is to be treated as a fully standalone risk type – at least not for now when the discipline is at its nascent stage. However, nuances of climate change risk must be embedded into the business model, all components of risk management framework as well as into the roles and responsibilities of personnel across the three lines of defense, in addition to frontline functionaries. These themes are discussed in Part 3, the “how” part. The challenge, as some of my banker friends say, is that some of their senior/ board members feel climate change is a long-term challenge and needs to be viewed and planned as such. That is not true. The financial impact of climate change can manifest itself in the short term, medium term, and long term as well. Understanding these areas will be critical to effective management of climate change risks. Chronic physical risks will creep up on people while the acute physical risk will be a bolt out of the blue. The impact of transition risk will balloon out and stranded assets will lead to losses for the banks unless planned and acted on to stop loss. Being saddled with “stranded assets’ is a real threat, and this could happen both through physical and

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Chapter 5 Importance of Understanding and Acting on Climate Change

transition risks. Basel describes a stranded asset as an “Asset that at some time prior to the end of its economic life is no longer able to earn an economic return as a result of changes associated with the transition to a low-carbon economy.”1 Adverse climate change can result in banks being less diversified due to the potential of increase in the impact of events earlier considered as not correlated. Irrespective of where, how, or when the loss hits, it will have both a wealth and income effect, such as how credit risk materializes if the counterparty’s ability to repay or service the debt is impaired due to adverse climate change (income effect) or the bank’s inability to recover the loan dues in the event of default (wealth effect). Banks branches or geographies that have a large portfolio of “brown” assets (fossil fuel intensive counter parties) will face a significant impact on their books, as these counterparties will face the fury of transition risks the most as their business, because of policy, technology changes, changing preferences of investors and customers which disrupts their business, will experience a steep fall in earnings and higher funding costs. Investor/customer/market sentiments are critical factors for both the sustenance and growth of banks. Each of them is a huge pillar by itself. The reason I combined them together here is to highlight another powerful driver that banks need to contend with and be seen as positive contributors towards climate change, namely “social activism” which has become a huge force to reckon with, especially in the climate change space. Banks being market participants need to heed the staunch support the social system is putting behind constructive steps to combat adverse climate change by being vocal and visible about action or inaction by stakeholders, including banks, in the said direction. There is huge investment happening and will continue to increase manifold into green technologies as businesses transition. Banks can now plan new financial products, and be funders/lenders to new and evolving businesses. There are various estimates ranging from one trillion dollars to above that total of the funding required annually to fund transition and a sizable portion of that will pass through banking channels and there lies the opportunity. Another strong reason will be the vocal support of investors and customers for a sustainable future. The impact of climate change risks could be for a specific geography, a region or could be global, turning into systemic risks, hence there is such intense focus by regulators. These risks create, in addition to loan losses, potential externalities. There will be rising demand for higher accountability, intensive regulatory/policy scrutiny, and detailed disclosures supported by auditable data. At the extreme end, the potential of removal of subsidies and revocation of a license to operate either explicitly through government regulation or implicitly through social activism are also remote possibilities.

 BIS Climate-related risk drivers and their transmission channels (April 2021).

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Action or inaction of climate change initiatives impacts reduction of greenhouse gases, carbon emission, fossil fuel consumption, and carbon footprint on the one hand, and increase in production/use of renewable energy, green technology and improving energy efficiency on the other. All of this impacts both the banks’ as well as its counterparties’ competitive positioning. From an opportunities perspective, TCFD speaks of the sample of the size of business – transition to low carbon economy will require an average of around $3.5 trillion in the energy sector per year for the foreseeable future. Investment requirements are huge, in the trillions of dollars with infrastructure investments alone being in the range of six trillion dollars per annum up to 2030 (OECD 2017). Climate change therefore will be both a source of risk and opportunity – a well thought out, well documented balancing act is what will be required. Multiple threads of drivers make it clear why understanding and acting on climate change initiatives is a business imperative for banks. Drivers for change can broadly be summed up as: – – – – – – –

Adverse climate change impacts banks’ books – both balance sheet + P&L, not to mention cashflows and liquidity management Need to support customers in their transition to low carbon options Regulatory, policymakers’ directives and scrutiny Market and investors’ focus Aligning with customer preferences for greener options. Tracking of progress by public and societal activism Need to cut losses or harness new opportunities.

In the ultimate analysis, the objective of banks is to build a healthy, growth oriented resilient sustainable business. Banks create wealth by managing risks well and not by holding higher capital, which might be one of the tools regulators could wield to nudge banks towards sustainable options. Engaging with credible green businesses with more favorable terms relative to credible brown businesses is a way forward.

Chapter 6 Challenges for Banks in the Climate Change Risk Management Space Nothing will ever be attempted, if all possible objections must be first overcome. –Samuel Johnson

In a constantly shifting landscape with evolving policies, green technologies and uncertainties, multiple players coming up with different initiatives/directives/disclosure requirements does present a multilayered challenges matrix. As a response to the pandemic, the digitization of banking is happening at a breakneck speed. The industry is still trying to acclimatize to the new normal, while coping with increased cyber threats, as well as to supply chain disruptions. Add to this geopolitical instability, a razor focus on sustainability, and it will be clear that banks are operating in an external environment that is in a state of flux and particularly demanding at the same time. The endeavor is still at its nascent stage. There are many issues that need to be resolved and/or streamlined, starting from the uniform definition of climate-related financial risks, the common understanding of what is “green” versus “brown,” shared acceptance of metrics and measurement methodologies, standard disclosure requirements, lack of the underlying data even for the initial set of disclosures, and reporting requirements. Given the complexity of the climate change risk canvas, challenges can be grouped, broadly, into three dimensions or segments for understanding purposes. An important caveat is that each of these segments interact with one another in intricate ways which has a negative multiplier effect. This is what complicates the universe of climate change risk management.

Internal

Data Alignment across multiple functions and role holders Skill set availability

Counterparty related

Data Risk assessment Pricing

External environment

Data Uniform taxonomy Industry standard disclosure norms

Challenges Banks Face

Figure 6.1: Broad segmentation of challenges. https://doi.org/10.1515/9783110757958-008

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Figure 6.1 captures the three broad segments/dimensions and the top three challenges of each of the segments. It is important to notice that the factor most prominent and common across the three segments is data, or more precisely the lack of it. –

–

–

Dimension 1 – internal factors. Drawing up workable internal sustainable business model and an operational construct across the three areas of risk management, sustainable financing/green banking, and governance structures is challenged. Climate change risk, at one level, impacts multiple risk categories as well as both micro and macroeconomic variables that influence models, analytics, and responses to the different stakeholders. At another level, it runs across multiple functions and departments within the bank across a complex interplay of processes, practices, businesses, and accountability matrices. Dimension 2 – ensuring positive sustainability alignment with counterparty realities, namely ensuring directional alignment between the sustainability trajectories of the bank and their counterparties, to support each other’s efforts towards net zero transition. This is challenged at multiple levels. There will be an expectation of having the ability to understand the carbon footprint of individual transactions – the impact of the entire lifecycle of the relationship that the transaction initiates both at the bank’s end as well as that of the counterparty. That is easier said than done as the counterparty lifecycle covers right from raw material sourcing to production, transportation, sale, and its use by end customers, as well as the final disposal. Each of these steps has an implication on the environment. Compare this to the existing responsibility of looking at the transaction/contract in terms of the potential of financial risks (credit, market, and liquidity) and a little on the nonfinancial risks that the contract poses to the bank. Now it is not just about the financial safety of the bank’s funds but also the impact it may have on the climate. Both financial viability and the usage (context and impact) become important. From a bank’s perspective, the risks have “double materiality” and therefore need to be viewed and measured both from “outside-in” and “inside-out” perspectives. Dimension 3 – external ecosystem. Banks will need to look at the impact not just at counterparty level but at industry and sector level as well. Information about transition pathways, across geographies, and the time horizon committed will be required as data points to compute their portfolio level emissions financed and temperature aligned, to arrive at a net zero path at a sector/geography/industry level. The combination of the three dimensions present banks with multilayered interwoven threads of challenges in the climate change risk management space. A few of them are discussed hereunder.

Scarcity of Reliable and Standardized Data The biggest challenge that banks face is data availability and its reliability – the new data canvas is daunting to say the least. Internal and external data of climate related financial information, at the right granularity and detail, to support standards, disclosure requirements, regulations and help make informed decisions about the risks and opportunities being assumed is the ask. The twin problems are a) such data is scant as of now and b) even that scant data is to be obtained from multiple sources. The translating of environmental and non-economic data into metrics to support quantification of risks in financial terms. While this is still a “data’ issue, it requires a

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specific call out from a climate-related financial risks perspective. As FSB1 rightly highlights, climate-related risks require data and tools with which to translate the effects of extreme weather events, or changes in the cost or permitted quantity of entities’ emissions, into changes in the value of financial assets and liabilities. Similarly, measuring the impact of policies to reduce emissions requires data with which to assess the effect of decreases in – or increases in the price of – carbon emissions on firms’ cash flows and balance sheets.

Risk Assessment Capability How to assess the “credibility” of a business proposal, because the tag “green” by itself does not ensure the soundness of the enterprise. BIS2 officials rightly point out that “there are risks for financial stability from both sides – those linked to exposures against overvalued emission-intensive assets (“brown vortices” or “brown runs”) – one should not underestimate those linked to exposures to either overvalued “green” assets or to assets that purport to be green (“green bubble”).” The challenge is, therefore, not jumping from brown to green but to put in the standard rigor of analysis to both. Themes that make risk assessment challenging are: – – – –

Lack of forward looking, granular, and verifiable data make it difficult to assess firms’ exposure to climate risk, both at present and in the lifetime of the project. Goals and targets of counterparty do not translate into actionable, trackable, and measurable activities, given a) uncertain climate pathways and b) multiyear project timelines Pegging collateral to environment aligned businesses wrought with uncertainties Pricing of climate change risk

Measurement and Modeling of Climate-related Financial Risks Modeling and forecasting extreme events – modeling climate-related financial risks are challenged as both history and forward-looking data is scarce. Climate risk events are non-linear in their transmission. It is a complex exercise on multiple fronts given that the climate models themselves are hypothetical and that the potential climate effects could range widely among geographies, industries, and across a wide spectrum. One of the approaches being used are scenario analysis and stress testing.

 Financial Stability Board, The Availability of Data with Which to Monitor and Assess ClimateRelated Risks to Financial Stability, July 7, 2021.  BIS, Finance and climate change risk: managing expectations, https://www.bis.org/speeches/ sp220607.pdf.

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Stress testing – when I asked a banker friend, who heads the global stress testing function of a multi-country global bank, what he would cite as the top three challenges he and his team face in executing a climate change stress test required by regulators, without blinking an eye, he said: – – –

Data Models Scenarios

Planning and Execution Time Horizon The time horizons to measure and manage most climate change risks are uncertain and dependent on the risk drivers. There are goals that banks are setting for 2025, 2030 for themselves, and 2050 to 2070 for their businesses. Climate patterns differ by geography and would materialize over uncertain and extended time horizons which are beyond the typical business cycles of banks. This means that the bank’s planning horizon needs to tune itself to the same (the current planning range is one to three years). It is equally a problem for central banks. –

–

Unfamiliar planning time horizons – typical forecasts by central banks are on a quarterly basis, as banks do detailed planning for a year and strategic planning for three years to a maximum of five years. Corporates can forecast their cashflows on a quarterly basis and fund flows for a year. Unpredictable impact timelines – These could be immediate/near term, short, medium, long, exceedingly long terms. Physical risks like earthquakes, forest fires, heat waves, etc. could strike in the immediate to short term. The time horizon of most of the transition related risks are out into future across different scales of time – medium to long term. Liability risks could manifest themselves anytime.

Non-standardized Disclosure Norms The size of this problem has been well captured by the International Monetary Fund in one of its blog,3 “with more than 200 frameworks, standards, and other forms of guidance on sustainability reporting and climate related disclosures across 40 countries, part of the problem is the multitude of existing frameworks currently used by firms and financial institutions, which undermines consistency and comparability.” The ability to assess both the value and the risk of the project is quite difficult for now. Comparability is, currently, not possible in the absence of uniform taxonomy

 Caio Ferreira, Fabio Natalucci, Ranjit Singh, Felix Suntheim, How Strengthening Standards for Data and Disclosure Can Make for a Greener Future, IMF Blog, May 13, 2021.

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and standardized disclosure norms. These and the common framework of financial sustainability, calibrated metrics, etc. are other aspects that need ironing out.

Skill Requirement A nuanced understanding of the impact of climate change on the bank’s exposures, of being able to anticipate risks and opportunities associated with climate-related financial risks, as well as challenges in transition to low carbon marketplace, is a new and involved skill set. The ability to understand the foregoing, with a capability to put in place timely responses, is heavily challenged. Recruitment and training of personnel who can look through the lens of climate with carbon constraint is an urgent need. Risk taking is part of banking business, but the required insight into what are acceptable and non-acceptable risks in the climate change space, as well as the ability to have a forward-looking understanding of what is likely to come down the pipeline and navigate volatility, require a different skill set. Specialist skills of deep appreciation of aspects like climate change risks, required underlying data characteristics, data analytics, and broader digital alignment are some of the niche skills that would be required.

Interpretation Risk I have spoken of “Interpretation risk”4 in my earlier book as “the risk of likely differing interpretations of ambiguous, untested or elaborate laws, regulations and standards.” Banks are going almost blind here, as there is not much precedence or clarity yet. One of the big risks that banks face and will continue to face for some time is the interpretation of the multitude of regulations, guidelines, and disclosure requirements. Regulators can take the lead in promoting clarity around the treatment of environmental exposures. In summary, fundamental challenges like data gaps, simple uniform estimation methods and disclosures, uncertainty associated with vagaries of climate, and interpretation of the multiple norms will test banks’ ability to manage climate-related financial risks. How some of these challenges can be mitigated through structured approaches, as well as advances in some of the specifics, is addressed in Part 3 the “How” part.

 Saloni P. Ramakrishna, Enterprise Compliance Risk Management – An Essential Toolkit for Banks and Financial Services, Wiley (2015).

Chapter 7 Players of the Climate Change Risk Landscape We must move beyond climate talk to climate action. –Ted Turner

Adverse climate changes can occur due to vagaries of nature or fostered by human, business, or market imperfections, which in turn have both financial and economic impact, not to mention human and environmental impact. The size of the problem is huge on multiple fronts. As rightly pointed out by BIS (Bank for International Settlements) seniors,1 “Greening the economy,” i.e. cutting CO2 emissions to address the “physical risk” of huge climateinduced damage, will call for a major reallocation of resources – a shift from emission-intensive (“brown”) to emission-light (“green”) activities. This reallocation is bound to be painful, hard to engineer, and fraught with “transition risks.”

It is a collective effort across stakeholders in which financial services is a key but only one part of the whole. A global ecosystem of governments, policy makers, regulators, financial service industry participants, global associations, other public and private enterprises will collectively shape the climate change risk narrative, its shape, direction, and pace. It is important to note that it is a global ecosystem of stakeholders. The coming together of these varied stakeholders in a constructive collaboration will be the key towards the right direction. As I have said in my blog climate change risk management, “In a sense it is everybody’s job but with clear delineation of areas of operation and accountability for the same,”2 which will be required for this effort to move forward in a positive way. Both intra and inter stakeholder alignment is the big ask. In this chapter, an overview of the stakeholder ecosystem and a very brief introduction to some of the important participants is covered. The sample of individual members under each category are mentioned briefly, as representatives of their operational area, reach, influence, and contribution of the group they represent (Figure 7.1).

 BIS, Finance and climate change risk: managing expectations, https://www.bis.org/speeches/ sp220607.pdf.  Saloni Ramakrishna, Climate change risk management – whose job is it anyway? Finextra, February 28, 2022. https://doi.org/10.1515/9783110757958-009

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Regulators

Other important stakeholders

Governments & policy makers

Global associations

Public & private enterprises + Individuals & households

Investors & customers Banks & other financial services industry participants

Figure 7.1: Different stakeholder segments in climate change ecosystem.

Regulators Regulators are one of the major stakeholders and painters of climate change risk canvas – both at micro and macro prudential levels. They are one of the most active participants in propounding and leading the way in both supporting banks contributing positively to combatting adverse climate change as well as in streamlining the path towards a more sustainable financial system. This is guided by multiple objectives which are within the supervisors’ remit, be it in ensuring financial stability, proactively detecting, and arresting systemic risk or ensuring individual participants (banks, insurance, and asset management firms, etc.) are safe as the entire ecosystem transits towards a resilient low carbon economy. Various regulator groups are working towards melding in approaches to manage and mitigate climate change related risks into supervision and financial stability monitoring. Regulators, broadly, can be segmented into three categories (Figure 7.2). Regulators with global area of operation. Given below are three representative regulators with global reach and influence on multiple aspects including climaterelated financial risks for banks. While they are primarily guides to national regulators, they also exercise considerable influence on the individual banks and other financial services industry participants as they set global standards for the industry. In the climate-related financial risks space, their work assumes additional significance

Governments Authority

European Banking

Europe Central Bank

Regional

Asian Development Bank

(Sample)

Figure 7.2: Sample banking industry regulators in climate-related financial risk space.

Central Banks

National

Regulators

African Development Bank

Financial Stability Board - FSB

Basel Committee on Banking Supervision - BCBS

Global

International Organization of Securities Commission (IOSCO)

Regulators

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Chapter 7 Players of the Climate Change Risk Landscape

as the risks are global in nature and will impact all industries/sectors, geographies, and economies as well as individuals and households. By setting guidelines, coordinating across different players, and striving towards standardization, they are at the forefront of constructive efforts in the space. –

–

–

–

–

Bank for International settlements (BIS) promotes global monetary and financial stability through international cooperation. On the banking side, the Basel Committee on Banking Supervision (BCBS) “is the primary global standard setter for prudential regulation for banks and provides a forum for regular cooperation on banking supervisory matters. The mandate of the BCBS is to strengthen the regulation, supervision, and practices of banks worldwide with the purpose of enhancing financial stability.” BCBS, as the premier body on banking regulations, has come out with some critical papers/documents which are both directional as well as updates/status reports about climaterelated financial risks. Some of the concepts, survey results, guidance notes, and the principles have been referred to in different parts of the book where appropriate. Financial Stability Board (FSB)3 “is an international body that monitors and makes recommendations about the global financial system . . . promotes international financial stability; it does so by coordinating national financial authorities and international standard-setting bodies as they work toward developing strong regulatory, supervisory, and other financial sector policies.” The active contribution that FSB is doing in bringing together and coordinating, at a global level, the work being done on climate-related financial risks by different disclosures and standards setting organizations serves as a strong reference content for practitioners in the space. Its documents covering stocktaking, promoting climate-related disclosures through TCFD (Task Force on Climate-related Financial Disclosures), sharing of supervisory and regulatory approaches in the space have all been sources of reliable information and direction. Information from these documents along with their roadmap series are referred to in the book as appropriate. International Organization of Securities Commission (IOSCO) – IOSCO is the global standard setter for securities markets regulation. It works in close cooperation with the G20 (Group of Twenty – An intergovernmental forum) and FSB to address emerging financial vulnerabilities that could affect global financial stability. Given that securities will play a crucial role in the sustainable finance space as well as in the overall finance and economy, IOSCO plays a two-way crucial role, one that is investor focused and the other that is multi-stakeholder focused in an effort to standardize disclosures and reporting in the sustainability space. Regional Regulators – one of the important examples in this category is European Banking Authority (EBA) and European Central Bank (ECB) – EBA is the banking regulatory authority, responsible for maintaining financial stability throughout the European Union. European Central Bank ensures that banks follow the directives of EBA. EBA is one of the most active regulators in the climate-related financial risks space. It has influence at two levels – at one level on its member country supervisors/banking regulators and at another level as the frontrunner of climate change initiatives including the climate stress tests. Central Banks of individual nations – BIS lists these regulators by country. Every country typically has a banking regulator, or multiple in some cases. The United States of America is an example of the latter.

 Financial Stability Board, About the FSB, https://www.fsb.org/about/.

Regulators

– –

–

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Central Banks of individual countries are important players as they can influence the complicated, interrelated climate change issues and guide their member banks on the path to the low carbon economy. They can weave the global, regional regulators/agencies’ initiatives and their countries’ specifics into a coherent program to further the net zero effort. They can put to effective use both Incentives and disincentives to nudge financial services industry participants as well as investors and corporations towards sustainable initiatives. They can set benchmark interest rates that determine prices of goods and services influencing consumption patterns, money, and credit supply. These have an impact on both the investment in climate change initiatives and the terms of such investments. Sharing of market analysis and findings not just with banks but also with other stakeholders enables a faster learning curve for all. Central banks are in a strong position to be information/knowledge conduits, particularly the impact of adverse climate change, carbon transition on macroeconomic indicators like inflation, commodity prices, GDP, etc. This data/ information helps banks to refine their models as most models have these as variables. This will also help banks with better analysis and decisioning.

It is important to note that central banks, while being guides and overseers of commercial banks, are implementers of the pro-climate change initiatives for their own operations and most of them are walking the talk by – – –

Being transparent about their own operations that face or contribute to climate change risks and their actionable roadmaps to address the same. Decarbonizing their operations through the green bonds route. Aligning fiscal and monetary policies towards a planned transition to the net-zero economy.

There is a fine line however, as to how far central banks can go in “mandating” specific business direction that banks take, as they are not expected to pick winners and losers. Banks plan and execute their businesses based on their business models and agreed strategy. The choice of which legal businesses they lend to or finance is within their realm, at least in theory. Central banks can influence the direction through the various tools they have including capital buffers, higher RWA (Risk Weighted Assets), and thereby higher capital requirements for brown assets which would be a disincentive for banks to lend to non-sustainable projects.

Governments/Policymakers Governments through their policies and direction on the subject have an important impact on all stakeholders. Unlike other financial services directives, which largely stem from the regulators, both banks and their counterparty businesses are directly influenced by government directives in the climate change space. This is so because governments can, through both carrot and stick flavored policy interventions, shape the contours of climate change journey. This can take the shape of carbon tax structure, limits on emissions, penalties for breaching of limits, mandating renewable energy contributions and incentives for meeting and exceeding the expectations, etc. In addition, to lead by example, governments are looking at their own contribution to create a sustainable economy. A sample can be from United Kingdom, which

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along with the EU has taken active advances in leading the way towards fostering a more sustainable economy. According to the UK Government,4 To help the UK meet its 2050 net zero target and other environmental objectives, the government will issue its first Sovereign Green Bond in 2021 subject to market conditions.” “The UK will also implement a green taxonomy – a common framework for determining which activities can be defined as environmentally sustainable. It will take the scientific metrics in the EU taxonomy as its basis and a UK Green Technical Advisory Group will be established to review these metrics to ensure they are right for the UK market.

Given the global nature of climate change and its far-reaching impact, intergovernmental groups are also active in the space. This is enabling cross geography collaboration facilitating learning from one another as well as formulating global responses that are complimentary and supportive of the larger goal of transition to sustainable economies. A couple of examples in this group are the G20 group of countries and IPCC (the Intergovernmental Panel on Climate Change).

G20 (Group of Twenty) An intergovernmental forum comprising of nineteen countries and European Union. This is a powerful forum. It is reported that it accounts for around 90% gross world product, 75–80% of international trade, two thirds of global population, and roughly half of the world’s land area.5 Given their collective presence, it is not surprising that they contribute about three fourths of global greenhouse emissions. This group and its initiatives are critical in the space.

IPCC (The Intergovernmental Panel on Climate Change) The objective of IPCC6 is “to provide governments at all levels with scientific information that they can use to develop climate policies . . . their reports are key inputs into international climate change negotiations. IPCC is an organization of governments that are members of United nations and World Meteorological Organization (WMO), currently 195 members.”

 Gov.UK Chancellor sets out ambition for future of UK financial services, November 9, 2020.  Wikipedia (n.d.).  About IPCC (The Intergovernmental Panel on Climate Change), https://www.ipcc.ch/about/.

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Important Global Associations/Collaborators This groups’ contribution, in terms of identification of trans-boundary, trans sectoral impact and communicating the same, is immense (Figure 7.3). Since there are so many potential paths for risk transmission, they may not be visible to banks operating in single jurisdictions. This group is playing a significant role in setting standards and shaping the narrative of climate change risk management of banks and other components of the financial services industry. Graphic below captures a sample of some of the important organizations and a very brief note on each of them.

Task Force on Climaterelated Financial Disclosures

TCFD

NGFS

Global Associations (Sample) Set Standards, disclosure guidelines, stress testing and modeling methodologies, etc.

ISSB

GHGP

UNEP FI

Network for Greening the Financial System

International Sustainability Standards Board

Green House Gas Protocol

UN Environment Programme Finance Initiative

Figure 7.3: Sample of Global Association.

TCFD (The Task Force on Climate-related Financial Disclosures) TCFD established by Financial Stability Board and Bank of England. It is evolving into a leading source of investor led guidance. Its recommendations are structured around critical aspects like risk management, metrics, governance, and strategy. UK has made TCFD disclosures mandatory. Its objective is to enable standardization of reporting requirements of climate change.

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NGFS (Network for Greening the Financial System) This is a group of central banks and supervisors, which on a voluntary basis are willing to share best practices and contribute to the development of environment and climate risk management in the financial sector, and to mobilize mainstream finance to support the transition toward a sustainable economy.7 The NGFS brings together 114 central banks and supervisors and eighteen observers. Together, they represent five continents and more than 85% of global greenhouse gas emissions and are responsible for the supervision of all of the global systemically important banks.

The objective of NGFS8 is a transition towards a sustainable economy. – – –

Help strengthening the global response required to meet the goals of Paris agreement Enhance the role of financial system to manage risks To mobilize capital for green and low-carbon investments in the broader context of environmentally sustainable development

Climate scenarios proposed by NGFS have been the basis of the scenario analysis by supervisors across multiple geographies. We will visit some of these and their progress as well as insights under chapter covering scenario analysis and stress testing.

ISSB (International Sustainability Standards Board)9 “The intention is for ISSB to deliver a comprehensive global baseline of sustainability related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities to help them make informed decisions.” The ISSB, under the aegis of IFRS foundation, is set to evolve as the premier disclosures’ standards setting body.

GHG (Green House Gas) Protocol10 GHG “set the standards to measure and manage emissions. It supplies the widely used greenhouse gas accounting standards. This helps a standardized framework to measure and manage GHG emissions from private and public sector operations, value chains and mitigation actions.”

 NGFS, NGFS publishes its 2022–2024 work program, May 30, 2022.  NGFS, https://www.banque-france.fr/en/financial-stability/international-role/network-greening-finan cial-system.  International Sustainability Standards Board, https://www.ifrs.org/groups/international-sustainabil ity-standards-board/.  Greenhouse Gas Protocol, https://ghgprotocol.org/.

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Disclosures, under the GHG Protocol, are classified into three categories – Scope 1, Scope 2, and Scope 3. “Scope 1 emissions are direct emissions from owned or controlled sources. Scope 2 emissions are indirect emissions from the generation of purchased energy. Scope 3 emissions are all indirect emissions (not included in scope 2) that occur in the value chain of the reporting company, including both upstream and downstream emissions.”11 Between them, the three scopes cover different modes of emissions, some of which may have been missed if only Scope 1 category or even Scope 2 were included. It is Scope 3 in combination with 1 and 2 that makes this a comprehensive approach.

UNEP Finance Initiative The United nations Environment program Finance Initiative focuses on aligning economies with sustainable development and shaping the global sustainable finance agenda. The Principles of Responsible Banking12 expounds six principles that the signatory banks (currently over 270 banks which covers 45% of banking assets) commit to embed across all business areas at the strategic, portfolio, and transactional level.

PCAF (Partnership for Carbon Accounting Financials) guidance on standards to assess and disclose emissions. Established in 2015, it helps financial institutions assess and disclose the Green House Gas (GHG) emissions at a fixed point in time, in line with their accounting cycle, from their loans and investments through GHG accounting: “Measuring financed emissions allows financial institutions to make transparent climate disclosures on their GHG emissions exposure, identify climate-related transition risks and opportunities, and set the baseline emissions for target setting.” They have developed the Global GHG Accounting and Reporting Standard for financial services (the standard) covering six asset classes.

CFRF (Climate Financial Risk Forum) In addition to international bodies across continents, there are bodies within a country, across different verticals of financial services, doing serious work on understand-

 Greenhouse gas protocol, FAQ.  UNEP Finance initiative, Principles of responsible banking.

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Chapter 7 Players of the Climate Change Risk Landscape

ing, assessing, and addressing financial impact of climate change13. One such example is the Climate Financial Risk Forum, with the objective of building capacity and sharing best practices across financial regulators and industry to advance financial sector responses to financial risks from climate change.

Banks and Other Financial Services Institutions Banks are the primary finance providers for individuals, households, SMEs (Small and Medium Enterprises – some call this the commercial segment), and Corporates. They shape their business portfolios based on their business model, goals, and risk appetite. Given the explosion of climate change awareness, related financial losses, regulators and policymakers’ attention and social activism, banks are choosing to be “part of the solution” in the journey towards the low carbon economy. Active lending and better terms (underwriting, pricing, repayment models, etc.) will be more towards sustainable options. Banks are exposed to climate change risks not only from their own operations but also from their clients’ operations.

Investors and Customers As one of the important fund providers, investors are an important set of stakeholders. They will influence both the sentiment and flow of funds towards more sustainable projects. Investors are an interesting category of stakeholders. They are both affected and can affect climate change landscape. That is because they, along with banks, are the major source of funding for alternative low carbon intensive solutions, disruptive technologies. On the other hand, they would have earlier invested in high carbon intensive businesses. In the latter case, they would be keen to see the transition of these businesses to the desirable low carbon intensive group, which is the reason this set of stakeholders are strong advocates of transparency. Customers are at the core of every business. Their preferences and the social activism associated with amplifying the global ask of transition to low carbon options will be a big propeller in that direction.

Corporates and Other Counterparties Corporates are big players in the economy and have an even bigger role in climate change initiatives. Large, SME, and other commercial establishments are increasingly becoming aware of the risks they face if they do not transition to cleaner greener options. For fossil fuel intensive corporates, it is a survival challenge as they need to identify workable transition paths to net zero goals on the one

 Climate Financial Risk Forum (CFRF), https://www.fca.org.uk/transparency/climate-financial-riskforum.

Other Important Stakeholders

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hand and prepare themselves for new age “green” competitors on the other. Corporates realize that it makes good business sense to plan out workable transition trajectories. The top advantages are: –

– –

Ensuring funding on better terms – From investors – From market – Debt – Equity – From Banks – Better pricing – Better repayment terms Higher revenue through customer preferences of sustainable options New avenues of growth, both products and markets.

Other counterparties like individuals, households, and broadly the entire retail segments are important stakeholders also because of their impact on multiple fronts through their preference for environment friendly options and products like low emission vehicles, smart houses built on sustainability principles, and the like.

Other Important Stakeholders

Rating Agencies

Other Players

Research Institutes

Sample

Data Providers

Figure 7.4: Other significant players.

• S&P Global • Fitch Ratings • Moody’s • ,,,,,,,,,

• IPCC - Intergovernmental Panel on Climate Change • USGCRP - U.S. Global Change Research Program • IIASA - International Institute for Applied Systems Analysis • …….

• The World Bank • International Monetary Fund • MSCI • FTSE • ………..

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Chapter 7 Players of the Climate Change Risk Landscape

The other significant stakeholders (Figure 7.4) are rating agencies, research institutes, and data providers. These are powerful influencers as they factor in environmental footprint (greenhouse gas emissions, use or misuse of natural resources, pollution, etc.) and will be the sources of objective information that can then be used across the spectrum to make informed decisions. Special mention is required of the following two organizations which are making important contributions to the body of work on climate change as relevant to banks. –

–

International Monetary Fund – an important support system sharing insights into macrofinancial transmission of climate risks both in terms of data and trends. Special mention is made of the Climate Change Indicators Dashboard14 – “a statistical tool linking climate considerations and global economic indicators” that brings together climate–related data needed for macroeconomic and financial policy analysis. World Bank – the World Bank is an active player in climate change initiatives,15 leading with multiple initiatives including “being the biggest multilateral funder of climate investments in developing countries.”

 IMF – Climate Change Indicators Dashboard.  The World Bank, 10 Things You Dint Know About the World Bank Group’s Work on Climate Change.

Part 3: The “How” of Managing Climate Change Risks – Building Blocks

Practitioner’s Note The Art and Science of Managing the Emerging but Fundamentally Transforming Climate Change Risk Marc Irubétagoyena As a practitioner, the experience of working on ECB (European Central Bank) and other regulators’ climate change systematic risk analysis was a big challenge to say the least and a huge learning experience at the same time. As head of Stress Testing and Financial Simulations of a global bank, I have been part of many involved and challenging exercises as required by multiple regulators across multiple jurisdictions, running close to a hundred stress tests yearly. Climate risk analysis, I can say with firsthand experience, is of a different scale and complexity, demanding an exponential expansion of variables to consider, over wider time horizons ranging from one to thirty years and involving new approaches with both statistical and empirical modelling. For starters, the stakeholders’ landscape is vast with notably business lines much more involved than in traditional regulatory stress testing. From a strategy and influence perspective, an organization’s engagement right from the front seat is critical given the impact expected on the image of the institution. There are two levels of internal front line challenges in operationalizing the process. First, it is difficult for organizations to design a clear strategy involving all stakeholders and second, to ensure alignment for implementing a relevant and timely risk management framework over long periods. Failure in defining the adequate roadmap triggers both strategic loss of momentum and greatly increases investments. A significant adaptation of the risk management framework, throughout the organization, must be put in place, leaving limited time to implement the transformation. As a matter of fact, the full risk management cycle from risk anticipation to risk appetite to measurement to monitoring, mitigating and reporting has to be revamped to cover climate change risk drivers. Regulators and supervisors are forcing changes in this space at high speed with an imposed involvement of senior managers and boards of the institutions to self-attest that systems and controls are in order. Like Ms. Saloni Ramakrishna persuasively articulates, it is vital for organizations to follow a systematic pathway in building the various complementary bricks of analysis required to identify and quantify risks increased by climate change, with the transmission channels involved in the transformation. Starting from data demands, both historical and forward-looking inputs for quantitative modelling, all the way up to the ramp-up of macro-economic and sectoral expertise to design relevant scenarios are to be assessed. It is a given that all necessary pieces/components (data, models, scenarios, et al.) are not already there, however waiting is not an option. A mix of traditional risk analysis approaches with more exploratory ones is required. https://doi.org/10.1515/9783110757958-010

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On scenario design, for example, macroeconomic scenarios are provided for climate change by the Network for Greening the Financial System but insufficient sectoral information is provided on how the transition is effectively achieved. The International Energy Agency is building sectoral transition scenarios providing much more detailed information on the technological switches required to meet the emission targets, in a range of temperature evolution trajectories, but a global macroeconomic consistency is not given. Banks have thus to pick a starting set of scenarios and develop the missing components to reach a consistent set of fully described and consistent scenarios. A similar complexity is generated by data availability which, on most required dimensions, is partial. It requires organizations to progressively develop through internal and external trusted sourcing, while accepting in the meantime to initiate analysis processes with proxies. Fast tracking a first acceptable framework will enable, while pursuing progressive consolidation of that framework, to initiate climate risk analysis feeding business and risk management key processes. This step is a lengthy one due to the number of parties involved, which demands that it be launched as soon as possible with a first set of quantitative and qualitative approaches. Market expectations are also high, and they will keep on increasing on both risk quantifications and standardized disclosures. Each institution will have to simultaneously meet the minimal disclosure expectations and to provide relevant risk analyses, feeding its strategy, that will be necessary to frame a grounded understanding of the evolution of risk profiles under the climate change context. Risks of impairing the image of an institution are significantly increased with climate change communication given the wide range of stakeholders having different expectations from the financial institutions’ disclosures. Given that compliance to these expectations is expensive it makes sense to ensure that money is spent wisely so that major risks are avoided before they become a problem. The blueprint that Ms. Saloni Ramakrishna details in the “How” part of the book captures these principles elegantly and fleshes them out through actionable frameworks. Marc Irubétagoyena

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Marc Irubétagoyena, an engineer graduated both from Ecole Polytechnique and French National School of Economics and Statistics, is Director of BNP Paribas in charge of Stress Testing and Financial Simulations, covering notably climate risk analysis. Mr. Irubétagoyena is a reputed banking risk practitioner with varied experience. He was previously strategic consultant for Arthur Andersen, involved in derivative trading front office activities; board member of BNPP’s propre trading activities; and has had diverse financial experience as CFO of BNPP’s Global Market activities, and now a Group Risk Board executive.

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Section Abstract Objective – To outline a practical, functional framework for banks to create and navigate the climate change risk universe. This part seeks to provide the building blocks with an operational and actionable framework. Covering the “Principles for Effective Management and Supervision of Climate-Related Financial Risks” as enunciated by the Basel Committee on Banking Supervision and other regulators. It looks at the various risk functions right from risk appetite to risk identification, assessment, measurement, scenario analysis, the stress testing and mitigation facets of climate-related financial risks. It addresses the important aspects of disclosures and reporting mandates.

Chapter Abstracts –

–

–

–

Chapter 8 – looks at what a building blocks approach will look like and the advantages of approaching the complex climate change risk management in a structured way, as opposed to letting each component be managed in isolation. It emphasizes the fact that climate change risks are multilayered, multithreaded, intertwined and hence looking at the various components of climate change risk management framework as a set of connected units and designing them in this way will save a lot of time and effort. Chapter 9 – presents a brief overview of the Basel Committee’s “Principles for Effective Management and Supervision of Climate-Related Financial Risks.” Principles are foundational and form the first building block of creating a robust climate change risk management framework. A quick look is also taken at other regulators who have articulated a principles-based approach to managing this new and emerging risk universe. Chapter 10’s focus is to take a bird’s eye view of the components of a good risk appetite statement of a bank and how risk appetite for climate change risks can either be enunciated as an integral part of the overall enterprise risk appetite statement or be called out specifically. Samples of good practices as enumerated by regulators are discussed. The components of a climate change risk appetite statement are looked at using four examples. Chapter 11 while bringing to fore the centrality and importance of climate-related data, explores the key challenges as well as ways to chalk out workable solutions to traverse the challenged path. It explores important themes and practical approaches that banks can consider while building a robust, scalable data management blueprint. It looks at a sample set of data specifics and advocates a segmented approach to plan the data acquisition.

Chapter Abstracts

–

–

–

–

–

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Chapter 12 – looks at the concepts of identification, assessment, and measurement of climate-related financial risks by banks. It explores the various aspects of assessment like scope, types, methods, stages, and tools of assessment. Measurement factors like data requirement, models and methodological considerations are delved into. The measurement methods that are more in practice amongst banks are briefly described, along with top-down and bottom-up approaches. Metrics measuring GHG emissions like absolute, economic, physical emissions intensity and weighted average carbon intensity, Scope 1, 2 and 3 are briefly surveyed. A sample of quantitative indicators and the possible approach to arrive at these metrics is looked at. Chapter 13. Scenario analysis and stress testing are the more important tools for banks to gauge the potential impact on their businesses that could be caused by climate change mitigation actions at various levels of the economy. This chapter explores the nuances of the relevant concepts involved like scenarios, scenario analysis, sensitivity analysis and stress testing through sample literature review, both from regulators and global organizations. It then looks at the life cycle of the process right from designing to constructing with variables selection all the way to outcomes. A sample of approaches of different regulators is looked at, rounding off the discussion with the usefulness of these analyses not just for risk measurement but also as input into the balance sheet planning and strategy of the banks. Chapter 14 delves into the mitigation, control, and monitoring methods of the evolving discipline of climate change risk management. It looks at the strategic measures like risk avoidance, acceptance, transfer, and control in the context of climate change risk. Both proactive and reactive mitigation measures are briefly discussed. The chapter explores tracking and ensuring strong controls for the known risks through a potential model that factors in both design effectiveness and implementation effectiveness. Chapter 15. Disclosures are a vital part of climate change risk management, primarily to understand the two foundational questions of how climate is impacting banks and how banks are affecting climate change mitigation initiatives. This chapter explores how regulators as well as global organizations like the Task Force on Financial Disclosures (TCFD) and International Sustainability Standards Board (ISSB) are (or will be) leading the requirements in the space. It also looks at some of the important metrics like financed emissions, green assets ratio (GAR), banking book taxonomy alignment ratio (BTAR), green and brown measures in the space. Chapter 16 suggests a unified three component framework model, viz. strategy, structural and operations, for operationalizing climate change risk management in banks. Each of these are an integral part of the other. The first defines bank’s

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strategy and approach to climate change risk management by clearly articulating objectives, goals, and governance structures. The second works toward creating the required structures that enable realization of the strategic objectives. The third lays out the actions, processes, workflows, and templates to actualize the structural goals and intent.

Chapter 8 Building Blocks – The Big Picture Talk does not cook rice. –Chinese Proverb

Climate change risk management is a paradox as it is a combination of both uncertainty and risk deeply intertwined with one another. The “uncertainty” is in the relative inability to predict the climate paths, their timing, intensity, direction, and correlations. At best, through multiple what if scenarios/stress paths, an estimate is made of the possible climate pathways. The next step of assessment of the likelihood, frequency, and intensity of impact on the traditional risk categories of the banks is the “risk” angle. It is this unique combination of uncertainty and risk that make managing climate-related financial risks a complex exercise, specially at this nascent stage of the discipline’s evolution. Banks are exposed to climate change risks regardless of their size, complexity, and business model, as the Basel Committee rightly points out. These can quickly translate into traditional financial risks. The other aspect is the materialization of climate-related financial risks over varying time horizons. Inbuilt dynamism and flexibility is required to manage these risks, especially as it is an evolving discipline with more questions than answers at this time. Too many moving parts – structural changes in the economy, climate path changes, corporate and financial system responses to transition to a low carbon economy, competitive landscape, etc. – all contribute to the flux. The first step from a bank, is to understand that there are three distinct aspect of climate change that they need to work on, as represented in Figure 8.1. While all the three are deeply interconnected, there are typically different groups within the bank that work on each of these areas. Since the focus of this book is on climate change risk management, this part speaks largely to the “How” aspects of that area.

Climate change risk management

Path to NetZero in bank’s own operations

Sustainable finance

Figure 8.1: Broad areas of Climate change management for Banks. https://doi.org/10.1515/9783110757958-011

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Chapter 8 Building Blocks – The Big Picture

Most banks have, or are in the process of, making commitments about the net zero targets, both of their own operations as well of their businesses. To actualize these commitments, while ensuring that their firms are safe and on sound ground of growth, a very involved planning and precision execution is required. Step one is to plan out the path to net zero. Some goalposts for proactively managing the net zero journey are: – Set bank level net-zero targets and emission metrics as part of risk appetite. – Align portfolio level emission targets to bank level targets through appropriate lending policies. – Put in place methodology and processes to measure financed emissions and temperature alignment and track through heat maps. – Identify and find potential clients with credible projects amongst environment friendly growth sectors. While the client being in the “green sector” is an important factor, equally important is assessment of credit worthiness and collectability fundamentals like credible cashflow projections, market assessment, competitor analysis, financial soundness, and stability of both the project and the borrower. A project being in the “green zone” does not automatically make it a viable credit risk for the bank. This must be headlined, as otherwise the principle can be upended and fast. – Before the market stabilizes there will be a beeline for the clients with the right credentials who will demand premium rates and may get these, given that demand will outweigh supply initially. Pricing, project viability, and borrower credibility will all be important factors. – Robust and realistic targets and tracking mechanisms to track net zero milestones are to be put in place. – A support plan to help clients navigate their transition journeys successfully is critical to actualizing the net zero targets. – Understanding of the interconnectedness of financial risk due to climate change with the traditional financial and non-financial risks by banks and weaving that knowledge into their approach blueprint will save cost and pain down the road. Once the goal posts are set, the next step is to plan a systematic structured approach to execution and that is where the connected building blocks approach comes into play. Regulators hope that through strong corporate governance and robust risk management frameworks, the myriad of risks presented by climate change to banks can be managed as all players learn from the experience. Principles for climate-related financial risk management provide the foundation on which the building blocks are set to navigate the new and involved universe of climate change risk. OCC’s Strategic Planning principle mentions that banks should “consider material climate-related financial risk exposures when setting the bank’s overall business strategy, risk appetite, and financial, capital, and operational plans.”

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Public communications about banks’ climate-change strategies should be “consistent with their internal strategies and risk appetite statements.”1 Regulators, both global and regional have, or are, sharing/discussing principles of managing climate-related financial risks, as a foundation to a structured approach to managing these new risk clusters. Principle 16 of the Basel Committee2 speaks of fostering cross-border collaboration; home and host supervisors of cross-border banking groups should share information related to the climate risk resilience of banks and banking groups, leveraging existing frameworks for sharing information and undertaking collaborative work. The OCC, for example, clearly states that “As part of forward-looking strategic planning, the board and management should address the potential impact of climate-related financial risk exposures on the bank’s financial condition, operations (including geographic locations), and business objectives over various time horizons.”3 The idea is not just risk managing, it is about embedding risk analysis outputs and insights into business decisions, integrating with enterprise-wide frameworks for management of climate change, extending or modifying where relevant. Particular focus needs to be given to enterprise risk management constructs, fundamentally, blending climate change risk management into business strategy and execution. Through this part on “how” to operationalize a robust climate change risk management framework in a bank, a building block approach is proposed. A building block approach provides multiple advantages; with my banker hat on, the top five advantages in my opinion are: – – – – –

Creates a principles-based approach right from the word go. Helps bank think logically through the process and progress rationally. Builds flexibility into the design, a core requirement for a solution space that will grow, and rapidly, over the coming years. Each block, while allowing for changes within itself, also ensures that the interlinks are not missed out while considering alterations. Builds in an “incrementalism” approach to gather and grow data and information points, more so since sparse data is one of the major challenges that banks are facing in this space.

Figure 8.2 captures the broad building blocks starting with principles as the foundation. The subsequent chapters of this part cover each of the building blocks in some detail.

 Office of the Comptroller of the Currency Principles for Climate-Related Financial Risk Management for Large Banks (December 2021).  Basel Committee on Banking Supervision – Principles for the effective management and supervision of climate-related financial risks (June 2022).  Office of the Comptroller of the Currency Principles for Climate-Related Financial Risk Management for Large Banks (December 2021).

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Reporting and Disclosures

Risk Assessment Measurement Process

Board approved climate change Policy

Scenario Analysis and Stress Testing

Risk Organization – Operating Model

Risk Mitigation & Monitoring

Risk Appetite articulation

Risk Data Constructs

Principles of Managing Climate-related Financial Risks

Figure 8.2: Graphic representation of the building blocks for creating a robust climate change risk management framework.

Chapter 9 Principles for Effective Management of Climate-related Financial Risks It is better to take many small steps in the right direction than to make a great leap forward only to stumble backward. –Chinese Proverb

The foundation of a strong edifice for climate change risk management will be a set of sound guiding principles agreed by the principal stakeholders. The Basel Committee on Banking Supervision (BCBS) principles articulation sets such a common global baseline for both banks and regulators alike. These enable regulators to gauge the intent and direction of the firms under their jurisdiction with the principles as the overarching construct. For banks too, having a set of principles to build their climate change frameworks is the right starting point. The Basel Committee, as the global standards setting body for the banking industry, while not issuing regulations by itself, does design frameworks and principles (Figure 9.1) that become direction setting for the financial services industry. Their June 2022 articulation of principles for effective management and supervision of climate-related financial risks is the most extensive articulation of a principles based coordinated approach to climate change risks for both banks and their supervisors. The stated objective of the principles1 is “to achieve a balance in improving practices related to the management of climate-related financial risks and providing a common baseline for internationally active banks and supervisors, while maintaining sufficient flexibility given the degree of heterogeneity and evolving practices in this area.” The Basel Committee intends that this will “promote principles-based approach to improving risk management and supervisory practices related to climate-related financial risks,” which is why they are segregated into two main components, one set as a guidance to banks and the other as a guidance to supervisors. The principles are intended to be applied “on a proportionate basis depending on the size, complexity and the risk profile of the bank.”2 Important to take cognizance of the comment on “proportionate basis,” as the intensity of the impact of climate change risks will be different for different banks depending on various factors. The expectation across the regulatory bodies is that banks and their boards understand the climate-related financial risks they carry on their books – both current and potential exposures – and incorporate strong corporate governance structures

 BCBS, Principles for the effective management and supervision of climate-related financial risks, June 2022.  Ibid. https://doi.org/10.1515/9783110757958-012

Principle 4

Internal Control Framework Capital and Liquidity adequacy – Principle 5

Risk management process – Principle 6 Management monitoring and reporting – Principle 7

Scenario analysis – Principle 12

Operational Risk – Principle 11

Liquidity Risk – Principle 10

Market Risk – Principle 9

Credit Risk – Principle 8

Management of risks

Principles 16 to 18

Responsibilities powers and functions of supervisors

6 Principles

Supervision,

Prudential regulatory and supervisory requirements for banks – Principles 13 to 15

Figure 9.1: Principles for effective management and supervision of climate-related financial risks. Source: Adapted from BIS Principles for effective management and supervision of climate – related financial risks – June 2022

Principles 1 to 3

Corporate Governance

Effective Management 12 Principles

Climate-related financial risks BIS Principles

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Chapter 9 Principles for Effective Management of Climate-related Financial Risks

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and oversight around the processes and policies. Under the governance set of principles and guidance, they require banks to consider whether incorporation of material climate-related financial risks into business strategy and risk management design warrant changes to compensation policies. Banks in the Eurozone are expected to disclose how they link remuneration to sustainability goals. Capital is an important tool for supervisors as well as a good buffer for banks to tide over temporary business as usual imposed losses. Liquidity buffers are equally critical to tide over short spells of funding challenges. Basel principles expect incorporation of material climate-related financial risks in banks’ ICAAP (Internal Capital Adequacy Assessment Process) and ILAAP (Internal Liquidity Adequacy Assessment Process). Banks need to evaluate both liquidity and solvency impact of climate-related financial risks that may materialize on their capital planning horizons, especially the risks identified as material. Principle 5 calls these out specifically. Capital is very deeply intertwined with the risk profile of the banks. Regulators are encouraging banks to incorporate climaterelated financial risks in their ICAAP and ILAAP processes to ensure capital and liquidity coverage. For market risk, banks are to evaluate the potential risk of losses due to increased volatility of its portfolios, including shock scenarios of negative variations of liquidity of assets exposed to climate change risk. The other aspect that needs to be considered while evaluating market risks is the speed at which exposures could be closed out as well as the impact on pricing and availability of hedges. The ILAAP process needs to take into cognizance the potential of impairment of its liquidity position across different time buckets/horizons, either due to stress on net cashflows or due to a decrease in the value of assets impacting their HQLAs (High Quality Liquid Assets) and their liquidity buffers. Regulators expect banks to assess and manage climate-related financial risks (CRFRs) through the lens of existing categories of risks that they work with (credit risk (inclusive of counter-party credit risk), market risk, liquidity risk, and operational risk). This is clear from perusal of principles 8 to 11 where a call out is made to identify and consider “material” climate-related risks and depending on their characteristics and impact treat them under the relevant risk category. The Australian Prudential Regulation Authority (APRA). is seeking to ensure that APRA-regulated institutions manage the risks and opportunities that may arise from a changing climate in line with APRA’s approach to other types of risks. It made clear that its purpose is to prompt regulated entities “to move more swiftly from awareness to action, to ensure institutions are equipped to adapt and respond to the substantial changes in the international economic and regulatory environment that are in train.”3 The counsel of moving swiftly and acting speedily is both sound and practical.

 Australian Prudential Regulation Authority, Prudential Practice Guide, CPG 229 Climate Change Financial Risks, November 2021.

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Of particular emphasis by the Basel Committee is the suggestion of identifying, assessing, and monitoring risk concentrations of industries, economic sectors, and geographies within and between climate-related risk categories. Concentrations are indeed a big concern as climate risk drivers can have a simultaneous impact on Industries and economic sectors, snowballing into concentrated exposures causing huge damages which could trigger a contagion effect. Basel defines, risk concentration4 as any single exposure or group of similar exposures with the potential to produce (i) losses large enough to threaten a bank’s creditworthiness or ability to maintain its core operations or (ii) a material change in a bank’s risk profile. In the context of climate-related financial risks, concentrations could be within and between risk types associated with climate-related financial risks (e.g., between physical risk and transition risk, or between traditional financial risk types) and they could include, but not limited to, geographies, sectors, and counterparties.

These principles are in close alignment with pronouncements by other regulatory authorities like the Office of the Comptroller of Currency, USA (OCC – December 2021) for large banks and the Federal Deposit Insurance Corporation, USA (FDIC- March 2022). The alignment and similarity are not surprising, given that principles are fundamental tenets that guide banks to navigate this new and complex risk universe. There are some slight variations however, based on the focus. For example, FDIC and OCC principles look at large banks (with USD $100 billion in assets), while Basel principles are for all banks (subject to proportionality). Alignment paves the path to standardization, cross jurisdictional harmonization, information sharing, and benchmarking. The OCC’s draft Principles for Climate-Related Financial Risk Management for Large Banks5 (Figure 9.2) provide banks with “a high-level framework for the safe and sound management of exposures to climate-related financial risks, consistent with the existing risk management framework described in existing OCC rules and guidance.” These help “bank management make progress toward answering key questions on exposures and incorporating climate-related financial risks into banks’ risk management frameworks.”

 BCBS, Principles for the effective management and supervision of climate-related financial risks, June 2022.  Office of the Comptroller of the Currency, Principles for Climate-Related Financial Risk Management for Large Banks, December 2021.

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Governance

Scenario Analysis

Policies

Climate-related Financial Risks OCC’s SIX Principles Strategic Planning

Data, Risk Measurement

Risk Management

Figure 9.2: Principles for climate-related financial risk management for large banks (Office of the Comptroller of the Currency).

It is interesting to note that the Basel Committee, in its guidance to the supervisors, looks to them to ensure that they have adequate resources with expertise to assess banks’ management of climate-related financial risks. This has been rightly called out as the space with all its complexities is not very familiar to all stakeholders, including some of the supervisory staff. Principles, as stated at the outset of the chapter, set a logical and robust framework for managing this new and evolving risk cluster space. Non-alignment with the principles, in addition to opening banks to sizeable financial risks, could expose banks to a multitude of non-financial risks including regulatory, conduct, and reputation risks. Hence, a thorough understanding of the principles is the starting point to “how” to create and manage climate-related financial risks.

Chapter 10 Risk Appetite Statement (RAS) If you must play, decide three things at the start: the rules of the game, the stakes, and the moment to quit. –Chinese proverb

An organization’s risk appetite statement (RAS) is “the amount of risk it is willing to accept in pursuing its strategic objectives. This sets the parameters within which management and the organization is expected to operate.” ISO 31000 defines RAS as, “The amount and type of risks that an organization is prepared to pursue, retain or take.” Figure 10.1 captures the essential components of a RAS. There are other terms that are used as synonyms of RAS. The most common one in that category is risk tolerance. However, there are some crucial differences. According to the Institute of Internal Auditors (IIA), both risk appetite and risk tolerance set boundaries of how much risk an entity is prepared to accept Risk appetite focuses on the level of risk a bank considers acceptable, given their strategic objectives – a broader statement articulating its risk capacity. Risk tolerance, on the other hand, is more narrowly defined, set as an acceptable level of variation around risk objectives. Through the “Strengthening Enterprise Risk Management for Strategic Advantage,” document, Committee of Sponsoring Organizations (COSO) mentions that risk tolerance is the “levels of variation the entity is willing to accept around specific objectives, it reflects the variation in outcomes related to specific performance measures linked to the objectives the entity seeks to achieve,”1 a specific range of risk variation that an organization can take and is aligned to its risk appetite. Together, these two describe the risk posture of an organization. Other related terms in the space are: – Risk capacity – the amount and type of risk an organization can support – a boundary. It is not a single number. The amount varies across risk types, scenarios, geographies, and lines of businesses. This is usually planned based on the strength and size of its capital. – Risk target – the optimal level of risk the firm wants to take in pursuit of its specific business objectives. – Risk limits – these are maximum levels of risk exposures for a given portfolio/customer/geography/product, etc. Breaching the limits triggers, or should trigger, mitigation and control actions.

 COSO, Strengthening Enterprise Risk Management for Strategic Advantage (n.d.). https://doi.org/10.1515/9783110757958-013

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Alignment to climate change strategy of the bank Ownership, accountability & responsibilities, including Board

Communication modes, frequency, etc. Components of a Risk Appetite Statement (RAS) for a bank

Risk appetite scale Qualitative criteria

Time Horizons – For risk assessment, for review of RAS Risk appetite scale Quantitative criteria KRIs

Figure 10.1: Broad set of components of a Climate change risk appetite statement.

Having drawn the contours of a RAS, the next step is to have risk appetite for climate change risk articulated. Defining a risk appetite statement for climate risk is challenging, given that the underlying concepts themselves, their inter-relationships, and correlation effects are complex. Adverse climate change has always been one of the known risks, mostly tucked away under operational risk as loss to physical assets by physical risk events. It was the 2015 Paris agreement that brought it to attention and from 2018 it has been top of the agenda of all banks, at least in terms of acceptance and articulation. It deserves focused attention and action on multiple fronts (as discussed in Chapter five of the book). Climate change risk is viewed as a driver of other traditional risk categories of a bank. Some of the risk categories impacted by climate change risk are listed hereunder, with a caveat (repeated) that climate change risks cut across risk categories and could simultaneously impact many of them: – Credit risk – Market Risk – Liquidity Risk – Operational risks – business continuity – Reputation risk – Capital risk

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Liability risk Regulatory risk

With the focus on climate change risks, banks must calibrate climate-related financial risks (CRFR) management programs, policies, their business models, and their strategic and operational realities. Basel principles expect banks to clearly define and address CRFR in the risk appetite statements including development of key risk indicators for managing those risks. The Climate Financial Risk Forum guide 2021, in its climate risk appetite statements,2 clearly states that “Developing a climate risk appetite statement (RAS) is an essential aspect of climate risk management, to align understanding of the level and type of risk that is accepted in pursuit of a firm’s strategy” The document discusses, in terms of industry group, specific aspects of climate risk appetite: – “The impact of climate change on the firm through physical and transition risk. – The impact of the firm on the climate through net zero (or other) alignment The most widely applicable financial risk categories, e.g., credit risk” The European Central Bank, describing good practices in this space in its report on supervisory review of banks’ approaches to managing climate and environmental risks, mentions the following “qualitative statements generally comprise targets or guidelines on the institution’s willingness to take on certain risks, while risk indicators are developed based on a (partly) quantitative methodology.”3 As examples of good practices, it states the following

Qualitative Statements Some institutions have included statements on excluding or phasing out certain exposures immediately or within a certain period. For example: – to stop financing real estate or business activities that are in areas where biodiversity may be negatively affected. – to stop financing thermal coal activities, coal-fired power plants, and production of shale gas Some institutions have included statements on engaging with all their corporate clients to ensure that each client has a dedicated transition plan (with a formal diversification strategy) in place. For example:  Climate Financial Risk Forum Guide 2021: Climate Risk Appetite Statements, October 2021.  European Central Bank, The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks, November 2021.

Qualitative Statements

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continuing to encourage corporate clients to improve their climate-related risk management. ensuring that counterparties measure and disclose climate-related impacts in line with the recommendations of the Task Force on Climate-related Financial Disclosures calling for counterparties to comply with the Paris Agreement, for example by phasing out coal and unconventional fossil fuel production.

The Office of the Comptroller of the Currency (OCC), as part of its risk management principle, says “Material climate-related financial risk exposures should be clearly defined, aligned with the bank’s risk appetite, and supported by appropriate metrics (e.g., risk limits and key risk indicators) and escalation processes.”4 Reserve Bank of India’s (RBI) discussion paper on climate risk and sustainable finance5 speaks of how The risk appetite framework of REs (Regulated Entities) could include the risk exposure limits and thresholds (limits on credit exposures and collaterals on sectors and geographical areas exposed to climate risks) of financial risks that the RE is willing to take. While formulating the risk appetite framework the Board would need to ensure that it considers the factors like the longterm financial interest of the RE, results of stress testing and scenario analysis. Speaking of good practices, the RBI mentions “REs may integrate climate-related risk indicators in their risk appetite framework. “These climate-related risk indicators shall consist of objective and measurable metrics.” The limits may cascade down to the sector and portfolio level contingent on the type of indicator. It may comprise both qualitative and quantitative elements. To illustrate, the climate-related risk indicators are: – Concentration in CO2/GHG-intensive assets – Carbon emission footprint of portfolio

Different firms have (or will) take different approaches to articulate their risk appetite for climate-related financial risks – some may embed it in the overall RAS of the bank (either at group level or at individual entity level). This appears as the general preference of banks at this stage as the impact of climate change risk is being assessed through the tradition risk landscape of the bank. Some firms may opt for a separate climate change risk/ESG RAS. Given hereunder are four examples of RAS, each highlighting some critical inputs into an actionable risk appetite. Example one highlights how risk appetite for Climate-related Financial Risk (CRFR) is embedded in the overall RAS.

 Office of the Comptroller of the Currency, Principles for Climate-Related Financial Risk Management for Large Banks, December 2021.  Reserve Bank of India, Discussion Paper on Climate Risk and Sustainable Finance, July 2022.

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Risk Appetite Statement (RAS) Example 1: Nordic Investment Bank The bank defines RAS as “a written articulation of the Bank’s risk-taking, risk mitigation and risk avoidance, taking into consideration the Bank’s statutory requirements. It contains risk category specific statements and forms a tool for the Board of Directors and senior management to guide and monitor the Bank’s risk-taking activities” (“Risk Appetite Statement – Nordic Investment Bank”). Articulating their approach to climate change risk, the bank states that they are committed to the objectives of the key international climate-related action plans for banks and recognize that climate change exposes the Bank to physical and transition risks but offers opportunities as well. We are committed to enhancing our climate risk management and to integrate it into our overall risk management framework. Our business strategy will support and assist our owners, clients, and counterparties in their journey towards a climate resilient economy. We are willing to finance our clients to support their transition towards a low-carbon economy. We encourage our clients to clearly define and communicate their climate-related commitments and to develop and execute effective strategies to mitigate climate risks.6 It is a comprehensive statement that embeds climate risk appetite within the overall RAS. This is in line with the stakeholders’ approach to look at climate change risk within the overall enterprise risk management framework of the bank. It covers essential information, for example – It clearly states adoption by the Board of Directors (BOD) which gives it the legitimacy, relevance, and importance. – It gives all relevant dates like adoption date, date of entry into force, review cycle (at least annually), and the document (with date) it replaces – It speaks of ownership, implementation, and control responsibility.

Risk Appetite Statement, Example 2 Green Climate Fund7 speaks of three levels of appetite for risk taking, from zero tolerance to considerable tolerance, that differ across risk types: – Prohibited risk taking (“zero risk tolerance”): activities that the GCF will not engage in and for which the GCF will have zero risk tolerance. – Risks to be carefully managed and where practicable minimized (“moderate risk tolerance”): risk taking based on activities that are a by-product of operating a materially significant fund. – Risks taken to achieve strategic impact (“considerable risk tolerance”): risks required to be taken to fulfil the GCF mandate, to be compensated through climate change impact.

 Nordic Investment Bank, Risk Appetite Statement adopted on June 7, 2022 with entry into force as of June 16, 2022. https://www.nib.int/files/93baa38195f247179b5c242bdec55c157b4288d5/risk-appetitestatement-june-2022.pdf.  Green Climate Fund, Risk appetite statement (Component II), https://www.greenclimate.fund/sites/ default/files/document/risk-appetite-statement-component-ii.pdf.

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Example 3 An interesting and horizontal example of managing climate change risks is Rolls-Royce’s statement on climate risk: Risks that are within our control, such as transitional risks associated with product emissions, are more easily mitigated through the development of technology. Those risks that are outside our control are better managed through risk transfer (for example the purchase of business continuity insurance to safeguard against the physical risk of extreme weather disrupting our supply chain). Risks that conform to the Group’s defined risk appetite are either accepted or controlled through less direct methods.8 The focus here is the acknowledgement that different risks are a reality and “how” the risks will be managed is the important aspect to be considered.

Example 4: A Hypothetical Corporate Bank Table 10.1: Example of a possible corporate bank RAS. Risk appetite statement: Bank X is committed to (i) managing the transition and physical risks faced today and under future scenarios; and (ii) managing the risks associated with the strategic commitment to align to net zero Transition risk

In client portfolio – Transition risk scores for customers in high transition risk sectors – Carbon asset risk of portfolio – Impairment/ECL to high-risk sectors under a specified stress scenario – RWA utilization of high-risk sectors – Where the above metrics are not available, consider existing metrics (such as those below) with a high-risk client overlay. This simpler approach does not take into account readiness and could be more effective for portfolio review – Impairment charges as percentage advances for high transition risk sectors – Percentage limit on exposures or investments in high transition risk industries – Client on-boarding and transaction level risk assessment processes/coverage measures – Specific credit, concentration, and sectorial policies

Physical risk

To client portfolio – Percentage of portfolio exposure to high physical risk locations under identified scenario X – Specific credit, concentration, and sectorial policies – To operations (direct) or supply chain – Annual loss under 1/250 scenario to be within the agreed upper limit.

 Rolls Royce, Statement on Climate-Related Risk, https://www.rolls-royce.com/~/media/Files/R/RollsRoyce/documents/sustainability/Climate-related%20risks%20statementRolls-RoycePLC.pdf.

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Table 10.1 (continued ) Alignment/ Alignment metrics: strategy – Portfolio warming potential. – Portfolio temperature alignment tools – Weighted-average carbon intensity – Percentage of portfolio with green taxonomy – strategic metrics that track against firms’ commitments – Percentage of commitment reached on renewables/sustainable – financing – Reduce its thermal coal exposure to zero by 2030 Source: Climate Financial Risk Forum Guide 2021, Climate Risk Appetite Statements October 2021, Published by CFRF Drawing pointers from the regulatory guidance and real-life examples of organizations on the framing of RAS (Table 10.1), a few themes that shape a workable RAS would be – Aligned with risk strategy – RAS needs to be in alignment with the risk strategy of the bank. Understanding of key risks from climate change and environmental demands and their potential financial impact on the books of the bank is at the core of setting a credible risk strategy. – Realistic estimation of cost of inaction for the bank, not merely in the short or medium term but in the long term as well, is an important part of strategy and risk appetite formulation for climate change risk. Three vital aspects to keep in context are: – The business model can support the strategy and the risk appetite. – It is in line with the overall climate change management goals set and articulated by the bank. – It is operational with specific actions and timelines. – Comprehensive coverage – A climate RAS, typically, needs to address physical, transition risks, and alignment to climate goals of the firm (net zero, a temperature target, or some other strategic climate-related objective) – RAS to speak of both the impact climate change risk will have on the bank and the impact the bank will have on climate change. The first is the bank’s management of climate change risk, the second is its commitment to a net zero path. – Board adoption – Board having clarity on “material” climate-related financial risks and assigning responsibility to an identified steering committee with board oversight is at the core of risk appetite formulation. – Board’s approval and adoption of RAS that clearly and simply articulates climate change risks that the bank is exposed to, their assessment, mitigation, management, and framework of accountability. – Ownership – CRO is usually the owner of the risk appetite statement. – Appetite levels – Firms usually grade their risk appetite into the following: – Zero appetite – zero risk tolerance, for example to non-compliance with regulatory mandates – Medium appetite – medium tolerance, for example concentration levels as a percentage of the portfolio with adequate mitigation and control measures – Higher appetite – for example higher risk appetite for higher revenue contribution but moderate climate risk impact that fits into their overall net zero plans.

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Metrics Both qualitative and quantitative components –

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The qualitative requirements could include – Mandatory processes like automatic screening of new businesses. – Review of all existing accounts that are vulnerable to climate change risks. – Material climate-related financial risks identified and tracked. Quantitative – setting up “bounding metrics”:9 a single or small number of metrics that set bounds around the amount of climate risk that an institution is willing to take. The metric represents the key elements that drive the risk appetite. Examples include: – Carbon asset risk of portfolio. Incorporating carbon intensity as a proxy for transition risk, lifespan of physical assets, and EBIT for individual customer names. – “Climate Value at Risk” (VaR) – present value of climate costs or profits divided by market value Trackers, limits, and thresholds for greenhouse gas (Scopes 1–3) emissions Determining the boundary of climate risk the bank is willing to accept – Sustainability targets – Determining how safe is safe? Potential metrics and thresholds set at portfolio level such as – proportion of properties with an energy performance certificate (EPC) rating at a particular level – Proportion of portfolio exposed to high physical risk – Proportion of portfolio exposed to high transition risk – Potential limit for new accounts in identified vulnerable segments – Acceptable risk per RAS versus actual vulnerable portfolio Review frequency – Risk appetite statements can be dynamic and flexible with shorter review timelines initially (say a year, unless a material event or circumstance requires otherwise) to fine-tune based on experience, observation, and regulatory guidance. Corporate memory – Creating a corporate memory by clear documentation and communication that is accessible to all stakeholders of the bank.

Risk appetite statement then becomes the fulcrum for the cascading effect of climate change risk which Figure 10.2 tries to capture at a high level.

 Climate Financial Risk Forum Guide 2020, Risk Management Chapter, June 2020.

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Board Level Risk Appetite Statement E.g. The bank is committed to managing physical risks today and under forward looking scenarios

Board – Risk Appetite Metric E.g. Concentration of clients exposed to extreme flood risks today, currently without adequate adaptation plans; target threshold 10%

Regions- Risk Appetite Metrics E.g. Clients operating in South East Asia may need more appetite on flood risks than Western Europe; so threshold could be set at 15% for Southeast Asia, and 5% for Europe

Business Segment - Risk Appetite Metrics E.g. Within the same region, Small and Medium Enterprises may have less adaptation readiness than large corporates; thresholds for these segments could reflect that, and over time be calibrated to evolving risk profile

SECTOR E.g. Within the same business segment, the agriculture sector may need different risk appetite to the oil and gas sector. Also within a sector, different sub-sectors or activities may need different risk appetite

Figure 10.2: Cascading effect of climate change risk. Source: Climate Financial Risk Forum Guide 2021, Climate Risk Appetite Statements, October 2021, Published by CFRF.

For the next couple of years, all aspects of managing climate-related financial risks including risk appetite statements will be evolving as an iterative learning process to stay aligned with the broader climate change risk management strategy and process.

Chapter 11 Climate-related Risk Data Perfect cannot be the enemy of good. –Lael Brainard

Bankers are increasingly becoming aware that unmanaged or under managed climate change risk will impact the bank’s profitability, solvency, and liquidity. Assessing and measuring is, however, challenged on various fronts with data and models as some of the top problems confronted. Accurately accounting for the impact of climate change risks on the books of the bank is difficult due to the lack of required data at the required granularity and quality. The centrality and importance of relevant data is a given. Reliability on the inferences drawn from models, analytics, scenarios, stress testing exercises, and disclosures of banks is squarely dependent on the availability, quality, and reliability of the data used and that is suspect at this stage. Principle 7 (Basel Committee’s principles of managing climate-related financial risks) states, “A bank’s risk data aggregation capabilities should include climate-related financial risks to facilitate the identification and reporting of risk exposures, concentrations, and emerging risks. Banks should have systems in place to collect and aggregate climate-related financial risk data across the banking group as part of their overall data governance and IT infrastructure.”1 Broad categories of information required like risk drivers, vulnerabilities, exposures, and concentrations are all at various levels of granularity and availability. Given that the raw data’s detail and consistency are a way away, aggregations are bound to be a little off in the initial stages.

Data Challenges Data challenges fall into three broad categories (Figure 11.1). Solving one category without another makes the exercise sub-optimal. – – –

Data availability – granularity, detail, accessibility. Data reliability – quality, verifiability, traceability. Data comparability – standards-based.

 Basel Committee on Banking Supervision, Principles for the effective management and supervision of climate-related financial risks, Basel Committee on Banking Supervision (2022). https://doi.org/10.1515/9783110757958-014

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Data Availability

Data Reliability

Data Comparability

Figure 11.1: Broad areas of Data Challenges.

Data Availability This is the starting point and its reliability is what makes the exercise relevant or otherwise. On data availability, Basel Committee summarizes succinctly that the data types and classes required for objective assessment of climate-related financial risks are different and new to the banking system: Assessment of climate-related financial risks will require new and unique types of data, different to the data banks have traditionally used in financial risk analyses. The data needed to map risk exposures and translate climate-related risks into financial risk estimates may be only partially available and may not meet traditional data quality standards, such as the length of history, completeness, and granularity needed to support the risk decision-maker. Moreover, data describing the historical relationship between climate-related impacts and their economic and financial consequences may not be representative of future climate-economy or climate-financial relationships.2

As an example, emission data (Scope 1 to 3), one of the key data points, is scarce. It is central to credit risk assessment across the lifecycle of the loan, measuring and reporting on net zero milestones. Emission data is a critical component for assessing climate-related risks, for instance, to arrive at the Green Asset Ratio (GAR – discussed in Chapter 12). There are pointers/suggestions how such problems might be overcome, but for now banks need to look at workarounds.

 Basel Committee on Banking Supervision, Climate-related financial risks – measurement methodologies (April 2021).

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Data Reliability and Data Comparability These two themes are closely interwoven, as dependable, consistent, and comparable data are central here. Benchmarking or comparison of climate change risk metrics is a while away, given that the standards are just evolving. The difference in the construction of climate scores/ratings or incorporating climate factors into existing rating constructs to create a climate change risk adjusted rating makes comparison and benchmarking difficult. Interestingly and sometimes frustratingly, for the same client, different rating approaches can give different scales depending on the underlined models, factors, and their weightages. This is a serious problem. Heterogeneities at various levels, understanding and selection of critical variables, and model constructs are likely to lead to different scores for the same client. For instance, Tesla could receive two quite different scores, from different index providers, say MSCI & FTSE. This could be because one is focused on the product (the car) which is environmentally friendly and hence gets a good score, while the other looks at the entire supply chain. In the latter case, if some of the suppliers that provide components and services for making of the Tesla product are emission intensive and the supplier’s emission contribution (Scope 2 and 3) are factored into the overall score/ index, the score could be negative, thus resulting in widely different results for the same company. These hurdles will be overcome over time, as standards evolve and stabilize, but for now these idiosyncrasies are real. Summing up the data challenges, Network for Greening the Financial System (NGFS), in its July 2022 final report on bridging data gaps, groups the key data challenges into nine broad categories, as reflected in Figure 11.2. Some of the themes fold into the topics that are usually discussed under the realm of data challenges. The five themes mentioned at the bottom of the pyramid are focused on climate change risks. A mention needs to be made of two of the five themes in the base segment that are usually relegated to behind the scenes. These are: cost of granular data and capacity building.

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Trust/ Auditability

Estimation/ Modelling Relevant Benchmarks

Specific Location Information

Costs for Granular Data

Incomplete Information Combining Physical Risk Data Forward looking Transition Risk

Capacity Building

Figure 11.2: Key challenges for climate-related data. Source: Network for Greening the Financial System, Technical document, Final report on bridging data gaps, July 2022.

The Costs for Granular Data Per NGFS, “More than sixty-five organizations or private vendors provide different levels of emissions data, yet only seven of them are open sources. In terms of granularity, most (30%) of the data provided are at counterparty level, with only 3% at location level.” Three important takeaways here are: – – –

One is that while there is some data, far less is available as open source. The balance has an associated “cost” factor. This raises both the “availability” and “cost of carbon neutrality” concerns. Two is that locational data is sparser. Three is that the data point mentioned is about emissions. Even within emissions, a whole new class of data for banks, the data providers may not be covering all three scopes of emission (Scope 1 to 3).

Capacity Building As enumerated by NGFS, capacity building is developing an understanding of sciencebased metrics to correctly convert them to financial risks. They point out that about 20% of the raw data items that support the metrics for measuring physical vulnerability and transition sensitivity are science based. I would extend the “capacity building” requirement beyond the science-based metrics awareness.

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The other facet to focus on is in the climate change risk skill bolstering that is required at an organizational (bank’s) level. Understanding the various data classes, their appropriate interpretation, and their interrelationships is critical. Without the relevant understanding of the subject, it would be difficult to select the right data elements to be used (both for modelling and disclosure) and to interpret the results correctly and contextually, if the domain appreciation is missing. This falls under the skill and domain knowledge capacity building requirement that was discussed in Chapter 5 and is within the realm of individual banks. Regulators too, understand and acknowledge data challenges. Per the ECB,3 “Owing to the constant evolution of C&E (Climate and Environmental) risk management, the ECB is aware that data and methodological gaps may make it difficult to fully implement the supervisory expectations in some cases. The ECB expects institutions to adopt a strategic approach and to take intermediate steps as appropriate.” There are two takeaways here. The first is the sparse availability of relevant data in meeting the “supervisory expectations” that the ECB highlights. The other equally, or perhaps more, important aspect is the ability of banks to risk manage climate change, with data, models, and methodological challenges that they face. While the challenges are real, what is equally true is that climate-related financial risks are a tangible reality today and will get only deeper and more complex. Varied and sometimes innovative solutions will be needed to address these.

Three Ways of Response to the Data Problem For the given situation, there are three responses that institutions look at: 1. Inaction – quoting data issues as the reason. This, however, is not an option nor does it make business sense, especially from the climate-related financial risk management perspective. It does not make a credible excuse either. There are words of wisdom from Frank Elderson, vice chair of the Supervisory Board of the ECB on the subject: “Patchy as the data may be for now, it will enable progress in climate issues. And in any case, banks do already have access to enough information to start making real progress.”4 2. Reactive response – working with what is available. 3. Proactive, the recommended response – extending and enhancing what is available. Three distinct kinds of initiatives are discussed here as a sample of this approach as reflected in Figure 11.3.

 European Central Bank The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks, November 2021.  Keynote speech by Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, Emerging climate-related risk supervision and implications for financial institutions.

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Proactive approaches to addressing the data challenges

Innovate (as a parallel initiative)

• Using proxies and assumptions as intermediate alternatives • Developing own indicators to gauge the direction and riskiness

Leverage data from Regulators and opensource providers

• NGFS • TCFD • IMF • PCAF • ….

Developing a scalable Data “Blueprint”

• Data Architecture and Management policy covering the entire life cycle of data management right from Data Ownership to its usage and ultimate archival

Figure 11.3: The proactive response to data challenges. –

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Be realistically innovative with the available data. Innovation could take the form of creating specific indicators or proxies: – As Frank Elderson states, “Some banks are proactively trying to overcome the scarcity of climate-related data by independently developing their own indicators – such as financed carbon emissions, financed technology mix and energy performance certificates – to identify corporate clients with high sensitivity to climate transition risks – they have then set limits at portfolio-level to manage those risks.” – There are data sets currently unavailable, unreliable or lack the required granularity. Innovating proxy or representative indicators during the transition period is resorted to in such cases – A sample of this category are given hereunder: – Data on supply chains of counterparties. – Transmission paths across sectors. – Climate paths – particularly longer term – Emission data – particularly Scope 2 and Scope 3 – BCBS, acknowledging this challenge, suggests, “Where reliable or comparable climaterelated data are not available, banks may consider using reasonable proxies and assumptions as alternatives in their internal reporting as an intermediate step.”5 The emphasis is on the “intermediate” part as a transitory phase until more real data sources become available. Leverage climate data and/or data sources identified by regulators and global organizations, who are keenly aware of the challenge and are making progress on bridging data gaps in a systematic way – to track and use what is relevant. Four examples are: – From CFRF’s (Climate Financial Risk Forum} Guide on Climate Data and Metrics – October 2021 – which captures at an elevated level the gaps, actions being taken to address them, and options to accelerate progress (Table 11.1):

 Basel Committee on Banking Supervision, Principles for the effective management and supervision of climate-related financial risks, June 2022.

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Table 11.1: Sample of data gaps and actions. A Selection of Climate-related Data Gaps, Actions, and Options Climate-related data gaps

Information relating to corporate transition plans to support forwardlooking assessment of risk and alignment Sector, and geography, specific transition plans to help assess transition risk exposures Physical risk data on vulnerability of assets as well as hazard and exposure

Actions being taken to address these

Central banks and supervisors, for example, through NGFS are providing more granular parameters to support scenario analysis Financial firms are starting to request information on transition planning from corporate clients. This will be accelerated further through initiatives such as GFANZ and implementation of new guidance from TCFD

Options to accelerate progress

Continued development of bottom up, granular approaches to climate risk and analytics, including probabilistic scenarios and open data approaches Increased engagement with governments on sovereign risk assessment and publication of sector and jurisdiction specific transition pathways Accelerating development, and harmonization, of approaches to assess the robustness of corporate transition plans (e.g., transition pathway initiative, climate transition pathways) Greater availability, and accessibility, of physical risk data, particularly relating to vulnerability as well as exposure, and the impact of chronic as well as acute climate hazards

Source: Climate Financial Risk Forum Guide 2021, Climate Data and Metrics (October 2021).

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Network for Greening the Financial System, the detailed directory, mentions that, “In total, the final directory contains 329 unique metric/methodology combinations and 1,262 raw data items, of which 62% are backward-looking and around 26% have an annual frequency. More than 40% of the combinations of asset classes and use case (i.e., more than 2,200 combinations) in the directory involve data items related to transition. Most of the data are aggregated at counterparty level (about 30%) and at country level (23%).” Partnership for Carbon Accounting Financials (PCAF), data6 providers for computing GHG emissions, states that,

For Option 1 (reported emissions), PCAF recommends either collecting emissions from the borrower or investee company directly (e.g., company sustainability report) or third-party data pro-

 Partnership for Carbon Accounting Financials. The Global GHG Accounting and Reporting Standard Part A: Financed Emissions. Second Edition, December 2022.

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viders, such as CDP, Bloomberg, MSCI, Sustainalytics, S&P/Trucost, and ISS ESG. Data providers typically make scope 1 and 2 emissions data available. –

International Monetary Fund’s (IMF’s) climate change indicator’s dashboard7 headlines its dashboards as follows:

In collaboration with other international organizations, the IMF has identified and developed a range of distinctive indicators that demonstrate the impact economic activity is having on climate change. These indicators have been grouped into five categories: economic activity, crossborder, financial and risks, government policy and climate change data. Building a robust, scalable data management blueprint that can capture data, maintain, manage, and expand its framework seamlessly. Even if there is no data for now, the blueprint can have data structures planned for filling out when the data comes in with the ability to create relationships between the data elements. This theme is the focus of the next part of this chapter.

Developing a Scalable Data Blueprint – Some Pointers Drawing from the experience of having partnered with multiple banks (both global and domestic) in their data management, transformation, and strategy initiatives for over two decades, I am listing some pointers that successful projects followed. Before I go further, there is a callout to the “right” technology solution, the oil that lubricates an effective data strategy and glues together the different components. I will discuss this in Chapter 16 which focuses on the operating model that melds climate-related financial risks into the enterprise risk management framework. For now, the attention is towards the nuances of developing a robust scalable blueprint for the entire life cycle of data management. The four big themes to focus on are scalability (to hold the expected geometric multiplication of climate data), extendibility (to do so in an orderly way), flexibility (to accommodate newer data, data structures, and greater qualifier information), and incrementalism (to grow the body of data incrementally). To support forward looking assessment of climate change risks, it is suggested that relevant stake holders like data scientists, hardcore risk professionals, and FP&A teams come together to blend in data structures that might be required to capture potential tail risks (climate value at risk and implied temperature increase), etc. –

Drawing up a comprehensive data architecture and management policy is both for creating a corporate memory and for having uniform communication across the organization. This would broadly cover the following themes: – Data ownership – appointing a data steward with authority, responsibility, and accountability for sourcing and owning data is an essential first step, with special focus

 International Monetary Fund, Climate Change Indicators Dashboard, A statistical tool linking climate considerations and global economic indicators.

Developing a Scalable Data Blueprint – Some Pointers

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on climate change related data. This is because data requirements and their use in this space is in its nascent stage but are fast evolving. Data constructs/architecture – have data constructs that are flexible, can expand incrementally as new data requirements/sources are identified, accommodate data at the required granularity and detail so that banks do not have to revisit the drawing board repeatedly or hit the reset button every time. Care should be taken that the architecture is in harmony with the enterprise risk management data framework of the bank because, as of now, outcomes of climaterelated financial risks are viewed through the lens of traditional risks of the banks. Data sourcing – climate-related data is nuanced and is risk driver flavored. For example, the data required for physical risk and transition risk would be different, particularly from external data perspective. From a physical risk standpoint, the location of the counterparty operation will be critical to assess vulnerability of the bank’s exposure. On the other hand, from the transition risk angle, the policies, and economic activities of the operations of the counterparty become significant, e.g., carbon sensitivity measures like GHG emissions, their link to productive capacity, measures taken by the counterparty to transition to low carbon options. Aspects that require particular attention are: – Data detail should be expected at a contract level across the canvas to support risk management, disclosures, reporting, and oversight. – Incremental data acquisition and capture approach to be planned as models and measurement methodologies will evolve. – Data Quality framework – running data quality checks and reconciliation routines as data enters the data constructs avoids a lot of effort down the line. Data processing and usage – as discussed under data challenges in this chapter, understanding and use of data influences the outputs and their interpretation in the climate related risks. Clear documentation on both the processing steps and the usage of data, contextualized to climate-related financial risks, is a core requirement. This will help both in enabling external scrutiny as well as course correction when needed (which would often be in the initial learning phase). Some of the central themes under this heading are: – Data transformation routines. – Data aggregations. – Modeling and analytics. – Reporting – Internal reporting – External reporting and disclosures Data history, storage, and archival policy – this aspect needs special attention as history data as well as future indicators for climate change, particularly transition aspects, are very sparse. Planning data records management well will enable banks to build history over time.

Approach to climate data collection – approaches, whether top down, bottom-up or hybrid, is determined by the data availability. A segmented method has been proven to give optimal results. Multiple ways of segmenting are possible, which when combined innovatively can result in easier and faster outcomes. Samples could be data categories based – one way could be counterparty specific, Industry/sector-specific, disclosure-specific, regulatory specific, etc., or the other as elucidated in Figure 11.4.

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Data describing physical & transition risk drivers

Three Broad Data Categories

• Needed to translate climate risk drivers into economic risk factors to arrive at climateadjusted economic risk factors

• Needed to linking climateData describing the adjusted economic risk factors vulnerability of exposures to exposures

Financial exposure data

• Needed to translate climateadjusted economic risk into financial risk

Figure 11.4: Data categories. Source: Adapted from BCBS, Climate-related financial risks – measurement methodologies (April 2021).

Incrementalism is the only realistic way to tame the data problem. As standards evolve, using some of the approaches that proved helpful in earlier situations and enhancing them with climate change risk data related new techniques will stand banks in good stead, and will add to the industry practices. Some themes and illustrative data specifics are listed below: – –

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A starting point is to have a robust data architecture and constructs in place. Next, a stepwise approach to flesh out climate-related data will be beneficial. This can be achieved by classifying the data requirements into four sets or buckets and populating these sets as enumerated here: – First set – identify mandatory data fields and focus on these first. – Populate available data. – For non-available mandatory data, start gathering on war footing, particularly at loan origination and loan renewal points. – Second set – essential information that is not available currently – start with proxy and build. – Third set – optional information but with analytical value – start with proxies. – Fourth set – optional information. Come back to this once the other three sets are moving smoothly. Another useful intervention is to flag data into separate groups, such as, as real data (validated), real data (not validated), proxy data, and data from unverified sources. This will help create specific strategies to each category that helps enhance their quality and use.

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Data Specifics Understanding the nuances of data required for climate change risk management inclusive of the data available within the books of the bank is a starting point. This can be augmented with those that can be obtained easily from counterparties/open-source data bases. Where data is not available, proxies that can be used in the interim help banks start to gather the relevant data. There are three data sources for collating/sourcing climate-related raw data. These are banks, clients/counterparties, and external sources. Listed below are some of the data points which, while far from being exhaustive, are indicative of the contours and depth of the type of data required. –

From bank’s books – collating client, location, portfolio, currency specific exposures and related details is a strong start point for two reasons. One is that it is doable as the data (at least in theory) is under bank’s control and the second is that this data needs to be mapped to the client and external data to be able to assess, measure, and mitigate climate-related financial risks. – Bank’s own operations – Location of various facilities – Resource usage and performance data (power, water) – Bank’s businesses – Bank’s portfolio groupings, product, and capital information, risk appetite, etc. – Cross border exposures across customers as well as for a given counterparty. This will help arrive at and address concentration risks. – Historical data on climate change risks of the counterparty – while this is not likely to be representative of the nature or scale of the future risk, they set a context. – Exposures at default (EAD with exposure details) – Impact when risk materialized (LGD) – Recovery details – Client information – Location of operations (not just HQ details), exposures (both direct and indirect exposures), industry, rating, default history, etc. – Risk transfer and mitigation related information both at client and product/facility related – Insurance – Financial instruments – Subsidies – Government guarantees – From the client’s books – their ecosystem details along their entire supply chain (their own and their suppliers’ and customers’ operations). Individual firm level data help capture variations in entities’ economic environments and the interlinkages. Some of the specific data points could be: – About the client – Sector – Industry – Lifecycle details of their product/s and projects

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Location details where counterparties are firms (commercial, SME, corporates, etc.) – Firm’s operations – Firm’s Assets – Suppliers – Customers – Location details where counterparties are household – Property location – Borrower location – Activity – Reliance on fossil fuel or renewable energy – Product – sustainability oriented or otherwise – Supply chain – Suppliers – Third party service providers – Customers – Product usage and disposal mechanisms – Nothing to dispose – Biodegradable – Polluting – Client Financials including project cash flows – Client transition paths and milestones – where movement is from carbon intense activity to a less carbon footprint – Greenhouse gas emission data (Scope 1 to 3) – Sensitivity to energy prices or carbon emissions – In sourcing raw material – In third party outsourcing – In production – In distribution From external sources for climate related data/scores, emission data, etc. for both physical and transition risk drivers – – – – – – –

Climate events (be they through macro or micro economic transmission channels arising from either physical or transition risk drivers) that can impact businesses Weather variability and patterns – past and current Projections on important indicators for both physical and transition risk drivers (like temperature and sea level rise) Data on climate risk drivers and Vulnerability maps/data points of sensitive physical risk event Industry specific climate data specially transition related Location specific climate data

Data gathering is a massive collaboration effort between the various stakeholders. A good place to begin is from the bank’s internal data and make their counterparties partners in the endeavor. It is critical that counterparties/clients share climate related data across their supply chain. This will be central to both analyzing climate change risks as well as complying with the required disclosures. This is going to be an evolutionary and incremental effort.

Chapter 12 Identification, Assessment and Measurement of Climate-related Financial Risks It’s better to solve the right problem approximately than to solve the wrong problem exactly. –John Tukey

The subject of climate change risk, its reality, and our understanding of it is evolving at a rapid pace. In parallel, though not at the same speed, the knowledge regarding required data, models, and methodologies to measure and mitigate these risks is also evolving. The requirement, as we move forward, will be to identify, assess, and prepare for climate change risks from both qualitative (expert judgement), quantitative (metrics and measurements), and scenarios perspective. Scenarios are not limited to just green swan events (the green swan concept is discussed in the next chapter) but a range of possible outcomes. From financial risks perspective, the concern banks have is that their business and profitability may be adversely impacted due to an increase in both financial and nonfinancial risks. This could be from expected and unexpected credit losses, market losses, legal claims, or operational/reputational losses. The unique, complex, multilayered, and interconnected aspects of the subject do pose both data and measurement challenges. From progress perspective, credit risk leads in the measurement and methodologies evolution. Both regulators and financial institutions are looking closely at the resultant impact of physical as well as transition risks (that will result from the economy moving towards a low carbon world and related climate policies). All concerned are acutely aware of the lack of required climate data. At present, the available emission data needed to assess and manage carbon footprint is limited with its data quality suspect. This is because of inconsistent disclosures by corporates and almost non-existent disclosures from small and medium enterprises (SMEs) and commercial segments. Banks with higher exposure to carbon emissions are more exposed to transition risks. The BCBS report1 summarizes the challenges both on data and methodologies: While conventional risk management tools may serve as a springboard for climate-related financial risk measurement, the impacts from climate risk drivers contain unique features that could challenge the incorporation of these risks into existing processes. A particularly high exposure granularity may be needed to assess both physical risks (geolocational data given spatially varying characteristics of climate impacts) and transition risk (counterparty- and industry level data capturing risk resulting from a shift from a high- to a low-carbon economy). This need arises from heterogeneities at various levels (e.g., sectoral, jurisdictional or geographic). Further key

 Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021). https://doi.org/10.1515/9783110757958-015

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conditioning elements relate to uncertainty stemming from data, models, or the limited ability of the past to act as a guide for future developments. On the methodological side investments will be needed to account for uncertainty spanning three areas: intrinsic future uncertainty inherent to projections of physical and transition risk drivers and ensuring standardized scenarios; measurement uncertainty related to data gaps, which may limit the suitability of back testing to calibrate loss or damage functions; and modelbased uncertainty, with more work needed for a robust quantitative assessment of identified climate risk drivers and their impacts on banks – including risks to counterparties, assets, liquidity and operations. The systemic nature of climate change might imply many interconnections and feedback loops, non-linearities and tipping points. Areas of methodological work warranting further investment include granular climate risk exposure analysis, as well as enhanced scenario analysis capabilities bridging climate science with financial modelling.

It is acknowledged that there is a lot to be put in place to be able to have a robust ecosystem in place to confidently measure climate-related financial risks. The exercise, however, needs to start in earnest immediately (if not already done so), with what is available and can be sourced or derived. This is because the climate change risks are now. The next part of this chapter explores the aspects of identification, assessment, and measurement of the financial risks that climate change poses to banks, primarily from a credit risk angle, as that is where there is some real progress.

Identification

Hazards/ Drivers

Stranded Assets

Exposure

Vulnerability

Figure 12.1: The three main components whose interaction results in Climate change risk.

Climate change risk results due to the interaction between a hazard/driver (physical or transition) an exposure to the said driver, either geographically or jurisdictionally) as well as a vulnerability – Figure 12.1 reflects this. While the risk driver is external to the counter-party or the bank, two firms in the same location may not have the same

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impact of the risk and this is dependent on the relative vulnerability. The outcome of locational disadvantage may result in some loss, that combined with higher vulnerability results in stranded assets (Assets that have been prematurely devalued or have been converted to liabilities resulting in losses) “ECB has identified climate change as a key risk factor with around 80% of European Banks already exposed to climate-related physical risks.”2 Mapping of climate risk drivers to financial exposures requires identifying, classifying, and differentiating risks across exposures. The starting point for the entire life cycle of managing climate-related financial risk is the clear articulation of an inclusive risk appetite statement and strategy plan. These are expected to state the markets, sectors/industries, and customer segments that the bank plans to cover, the products and services (current and proposed) that the bank offers, and their risk tolerance. This aspect has been discussed in some detail in Chapter 10 of this book. The next step is to blend climate change risk factors into identification and assessment across different risk categories. Like the BCBS report points out, progress has been largely on credit risk side, with some work on market risk while the quantifying methods of other risk categories is at a nascent stage. In the climate change risk universe, identification is not just of the known risks, but having the ability to spot the latent and emerging risks due to climate change. Identification starts with spotting and tracking the triggers and propagation of a potential risk from a weather event. This can be done at two levels. The first level, is to track the climatic transmission through related and linked nature of climate and its effect like global warming. The second level involves gauging the potential of resource crunch/scarcity that could be initiated or propagated due to actions taken to arrest the negative effects of climate mitigation. The other aspect, from a geography perspective, that banks need to be cognizant of, is that “some countries will be more affected than the others depending on exposures to transition risk stemming from the economic structure (e.g. importers or exporters of emission-intensive energy inputs) as well as exposure to physical risk”3 – vulnerability maps need to factor this in. Identification involves detection of the portfolios, exposures that may be affected by climate change like value impairment, declining demand and devaluation of assets, stranded assets increasing costs, etc. Value impairment affects the bank’s books by exposing them to both credit and market risks. Once the risks are identified, the next steps are measuring the exposure to these risks on the one hand and putting in place control and mitigation measures on the other.

 Keynote speech, Frank Elderson, Member of the Executive Board of the ECB and Vice-Chair of the Supervisory Board of the ECB, “Patchy data is a good start” (June 16, 2021).  Claudio Borio, Stijn Claessens, Nikola Tarashev, BIS – Finance and climate change risk: managing expectations, https://www.bis.org/speeches/sp220607.pdf

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From a credit risk perspective, a proper credit underwriting process for all proposals aims to avoid a “green bubble effect” where assets are mispriced or commercial viability including those with upcoming market competition or consumption are not assessed thoroughly. The broad identification is how a borrower (corporate or otherwise) interacts with the environment. Examples of key risks to be considered by banks in the lending portfolio are: – – –

Impact of decline in assets value in either the short term or long term due to physical or transition risk Borrower’s/corporate’s ability to repay in time or repay at all due to climate change risk drivers Potential challenge of climate risk drivers creating “mortgage prisoners” in high-risk properties

Assessment Risk assessment is estimating probabilities and the magnitude of financial losses. Assessing climate-related financial risk exposures is an involved process, more so when banks are going partly blind here, especially regarding the possible climate paths and transition trajectories. Therefore, potential losses are to be assessed against multiple plausible scenarios across various time horizons. Given the difference in the characteristics of climate risk drivers, they are assessed separately, of course, being cognizant of the fact that these may be dependent on or influence each other. Assessment of velocity or speed with which an event can impact the firm is critical. From a lending and investment perspective, two critical assessments (double materiality) need to be made to make an objective evaluation. – –

Counterparty’s impact on climate change and Impact of climate change on the counterparty and their business

Factual analysis of these two themes will inform the alignment between climate returns and financial returns. It also informs the climate-related financial risks that the counterparty is exposed to. Companies in sectors like energy, utilities, mines, and materials contribute to more than two thirds of the global emissions. While this is understood at the top level, converting the emissions to financial risk metrics is problematic today. Without scope 1, 2, and 3 data on carbon emissions, a foundational input to assess the true climate change related risks, a realistic assessment is challenged. What is being focused on is the bank’s ability to assess or measure counterparties’ effect on natural resources and physical environment. The next level of detail is appraising its contribution to greenhouse gas emissions, carbon footprint, energy intensity, usage of resources, and waste policies. From the list it will be clear that these data points will be difficult to get and hence approximations may be used by banks. What is relevant is that these factors should be there in the overall scheme of assessment, both for financing as well as pricing.

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The first step of the assessment exercise is putting in place a foundational framework, which can grow organically. Frameworks that not only assess the bank’s climate risk blended in exposure and risk factors but also can assess the viability, measurability, and direction of the counterparty’s transition plans and paths (transition arcs) are needed. The requirement is for forward looking measurement methodologies. Environmental factors like emission compliance violations, ownership of contaminated land, and hazardous waste generation are all important data points which are not available easily today. This will be am evolutionary process. Supervisors recognize that banks lack adequate assessment tools and capabilities, in addition to data limitations, which impairs their ability to address climate risks well. Figure 12.2 highlights the conceptual assessment framework suggested by the BCBS Report. The framework contains four components covering risk identification, exposure mapping and measurement, risk quantification and finally risk management.

Climate-related financial risks 1 Risk identification

Climate risk drivers | Transmission channels (see companion report on transmission channels)

2 Exposure mapping and measurement

Methodological considerations Conceptual considerations Granularity | Topdown vs. bottom-up | Risk mitigation | Heterogeneities | Uncertatinty Data needs Risk drivers | Vulnerabilities | Exposures Risk classification

3 Risk quantification

Economic impact modelling Forward-looking assessments Scenario design | Time horizon | Balance sheet assumptions

Exposure measurement metrics and indicators Credit risk

Market Liquidity Operati Other risk risk onal risk types risk

Sensitive sectors and carbon-related assets Alignment and financed emissions Ratings and labels Vulnerable exposure to hazards

Risk measurement approaches Scenario analysis

Stress testing

Sensitivity analysis

Other practices

4 Risk management

Figure 12.2: Conceptual risk assessment framework. Source: BCBS, Climate-related financial risks – measurement methodologies (April 2021).

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The next step of assessment is risk classification. This is required to build a vulnerability intensity map or grading exposures based on their relative vulnerability to climate change risks, not just as part of exposure mapping but also for pricing and managing the risks. Classification is an exercise at risk differentiation, as assets with similar characteristics from a traditional assessment perspective may be impacted differently by climate-related risks, depending on their location, customer/investor sentiments, weather patterns, climate policies, and other heterogenous factors. Speaking of assessment of climate-related financial risks, BCBS mentions that, To assess exposures’ vulnerability to physical risks, a comprehensive matching of physical hazards with the location of relevant physical touchpoints can facilitate the estimation of potential economic impacts and, ultimately, of the potential disruption to the contractual cashflows of a bank’s lending exposure . . . . information about interconnections among retail, corporate and municipal borrowers may be required to assess impacts from deterioration in local economic conditions arising from severe or chronic weather events.4

Risk assessment is challenged in the case of financial risks of adverse climate change, which often are catastrophic, both by their own force and the possibility of a cascading impact of inter-relationships at multiple levels. Transmission risks carry their own set of difficulties, including the effect of interplay between different variables like: – – – – –

Cross border (simultaneous intra and inter geographical impact) Cross sectors Cross industries Cross risk categories (both financial and non-financial) Cross time (across time horizons spanning from a few years to a few decades)

It will be important for banks to look at impact of climate change risks across the complete life cycle of loans and investments, from origination to maintaining/monitoring, all the way until its closure. The origination is the gateway where identification of the projects/activities to lend or invest is made. What will change is that while the financial viability of the project was at the core of accepting a borrower or an investment opportunity earlier, now, environmental viability, not just of the borrower’s activity but their entire ecosystem right from his suppliers to their customers, must be factored in. Various aspects of assessment, in the climate change risk context, are explored briefly in the subsequent paragraphs.

 Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021).

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Scope of Assessment It is important to set the scope as one of the initial steps of risk and vulnerability assessment. This boundary definition helps set focus as well as provide reference targets for teams at operational level. Broad coverage of scope: –

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Objectives setting – at dimensions like industry, geography, time ranges, borrower/counterparty, products, facilities, etc. A red (to avoid), amber (to proceed with caution),and green scale (preferred segments) is an effective way to flag the relevant dimensions (or a combination of them). Vulnerability limit setting – this determines the maximum vulnerable/sensitive exposure the bank is willing to take in the climate change risk space, based on its risk appetite and risk tolerance. These are set at deal, customer/group, country, and portfolio levels, and other aspects of importance. Factoring in heterogeneities related nuances – it is vital to understand and factor in heterogeneities that impact climate-related financial risks, like jurisdictional and sectoral, in selecting and applying assessment and measurement approaches.

Types of Assessments –

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Feasibility assessments – simple sorting, top-level filtering out of climate change risk-sensitive proposals. One of the often used method by banks is questionnaire based qualitative assessment, as part of their loan and investment approval process. This method, now, with appropriate climate related aspects added, is being used for first level screening. This is more of an elimination approach than selection. The proposals that pass this process are then subject to other more specific measurement methodologies. History data-based assessments – this method is slightly challenged in climate-related risks in general and transition risks in particular. This is because there is a possibility of some data on earlier natural disasters as banks have faced physical risks across time. The question is has that data been compiled, cleaned, stored, and is in a usable form. If yes, then this is a valuable source on the physical risk side, but no such structured data will be available on the transition risk side. Market players-based assessment models – this mode is what the industry is tending to in the short term. There are public and private sector players offering services (private, paid services far outweigh the public sources). This trend is more visible in seeking models that provide climate blended rating of counterparties for risk assessment. Insurer’s assessments – reaching out to the insurer’s assessments is less resorted to by banks. Insurance firms have been doing catastrophe modeling for some time now, particularly on the natural hazards side. It is a good starting point, especially for those financial organizations which provide both banking and insurance products and services.

Risk Assessment Methods There are different methods, all in early stage of development and calibration, as there is not enough historical data. The sample methods mentioned below have distinct factors considered and thereby distinct inputs and outputs. Various time hori-

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zons of diverse kinds of exposures and the potential of climate factors impacting them uniquely is another wrinkle in both the assessment and modeling effort. –

Portfolio Alignment Method This method helps banks, investors, regulators, and other stake holders assess the alignment of portfolio with globally agreed climate targets. The objective here is to assess the degree to which portfolio impacts climate, which is more a compliance assessment approach than for understanding risk contours. However, from a climate change risk management perspective, two indicators from this method are important for banks. One is from the limit management angle where proposals that will negatively affect agreed climate targets can be proactively checked. The second is identifying and acting on current and proposed businesses that are higher on the emission scale, as there would be greater impact of transition risk on these.

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Risk Framework Method This method is in the familiar risk management processes of the bank. The main difference stems from the fact that most of climate change risks fall within the forward-looking risk assessment methods, including scenario and stress testing approaches. This is so because greater part of negative financial impact of climate change risks are expected to be in the future. Sensitivity of the bank’s portfolio to potential adverse climate changes and the impact (likelihood, frequency, and severity) on the bank’s books is what is assessed here.

For example, loan appraisal systems, in addition to the regular creditworthy assessment components, will need to factor in inputs as well as outputs of the firms in terms of impact of environment (climate change, nature’s resources, contribution to pollution, etc.). Holding lesser capital as some assets fall under the “green” category could easily backfire if the underlying assessment has been weak and missed inherent credit risk (increased leverage is the result that adds to the potential instability). I cannot overemphasize the importance of ensuring project/business viability, and not be solely guided by the apparent “greenness” of the proposal. This is where the traditional wisdom of assessing the inherent feasibility of the proposal is required to be combined with the sustainability aspects. –

Exposure Method This method focuses on evaluation of the effect of climate change risk on individual borrowers/exposures. Specific risk factors, based on the sensitivities of the segments and sub-segments of the borrower’s/firm’s business to the climate change risk indices, are key factors here. It is critical to determine the level of exposure detail relevant for risk assessment. This will be bank specific depending on their portfolios and geographical spread, and needs to be in line with its risk appetite.

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Vulnerability Assessment Method Climate vulnerability assessment is a valuable tool in the arsenal of banks, to proactively identify and take an informed decision about financing counterparties or investment plans. APRA is lead-

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ing “a climate vulnerability assessment (CVA) program – a bottom-up exercise featuring two climate scenarios: a delayed transition scenario with high transition risks; and a current policies scenario with more severe physical risks due to limited climate action.”5 Figure 12.3 captures both the vulnerabilities, their impact on climate change-related features, and vice-versa, amplifying financial system weakness.

Possible Transmission from Climate-related Risks to Financial System Vulnerabilities

Climate-Related Risks Physical Risk – Chronic climate shifts – Acute climate hazards Transition Risk – Technological innovation – Climate policies – Investor/consumer preferences

Examples of Climate Change-Related Features

Financial System Vulnerabilities

Climate pathway uncertainty and nonlinear effects

Asset valuations

Modelling challenges

Leverage in the financial sector

Institutional distortions and policy asymmetries Opacity of exposures

Correlated exposures

Loss absorption disruption Funding risks

As climate-related risks evolve, climate change-related features are likely to become more salient and amplify financial system vulnerabilities. These financial system vulnerabilities also have the poterntial to interact with climate change-related features and be further amplified through feedback loops,as shown by the blue curved arrows.

Figure 12.3: Amplification of financial system vulnerabilities. Source: Brunetti, Celso, John Caramichael, Matteo Crosignani, Benjamin Dennis, Gurubala Kotta, Don Morgan, Chaehee Shin, and Ilknur Zer (2022). “Climate-related Financial Stability Risks for the United States: Methods and Applications,” Finance and Economics Discussion Series 2022–043. (“Climate-related Financial Stability Risks for the United States . . .”). Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2022.043.

A focused tracking of identified vulnerable segments, at shorter time intervals, will stand banks in good stead. Below is a sample of potential vulnerable portfolio segments due to climate change: – – –

Defaults of home loans, mortgages, and real estate portfolio in low lying areas Closure/de-functioning of coal and other fossil fuel powered businesses before the end of their economic life – creating stranded assets Crop failures resulting in default of agricultural loans with second order impact on meat, poultry, and diary businesses

 Reserve Bank of Australia, International Bank’s Response to Climate Risk, https://www.rba.gov.au/ publications/fsr/2022/apr/pdf/box-a-international-banks-response-to-climate-risk.pdf

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Stage-based Assessments Initial Assessment This is when a new loan or investment is being evaluated. The impact of climate change on the counterparty and its resilience to the same is a crucial step in risk assessment. At this stage, potential exposure of the bank to financial risk due to adverse climate change is being estimated. It could cover the following steps: –

– –

Understanding proposed business through the lens of climate change risks and its impact on the portfolio characteristics like – Product type (e.g., home loans, mortgages in physical risk susceptible area) – Geography (known climate path impacts) – Counterparties (both lending and investment portfolios) – Businesses of customer (brown or green) – Jurisdictional approach (climate policies) Overlay of both internal and climate data on portfolio characteristics Assess material risks and the potential of loss – frequency, likelihood, and severity of both existing and upcoming risks, based on scenario analysis.

A non-exhaustive list of factors that need a closer look is mentioned below. These have the potential of affecting the risks that adverse climate change has on banks. Each of them needs to be factored into both investment and lending appraisal and approval systems of the bank. As can be seen, these impact one, two or all three climate-related financial risk drivers (physical, transition, and liability risks). – Technology, its alignment to climate goals – Supply chain of the counter party – Litigation potential – Physical assets and their location – Regulatory requirements – Possible reputational impact on the bank.

Ongoing Basis This is, as the title suggests, to be done on an ongoing basis, as a part of risk monitoring and mitigation. There should be a particular focus at the time on renewal of facilities or review of the portfolio exposed to identified sensitivities, driven by any of the climate risk drivers. Mapping out typology of risk transmission that clearly lays out whether the root cause is climate related or caused by other factors is important (Figure 12.4). Basel principles (8) require that financial climate risks be assessed through the credit life cycle, from onboarding to closure. Climate-related risk profiles are expected to be created. Identifying potential concentrations of exposures to climate change risks across various dimensions, counterparties, sectors, industries, products, geogra-

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phies, portfolios, time ranges, jurisdictional policies, etc., is essential to protect banks’ books (balance sheet + P & L). Concentrations – a new kind of concentration analysis will be required, both on the assets side and liabilities side. As an example, decisions on lending or deposittaking from customers, where the economy is dependent on carbon-intensive activities, requires a closer look not just from a standalone risk perspective, but also their impact on concentrations that could multiply risks. To support this effort, creating “vulnerability maps” to identify hot spots is a good starting point. It can be done as a top-down or bottom-up exercise and will be a great aid for operational teams. Looking out for firm specific risks must be combined with spotting signals of systemic risk. The cascading and combined impact of inter-related risks across sectors and geographies that have a potential of resulting in systemic risk needs a close watch. Regulators will be tracking these aspects closely, but banks also need to keep a tab.

Mapping of Sensitive Sectors – Sample

Figure 12.4: Sensitive sector mapping6.

 European Central Bank The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks,– November 2021.

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Assessment Tools Tools and techniques for assessing climate change risks are at a nascent stage but evolving. Climate screening and assessment tools – the World Bank7 has created climate and disaster risk screening tools, which is a public source. This is particularly useful for projects. They support both rapid screening assessment and in-depth screening assessments for identified sectors/industries. Any source that can provide an objective, robust, and realistic input into the measurement/risk quantification process is a step forward. Some of the other assessment tools could be from public sources or those that are regionally developed. There are assessment models developed by private sector players as well. A small sample is mentioned hereunder: – –

– –

Specialized agencies that develop climate risk indices for individual corporates like MSCI, FTSE, etc. Credit rating agencies like S&P who integrate ESG/climate factors into their credit assessment models. They consider impact of ESG factors on individual components of the credit rating model like impact on cash-flows, leverage, sales, etc. Other scoring models commercially available Some large banks are also in the process of developing in-house models

Measurement Measuring the impact of climate change on business decisions (particularly lending and investment decisions) and the process of integrating climate nuances into bank’s enterprise risk management and valuation frameworks is work in progress as the canvas is complex. The effort is to quantify climate-related financial risks, to understand and document the paths of the significant economic variables that materially impact the performance of asset portfolios in their books. At the top level, the translation of climate risk drivers into financial risks falls broadly into three connected steps of effort, captured in Figure 12.5.

 The World Bank, Climate and Disaster Risk Screening Tools, https://climatescreeningtools.world bank.org/

Measurement

129

Translating climate risk drivers into economic risk factors

Linking climateadjusted economic risk factors to exposures

Translating climate adjusted economic factors into financial risks at exposure level

Figure 12.5: Broad steps involved in converting climate risks to financial risks.

The BCBS report8 rightly points out that Frameworks to systematically translate climate change scenarios into standard financial risk are not in place and currently require a mix of approaches. Initial scenario analyses and stress tests have in many cases focused on selected portfolios or exposures (for transition risks), and selected hazards (for physical risks) . . . Challenges include the range of impact uncertainties, limitations in the availability and relevance of historical data describing the relationship of climate to traditional financial risks, and questions around the time horizon

The frequency, likelihood, and severity are affected by a number of variables in addition to the primary risk drivers (physical or transition risks). These could be external to the bank like location (country/region/city), or amplifier interdependencies between transmission channels and the climate risk drivers themselves. Internal factors that influence both the measurement as well as the risk multiplication include portfolio concentrations of the bank, exposures, interlinks, controls, and mitigants in place. These will need to be factored into both risk assessment and measurement of the final impact category – credit, market, liquidity, or non-financial risks. Broad data categories required for measurement of climate-related financial risks are represented in Figure 12.6. Risk data requirements and its related issues have been discussed in detail in Chapter 11. It is mentioned here to understand that relevant data (or proxies) is foundational to measuring the risks.

 Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021).

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Data describing physical & transition risk drivers

Three Broad Data describing the Data Categories vulnerability of exposures

Financial exposure data

• Needed to translate climate risk drivers into economic risk factors to arrive at climateadjusted economic risk factors

• Needed to linking climateadjusted economic risk factors to exposures

• Needed to translate climateadjusted economic risk into financial risk

Figure 12.6: Data categories required for measuring climate-related financial risks. Source: Adapted from BCBS – Climate-related financial risks – measurement methodologies (April 2021).

Broadly, the variables that affect exposure to climate change risks are – –

–

Physical risks related – both upstream and downstream impacts for banks themselves and their clients because of an adverse physical risk event. Transition risks related – changes in asset values, both primary and collateral, as well as the borrower’s propensity to pay, across the lifetime of the loan. This includes the impact of external actions like government-imposed taxes and penalties. Alignment related – changes in business models and the portfolio selection, both for lending and the investment portfolio.

Risk Quantification Banks need to assess and quantify climate-related financial risks (physical and transition risk drivers), on their lending, investment, and other businesses across different time horizons. The metrics cover credit exposures and Investments across different dimensions like geography, sector, jurisdiction, etc. These are required for banks to assess the climate change risks they carry on their books as well as for reporting purposes. Quantifying climate-related financial risks is a three-step process (broadly speaking) as stated earlier in the chapter. The three columns in Figure 12.7 speak of the climate change risk drivers, their transmission channels, and sources of variability, all of which impact the quantum of risk as well as the potential of loss, viewed through the lens of traditional risk categories of the banks. Any attempt at quantification needs to include these elements and their inter-relationships.

Risk Quantification

131

Figure 12.7: Financial risks from climate risk drivers. Source: BCBS, Climate-related risk drivers and their transmission channels (April 2021)).

A different view of the same themes is presented in Figure 12.8. This captures impacts climate change risks are likely to have on micro and macroeconomic aspects as well as financial risks. Equally important is the fact that this highlights the interlinks and how there are intra and inter-related impacts – the amplifying effect. Methodologies, metrics, and models in measuring climate-related financial risks are evolving. There is an ongoing effort to develop these based on climate risk drivers and transmission channels, mapping them to portfolios and exposures, modeling behaviors, and their correlations against multiple plausible scenarios. Banks have limited experience in modeling/forecasting dynamic climate change patterns and their impact on banks’ books over different time horizons – especially the longer-term ones. It is largely an unchartered territory yet needed to be done accurately and soon. In this context, the ECB saying it is a “learning period” is most appropriate. There is a growing market of climate solution providers. The offerings range from data to index to models. These can be public sources, from global organizations like the World bank, International Monetary Fund, and United Nations on the one side, to paid providers on the other. Most banks are resorting to third party sources for now. A word of caution: blind dependence without a proper understanding of the third-party capabilities on models may lead to “model risk.” Banks are expected to have clarity and understanding of the end-to-end process, strengths, weaknesses, and limitations, including the data used, its quality, model details, and modeling thresholds. A proper assessment of the

Market risk

Liquidity risk – Increased demand for liquidity – Refinancing risk

Operational risk – Supply chain disruption – Forced facility closure

– Increased insured losses – Increased insurance gap

Underwriting risk

– Repricing of equities, fixed income, commodities etc.

Figure 12.8: Transmission channels – climate risks to financial risks. Source: Network for Greening the Financial Services (NGFS) Climate Scenarios for central banks and supervisors, June 2020.

Economy and financial system feedback effects

– Capital depreciation and increased investment – Shifts in prices (from stuctural changes, supply shocks) – Productivity changes (from severe heat, diversion of investment to mitigation and adaptation, higher risk aversion) – Labour market frictions (form physical and transition risks) – Socioeconomic changes (from changing consumption patterns, migration, conflict) – Other impacts on international trade, government revenues, fiscal space, output, interest rates and exchange rates.

Macro Aggregate impacts on the macroecomy

Businesses Households – Property damage and business – Loss of income (from weather disruption and health impacts, disruption form severe weather – Stranded assets and new capital labour market frictions) – Property damage (from severe expenditure due to transition weather) or restrictions (from – Changing demand and costs Low-carbon policies) increasing – Legal liability (from failure to costs and affecting valuations mitigate or adapt)

Credit risk

Micro Affecting individual businesses and households

– Defaults by businesses and households – Collateral depreciation

Financial risks

Economic transmission channels

Climate and economy feedback effects

– Chronic (e.g. temperature, precipitation, agricultural productivity,sea levels) – Acute (e.g. heatwaves, floods, cyclones and wildfires)

Physical risks

– Policy and regulation – Technology development – Consumer preferences

Transition risks

Climate risks

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Financial system contagion

Models

133

methodologies and models banks adopt in their journey towards translation of climate change risks to quantifiable financial risks is in its “learning” phase.

Models A model refers to a quantitative method, system, or approach that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions to process input data into quantitative estimates.” A model consists of three components: – An information input component, which delivers assumptions and data to the model – A processing component, which transforms inputs into estimates; and – A reporting component, which translates the estimates into useful business information.9

Considerations to be kept in perspective while embarking on modeling, choosing appropriate assumptions and appropriate parameters as well as data will be critical in determining the reliability of the outputs. Soundness and verifiability of the process/logic/ outputs of the models are foundational to the effectiveness of models. Constant review of the models is necessary as it is an evolving field. Links between industries and geographies are critical inputs to understand and model risk transmission. The difficulty with modeling high impact and low probability events is the lack of historical data. Concerning model risk, an “Increased use of models that extend out over a long timeframe will increase the level of model-related risk, and the uncertainty in model outputs will be greater than with shorter-term forecasts. Some of this will be driven by assumptions and data availability (e.g., for external natural catastrophe models and internal mortgage models).”10 Climate change risk modeling is challenged on multiple fronts: – – – – – – –

– –

Availability of relevant and clean data Ability to build a transparent defendable climate change risk adjusted model Ability to back test climate models given the sparse data history The non-linearity of climatic paths that make them hard to model Identification of climate tipping points, and the potential irreversibility of climate patterns at a point, which change the landscape forever Secondary and tertiary impacts, such as market changes, customer business viability, and marketability of their products Mapping climate change risk drivers over longer periods of time, given the shorter period modeling and management that banks are used to. Customer behavior, capital paydown, inflation, and house price inflation all have much greater impacts over longer periods Splitting of housing stock which does not lend itself to splitting like other industries Categorizing unsecured products like credit cards, personal loans, etc., by emissions they generate

 Supervisory guidance on model risk management. Board of Governors of the Federal Reserve System Office of the Comptroller of the Currency (April 2011).  Climate Financial Risk Forum Guide 2021: Climate Risk Appetite Statements, October 2021.

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Guidance and Current Efforts on Modeling and Measuring Climate Risk Drivers The BCBS Report11 suggests Physical risk drivers (physical hazards) can be linked to financial exposures using damage functions12 that define the impacts of specific hazards on the real assets and activities that generate financial flows. The disruptions to assets, activities and their corresponding financial flows can then be integrated, in principle, into established risk models that dimension financial risk parameters . . . specific damage functions will be informed by sectors, severity of hazards, time horizon factors and geospatial idiosyncrasies. A challenge when using damage functions is the degree to which empirical functions are available or complete for all sectors, exposures, and hazards. Concerning, the transition risk, “impacts of the shift from a high- to a low-carbon economy (transition risk) can be estimated using models linking specific transition risk drivers to the economic factors that generate financial flows. Similarly, to physical risks, projected disruptions to financial flows could, in theory, be integrated into conventional models of financial risk measurement.

A word of caution though; as highlighted through the book, the interlinks are to be factored in and hence the impact of both risk drivers “jointly” need to be considered to get a more realistic picture. An overview of risk tools is listed through UNEP13 which details 18 transition risk tools and analytics. It also provides an overview of 19 physical risk tools and analytics. The list is a compilation of available tools and analytics at the time that document went to print. Measurement approaches and models of climate-related financial risks, for now, are largely focused, as the BCBS report points out, on credit risk: “credit risk modelling has contrasted with a lesser focus on market risk, and a very limited focus on liquidity and operational risk. Credit risk quantification efforts are focused on addressing risks to corporate lending and real estate exposures, whereas other risk assessments, including on reputational risk, have remained predominantly qualitative.”14

 Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021).  Damage Function, “Relationships translating the effect of a specific hazard or change in global mean temperature affecting a building structure or the real economy into a damage ratio, which is the ratio of the repair cost to its replacement value,” BCBS Climate-related financial risks – measurement methodologies (April 2021).  Paul Smith, UNEP-FI, The Climate Risk Landscape A comprehensive overview of climate risk assessment methodologies, 2020.  Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021).

Market Risk

135

Market Risk VaR (Value at Risk) models will need a relook in terms of assumptions and data sets (historical or scenario based future situations) on the one hand and an understanding of the tail risks assumed on the other. Melding of climate forecasting inclusive of factors (like rate of occurrence/reoccurrence of climate disasters, frequency, likelihood, and severity) into market risk models are required to get a pulse of risks. The tradition of hedging will also need to be adjusted for “climate factors’ that are changing the risk contours. Blending in climate vulnerabilities – melding climate nuances and translating climate-adjusted economic factors into financial risk is required – this includes, for example, potential adjustments to the probability of default (PD) and loss-given-default (LGD) parameters in the credit valuation process or revenue forecasts in the strategic planning process. Mortgages, home loans, real estate exposures will be of greater focus initially as they are likely to be most impacted by both physical and transition risks, based on vulnerability assessment at sector level. Measuring both “gross” and “net” exposures is essential as they give different insights. Gross exposure is important, the Basel report points out, “for two main reasons: 1) Understanding exposure without incorporating risk offsetting practice can help inform the risk decisionmaker about the present magnitude of climate-related risks and how these risks might evolve over time; and 2) mitigants may lapse, change, fail to materialize, or become obsolete, reducing their reliability to effectively offset risk.” The big challenge is to forecast financial performance of corporates against multiple climate scenarios by translating climate scenarios into sector specific supply demand elasticities and market dynamics and then to potential financial performance data at borrower/industry level. This input is then used to climate adjusted credit rating/scores and predict probability of default. These endeavors are at initial stages of evolution. Efforts are on across academia, global organizations, and private sector participants. The following is an overview of two samples. The first is from NGFS (Figure 12.9). The second is a sample model, one developed by Tsinghua University, mentioned here to highlight the active role academia are playing in this space. Tsinghua University developed a climate physical risk assessment framework for banks (Figure 12.10) to analyze credit risks arising from the impact of physical risk under various climate scenarios (sectors like transportation, housing, agriculture, etc.). Their analytical framework has two major components: –

A disaster loss model – used to estimate the value loss of physical properties due to damages or financial loss because of business interruptions due to natural disasters. The disaster loss model consists of four modules: the exacerbation module, the hazard module, the asset exposure module, and the vulnerability module.

Energy trade

Population

Labor productivity impact

Median GDP change rate

High GDP change rate

Country-level temperature

30+ macro-regions 180+ countries

Physical risk variables

Economic damages from typhoons

Economic damages from floods

Figure 12.9: Indicative models, data and navigation tools from NGFS. Source: NGFS Scenarios for central banks and supervisors, September 2022

30+ macro-regions 180+ countries

Transition pathways variables

Carbon price Energy price

Some variables are available only at macro-regional level, others are downscaled at country level.

NGFS scenarios

Investment

Agricultural production

GDP

Policy cost

Agricultural demand Land cover

Electricity cost

Carbon sequestration

Food demand

Consumption

Electricity capacity

Emissions Energy use

Unemployment

Productivity Public investment

30+ macro-regions 50+ countries

Macro-financial impacts

Private investment

Central bank intervention rate

Exchange rate

House prices Equity prices

Long term interest rate

Inflation rate

GDP

Coal/gas/oil consumption

Coal/gas/oil price

The NGFS scenarios consist of a set of climate-related and macro-financial variables available for each model, scenario and geography.

136 Chapter 12 Identification, Assessment and Measurement of Climate-related Financial Risks

Market Risk

137

– A group of financial models which takes the output of the disaster loss model as input to adjust the estimates of the components of financial statements such as assets, liabilities, revenues, and P&L components. The adjusted variables are used to estimate various financial ratios.

Disaster mode/loss model 1 Climate exacerbation module 2

Hazard module

Vulnerability module

3

4

Business interruption loss Physical damage loss

Assets exposure module

Estimated business interruption loss

Estimated property value loss

Financial models Adjusted GDP growth/ Income

Credit risk model

Adjusted Revenue/ Cost/ Profit

Valuation model

Adjusted Loan to value ratio (LTV)

Actuary model

Figure 12.10: Sample Model for physical risk assessment. Source: NGFS, overview of Environmental Risk Analysis by Financial Institutions, September 2020.

There are models and methodologies developed and many more that are work in progress at industry level as well. Each of these come with their strengths and weaknesses across various aspects like complexity of the model, computational intensity, realistic assumptions, availability of required data, and transparency of the process. Listed in Table 12.1 is a sample set of approaches and their top-level strengths and weaknesses as mentioned by BCBS and other researchers. The approaches that are more in practice amongst banks are –

What if analysis – this is the broad class of plausible situations and their potential outcomes, which can be used both on the opportunity and risk side. The focus here is risk, hence a closer look at the risk side analyses comes under this umbrella. These are discussed in some detail in the next chapter. – Scenario analysis – a forward-looking projection of risk outcomes, with steps typically involving – Identification of plausible physical and transition scenarios – Linking the impact of scenarios to financial risks – Assessing counterparty/industry/sector vulnerability to the risks – Calculating potential of loss from the exposure – Stress testing – a specific subset of scenario analysis, to evaluate a financial institution’s resilience to climate induced economic shocks. Regulators globally are requiring banks to be part of stress tests. – Sensitivity analysis – another subset of scenario analysis with a clear objective of evaluating the effect of specific variables on economic outcomes. This is more effective in

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–

–

–

transition risk assessment where it is important to gauge the effect a change in policy can have on economic and financial outcomes. Climate risk scores and ratings – there are multiple third-party offerings in this space. Here climate risk blended risk ratings of corporates, portfolios, and countries are modeled. The rating/score is arrived at by a combination of risk classification with a set of grading criteria. Grading is based on both qualitative and quantitative aspects Climate value at Risk – this is the extension of the traditional VaR construct to include climate related nuances. These forward-looking, portfolio-level metrics quantify the impacts of climate change on the value of financial assets over a given time horizon at a given probability under particular climate scenarios. Agent-based models – computer based models that simulate the actions and interactions of autonomous elements. They link together disparate groups of factors. These could be the basis for scenarios. The combination of climate and economic interactions to measure climate risk at the portfolio level of banks is an evolving method.

The outcomes of each of the methods mentioned are used for quantification/mitigation of risk on the one hand and for strategy planning on the other.

Models and methodological overview Table 12.1: Comparison of models and methodologies. Models and methodological overview – high-level comparison Methodology and Key Assumptions

Strengths

Weaknesses

Time Horizon and applicability/ complexity

Scenario Analysis, Stress Testing, Sensitivity Analysis✶

Examines multiple future pathways and outcomes Helpful for risk management and strategic decision-making Applicable to many stakeholders Does not require extensive modelling capacity Forward-looking nature helpful for risk management and quantification Can conduct both micro prudential and macroprudential assessments

Limited climate and financial data available

Short to long term

Can be challenging to translate longer-term results into meaningful action

Highly applicable

Key assumption/s:

Detailed financial and climate data

Models and methodological overview

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Table 12.1 (continued) Models and methodological overview – high-level comparison Methodology and Key Assumptions

Weaknesses

Time Horizon and applicability/ complexity

Agent-based Models Captures interactions and feedback mechanisms between agents and the financial and real economy Key assumption/s: Incorporates heterogenous agent assumptions Accommodates network effects Rational It accounts for network effects expectations and and risk amplification perfect information mechanisms

Requires detailed data to build agents’ behavioral rules

Short to long term

Agents’ behavior may not be rational and representative

Complex

Input-output Models

Details environmental impacts at an industry level

Short to medium term

Key assumption/s:

Can capture impacts of demand for goods and services on energy and resources Computationally simple and requires less assumptions

Cannot capture big technological advances as they are based on historical input-output tables Mainly focus on supply chain disruptions

Assumes that the history is a good representative of future trends Other Practitioner Approaches✶: Climate risk scores and ratings, Climate VaR, Natural capital analysis Key assumption/s: Detailed financial and climate data

Strengths

Requires industry level environmental and linkages data

Simpler than traditional Scores and ratings have modelling methods different methodologies, Applicable to many stakeholders making comparison and interpretation difficult Climate VaR helpful for quantifying extent of systemic exposure Most risk for climate VaRs is concentrated in the tail; may Natural capital analysis is inadvertently enable myopia somewhat applicable for risk management

Highly applicable

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Table 12.1 (continued) Models and methodological overview – high-level comparison Methodology and Key Assumptions

Strengths

Integrated Assessment Models (IAM) Key assumption/s:

Integrates climate and economic Most IAMs do not model projections money, finance, or banking

Highly aggregated, general equilibrium theory, simplified climate models

Typically relies on a smooth scalar damage function of chronic physical risk Lacks resiliency to imperfect information and unforeseen endogenous events, such as technology or policy change Black box effect

Computable General Equilibrium (CGE) Models Key assumption/s:

Weaknesses

Time Horizon and applicability/ complexity Short to long term Highly applicable

Projections are internally consistent Allows for cost benefit analysis of climate mitigation

Highly aggregated

Quantifies general equilibrium effects by accounting for interlinkages across many economic sectors and agents Can be flexibly adjusted to multisector, multicounty, or global set-ups

Strong assumptions including Short to long term perfect information

The “black box” aspect

Somewhat applicable

Incorporates uncertainty in agent decision-making and endogenous changes in innovation technology In extensive use by central banks for policy analysis

Trade-off of computational intensity and the degree of details that the model can handle Assumption of rational expectations

Short to long term

Perfect information, exogenous technology, no adjustment costs in production, and inelastic supply of labor Dynamic Stochastic General Equilibrium (DSGE) Models Key assumption/s:

Rational expectations

Somewhat applicable, with certain limits on model size

Methodology Considerations

141

Table 12.1 (continued) Models and methodological overview – high-level comparison Methodology and Key Assumptions

Strengths

Statistical Methods Intuitive and relatively easy to Key assumption/s: estimate and interpret These methods tend to ignore equilibrium considerations

Weaknesses

Rely on partial equilibrium view of the world Mostly focused on past data and, thus, inherently backward looking

Time Horizon and applicability/ complexity Short to long term Highly applicable

Adapted from Climate-related Financial Stability Risks for the United States: Methods and Applications 2022–043. Brunetti, Celso, John Caramichael, Matteo Crosignani, Benjamin Dennis, Gurubala Kotta, Don Morgan, Chaehee Shin, and Ilknur Zer (2022). “Climate-related Financial Stability Risks for the United States: Methods and Applications,” Finance and Economics Discussion Series 2022–043. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS. 2022.043 Notes: ✶See text for discussion on approaches that are more in practice amongst banks.

Methodology Considerations Some of the important considerations are granularity at which analysis is to be done, approach to be adopted (like top down or bottom up), data issues like availability, reliability, relevance, heterogeneity, etc. The approach adopted influences both exposure mapping and risk estimation. Top-down approach – is where information/values are computed at a dimensional combination, say, sector/industry of metrics (like emission averages). This is then cascaded down to its component parts. The dimensioning of risk is done at an aggregated level, with the risk measures so arrived being attributed to the components. The assumption is that the data/averages at aggregate level are representative of its constituents. Assessment is typically at higher level like portfolio, geography, or bank. The advantage here is that it is a simpler approach with the greater possibility of availability of climate-related data at an aggregated level. The disadvantage is influence of risk as individual exposure/firm is ignored. Bottom-up approach – starts from individual asset/counterparty level, which it then aggregates across different dimensions. Essentially, dimensioning of risk is done at the component level and then rolled up to provide a consolidated view of risk. The effect of physical and transition risk drivers are assessed at the loan/counterparty level. The

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advantage here is that the impact/contribution of specific constituent to risk can be captured. These then can be aggregated to risk category level like market and credit risk. The difficulty is twofold. One is the availability of data at that fine grain and two is the ability to understand and build correlations that could amplify or diversify risk, to represent an accurate aggregation. This approach, more challenged but more accurate, requires that the collective impact be arrived at by factoring the almost infinite state of being interconnected, interacting micro variables and their effect. The bottom-up modelling approach uses counterparty financials, climate adjusted borrower level credit scores, particularly if it is a corporate client, with industry and geography level data. Some specific metrics – required both for risk management as well as for disclosures/ reporting.

GHG Emissions Climate transition risk is related to the emission footprint. Different models are being suggested to quantify carbon footprint of the firm. This will help put in place mitigation processes to reduce credit portfolio’s exposure to transition risk. MSCI speaks broadly of two approaches: – –

Direct decarbonization (reducing total greenhouse gas footprint) target as a constraint on portfolio selection/construction process or Tilting portfolios toward constituents with better climate profiles

Approach to computing GHG emissions, the Global GHG Accounting and Reporting Standard for the Financial Industry, details the GHG accounting framework. Figure 12.11 captures the three possible sources of emission – Scope 1, 2 and 3.

GHG Emissions

143

Figure 12.11: Scope 1, 2, and 3 emissions. Source: GHG P- Corporate Value Chain (Scope 3) Accounting and Reporting Standard – Supplement to the GHG Protocol Corporate Accounting and Reporting Standard.

Table 12.2 provides simple explanations of the three scopes (Scope 1, 2 and 3) Along with scope 1, 2 and 3, reference is also made to scope 3 category 15 emissions. This category is applicable to investors and companies that provide financial services. Category 15 is designed primarily for private financial institutions (e.g., commercial banks), and is also relevant to public financial institutions e.g., multilateral development banks, export credit agencies, etc., hence of particular relevance to banks. Financed emissions (Table 12.3) include portfolio, counterparty, project level aggregations of emissions allocated proportionately based on financial exposure, across industry and geography. Net-zero targets, including financed emissions, have been set for 2050 by most banks. The difficulty is in how these can be quantified. This concept is also discussed in the disclosures chapter (Chapter 15). The Standards document15 provides an asset class based (6 asset classes) methodology (Figure 12.12) for measuring financed emissions with the following detail of emissions: – Asset class definition – Emission scopes covered  PCAF, The Global GHG Accounting and Reporting Standard Part A: Financed Emissions. Second Edition, 2022.

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Chapter 12 Identification, Assessment and Measurement of Climate-related Financial Risks

Table 12.2: The Three scopes and category 15 emissions. Scope  emissions

Emissions from operations that are owned or controlled by the reporting company.

Scope  emissions

Emissions from the generation of purchased or acquired electricity, steam, heating or cooling consumed by the reporting company

Scope  emissions

All indirect emissions (not included in scope ) that occur in the value chain of the reporting company, including both upstream and downstream emissions.

Scope  category  emissions

This category includes Scope  emissions associated with the reporting company’s investments in the reporting year, not already included in Scope  or Scope . This category is applicable to investors (i.e., companies that make an investment with the objective of making a profit) and companies that provide financial services. Category  is designed primarily for private financial institutions (e.g., commercial banks), but is also relevant to public financial institutions e.g., multilateral development banks, export credit agencies, etc.

Table 12.3: Financed emissions metrics. Metric

Purpose

Description

Absolute emissions

To understand the climate impact of loans and investments and set a baseline for climate action

The total GHG emissions of an asset class or portfolio

Economic emissions To understand how the emissions intensity of intensity different portfolios (or parts of portfolios) compared to each other per monetary unit

Absolute emissions divided by the loan and investment volume, expressed as tCO e/€M invested

Physical emissions intensity

To understand the efficiency of a portfolio (or parts of a portfolio) in terms of total carbon emissions per unit of a common output

Absolute emissions divided by an output value, expressed as tCO e/ MWh, tCO e/ton product produced

Weighted average carbon intensity (WACI) 

To understand exposure to carbon intensive companies

Portfolio’s exposure to carbon intensive companies, expressed as tCO e/€M company  revenue

Source: The Global GHG Accounting & Reporting Standard for the Financial Industry, November 18, 2020.

– – – –

Equations to calculate financed emissions Data required Other considerations Limitations

GHG Emissions

Financing type & source Listed equity (equity)

Corporate bonds

Corporate finance

(debt) Equity in private companies (equity)

Use of proceeds

Activity Sector

Unknown

All

Unknown

All

Known

All

Unknown

All

Unknown

All

Loans Unknown

Real estate Motor Vehicle

Consumer finance

Equity & loans (equity & debt)

Asset class (as defined by PCAF)

Listed equity and corporate bonds

Business loans and unlisted equity

All other

(debts)

Project finance

145

Commercial real estate Motor vehicle loans

Known

All

Project finance

Unknown

All All other

Not yet developed by PCAF

Real estate

Mortgages

loans (debt)

Known

Motor Vehicle

Figure 12.12: Mapping of businesses to asset classes. Source: PCAF, The Global GHG Accounting and Reporting Standard for the Financial Industry. First edition, November 18, 2020. The general approach suggested by the standard16 for calculating financed emissions is Financed emissions = ∑I Attribution factori X Emissions (with i = borrower or investee) In the asset class wise calculations given below, the attribution factor is the first part e.g. (outstanding amount / (company equity + debt)) – Project Finance – (outstanding amount/(total project equity + debt)) X project emissions – Business loans and unlisted equity – (outstanding amount/(company equity + debt)) X company emissions – (outstanding amount/(enterprise value including cash +debt)) X company emissions – Commercial real estate – (outstanding amount/property value at origination) X building emissions – Mortgages – (outstanding amount/property value at origination) X building emissions – Listed equity and corporate bonds – (outstanding amount/(company equity + debt)) X company emissions – (outstanding amount/(enterprise value including cash +debt)) X company emissions

 PCAF (2020). The Global GHG Accounting and Reporting Standard for the Financial Industry. First edition, November 18, 2020.

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–

Motor vehicle loans – (outstanding amount/total value at origination) X vehicle emissions

A simple example of financed emissions for an oil and gas company is: GHG emissions of the corporate (1) = 1.0 million mtCO2e Attribution factor (2) = 0.25 Bank’s financed emissions (3) = (1X2) 250,000 CO2e This is then used to compute the estimated financial impact as follows Estimated carbon price (4) = 40 Dollars per tonne Estimated financial impact (3X4) = 10 million Dollars

Sample of Quantitative Indicators Concerning sample metrics for Financial Services, Table 12.4 captures a sample of indicators and approaches that some institutions have adopted, as listed by the European Central Bank in its document “on the state of climate and environmental risk management in the banking sector.” This catalog throws light on how banks are working out ways to capture climate change risks within the current constraints. Table 12.4: Sample indicators used by banks. Indicator

Definition

Approach

Flood risk indicator at client level

Exposure to clients at risk of flooding

For its mortgage and agricultural portfolios, one institution identifies geographical location data on its clients’ assets. It maps these data onto granular flood maps that allow it to use spatial statistics to identify assets subject to increased flood risk. This assessment is then aggregated to portfolio level to assess the total exposure at risk of flooding

Physical risk indicator at sector level

Exposure with elevated physical risk at portfolio level

One institution developed a physical risk indicator to assess risk sensitivities at sector and geographical level. Sensitivity is measured by using proxies which allow the institution to assess the elevated physical risk at portfolio level. Examples of these proxies include: – ND-GAIN vulnerability index – macro(economic) indicators, e.g., the percentage contribution of agriculture to GDP and the percentage of the population living below an altitude of 5 meters above sea level – sector studies

Sample of Quantitative Indicators

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Table 12.4 (continued) Indicator

Definition

Approach

Transition risk indicator at client level

Exposure to clients with elevated sensitivity to transition risk

For one institution each client is assessed in terms of their sensitivity to transition risk. This is determined based on a set of indicators that depends on the sector in which the client is active. This assessment is translated into a client score ranging from medium to high to very high sensitivity to transition risk. The total exposure to clients with elevated sensitivity to transition risk is measured against the bank's capital base. Examples of these sectorbased indicators include: Energy clients: – energy mix (renewable power generation revenues/total revenues) – geographical diversification (percentage of revenues generated across various geographic regions) – emission intensity (Scope 1+2 emissions under the Greenhouse Gas Protocol) Transport clients: – average age of shipping/aircraft fleet – low carbon capital expenditure allocation (percentage of capital expenditure allocated to emission reduction targets)

Transition risk indicator at sector level

Exposure to sectors identified as having elevated transition risk

Another institution has identified several sectors with elevated sensitivity to transition risk, on the basis of the recommendations of the Task Force on Climate-related Financial Disclosures (e.g., fossil fuel-based industries, CO-intensive manufacturing, and transportation activities). It then measures its exposure to clients from these sectors and seeks to mitigate the associated transition risk. To do so, it has set limits for those clients, e.g., to limit exposure to clients that generate more than a certain percentage of their revenue from coal.

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Table 12.4 (continued) Indicator

Definition

Approach

Climate value at risk indicator (CVAR)

The portfolio’s CVAR is a weighted aggregation of the CVAR of each asset in the portfolio

The CVAR represents the present value of the aggregated transition and physical risk costs as a percentage of the portfolio’s market value. It is a scenario-based approach to assessing the assetlevel impact given a set of transition risk (policy risk costs) and physical risk (extreme weather costs) scenarios. Depending on the severity of the impact under the various scenarios, each asset is classified as being at elevated risk or not.

Financed technology indicator

The share of coal in the institution’s One institution measures the share of coal in its energy portfolio primary energy mix portfolio (e.g., hydrocarbon producers) and its secondary energy mix portfolio (e.g., electricity generators).

Energy certificate indicator

The share of mortgages with collateral with an energy efficient energy label

For each mortgage client, the institution collects the government energy certificate of the underlying collateral. This energy certificate gives an indication of the energy efficiency of the building by measuring the dimensions of the building, the insulation of the roof and walls and existing installations such as boilers and solar panels. The bank tracks the share of homes with an energy-efficient certificate as part of the total collateral of the portfolio.

Source: European Central Bank, Banking Supervision, The state of climate and environmental risk management in the banking sector, November 2021.

Stringing the themes of this chapter, it can be said that they form a continuum with each stage throwing up important insights. At identification stage, this is the process of understanding the exposures, portfolios, and businesses exposed to climate change risk and vulnerability identification. A heatmap that captures this information at different dimensions aids both operational teams and senior management. The former benefit from quick reference to proposals they need to further or avoid. The latter get a quick summarized view of the state of play with respect to their exposures and risk. Assessment and measurement provide insights at two levels. The first is at a loan or investment level appraisal (once it passes the identification threshold) and the second at a portfolio or bank level to gauge the climate risk carried (Table 12.5). The information thus arrived at is used for disclosures or reporting, but, more importantly, for strategy formulation. Based on the risk outcome, banks plan risk response which could be pricing or stronger risk mitigation framework.

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Table 12.5: Double materiality overview. Motivation

Inputs

Outputs Actions

Impact of climate on balance sheet (risk assessment and measurement)

Scenario selection (e.g., baseline, tail, strategic)

Impacts

Taking management steps to reduce risks

Time horizon selection (e.g., today, short, medium, long)

Losses

Changes to pricing, lending practices, products, or services

Scope (e.g., exposures, sectors, asset classes)

Warning metrics

Regulatory engagement

Assumptions (e.g., static, or dynamic balance sheet)

Carbon intensity

Internal changes e.g., risk management/organizational structure

Impact of balance sheet on climate (measuring alignment)

Strategic decisions on portfolio

Improve disclosures

Source: Climate Financial Risk Forum Guide 2021; Scenario Analysis Chapter, October 2021.

Given the future focused measurement of the impact of climate-related financial risks, scenario analysis and stress testing has become the central pillar to get a directional sense of possible futures in terms of likelihood and severity. This topic is discussed in some detail in the next chapter (Chapter 13).

Chapter 13 Scenario Analysis and Stress Testing The public totally discounts low-probability high-consequence events. The individual says, it’s not going to be this plane, this bus, this time. –Amanda Ripley

The real test in climate change risk management is that the risks are difficult to forecast. Expert judgement and scenario/stress analysis continue to be core elements of measuring the potential financial risk due to climate change or its mitigation and adaptation measures. This is a dynamic, fast evolving field, as experience on one side and climate science on the other side progress and stabilize. Scenario analysis and stress testing are not new to banks. They have been part of an important toolset for many years past. These tools have been the structured, systematic source of inputs into strategy formulation and proactive risk practices. Industry has access to rich and deep literature and hands on experience of the subject. Scenarios enable exploration of plausible alternate futures as also the resilience of firms to potential stresses. These come with their set of limitations, however, more so in the climate change risks space. Here, they help banks assess business implications of climate change, which has a strong element of uncertainty. Stress testing is an evolving area for assessing the resilience of banks across multiple plausible climate scenarios and time horizons. Data availability and granularity make meaningful use of this tool difficult. The tests are focused on a few specific scenarios, industries/sectors, and large borrowers. At this point, qualitative aspects or proxy inputs are largely used. Broadly, the categories of challenges banks face are at two levels: Internal to the bank: – Data availability – Ability to understand and build correlations across a range of factors influencing the outcomes as well as across aggregations – Limited experience in building climate related scenarios particularly – Across transition risk drivers – Longer time horizons – Necessary skill set Industry level (Table 13.1): Table 13.1 captures industry level challenges and barriers for climate related stress testing exercises. The fact is that the possibility of erratic but sizeable shifts in asset prices and climate related losses due to catastrophic events, the potential impact of both idiosyncratic and or systemic risk, and thereby financial stability, is high. Therefore, climate related stress tests have become so important. There is not enough history data to model, which lends credence to the criticality of scenario analysis and stress tests in the climate change space. https://doi.org/10.1515/9783110757958-016

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Table 13.1: Challenges and barriers in the scenario analysis space. Challenges and barriers Breadth and magnitude of transition Climate change will affect all agents in the economy (households, and physical risks businesses, governments), across all sectors and geographies. It is hard to know where to start and which effects to prioritize in analysis. The risks will likely be correlated and potentially aggravated by tipping points, in a non-linear fashion. This means the impacts could be much larger, and more widespread and diverse than those of other structural changes. Extended and uncertain time horizons and feedback loops

The time horizons over which climate-related financial risks may be realized are uncertain, and their full impact may crystallize beyond most current business planning horizons. Conversely, social tipping points are rarely modelled but may mean some transition elements affect certain sectors abruptly, and thus using past data may not be a good predictor of future risks and currently there is often little economic incentive to take the short-term actions needed, and some major economic barriers.

Weakness of many climate economic Many economic models of climate impacts perform poorly in models higher warming scenarios, with simplistic damage functions that fail to reflect the compounding impacts of a cocktail of physical risks and social implications that are consistent with the science. Data gaps and comparability of disclosures

Firms may need to use additional metrics requiring new data and new modelling methods to capture climate impacts on the economy and their business. Such variables might include hazard factors for physical events or greenhouse gas emissions from specific economic activities. Firms are likely to find that their existing risk models will also need to be adapted to capture climate factors.

Cognitive bias

Cognitive bias must be recognized and accounted for when developing and using any type of scenario. For example, people unconsciously assess probability of a future event or outcome on the basis of how easily they can remember past examples or how easily they can imagine possible events.

Source: Climate Financial Risk Forum Guide 2020; Scenario Analysis Chapter June 2020.

Even so, since the risk forecast is into the future with the possibility of multiple plausible future climate paths and correlations between the various factors impacting climate-related financial risks, scenario analysis with its ability to look at multiple combinations of the future is one of the core “go to” tools. It helps create possible futures that capture the interplay of physical and transition risks, quantification of the resultant financial drives, to arrive at the potential overall effect both at aggregated level or at dimensional constructs of sectoral, geographical or portfolio. This will be

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an important input for planning both at operational and strategic levels. It helps estimate a financial position under severe but plausible scenarios. Regulators, globally, are also using the scenario analysis and/or the stress testing route to assess the vulnerabilities of the industry as well as its resilience to adverse climate or climate policy changes. ECB (Industry wide Stress tests), Bank of England (climate biennial exploratory scenario assessment), HKMA (climate risk stress tests), and the US (pilot exercise of scenario analysis with six banks) are samples of the regulatory direction. The three scenarios proposed by NGFS (Network for Greening the Financial System) are mostly in use for regulatory and reporting purposes, though big banks are working on a broader scope of scenarios for internal assessment and strategy planning. There are four terms that are used as an extension of one another in this context: scenarios, scenario analysis, stress testing, and sensitivity analysis. Sometimes they are assumed to be synonymous. Scenario analysis is the broader umbrella and allows understanding of the impact of possible futures on the banks’ books, some of which can be positive. Stress tests on the other hand looks at different scales of adverse outcomes. Regulators and global organizations have described these and related concepts, through their documents and policy pronouncements. Presented here is a quick curated sample literature review.

Scenario, Scenario Analysis, Stress Testing, and Sensitivity Analysis Scenario BCBS: “Scenario is a plausible description of how the future may develop based on a coherent and internally consistent set of assumptions about key driving forces (e.g., rate of technological change, prices) and relationships. Scenarios are neither predictions nor forecasts but are used to provide a view of the implications of developments and actions.”1 TCFD: “Scenario is a plausible, but hypothetical, path of development leading to a particular future outcome. Scenarios are not forecasts or predictions – they are “what if” narratives designed to inform and challenge strategic thinking.”2 The emphasis is on the fact that scenarios are not predictions. They are, like TCFD mentions, “what if” narratives.

 Basel Committee on Banking Supervision Climate-related risk drivers and their transmission channels (April 2021).  Task Force on Climate-related Financial Disclosures Guidance on Scenario Analysis for NonFinancial Companies, October 2020.

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Scenario Analysis BCBS: “scenario analysis is a tool that is used to enhance critical strategic thinking. A key feature of the scenarios analyzed is to explore alternatives that may significantly alter the basis for “business-as-usual” assumptions. Accordingly, they need to challenge conventional wisdom about the future.”3 Bringing in a risk focus, BCBS in a related document states that the “Scenario analysis is a tool that challenges assumptions made for the purposes of risk analysis.” TCFD’s description of scenario analysis is that it is “a process for identifying and assessing the potential implications of a range of plausible future states under conditions of uncertainty. Scenarios are hypothetical constructs and not designed to deliver precise outcomes or forecast. Instead, scenarios provide a way for organizations to consider how future may look if certain trends continue or certain conditions are met.”4

Stress Tests Basel defines stress test as “The evaluation of a financial institution’s financial position under a severe but plausible scenario. The term “stress testing” is also used to refer to the mechanics of applying specific individual tests and to the wider environment within which the tests are developed, evaluated, and used within the decision-making process.”5 NGFS6 describes the stress test as the evaluation of an FI’s financial position under a severe but plausible scenario to assist in decision making within the FI. The term “stress testing” is also used to refer not only to the mechanics of applying specific individual tests, but also to the wider environment within which the tests are developed, evaluated, and used within the decision-making process. While the definitions are almost similar, the objective of the exercise that NGFS focuses on, viz. to assist in decision-making, sets the context for the exercise.

 Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021).  Task Force on Climate-related Financial Disclosures, Recommendations of the Task Force on Climate-related Financial Disclosures, Final Report June 2017.  Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021).  Network for Greening the Financial Services Overview of Environmental Risk Analysis by Financial Institutions, September 2020.

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Sensitivity Analysis Climate sensitivity analysis is described by EBA as “An exercise without scenarios, assessing changes in portfolios’ risk attributes by changing some of the inputs in financial models based on shading and classification of exposures into ‘green’ versus ‘non-green’ (which determines an exposure’s vulnerability to climate-related events and policies).”7

Some Nuances How climate-related analysis differ from traditional analysis that banks use. OCC8 describes scenario analysis with clarity, bringing out the difference with traditional stress testing exercises banks are used to. It explains that climate-related scenario analysis refers to exercises used to conduct a forward-looking assessment of the potential impact on a bank of changes in the economy, financial system, or the distribution of physical hazards resulting from climate-related risks. These exercises differ from traditional stress testing exercises that typically assess the potential impacts of transitory shocks to near-term economic and financial conditions. An effective climate-related scenario analysis framework provides a comprehensive and forward-looking perspective that banks can apply alongside existing risk management practices to evaluate the resiliency of a bank’s strategy and risk management to the structural changes arising from climate-related risks.

EBA illustrates the distinction between traditional stress tests and climate stress tests as Stress test – “The evaluation of a financial institution’s financial position under a severe but plausible scenario. The term “stress testing” is also used to refer to the mechanics of applying specific individual tests and to the wider environment within which the tests are developed, evaluated, and used within the decisionmaking process.”9 Climate stress test – “Assessment featuring fully fledged scenarios that map out potential future development paths of transition variables (e.g., carbon prices), physical variables (e.g., temperature increases) and the related changes in macro variables (e.g., output in different sectors, GDP, unemployment) and financial variables (e.g., interest rates). These scenarios are then translated into changes in portfolio (risk) attributes.”10  EBA Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, eba/rep/2021/18.  Office of the Comptroller of the Currency,- Principles for Climate-Related Financial Risk Management for Large Banks.  EBA Report on Management and Supervision of ESG Risks for Credit Institutions and Investment Firms, eba/rep/2021/18.  Ibid.

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Federal Reserve Board Climate scenario analysis is distinct and separate from bank stress tests. The board’s stress tests are designed to assess whether large banks have enough capital to continue lending to households and businesses during severe recession. The climate scenario analysis exercise, on the other hand, is exploratory in nature and does not have capital consequences. By considering a range of probable future climate pathways and associated economic and financial developments scenario analysis can assist firms and supervisors in understanding how climate related financial risks may manifest and differ from historical experience.11

The fine distinction and the linkage between scenario analysis, sensitivity analysis and stress testing:

BCBS Typology of Forward-looking Measurement Methods Climate scenario analysis is a forward-looking projection of risk outcomes that is typically conducted in four steps:12 (i) identify physical and transition risk scenarios; (ii) link the impacts of scenarios to financial risks; (iii) assess counterparty and/or sector sensitivities to those risks; and (iv) extrapolate the impacts of those sensitivities to calculate an aggregate measure of exposure and potential losses. Scenario analysis can be performed at various levels of granularity to identify impacts on individual exposures or on portfolios Sensitivity analysis is also a specific subset of scenario analysis that is used to evaluate the effect of a specific variable on economic outcomes. In these analyses, one parameter is altered across multiple scenarios runs to observe the range of scenario outputs that result from changes in that parameter. In certain cases, several parameters can be changed simultaneously to observe interactions among parameters. Sensitivity analysis has often been used in transition risk evaluation to assess potential effects of a specific climate-related policy on economic outcomes, particularly in research settings to evaluate the range of economic impacts from the implementation of a carbon tax. With scenario analyses, a climate sensitivity analysis may be a useful tool for risk decision-makers to understand the range of potential climate impacts.

The advantage of sensitivity analysis is that they can provide a good initial estimate of portfolio sensitivity to the risk factor and help identify risk concentrations. Stress testing is a specific subset of scenario analysis, typically used to evaluate a financial institution’s near-term resiliency to economic shocks, often through a capital adequacy target. [. . .] Climate stress testing evaluates the effects of severe but plausible climate scenarios on the resiliency of financial institutions or systems. However, the uncertainty inherent in longer-dated assessments and the limited predictive power of historical observations to describe future climate-economic re-

 Federal Reserve Board announces that six of the nation’s largest banks will participate in a pilot climate scenario analysis exercise designed to enhance the ability of supervisors and firms to measure and manage climate-related financial risks, Press release September 29, 2022.  BCBS, Climate-related financial risks – measurement methodologies (April 2021).

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lationships render estimates of capital shortfall (or other measures of resiliency) less reliable than those of conventional stress tests employed by supervisors and banks to evaluate resiliency.

One other phrase that requires familiarization in the context of climate-related analysis conversation is Representative Concentration Pathways or RCPs. This is because the RCPs based climate scenario analysis is resorted to by banks.

Representative Concentration Pathways (RCPs) “Scenarios that include time series of emissions and concentrations of the full suite of GHGs and aerosols and chemically active gases, as well as land use/land cover. The word representative signifies that each RCP provides only one of many scenarios that would lead to the specific radiative forcing characteristics. The term pathway emphasizes that not only the long-term concentration levels are of interest, but also the trajectory taken over time to reach that outcome.”13

Scenario Analysis Life cycle Management at Banks – Some Pointers Principle 12 of BCBS, guidance on managing climate-related financial risks: Where appropriate, banks should make use of scenario analysis to assess the resilience of their business models and strategies to a range of plausible climate-related pathways and determine the impact of climate-related risk drivers on their overall risk profile. These analyses should consider physical and transition risks as drivers of credit, market, operational and liquidity risks over a range of relevant time horizons.14

The guidance is that scenario analysis of banks should reflect the climate-related financial risks that banks are exposed to (physical and transition) as relevant to their business profile, size, business complexity and geographical spread. The climate scenario models need to be subject to challenge and regular review by internal and external experts and audit; climate-related financial risks need to be part of the different kinds of stress tests including capital and liquidity stresses.

 Basel committee on banking supervision, Climate-related financial risks – measurement methodologies (April 2021).  Basel committee on banking supervision, Principles for the effective management and supervision of climate-related financial risks, June 2022.

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Types of Scenarios – –

Exploratory scenarios – scenarios that help explore a variety of futures. This is the normal approach used by banks. Normative scenarios – scenarios used to plan for a preferred future outcome. This is more for strategy planning and alignment to achieve a preferred future.

Scenario Analysis Process As CFRF points out, the scenario analysis process is iterative, as illustrated in Figure 13.1. They suggest a three-stage approach to operationalize climate scenario analysis, with sub steps within each stage.

3. Conduct exposure analysis

2. Identify climaterelated risks

Identify protential exposures to climaterelated risks

1. Examine transmission channels

5. Technological evolution

Develop suitable climate-related scenarios

Scenario Analysis Process 4. Socioeconomic context 10. Assess financial impacts and take appropriate action

Assess the financial impact

6. Climate policy landscape

7. Emission and temperature pathways

8. Define risk measure

9. Choose impact assessment tools

Figure 13.1: Climate scenario lifecycle (source: Climate Financial Risk Forum Guide 2020; Scenario Analysis Chapter June 2020).

Given the range of uncertainties that banks work within the climate space, a canvas of a wide variety of scenarios that chalk out multiple likely paths and futures can help banks plan. At the same time, a “paralysis by analysis” approach need be avoided. The wisdom is in finding the right balance and that will be an iterative process. Climate risk scenarios fall into three major categories. The first two are exploratory scenarios while the third one can be a normative scenario. – As required by regulators and policy makers – Based on the risk assessment of material risks of existing portfolio – As part of balance sheet planning – for planned portfolio constructs

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Designing Scenarios Scenarios need to be so designed that they can – Calculate impact on risk attributes like defaults, liquidity and capital demands, and recoveries. – Impact strategic objectives in climate change management space. The main categories of considerations that TCFD highlights in constructing scenarios are parameters used, assumptions made, analytical choices, and the potential business impacts (Table 13.2). Table 13.2: Key considerations in designing scenarios. Key Considerations: Parameters, Assumptions, Analytical Choices, and Impacts Parameters/Assumptions

Analytical Choices

Business Impacts/Effects

Discount rate – what discount rate does the organization apply to discount future value?

Scenarios – what scenarios does the organization use for transition impact analysis and which sources are used to assess physical impact both for central/ base case and for sensitivity analyses?

Earnings – what conclusions does the organization draw about impact on earnings and how does it express that impact (e.g., as EBITDA, EBITDA margins, EBITDA contribution, dividends)?

Carbon price – what assumptions are made about how carbon price(s) would develop over time (within tax and/or emissions trading frameworks), geographic scope of implementation, whether the carbon price would apply only at the margin or as a base cost, whether it is applied to specific economic sectors or across the whole economy and in what regions? Is a common carbon price used (at multiple points in time?) or differentiated prices? Assumptions about scope and modality of a CO price via tax or trading scheme?

Quantitative vs. qualitative or “directional” – is the scenario exercise fully quantitative or a mix of quantitative and qualitative?

Costs – what conclusions does the organization draw about the implications for its operating/ production costs and their development over time?

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Table 13.2 (continued) Key Considerations: Parameters, Assumptions, Analytical Choices, and Impacts Parameters/Assumptions

Analytical Choices

Business Impacts/Effects

Energy demand and mix – what would be the resulting total energy demand and energy mix across different sources of primary energy e.g., coal/oil/gas/nuclear/ renewables (sub-categories)? How does this develop over time assuming supply/end-use efficiency improvements? What factors are used for energy conversion efficiencies of each source category and for end-use efficiency in each category over time?

Timing – how does the organization consider timing of implications under scenarios e.g., is this considered at a decadal level ; ; ; 

Revenues – what conclusions does the organization draw about the implications for the revenues from its key commodities/products/services and their development over time?

Price of key commodities/ products – what conclusions does the organization draw, based on the input parameters/assumptions, about the development over time of market prices for key inputs, energy (e.g., coal, oil, gas, electricity)?

Scope of application – is the analysis applied to the whole value chain (inputs, operations, and markets), or just direct effects on specific business units/operations?

Assets – what are the implications for asset values of various scenarios?

Macro-economic Variables – what Climate models/data sets – GDP rate, employment rate, and which climate models and data other economic variables are used? sets support the assessment of climate-related risks?

Capital allocation/investments – what are the implications for CapEx and other investments?

Demographic variables – what assumptions are made about population growth and/or migration?

Timing – what conclusions does the organization draw about development of costs, revenues, and earnings across time (e.g., // years)?

Physical risks – when assessing physical risks, which specific risks have been included and their severity (e.g., temperature, precipitation, flooding, storm surge, sea level rise, hurricanes, water availability/drought, landslides, wildfires, or others)? To what extent has the organization assessed the physical impact to its portfolio (e.g., largest assets, most vulnerable assets) and to what extent have physical risks been incorporated in investment screening and future business strategy?

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Table 13.2 (continued) Key Considerations: Parameters, Assumptions, Analytical Choices, and Impacts Parameters/Assumptions

Analytical Choices

Business Impacts/Effects

Efficiency – to what extent are positive aspects of efficiency gains/ clean energy transition/physical changes incorporated into scenarios and business planning?

To what extent has the impact on prices and availability in the whole value chain been considered, including knock-on effects from suppliers, shippers, infrastructure, and access to customers?

Responses – what information does the organization provide in relation to potential impacts (e.g., intended changes to capital expenditure plans, changes to portfolio through acquisitions and divestments, retirement of assets, entry into new markets, development of new capabilities, etc.)?

Geographical tailoring of transition impacts – what assumptions does the organization make about potential differences in input parameters across regions, countries, asset locations, and markets?

Technology – does the organization make assumptions about the development of performance/cost and resulting levels of deployment over time of various key supply and demand-side technologies (e.g., solar PV/CSP, wind, energy storage, biofuels, CCS/CCUS, nuclear, unconventional gas, electric vehicles, and efficiency technologies in other key sectors including industrial and infrastructure)? Policy – what are assumptions about strength of different policy signals and their development over time (e.g., national headline carbon emissions targets; energy efficiency or technology standards and policies in key sectors; subsidies for

Business Interruption due to physical impacts – what is the organization’s conclusion about its potential business interruption/productivity loss due to physical impacts, both direct effects on the organization’s own assets and indirect effects of supply chain/ product delivery disruptions?

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Table 13.2 (continued) Key Considerations: Parameters, Assumptions, Analytical Choices, and Impacts Parameters/Assumptions

Analytical Choices

Business Impacts/Effects

fossil fuels; subsidies or support for renewable energy sources and for CCS/CCUS) Climate sensitivity assumptions – assumptions of temperature increase relative to CO increase? Source: TCFD Technical Supplement – The Use of Scenario Analysis in Disclosure of Climate-Related Risks and Opportunities (June 2017).

– – – – –

Scenarios designs must be in alignment with: Banks’ business size and profile Complexity of operations Portfolio composition Geographic presence Risk appetite and profile

Baseline Scenario From a flow perspective, the starting point is a baseline or business as usual (BAU) scenario. NGFS describes BAU as “A scenario based on the assumption that no mitigation policies or measures will be implemented beyond those that are already in force and/or are legislated or planned to be adopted” which it adapted from IPCC reports (Allen et al. 2014). Table 13.3 captures a sample of baseline scenarios.

Scenario Construction – – – – –

Selection of baseline scenario/s Scenarios with both orderly and disorderly transitions Dynamic balance sheet assumptions – especially for long term projections Scenarios for both short-term and long-term all the way to 2050 (some countries/ firms have a longer horizon, up to 2070) Separate physical and transition scenarios

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Table 13.3: Baseline scenario samples. Climate agnostic baseline (no incremental transition and physical risks beyond those already observed to date) Baseline scenario Either static or dynamic balance sheet assumptions

Strategic Scenarios (the scenario to which a firm wants to align its portfolio)

Probability weighted central scenario

Higher transition risk Current or pledged policies

Tail scenarios Higher physical risk

Adapted from Climate Financial Risk Forum Guide 2021; Scenario Analysis. October 2021

The aspects that help create specificity and clarity to the scenario definition are – Identification of material vulnerable exposures for the exercise – Selection of variables to be used – Table 13.4 represents a sample – Metrics and tools to be used – as a practitioner, I have always given importance to relevance, applicability to the bank as opposed to the latest or complex options. The objective is to get a realistic result that facilitates communication to the required stakeholders as well as initiate positive actions – Tailoring the selected scenarios to the use case – Time horizon selection – short, medium, or long. Table 13.4: Sample climate-risk variables. Climate Risk variable Physical risk variables

Transition risk variables

Global and regional temperature trajectories

Carbon price pathways

Macro-financial variables GDP (and its components)

Frequency and severity of chronic climate related Emission trajectories perils

Unemployment

Crop yield

Commodity and energy prices

Inflation

Land use

Energy demand

Productivity

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Table 13.4 (continued) Climate Risk variable Physical risk variables

Transition risk variables

Macro-financial variables

Energy mix

Household disposable income

Investment in energy

House prices

Energy prices

Interest rates Exchange rates Equity prices

Building scenarios is an involved exercise. Scenarios and stresses encompassing various time horizons, correlations between different positions, markets due to system-wide interactions, feedback effects, risk drivers, etc., all of which add to the amplifier effect, need to be designed to capture plausible futures. Typically, scenarios banks use are focused on either their material exposures or their vulnerable segments/businesses, or both. Table 13.5 captures some simple steps of designing a scenario analysis flow with transition risk as the example. A more holistic construct/framework is suggested by TCFD (Task Force on Climate-Related Financial Disclosures). Figure 13.2, a reproduction of TCFD representation, segregates the process into six components and stitches them together into an operational framework. One important term in the vocabulary of scenario definitions is the “green swan” concept. The low probability and high impact of climate risk events is what makes the green swan approach more real. Combining climate uncertainties with risk modeling amplifies the complexity of the exercise. The green swan15 is the new addition to the risk vocabulary, these are “climate black swans,” present many features of typical black swans. Climate-related risks typically fit fat-tailed distributions: both physical and transition risks are characterized by deep uncertainty and nonlinearity, their chances of occurrence are not reflected in past data, and the possibility of extreme values cannot be ruled out (Weitzman 2009, 2011). Green swans are different from black swans in three regards. “There is a high degree of certainty that some combination of physical and transition risks will materialize in the future” (NGFS 2019a, p. 4). Second, climate catastrophes are even more serious

 Patrick Bolton, Morgan Despres, Luiz Awazu, Pereira Da Silva, Frédéric Samama, Romain Svartzman, BIS, Banque De France, The green swan, Central banking and financial stability in the age of climate change, January 2020.

Develop financial risk drivers: Revenues – Cost – Capital Expenditure – Asset value

Calculate scenario adjusted financial risk drivers

Scenario Variables

Source: Climate Financial Risk Forum Guide 2021; Scenario Analysis Chapter October 2021.

Identify key vulnerabilities:Impact of policy changes – Impact of technology evolution – Capacity for sector and company to transition

Table 13.5: Stages in conducting transition risk scenario analysis.

Calculate climate adjusted financial statements at company level: – Income statement – Balance sheet – Cash flow statement

Run risk models with climate adjusted inputs e.g., – probability of default, – loss given default, – expected losses

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Physical Risks

Policy and Legal What scenarios (and narratives) are appropriate, given the exposures? Consider input parameters, assumptions, and analytical choices. What reference scenario(s) should be used?

Scenarios inclusive of a range of transition and physical risks relevant to the organization

Identify and define range of scenarios

4

Evaluate the potential effects on the organization’s strategic and financial position under each of the defined scenarios. Identify key sensitivities.

Impact on: – Input costs – Operating costs – Revenues – Supply chain – Business interruption – Timing

Evaluate business impacts

5

Use the results to identify applicable, realistic decisions to manage the identified risks and opportunities What adjustments to strategic/financial plans would be needed?

Responses might include – Changes to business model – Changes to portfolio mix – Investements in capabilities and technologies

Identify potential responses

Document and disclose: Document the process; communicate to relevant parties; be prepared to disclose key inputs, assumptions, analytical methods, outputs, and potential management responses.

What are the current and anticipated organizational exposures to climate-related risks and opportunities? Do these have the potential to be material in the future? Are organizational stakeholders concerned?

Reputation

Market and Technology Shifts

Assess materiality of climate-related risks

3

Ensure governance is in place: Integrate scenario analysis into strategic planning and/or enterprise risk management processes. Assign oversight to relevant board committees/sub-committees. Identify which internal (and external) stakeholders to involve and how.

Figure 13.2: Components and sequence of operationalizing climate related scenario analysis. Source: TCFD Technical Supplement – The Use of Scenario Analysis in Disclosure of Climate-Related Risks and Opportunities (June 2017).

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than most systemic financial crises: Third, the complexity related to climate change is of a higher order than for black swans: the complex chain reactions and cascade effects associated with both physical and transition risks could generate fundamentally unpredictable environmental, geopolitical, social, and economic dynamics.

Reference Climate Scenarios There are reasonable set of reference climate scenarios available. Examples for energy transition scenarios include agencies like IEA (International Energy Agency), IRENA (International Renewable Energy Agency), Greenpeace, Institute for Sustainable Development, and Bloomberg, etc. Intergovernmental Panel on Climate Change (IPCC) provides a range of physical climate scenarios. NGFS provides a baseline starting point for analyzing climate risks through standardized scenarios and related datasets on physical and transition risks as well as economic impact. Primary source of direction and data points for scenario analysis and stress testing are NGFS documents. The three NGFS scenarios are for orderly, disorderly, and hot house world for now. The fourth area is “too little too late” – scenarios under this umbrella are a work in progress. Figure 13.3 is a graphic representation

• Ambitious action to a net zero CO2 emissions economy

Orderly

Disorderly

• Action that is late, disruptive, sudden, and/or unanticipated

Hot house world

• Limited action leading to significant global warming, resulting in strongly increased exposure to Physical risks.

NGFS Scenarios

Too Little Too Late

Figure 13.3: NGFS scenario classes.

A late transition fails to limit physical risks

Stress Test initiatives by different regulators – a sample

167

of the NGFS scenario classes. The NGFS scenarios framework allows exploration and visualization of emission data. Banks are using different scenarios, be it the NGFS, IEA, Bloomberg, or RCPs (Representative Concentration Paths). Figure 13.4 represents a sample of climate scenarios that banks are using.

RCP 8.5 RCP 2.6 RCP 4.5 RCP 6 NGFS Disorderly Transition NGFS Orderly Transition NGFS Hot house world NGFS Too little, too late IEA Sustainable Development IEA Beyond 2°C (B2DS) IEA New Policy Scenario (NPS) IEA Energy Technology Perspectives 2 Degrees (ETP 2DS) IEA Current Policies Scenario (CPS) IEA 450 Bloomberg New Energy Finance New Energy Outlook (BNEF NEO) Deep Decarbonization Pathways Project (DDPP) Shell Other 0

5

10

15

20

25

30

Figure 13.4: Climate scenarios range (source: Climate Financial Risk Forum Guide 2021: Scenario Analysis October 2021).

Stress Test initiatives by different regulators – a sample The stress tests are largely coming from the regulators who advocate as well as use scenario analysis and stress tests themselves. This is to monitor financial stability on the one hand and to gauge resilience of its member constituents on the other. Banks also have a lot to gain from the tests as they help in understanding both the risks they are likely to be exposed to and the potential magnitude of loss.

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Some regulators have concluded the first round of stress tests (ECB, BOE, PBOC, etc.) while some are embarking on it (Like FRB). None of them have yet spoken of a direct capital impact. However, the results of these tests will flow into supervisory review processes with capital implications, in addition to other regulatory actions if found wanting. Table 13.6 shows a sample of different approaches taken by supervisors of different geographies. Table 13.6: Sample of approaches taken by different regulators. Practical examples of bottom-up, top-down, and hybrid approaches Country

Regulator

Approach

Canada

OSFI and Bank of A three-part hybrid approach in which top-down exercise determined Canada financial impacts were passed to banks to use propriety data to perform a bottom-up assessment according to a pre-specified exercise which was then aggregated across the financial sector by a final top-down exercise. In addition, there was a separate top-down analysis of equity exposure. The Canadian authorities intend to develop their capabilities in topdown climate scenario analysis to assess potential systemic risks.

EU

ECB

The ECB’s economy-wide stress test is strictly top-down, relying on extensive data collection and rigorous models run by the authority. The ECB considers a top-down approach to be the most appropriate method to capture cross-sectoral and system-wide aspects of climate-related risks. In its  exercise, it used data from single sources for firms’ balance sheet information and for emissions data and physical risk, noting that it enabled uniformity in terms of data quality. The ECB also used its own risk modelling, avoiding the difficulty in aggregating results from different models and calibration methods. For instance, credit risk parameters were assessed in the same model with the same variables and data for all firms. Having one single model also did not require alignment with individual banks, which allowed more flexible adaptations and efficiency.

France

ACPR

A hybrid approach with the main assumptions provided by ACPR but a complete bottom-up assessment carried out by institutions. Its pilot was the first bottom-up exercise to be carried out by a supervisory authority. One of its objectives was to raise the awareness of participating institutions. It also forced institutions to develop sectoral approaches to both quantify their exposures and improve their risk modelling frameworks.

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Table 13.6 (continued) Germany

Bundesbank

Currently developing a top-down climate risk stress test for the German banking sector with an initial focus on transition risks. The stress test will use reporting data (to replicate  banks’ corporate credit books) and debtor-specific data (balance sheet data, third-party greenhouse gas emissions data, and further information such as industry sectors).

Hong Kong

HKMA

In its pilot CRST, the HKMA prescribed three climate scenarios for banks to conduct bottom-up assessment of both transition risk and physical risk. However, the HKMA considers that the cross-sectoral, system-wide aspects are more easily addressed by some form of hybrid exercise, combining climate change scenarios and macroeconomic models. Financial institutions could then be asked to use their best efforts to undertake impact analysis or stress testing exercises. The HKMA believes such flexibility is warranted given the challenge of data availability and the varying level of sophistication among financial institutions. A bottom-up approach could also have the virtue of capacity building.

Japan

FSA

The FSA stands out in placing a greater priority on engagement with clients by financial institutions as a risk management tool. A bottom-up approach was adopted to allow financial institutions to use the results of scenario analysis for their active engagement with their clients. Provided the data gaps are addressed and common methodologies are established, the FSA expects to engage in intense dialogue with financial institutions on how their business strategy, including engagement strategy, can be improved based on the scenario analysis’ results. In this context, the FSA believes that micro-level sensitivity analysis of the successful transformation of the client’s business structure against continuation of the current business structure could also be a useful complement to scenario analysis to highlight impacts of clients’ actions.

Netherlands DNB

In , DNB conducted a top-down transition risk climate stress test based on granular corporate loan, equity, and bond holdings data. The objective was to assess financial stability risks by using a common methodology to assess transition risk vulnerabilities for banks, insurance companies, and pension funds. Due to the macroprudential nature of the stress test, a top-down approach was used. Furthermore, as DNB’s transition risk stress test was the first one conducted, methodologies had to be pioneered and financial institutions had at that time limited internal modelling tools available. In , DNB conducted an additional top-down climate stress test to assess the financial stability risks of severe floods.

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Table 13.6 (continued) Singapore

MAS

MAS’  thematic climate scenario analysis exercise will involve bottom-up assessments by participating financial institutions, with MAS specifying standardized assumptions and parameters under the different scenarios. The intent for this approach this year is to raise awareness among the industry players of the economic and financial implications of climate risks and encourage the collaborative development of relevant capabilities. A sharing of the learning points from the diversity of methodologies and approaches used would also accelerate such capacity building efforts. In preparation for this exercise, MAS also consulted selected financial institutions to better understand their analytical capabilities and the data requirements for the assessment of climate risks.

UK

BOE

The BoE used a bottom-up approach in its CBES exercise so that participating firms are encouraged to improve their capability to model climate-related financial impacts on their balance sheets. It also allowed the generation of important data on firms’ exposures and as such aids in the bridging of data gaps.

Source: FSB – Supervisory and Regulatory Approaches to Climate-related Risks, Final Report October 13, 2022.

ECB Stress tests – Scope, Objectives, and Coverage EBA Stress Tests details that physical risks (floods, wildfires, earthquakes, sea level rise, etc.) could have a “potentially severe” impact on bank loan losses. Exercise covered 1,600 lenders – about 80% of loans held in the euro area against three scenarios that account for different climate change risks over the next 30 years. A more realistic modeling of stress test is when intersectoral impact is considered due to the amplification effects of climate change. A reference model is explained in ECB’s paper on shock amplification in an interconnected financial system of banks and investment funds, which “shows how the combined endogenous reaction of banks and investment funds to an exogenous shock can amplify or dampen losses to the financial system compared to results from single-sector stress testing models.”16 The Scenario analysis and stress testing principles to assess the potential impact (exposures and losses) under different climate pathways are aimed at internationally active banks. Part of ECB’s stress testing objectives, in its benchmarking exercise, plans to compare and validate institutions’ emission models and calculations. Banks will be ex-

 European Central Bank Shock amplification in an interconnected financial system of banks and investment funds, Working Paper Series, No 2581/August 2021.

Bank of England’s (BOE) Biennial Exploratory Scenario (BES) Exercise

171

pected to quantify emissions associated with their own operations as well as the businesses they finance.

ECB 2021 Stress Test Results – Top Level Observations Losses on corporate loan portfolio, as assessed by ECB, based on their 2021 climate stress tests, were projected to rise, with corporate loan portfolios 8% more likely to default. Fifty percent of the 112 banks with combined assets of twenty-four trillion euro illustrate how climate change risks have material impact. However, only 28% of the banks have integrated climate risk into their credit risk classification.

ECB 2022 The ECB’s 2022 scenarios look at both short term and long-term stresses. Short term vulnerabilities in a three-year disorderly transition scenario were sparked by a sharp increase in the price of carbon emissions17. For the long term, three different transition scenarios over a 30-year horizon are looked at.

Bank of England’s (BOE) Biennial Exploratory Scenario (BES) Exercise The bank looks at this as a “learning exercise” to understand and manage climate change risks by banks18. It will also be inputted to BOE’s financial and supervisory policy. The objective of the exercise, as stated by BOE, is to explore the financial risks posed by climate change for the largest UK banks and insurers. BES uses three scenarios to explore the resilience of major UK banks and insurers to climate-related risks over a 30-year horizon. The first BES round focused on the size of exposures to climate-related financial risks. Observations from the first BES (2021) suggest that the costs will be lowest with early, well managed actions to reduce greenhouse gas emissions, no surprises there. A realistic observation is that projections of climate losses are uncertain as scenario analysis is in its infancy and there are important data gaps. The focus of the second BES (2022) will be to assess the impact of and the potential response to climate change risks on the business models of the participating organizations.

 European Central Bank Macro-financial scenarios for the 2022 climate risk stress test, 2022.  Bank of England launches a second round of the Biennial Exploratory Scenario (BES) exercise on financial risks from climate change, February 9, 2022.

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Federal Reserve Board’s (FRB) Pilot Climate Scenario Analysis FRB plans to launch its pilot exercise across six of the largest banks of United States in early 2023 and conclude around the end of the year. The board will publish details of the climate, economic, and financial variables that make up the climate scenario narratives. Participating banks will analyze the impact of scenarios on specific portfolios and business strategies.

People’s Bank Of China (PBOC) PBOC conducted climate change stress testing of the potential impact of China’s emission reduction targets on the banking system in 2021. The major focus was on looking at the impact of an increase in emission costs on the repayment capability of carbon intensive enterprises (like energy, steel, and cement) and the roll-on effect on the asset quality as well as capital adequacy levels of the participant banks. Twenty-three major banks took part in the tests. PBOC found that the capital adequacy, which is currently at 14.89%, would stay above 14% by 2030 in both mild stress and severe stress situations. Table 13.7, through three examples, shows sample outputs of supervisory tests. Table 13.7: Sample outputs. System-wide supervisory stress tests – output Three Examples BdF – Bank of France; ACPR – French Prudential Supervision and Resolution Authority

DNB – Netherlands Bank

BoE – Bank of England; PRA – Prudential Regulation Authority

Target variables Banks: asset side losses (credit, Asset-side losses counterparty credit, and market risks) Insurers: asset values and liabilities

Banks: credit book impairments Insurers: value changes in assets and liabilities

Timeframe for impact assessment

Periods during which the scenario variability is highest, i.e., , , , 

Once (at end of five-year horizon)

Every five years over the time horizon

Output breakdown

Geographical, sectoral, key counterparties (top )

Range of losses in the three industries (banks, insurers, pension funds – CET impact for banks)

Geographical, sectoral, key exposures (top )

Management actions considered

Yes (via dynamic balance sheet) No

Yes

Uses of Scenario Analysis and Stress Tests

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Table 13.7 (continued) System-wide supervisory stress tests – output Three Examples Reconciliation exercise

Yes

No

Communication BdF/ACPR disclose system-wide DNB published estimate of of result results and provide feedback to impact (aggregate CET individual firms changes) on Dutch financial sector

Yes, in a separate qualitative questionnaire BoE discloses systemwide results and provides feedback to individual firms

Source: Patrizia Baudino and Jean-Philippe Svoronos, BIS stress-testing banks for climate change – a comparison of practices (July 2021). BIS Sources: ACPR (2020, 2021); Allen et al. (2020); BoE (2019c, 2020, 2021a, 2021b); Vermeulen et al. (2018, 2019).

Uses of Scenario Analysis and Stress Tests The objective of scenario analysis and stress tests is to facilitate action in the right direction – to focus on the activities and initiatives that need to be taken at corporate, portfolio, and individual counterparty level. The Basel principles document summarizes objectives as – Exploring the impacts of climate change and the transition to a low-carbon economy on the bank’s strategy and the resiliency of its business model – Identifying relevant climate-related risk factors – Measuring vulnerability to climate-related risks and estimating exposures and potential losses – Diagnosing data and methodological limitations in climate risk management – Informing the adequacy of the bank’s risk management framework, including risk mitigation options – Shorter time horizons may be used to analyze the crystallization of risk within a bank’s typical business planning horizon at a lower level of uncertainty – Longer time frames, which carry higher levels of uncertainty, may be used to evaluate the resiliency of existing strategies and business models to structural changes in the economy, financial system, or distribution of risks19

 BCBS, Principles for the effective management and supervision of climate-related financial risks (June 2022).

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TCFD highlights the contribution of scenario analysis to greater strategy resilience and flexibility by – Testing a strategy and strategy options against a set of scenarios. – Identifying potential future threats or opportunities. – Identifying trigger points to set contingency plans in motion. – Serving as a basis for continuous monitoring and strategy adjustment. In addition, scenario analysis is also undertaken for the purpose of disclosures and/or as required by their regulators. It is also helpful in assessing portfolio alignment. The top two questions that get answered (or need to get answered) by assessing potential impact of stress are: 1) is it within the risk appetite set by the bank (future access to resources – financial and others); and 2) is the bank prepared for the outcomes (managing, mitigating risk, etc.), and, if not, planning measures that need to be put in place. Figure 13.5 captures climate scenario assessment process. Climate Scenario Asessment

Physical channel

Transition channel

Risk Identification

Macro-economic impact assessment tools Impact distribution by country, sector, asset class, etc.

– – – –

Scenario Socio-economic context Climate policy landscape Technological evolution Emission and temperature pathways

Credit risk ratings, expected losses, maket valuation, interest rate margins etc.

Assess Financial impacts and take appropriate action – Profit & loss statement – Balance sheets – Capital ratios – Risk appetite framework

Impact of decarbonisation and physical events on individual companies or specific assets Asset or company specifi impact assessment tools Risk Identification Physical channel

Transition channel

Figure 13.5: Impact assessment (source: Climate Financial Risk Forum Guide 2020; Scenario Analysis Chapter June 2020).

The top five actions taken by firms based on scenario analysis, as mentioned in CFRF Guide 2021 – Scenario Analysis report, are – Improved disclosures – Change in risk management processes and policies – Change in portfolio composition

Uses of Scenario Analysis and Stress Tests

– –

175

Change in products or services Change in organization strategy

Integration of scenario analysis with risk appetite framework is through “(i) calibration of thresholds through scenario analysis; (ii) projection of existing metrics; (iii) development of new metrics; and (iv) embedding in financial and strategic planning processes.”20 These are in order of growing maturity. As it is an evolving practice and outcomes of the scenario analysis will deeply influence strategic business decisions, it will be a good practice to have a dynamic scenario management process and execute it as a rolling time process to keep embedding the newer and more refined inputs to get better and reliable outcomes that mature over time. As a matter of prudence as well as good governance processes, it will be a healthy practice to subject the entire life cycle of scenario analysis management to review by experts (internal and external) and auditors.

 Climate Financial Risk Forum Guide 2021: Climate Risk Appetite Statement (October 2021).

Chapter 14 Risk Mitigation, Control, and Monitoring Process Start by doing what’s necessary; then do what is possible; and suddenly you are doing the impossible. –St. Francis of Assisi

The purpose of risk management, narrowly defined, is to reduce risk through various mitigation measures. The broader and more appropriate definition of effective risk management is to protect all stakeholders. The focus here is “all” stakeholders within the bank’s ecosystem. Climate-related risk management has broadened the boundaries of the inclusion of “active” stakeholders. While protecting the liquidity, solvency, profitability, and healthy growth of the bank have always been in focus, additional focus on reputation, regulatory, legal risks, sustainability, and contributing to the netzero journey of the economy have come into strong focus. This adds layers of complexity to mitigation, control, and monitoring in this space. The ECB, in its report on the supervisory review of banks’ approaches to manage climate and environmental risks, mentions that “virtually all institutions that performed a thorough materiality assessment expect C&E risks to have a material impact on their risk profile in the coming three to five years. Roughly half of the institutions expect C&E risks to have a material impact in the short-to-medium term. They view credit risk, operational risk and business model risk as being most sensitive to C&E risk drivers.”1 Figure 14.1 captures climate and environmental risk (C&E) materiality, as seen by the industry in the eurozone. A risk management program, to be effective, “needs to be able to proactively anticipate the potential events that may affect the organization, to set in place a mitigation and management process based on its business model, objectives, risk appetite and strategic direction within the context of its environment as reflected in the current and anticipated market, economic and competitive landscape.”2 According to a BCBS report, “an effective risk management framework for banks and supervisors should have three goals: first, to identify material climate risk drivers and their transmission channels; second, to map and measure climate-related exposures and any area of risk concentration; and third, to translate climate-related risks into quantifiable financial risk metrics.”3

 European Central Bank, The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks, November 2021.  Saloni P. Ramakrishna, Enterprise Compliance Risk Management: A practitioner’s handbook.  Basel committee on banking supervision, Climate-related risk drivers and their transmission channels (April 2021). https://doi.org/10.1515/9783110757958-017

Not material or no assessment done 41%

Material in short-tomedium term 4%

Both in short-tomedium and longer term 46%

Material in the longer term 8%

Figure 14.1: Materiality of climate and environmental risks.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Physical risk as material risk driver Transition risk as material risk driver

Operational risk

Liquidity risk Market risk

Credit risk

(percentages)

Business model risk

Percentage of institutions that assessed C&E risks as material in the short-tomedium term and/or longer term, both overall (left-hand panel) and broken down by risk types (right-hand panel)

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Mapping and measuring risk exposures are core building blocks of effective risk management framework. For climate-related financial risks, the risk drivers (physical and transition) differentiate these. Gross and net exposure estimation discussed in Chapter 12 will make it possible for banks to disaggregate the impact of risks and of mitigation measures. On a broader note, a consistent, standards based comparable global approach/methodology/disclosures will support understanding as well as contain vulnerabilities and potential financial losses and reduce the risks. The difference in the case of climate change risk as compared to traditional risks, whose management banks have honed over time through trial and error, is that one needs to anticipate the risks, their amplifications upfront, potential contagion, and the multi effect across geographies, sectors, and risk categories from risk factors arising outside of the bank. From the environment, the societal response to the environmental changes, customer behavior across their stated transition journey, to name a few areas, is where ringfencing risk through active mitigation and controls becomes central. Principle 6 details how “banks should consider risk mitigation measures such as, but not limited to, establishing internal limits for the various types of material climate-related financial risks to which they are exposed, e.g., in their credit, market, liquidity and operational risk profiles.”4 The effect of risk mitigants put in place to moderate or offset risks is central to managing any risk but more so in the climate change risks space. Clear definition, articulation, and communication of “materiality” to have uniform understanding across the organization in the context of climate-related financial risks, setting in acceptable thresholds based on the risk appetite of the bank, is a core part of the mitigation framework. The framework is to be designed in a way that it can, at the earliest possible point, identify climate risk concentrations and vulnerable pockets (across industry, economic sector, product family, geography). Thresholds, limits, key risk indicators that are in line with the mitigation, monitoring, and escalation paths go a long way in arresting unpleasant surprises. Risk offsetting options like hedging and netting as well as strategies like insurance, weather derivatives, and catastrophe bonds can be factored in to arrive at “net” exposures. Likewise, the measures that the bank’s counterparty takes to adapt to or mitigate5 climate change risk at its level will add or otherwise affect the “net” exposure of the bank. Hence, an important part of the mitigation, control, and monitoring program of a bank encompass guidance to, and positive alignment with, its clients on a synchronized journey towards a low carbon economy.

 Basel committee on banking supervision, Principles for the effective management and supervision of climate-related financial risks, June 2022.  Mitigation approaches target reducing the sources and stabilizing the levels of GHGs in the atmosphere; adaptation approaches target adjusting to actual or expected climate and its effects, particularly to moderate or avoid harm from these effects.

Understanding Climate Risks

179

Mitigation Risk mitigation is taking actions to reduce risk through clearly defined risk appetite, processes, and procedures on the one side and strong control measures on the other. It is early days to have focused mitigation, monitoring, and control frameworks for climate-related financial risks as the understanding of the risks and the potential of magnitude of losses is in its infancy. However, the risks are now and, therefore, some time-tested, flexible core structures that can organically grow, and lend themselves to course correction, need to be put in place. Getting started, iterating, learning, enhancing mitigation, monitoring, and control frameworks as a dynamic exercise will be required.

Understanding Climate Risks The first step in the mitigation and control process is to understand the ways in which climate risks impact bank’s business. Figure 14.2 is a sample of how natural disaster can lead to non-performing loans.

Natural hazard – climate risks

Capital destruction (incl. infrastructure)

– Inflation – Unemp.

Taylor rule

Sectoral labor force

Sectoral production

Sectoral labor force

Sectoral employment

Change in interest rate

Unemployment Labour force affected

– Sales – Price – costs

Non-Performing Loans

Firms’ profits GDP

Employment

Wages

Figure 14.2: Natural hazards transmission channels to NPL. Source: NGFS Physical Climate Risk Assessment, technical document (September 2022).

While banks have no control on the natural hazards per say, they can work from the left side of the graphic. Based on the vulnerability maps that map the potential physical risks to the portfolios of the bank, they can plan pre-emptive actions on the potential NPLs. Closer monitoring of the sensitive exposures will help either sidestep loss or minimize the impact of loss.

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Risk Response As part of principle 8,6 the Basel Committee suggests that Banks should consider a range of risk mitigation options to control or minimize material climaterelated credit risks. These options may include adjusting credit underwriting criteria, deploying targeted client engagement, or imposing loan limitations or restrictions such as shorter-tenor lending, lower loan-to-value limits, or discounted asset valuations. Banks could also consider setting limits on or applying appropriate alternative risk mitigation techniques to their exposures to companies, economic sectors, geographical regions, or segments of products and services that do not align with their business strategy or risk appetite. As can be seen, some very specific metrics have been suggested along with broad approaches here.

Strategic Responses One of the OCC principles for large banks on climate-related financial risk management, focusing on policies, states that bank management “should incorporate climate-related risks into policies, procedures, and limits to provide detailed guidance on the bank’s approach to these risks in line with the strategy and risk appetite set by the board.”7 The risk in climate change space is the risk of not being in sync with the environment. When not managed well, it impacts the bank’s objective of value creation. Robust management of the portfolio with strong mitigation and control framework is core to being alert and proactive where possible. When banks are faced with situations where being reactive is the option, then a fast response turnaround time is to be aimed for. The standard risk mitigation strategies (as reflected in Figure 14.3) that need to be extended to accommodate climate-related financial risks and its nuances include:

 Basel committee on banking supervision, Principles for the effective management and supervision of climate-related financial risks, June 2022.  Office of the Comptroller of the Currency Principles for Climate-Related Financial Risk Management for Large Banks (December 2021).

Strategic Responses

181

Risk avoidance

Risk acceptance

Risk Responses Risk transfer

Risk control & management

Figure 14.3: Risk responses.

–

–

Risk avoidance – risk appetite and risk tolerance, in the initial stages, will be low for climate change risks and rightly so. Avoiding risks, particularly in geographies or businesses which have been called out specifically as such, in the risk appetite statement is expected. However, a total avoidance of businesses that have climate related risks is not practical. That is because there would be very few businesses, if any, that will not be impacted by climate change. Hence grading these risks into low, medium, and high with the proper control framework around the former two with primary avoidance strategy for the high-risk category is a prudent approach. It is vital that the communication of the strategy and plans to work need to be simple and clear across the bank for this approach to succeed. Those risks that are not avoided flow into the next three strategic responses. Risk acceptance – risk acceptance, in its broader context, is the cost of staying in business. Care, in the climate space, is in understanding the accepted risks and putting in place the required control measures. While risk avoidance is a “costly” option in traditional risk categories, in climate-related risks it is the risk acceptance that could be very costly, if they are not ringfenced and managed effectively. It is a given that some climate-related financial risks will be accepted. What is within the bank’s purview is how effectively the accepted risks will be managed. What risks

182

–

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Chapter 14 Risk Mitigation, Control, and Monitoring Process

will be accepted under what conditions, what limits, and thresholds have all to be spelled out in clear and simple terms and communicated as such. Risk transfer – insurance is the primary risk transference mechanism, that both the clients of the bank and the bank itself resort to. In addition, weather derivatives, catastrophe bonds and other evolving areas of climate change focused risk transfer mechanisms are becoming relevant. Most of the transfer options are in the physical risk space. Risk controls – this aspect is discussed in some detail in the next part of this chapter.

Structural Mitigation and Monitoring Measures Delineating the activities and setting clearly spelled out responsibilities and accountability for the three lines of defense of a bank is critical to managing climate-related financial risks. – First line of defense – Front office to be trained/clearly communicated on how to understand, assess, capture, and track clients’ transition strategies and their climate change related mitigation plans (for physical, transition, and liability risk drivers as applicable to their businesses) during the following interactions: – Onboarding and credit application processing – Periodic credit review processing – Ongoing monitoring and communication – Additional focus during new product/service/business approval process – Second line of defense – Risk teams need to have clearly defined, well-articulated, and communicated climate-related financial risk management frameworks. Assessment and monitoring of climate-related financial risks need to be done independent of the front office and a healthy challenging of the front office assessments will build a learning organization. Tracking of the effective implementation and compliance of the policies and processes laid out is essential. – Third line of defense – Independent audit and internal control teams oversight completes the circumference of the structural mitigation and monitoring of climate change risks within the banks. This group provides an independent review and assurance of the control frameworks/systems. This function is expected to provide an objective evaluation of the operations of the first and second line of defense as well as the governance framework around climate-related financial risk management. Banks can state that non-reporting of risk breaches is unacceptable and the audit function is tasked to report such non-reporting.

Structural Mitigation and Monitoring Measures

–

183

Climate-related financial risks are a new area for the audit and internal control teams. This discipline will entail changes across the chain starting from governance principles, methodologies, processes, data usage, etc., hence, a welldesigned program that familiarizes these teams with expectations from independent oversight bodies will go a long way in making the process effective.

Speaking of good practices in mitigation of climate change risks, Reserve Bank Of India8 states that, REs may carry out substantial measures to mitigate or refrain from climaterelated risks that are not in accordance with their risk appetite. Measures can be developed in response to the RE’s (Regulated Entities) own assessment of the climaterelated risk concentrations. These mitigation measures may include: – Customers in sectors which are highly vulnerable to emerging climate risk may be subject to tenor limitations. – Customers with real estate collateral that do not meet minimum sustainability criteria may be subject to a lower loan-to-value limit – Customers for which production is directly dependent on weather conditions may require taking out insurance against extreme weather events (e.g., seasonal droughts, floods) – Customers in CO2 (Carbon Di-oxide)/GHG (Greenhouse Gas) intensive industries may require having a sustainable energy transition strategy – Monitoring timely and regular updating of the internal risk reports, the mitigation measures, and their effectiveness thereof – Ensure that the mitigation measures proposed based on the scenario analysis are not only achievable but realistic, credible, and consistent with regulatory environment. The results of stress testing and scenario analysis may also be used when reviewing the climate risk management policies and practices Climate risk mitigation measures – ability to estimate the effect of mitigants on moderating the potential of loss or offset risk taking is the essence here. – Proactive measures – preemptive measures to reduce the negative impact of climate change – Diversify portfolio – both product families and geographies – Portfolio distribution – new businesses in viable green options – Tracking and acting on vulnerable/sensitive spots based on vulnerability heat maps – Limits setting for exposure to climate risks – Exclusion of specific carbon intensive sectors

 Reserve Bank of India, Discussion Paper on Climate Risk and Sustainable Finance, July 2022.

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–

–

–

Insurance coverage – Insurance coverage opted by counterparties for their business – Bank taking appropriate coverage of its portfolio Reactive measures – responding to climate change risks embedded in businesses – Faster turnaround time – speed to action. This requires a well laid out framework and its execution. – Risk remediation framework – “Remediation implies the act or process of correcting, reversing, or setting right a deficiency; the prerequisite for which is identification of the deficiency and the impact it is likely to have. I look at redress and remediation at two levels. One the internal process improvement idea and the other meeting of the external commitment and requirements of remediation. Together it reduces the snowballing effect of risk. Therefore, it is imperative that there is a policy, process, and a dynamic program in place for managing remediation.”9 Capital market initiatives – Loan securitization – Loan sales – Hedging with weather derivatives and the like.

Controls It is accepted upfront there is an inherent risk in doing business, any business. This is truer in case of climate risk where assessing the depth of inherent risk is challenged, as discussed in Chapter 12 and 13. COSO defines inherent risk as “the risk to an entity in the absence of any action management might take to alter either the likelihood or impact.”10 The purpose of good controls is to reduce these inherent risks to manageable residual risks. Residual risks are a function of inherent risks and control effectiveness. Therein rests the centrality of strong control systems. Effective controls, well designed and meticulously implemented, are central to managing the evolving climate-related financial risks. Principle 411 of BCBS, covering internal control frameworks, states, “Banks should incorporate climate-related financial risks into their internal control frameworks across the three lines of defense to ensure sound, comprehensive and effective identification, measurement, and mitigation of material climate-related financial risks.” The Basel principle on Internal control details that while expecting that the existent board and management governance structures provide effective oversight of

 Saloni P. Ramakrishna, Enterprise Compliance Risk Management – An Essential Toolkit for Banks and Financial Services (n.d.).  COSO Enterprise Risk Management, Integrated Framework (2004).  Basel committee on banking supervision - Principles for the effective management and supervision of climate-related financial risks, June 2022.

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their internal control framework of material climate-related financial risks across the three lines of defense, there is also an acknowledgement of the complexities of climate change and the efforts to mitigate it. The expectation here is that banks would identify, assess, mitigate, and address the specificities of climate change like acknowledging, documenting, and incorporating material physical and transition risks into their RMS (Risk Management Systems).

Control Effectiveness Models The nature and effectiveness of controls is critical to the success of mitigation. The two aspects of control effectiveness are (Tables 14.1A and 14.1B): – Design effectiveness – Implementation effectiveness The values for these components can be sourced from questionnaires, expert judgement, or audit reports, though for now, as the climate-related content in banks is at its infancy, the former two are the options. Detail can be built in for strong and unified IT systems, proactive/reactive, review cycles, etc. on the design side and control breakdowns, breaches (in spite of the controls), ease of implementation (or the lack of it) etc. on the implementation side as data points for arriving at the effectiveness scale. Table 14.1A: Design effectiveness. Design Effectiveness Low Medium High

Table 14.1B: Implementation effectiveness. Implementation Effectiveness Low Medium High

These assessments can be across important dimensions like geography, line of business, product class, etc. to enable banks to have a more objective view and ability to initiate situation specific action.

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Table 14.2: Heatmap of control effectiveness. Control Assessment Implementation Effectiveness High Design Effectiveness

Medium

Low

High Medium Low

Table 14.3: Arriving at Residual risk. Inherent Risk (a)

Control Effectiveness (b)

Residual Risk as a function of (a) and (b)

Physical Risk Transition Risk Liability Risk

Control effectiveness is a function of design effectiveness and implementation effectiveness. A possible heatmap, by dimension, time stamped is represented in Table 14.2. Gathering information at different points in time and comparing improvement or otherwise of the control effectiveness will help system correction to better the process. Mitigation of inherent risk with effective controls to manageable residual risk with intelligent monitoring is what climate-related financial risks requires, as the discipline evolves. This will also enable the building in of flexibility and dynamic course correction, as the understanding of the space advances. Table 14.3, looks at deriving residual risk as a function of inherent risk and control effectiveness. Bank must decide if the residual risk so derived is within its risk appetite and risk tolerance. Designing and testing of control models and practices is an ongoing exercise, comprising of controls that monitor, detect, prevent, correct, or escalate climate related risks. Periodic assessment, in short periods in the initial stages and at longer intervals as the control mechanisms become more mature, can be the approach. The caveat, however, is that the periodicity is dynamic in medium and high-risk categories, based on heatmap indicators. Control policies, processes, and models need to be incorporated into programmed practices of the bank.

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Monitoring Active monitoring is the core of managing any risk but more so in managing climate change risk. The approach will do well to include both proactive and reactive measures. Risk monitoring through key risk indicators (KRIs) tracking, incident reporting, timely escalation where applicable, etc. The objective of mitigation and monitoring is to bring down residual risk to manageable levels. Prioritization of the exposures is material and has a high potential of loss if this action is missed, ensuring rigorous monitoring measures will be a good step to arrest the problem to a manageable level. Banks endeavor to support their customer’s transition journey and where not feasible they will do well to have a planned exit criteria and plan. The ECB12 suggests that Institutions are expected to monitor, on an ongoing basis, the effect of climate-related and environmental factors on their current market risk positions and future investments, and to develop stress tests that incorporate climate-related and environmental risks.

For internal reporting, it adds, institutions are expected to report aggregated risk data that reflect their exposures to climaterelated and environmental risks with a view to enabling the management body and relevant sub-committees to make informed decisions. For example, by developing client scorecards with a qualitative risk classification (e.g., low, medium, or high) or by using proxies as key risk indicators in the risk appetite statement

An efficient IT system will be the greatest asset in banks’ toolkit of risk monitoring and mitigation. Automation, alert generation, and action tracking are some of the aspects of a good IT system that assist both in proactive and reactive monitoring. Interactive and granular reporting, top level risk summarization for consumption by the senior executives with the ability to drill into problem areas, is a valuable tool in the monitoring of climate-related risk. The sophistication of both the processes and systems need to be in direct proportion to the complexity and geographical spread of the bank. Credit risk is an area of concern because it is the largest asset portfolio in most banks. From a progress perspective, of blending climate risk aspects into credit risk processes, the ECB, based on their 2021 climate stress tests, administered on 112 banks with combined assets of 24 trillion euro, found that only 28% of the banks have integrated climate risk in their credit risk classification. Having said that, it must be acknowledged that it is the area where blending climate related factors into risk measurement is better developed as compared to other risk categories.

 European Central Bank, The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks, November 2021.

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Credit losses both in terms of actual default as well as deferred/delayed payments impact capital and liquidity management in addition to its profitability. Climate change and its vagaries are impacting businesses that banks finance. Ratings, PD LGD, EAD, and haircut models all need to factor in climate change factors. Understandably, the energy sector and industries dependent on fossil fuels are more sensitive to climate risk factors while utilities, healthcare, and the like are less sensitive sectors. Stronger controls, mitigation plans, clearly articulated limits, and their implementation will hence all be important monitoring initiatives, specially for the sensitive sectors. The success as well as the challenge of monitoring and mitigating climate-related financial risks is in producing specific actionable steps. Sector specific control and remedial actions for high risk portfolios, for example remedial action to make housing stock more energy efficient, like the climate financial risk forum’s mention of a range of possible options, including: (i) Softer measures, such as watchlist monitoring and mortgage-product construction; or (ii) Firmer options, such as limiting the flow of business of higher-risk stock – via, e.g., exclusions from lending criteria or increased pricing (to reflect the risk). Given that there is low aptitude and appetite for taking on climate-related financial risks, bridging the gap between identification/assessing of risk and reversing or setting right deficiencies in a systematic manner is the responsibility of the remediation process. Equally important is the transparency of the monitoring and remediation process. This gives banks a better chance of avoiding negative perception and response by the stakeholders.

Chapter 15 Disclosures and Reporting Requirements It always seems impossible until it is done. –Nelson Mandela

Disclosure is reporting by an entity about information that market, policymakers, government or regulators expect from it. These reports, addressed to stakeholders, inform them about the businesses the bank is in and the risks it carries. This helps the stakeholders to make informed decisions. In the climate-related financial risk space, regulators require disclosure of key information like greenhouse gas emissions of both the bank and of its businesses (Scope 1, 2 and 3) as well as its exposures that are vulnerable to climate change. Summarizing the scope, TCFD recommends disclosure of “the actual and potential impacts of climate-related risks and opportunities on the organization’s businesses, strategy, and financial planning where such information is material” including “the resilience of the organization’s strategy, taking into consideration different climaterelated scenarios.”1 Disclosures cover assessment and management of material climate-related financial risks and opportunities, with greater focus on risks both from banks and to banks. There is less understanding of opportunities and less clarity on its disclosures here. Disclosures indicate that metrics and targets to measure and manage climaterelated financial risks are around sustainable financing, operational emissions, and financed emissions. Principles of effective disclosures for climate-related financial risks as enunciated by TCFD (Task Force on Financial Disclosures) are represented in Figure 15.1.2 While these principles are relevant to any disclosures banks make, a few are nuanced for climate, particularly 1, 5, and 6. TCFD recommendations are structured around four thematic areas with recommended disclosures under each of them, totaling eleven classes of disclosures: – Governance – disclosures around organization’s governance around climaterelated risks and opportunities, describing – The board’s oversight of climate-related risks and opportunities – Management’s role in assessing and managing climate-related risks and opportunities – Strategy – disclose the actual and potential impacts of climate-related risks and opportunities on the organization’s businesses, strategy, and financial planning where such information is material, describing

 Task Force on Climate-related Financial Disclosures Guidance on Scenario Analysis for NonFinancial Companies, October 2020.  Recommendations of the Task Force on Climate-related Financial Disclosures, Final Report June 2017. https://doi.org/10.1515/9783110757958-018

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Principles for effective disclosure of Climate-related financial risks Disclosures should Represent relevant information 1

Be specific and complete 2

Be clear, balanced, and understandable 3

Be consistent over time 4

Be comparable among companies within a sector industry or portfolio

Be reliable, verifiable, and objective

Be provided on a timely basis

5

6

7

Task Force on Climate-Related Financial Disclosures Recommendations

Figure 15.1: Principles for effective disclosures in the climate-related disclosures space. Source: Adapted from TCFD, Fundamental Principles for Effective Disclosure.

–

–

–

The climate-related risks and opportunities the organization has identified over the short, medium, and long term – The impact of climate-related risks and opportunities on the organization’s businesses, strategy, and financial planning – The resilience of the organization’s strategy, taking into consideration different climate-related scenarios, including a 2 °C or lower scenario Risk Management – disclose how the organization identifies, assesses, and manages climate-related risks, describing – The organization’s processes for identifying and assessing climate-related risks – How the organization’s processes for managing climate-related risks function – How processes for identifying, assessing, and managing climate-related risks are integrated into the organization’s overall risk management. Metrics and Targets – disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material: – Disclose the metrics used by organizations to assess climate-related risks and opportunities in line with its strategy and risk management processes – Disclose Scope 1, Scope 2, and if appropriate Scope 3 greenhouse gas (GHG) emissions and related risks – Describe the targets used by organizations to manage climate-related risks and opportunities and performance against targets

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Out of the four thematic disclosure areas required by TCFD, governance and risk management are more advanced in terms of disclosures as these two themes have been better fleshed out than the others. There are relatively more and detailed disclosures in the risk management space, particularly in the areas of risks identified, accounting policies, and the governance structures managing those risks. Banks appreciate that climate-related financial risks are overarching, impacting other risk categories, particularly credit, market, operational, regulatory, reputational, and compliance risks. Of note is that, except for the first two risk categories, the rest fall under what are traditionally referred as “non-financial” areas. Not surprisingly, the disclosures are most detailed in the credit risk space, on both qualitative and quantitative information. Basel principles require that banks should ensure monitoring how climate change risks will impact different areas of their businesses, credit and liquidity risk profiles, market positions and exposures, and operational risk constructs. Principle 73 clearly states that “A bank’s risk data aggregation capabilities should include climate-related financial risks to facilitate the identification and reporting of risk exposures, concentrations, and emerging risks. Banks should have systems in place to collect and aggregate climate-related financial risk data across the banking group as part of their overall data governance and IT infrastructure.” The topline objectives with which regulators collect climate risk data through disclosures are: – Micro-prudential – Bank specific risks and capital adequacy – Macroprudential – Sector level or financial system level risks – Macroeconomic – Impact on economic environment like inflation, productivity, etc. The typical modes of data collection have been – Surveys – Specific information requests – Stock takes – Climate scenario and stress tests – Specific reports and disclosure requirements There is a link between regulation, communication of the disclosure requirements, and the rigor with which they are pursued. The cases in point are banks in UK and Europe where the regulators have been highly active in the space. For UK banks (the prime listed banks), TCFD based disclosures are mandatory, and hence it is no surprise that they are at the forefront of the nature and detail of disclosures. Canadian and Australian banks have greater focus on their lending coverage in specific portfolios like in

 Principles for the effective management and supervision of climate-related financial risks, June 2022.

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mining and agriculture, two top industries that could be severely affected by transition and physical risk drivers as these countries are susceptible to climate risk drivers. Regulators require that banks and their clients disclose climate-related risks they carry – non-declaration or misleading disclosure can lead to regulatory and or liability risks as seen in the recent fine of $1.5 million for BNY Mellon bank.4 Based on disclosure or supervisory review, regulators derive multiple inferences, insights which they share with the market at an aggregated level. At a bank specific level, the inference/insight is used to put situation and bank specific measures into action. It is important that bank’s reporting/disclosures are in alignment with the regulatory expectations, directionally speaking. It will be difficult to implement the expectations right away. The tone and approach can be set in the direction suggested to ensure alignment. Table 15.1 captures banks’ integration with EBA’s expectation, for selected practices, in climate risk management space. “The supervisory assessment covered 112 Single Supervisory Mechanism (SSM) institutions with combined total assets of €24 trillion”5 and hence is representative of the banks in the Eurozone. Table 15.1: Alignment with supervisory expectation in climate and environmental risk space, a sample. Section Risk management

Expectations Selected Practices

Level of Integration

. The integration of C&E risks in credit risk sector lending policies

%

. The integration of C&E risks in credit risk classification procedures for debtors

%

. The assessment of the impact of C&E risks on the continuity of its operations

%

 The integration of C&E risks into the transaction due diligence of the investment process

%

 The conduct of an (ad-hoc) C&E-related stress test or sensitivity analysis

%

Notes: (1) This column refers to the expectations set out in the ECB Guide under which the practices fall (2) This overview of selected practices illustrates relevant trends across the sector (3) This is the percentage share of the 112 institutions that have integrated C&E risks into the corresponding practices Source: Supervisory assessment based on institutions’ responses to the request to perform a selfassessment and to develop implementation plans in the light of the ECB’s Guide on climate-related and environmental risks.

 US Securities and Exchange Commission Press release, May 23, 2022.  ECB, The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks (November 2021).

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Apart from the mandatory or voluntary disclosures to regulators and global organizations like TCFD, banks are increasingly including detailed information in their annual reports. The information shows that the greater focus of banks is on the risk management side. More than seventy five percent of banks that report indicate that climate related risks will have material adverse impact on their businesses. These banks are disclosing that they are integrating climate change risks into their enterprise risk management frameworks. From the disclosures, it appears that industries and sectors most impacted by transition risks are oil and gas, mining, coal, automotive and transportation, as they are dependent on a high-carbon economy which will be at cross purposes to transiting to a conscious net-zero world. From a physical risk perspective, agriculture and related areas, commercial real estate, and retail mortgage portfolios are highlighted. Climate-related credit risk is the most detailed section in the annual statements of banks encompassing both qualitative and quantitative disclosures, inclusive of exposure information with respect to carbon intensive industries as well as physical risk vulnerable portfolios. Some banks are issuing separate ESG reports, TCFD disclosure reports, models, and methodologies that are being used, etc. These can help build the brand equity of the respective banks that show positive alignment of supporting movement towards a low carbon economy in addition to providing important insights to all stakeholders including investors. The challenge is having the ability to get data through voluntary disclosures of relevant climate information from individuals, households, and SMEs/the commercial segment. The uptake of TCFD disclosures and sustainability reporting is work in progress. This is due to non-availability of the said data from the clients (especially the smaller ones). The four important challenges banks face in coming out with meaningful disclosures are: – “High quality comparable and consistent data are a necessary foundation for achieving convergence towards a common and consistent set of global disclosure standards.”6 Upfront investment by banks to understand the data classes and layout of a data architecture that can capture data at the required granularity and detail will stand banks in good stead. They would not have the required data at the beginning. But revising the data architecture and constructs every time they have new data or require a new data structure will be a costly affair. A fine-grained, scalable, and flexible data blueprint that will enable both addition of new data as well as new data structures can be a core design principle. – Lack of consistent and comparable industry level global standard for disclosures is a major impediment. Right now, there are no unified standards for disclosures

 Network for Greening the Financial System, Technical document, Final report on bridging data gaps, July 2022.

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and reporting that banks can work on that would enable consistent, comparable results across time and across banks. Effort is being made towards reaching this goal through TCFD and ISSB amongst others. Not enough understanding of climate change’s layered impact (first order, second order, and spill on/tertiary effects on bank books) Nascent understanding of linkages between actions and outcomes in climate change risk management.

Broadly speaking, regulators/policymakers/global standards setting bodies are looking for information relating to climate change risks, mitigation plans, green/brown assets in the books (EBA looks for green asset ratio or GAR, discussed later in this chapter). The European Union has the goal of becoming the first carbon neutral continent. To track progress towards this goal, the ECB will require detailed disclosures (Figure 15.2) from its constituents on various aspects including current carbon footprint and progress towards their net zero goals. There are a few global level disclosure standards setting bodies and some of them are listed below. There is an effort to align them into a smaller number, led by ISSB, that would become a common, consistent, comparable framework. The top four in the list below are the ones that have (or will have) high adaptation. While TCFD (Taskforce for Climate-related Financial Disclosures) is the forerunner in establishing standards, International Sustainability Standards Board (ISSB) is working towards subsuming, unifying, and standardizing disclosure requirements from other bodies including TCFD to create the “standard” in climate-related disclosures. Regional regulators like EBA and US SEC, while building on the TCFD framework, have added additional nuances. – Taskforce for Climate-related Financial Disclosures (TCFD) – established in 2015, TCFD’s disclosure framework on climate-related financial risks provides information to lenders, investors, insurers, and other stakeholders to make informed decisions. The framework covers the three climate risk drivers viz. physical, transition and liability risks. – Sustainability Accounting Standards Board (SASB) – launched in 2011, to better align sustainability fundamentals with financial fundamentals through International Sustainability Standards Board (ISSB). ISSB, under the aegis of IFRS framework, will work towards creation of a consistent global baseline for climate and sustainability related reporting, through its sustainability disclosure standards, or simply “the standards.” The first two standards S1 and S2 are in the works. These are discussed in the going forward chapter. The expectation here is that climate related disclosures will be made as part of the regular financial reporting, as the emphasis is on bringing to the fore the connection between financial statements and climate related information. The plan is to build on TCFD disclosures, as the lens for climate landscape through external disclosures, and

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Figure 15.2: Overview of disclosure obligations in the EU for financial services (source: EBA -ESG disclosures in the EU: financial institutions.jpg).

integrate climate-related financial disclosures into financial reporting and sustainability standards (ISSB). This will provide a comprehensive and consistent set of disclosures on firms’ path to net zero commitments. – EFRAG (European Financial Reporting Advisory Group) developing a suite of standards for EU companies and ESRS (European Sustainability Reporting Standards)

196

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US Securities and Exchange Commission – proposed climate reporting rules. These will require some disclosures and metrics in 10K submission as well as registration statements and financial statements. Global Reporting Initiative (GRI) – several stakeholders use GRI’s Sustainability Reporting Standards to report on the impact of climate change, social and governance matters. Carbon Disclosure Project (CDP) – businesses report on climate, water, and deforestation initiatives and impacts Partnership for Carbon Accounting Financial (PCAF) – standard to measure financed emissions, which can then be input into climate change related risks assessment. Value Reporting Foundation Climate Disclosure Standards Board

There are different quantitative indicators and metrics that industries are working with to measure, monitor, and manage climate change risks. A look at some of the metrics is listed in Table 15.2A to get a better understanding of their usage. Table 15.2A: Sample climate-related metrics. Climate-Related Metric Categories, Example Metrics and Climate-related targets Metric Category

Example Unit Example Metrics of Metric (TCFD noticed most common metric)

GHG Emissions MT of COe Absolute Scope , Scope , and Scope ;  emissions intensity

Absolute Scope , Scope , and Scope  GHG emissions Financed emissions by asset class Weighted average carbon intensity GHG emissions per MWh of electricity produced Gross global Scope  GHG emissions covered under emissions-limiting regulations

Example – Climate-Related Target

Examples of Financial Organization reporting this metric (Sources referred in TCFD Report)

Reduce net Scope , Scope , and Scope  GHG emissions to zero by , with an interim target to cut emissions by % relative to a  baseline by 

Temasek – “Focusing on Climate Change,” accessed May , . CPP Investments – Report on Sustainable Investing , November 

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Table 15.2A (continued) Climate-Related Metric Categories, Example Metrics and Climate-related targets Metric Category

Example Unit Example Metrics of Metric (TCFD noticed most common metric)

Example – Climate-Related Target

Examples of Financial Organization reporting this metric (Sources referred in TCFD Report) ING -Terra progress report, November , ,  BBVA – BBVA Report on TCFD , October , 

Amount or Transition risks Amount and extent percentage of assets or business activities vulnerable to transition risks✶

Volume of real estate collaterals highly exposed to transition risk Concentration of credit exposure to carbonrelated assets Percent of revenue from coal mining Percent of revenue passenger kilometers not covered by Carbon Offsetting and Reduction Scheme for International Aviation (CORSIA)

Reduce percentage of asset value exposed to transition risks by % by , relative to a  baseline

Amount or Physical risks Amount and extent percentage of assets or business activities vulnerable to physical risks✶

Number and value of mortgage loans in year flood zones Wastewater treatment capacity located in year flood zones Revenue associated with water withdrawn and consumed in regions of high or extremely high baseline water stress Proportion of property, infrastructure, or other alternative asset portfolios in an area subject to flooding, heat stress, or water stress Proportion of real assets exposed to : or : climate-related hazards

Reduce percentage HSBC – TCFD of asset value Update , exposed to acute Feb , ,  and chronic physical climaterelated risks by % by  Ensure at least % of flood-exposed assets have risk mitigation in place in line with the  projected -year floodplain

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Table 15.2A (continued) Climate-Related Metric Categories, Example Metrics and Climate-related targets Example – Climate-Related Target

Examples of Financial Organization reporting this metric (Sources referred in TCFD Report)

Net premiums written related to energy efficiency and low-carbon technology Number of () zeroemissions vehicles (ZEV), () hybrid vehicles, and () plug-in hybrid vehicles sold Revenues from products or services that support the transition to a lowcarbon economy Proportion of homes delivered certified to a third party, multiattributed green building standard

Increase net installed renewable capacity so that it comprises % of total capacity by 

UBS – “UBS extends sustainability leadership with rapid rise in  invested assets and advances in ambitious climate strategy,” March ,  Nordea – Green bond investor presentation, February , 

Percentage of annual revenue invested in R&D of low-carbon products/ services Investment in climate adaptation measures (e.g., soil health, irrigation, technology)

Invest at least % of annual capital expenditure into electric vehicle manufacturing Lend at least % of portfolio to projects focused primarily on physical climaterelated risk mitigation

Wells Fargo – n, “Wells Fargo Foundation and NFWF Announce Release of the Resilient Communities Program  Request for Proposals,” January ,  Goldman Sachs –  Sustainability Report, April , , 

Metric Category

Example Unit Example Metrics of Metric (TCFD noticed most common metric)

Climate-related opportunities Proportion of revenue, assets, or other business activities aligned with climaterelated opportunities

Amount or percentage

Capital deployment Amount of capital expenditure, financing, or investment deployed toward climate-related risks and opportunities

Reporting currency

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Table 15.2A (continued) Climate-Related Metric Categories, Example Metrics and Climate-related targets Metric Category

Example Unit Example Metrics of Metric (TCFD noticed most common metric)

Example – Climate-Related Target

Examples of Financial Organization reporting this metric (Sources referred in TCFD Report)

Internal carbon price on each ton of GHG emissions used internally by an organization

Price in reporting currency, per MT of COe

Internal carbon price Shadow carbon price, by geography

Increase internal carbon price to $ by  to reflect potential changes in policy

DBS Bank – Sustainability Report , March , , 

Remuneration proportion of executive management remuneration linked to climate considerations✶✶

Percentage, weighting, description, or amount in reporting currency

Portion of employee’s annual discretionary bonus linked to investments in climaterelated products Weighting of climate goals on long-term incentive scorecards for Executive Directors Weighting of performance against operational emissions’ targets for remuneration scorecard

Increase amount of executive management remuneration impacted by climate considerations to % by 

Barclays – Annual Report , February , , 

Source: Task Force on climate-related financial disclosures. Guidance on Metrics, Targets, and Transition Plans (October 2021).

Table 15.2B reflects the two additional categories that financial institutions are starting to report on, both on the opportunities side. The three broad classes of disclosures currently cover financed emissions, green/ brown financing, and operational emissions. Two other classes of information that will become important particularly in Europe (ECB Taxonomy standards) are Green Asset Ratio (GAR) and Banking Book Taxonomy Alignment ratio (BTAR).

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Table 15.2B: Sample Financial services organizations working with climate change related metrics. Metric Category

Example Metrics

Financial Organization examples with Sources referred in TCFD Report

Performance Impact of climate related risks or opportunities on financial performance

Increases in revenue from new products or services from climate opportunities Increases in cost due to carbon prices, business interruption, contingency, or repairs Changes to operating cash flow from changes in upstream costs Impairment charges due to assets exposed to transition risks Changes to total expected losses due to physical risks Probable Maximum Loss (PML) of insured products from natural catastrophes

Citi Finance for a Climate-Resilient Future II: Citi’s  TCFD Report, December , , . Hannon Amstrong – United States Securities and Exchange Commission Form -K, February , , 

Impact of climate related risks or opportunities on the financial position

Changes to the carrying amount of assets due to exposure to physical and transition risks Changes to the expected portfolio given climate-related risks and opportunities Changes in liability and equity due to increases or decreases in assets (e.g., due to low-carbon capital investments or to sale or write-offs of stranded assets)

Aberdeen Standard -TCFD and Environment Report, June , , . Investco –  Invesco Climate Change Report, July , , .

Source: Task force on climate-related financial disclosures. Guidance on Metrics, Targets, and Transition Plans (October 2021).

Financed Emissions From a risk perspective, financed emissions are both important and challenged, the latter because the data required to objectively compute this metric is not easily available. It is an important metric both for disclosure as well as for the bank’s own internal tracking and management. This is because the climate commitments made by banks are based on these metrics. When a financial institution invests or lends to firms, it accounts for a fraction of the firm’s emissions as part of disclosure of its carbon footprint. Financed emissions, therefore, are used to measure the climate impact by financial institutions as a sum of

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the fraction of emissions of the firms it finances through its investment or lending businesses. TCFD (Taskforce on Climate-related Financial Disclosures7): “The quantification of financed emissions, the expected trajectory of these emissions, and the ability of banks and investors to reduce emissions over time are important metrics to estimate the impact of transition risks and to mitigate these risks by steering portfolios in line with the transition to a net-zero economy.” EBA’s binding standards on Pillar 3 disclosures on ESG risks: The standards put forward comparable disclosures and KPIs, including a green asset ratio (GAR) and a banking book taxonomy alignment ratio (BTAR), as a tool to show how institutions are embedding sustainability considerations in their risk management, business models and strategy and their pathway towards the Paris agreement goals. In developing this framework, the EBA has built on the recommendations of existing initiatives, like those of the Task Force on Climate-related Financial Disclosures (TCFD) of the Financial Stability Board (FSB), but has gone beyond by defining binding granular templates, tables, and instructions, to ensure enhanced consistency, comparability, and meaningfulness of institutions’ disclosures.

Green Asset Ratio (GAR) This is a measure of bank’s financial commitment to sustainability (for reporting – particularly to EBA). This is based on EU Taxonomy (sustainability risk, sustainability factors, sustainable investments). GAR is a part of compliance with CRR Pillar 3 risk disclosures. It shows the EU Taxonomy alignment and carbon footprint of banks’ credit and investment portfolios of banks. Figure 15.4 captures the components of GAR.

Banking Book Taxonomy Alignment Ratio (BTAR) BTAR is the assessment of taxonomy-alignment of the bank’s balance sheet. This is additional information on exposure to non-financial corporates. The limitation here is that the taxonomy scoring will be on an “estimated” outside-in evaluation. This, for now, is on a voluntary basis as the data required to arrive at this metric is needed from both small and medium enterprises (SMEs) within EU and non-EU clients.

 Partnership for Carbon Accounting Financials, PCAF, The Global GHG Accounting and Reporting Standard Part A: Financed Emissions. Second Edition (2022).

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Figure 15.3: Overview of EBA disclosures (Pillar 3) with examples. Source: EBA summary of ESG Disclosures, Pillar 3, EBA summary of ESG disclosures, Pillar 3.jpg.

Figure 15.4: Green Asset Ratio components. Source: UN Environment programme, Finance initiative, practical approaches to applying the EU Taxonomy to bank lending. Notes: “the application of the GAR is under the EU Taxonomy. Since publication, different FAQs and clarifications have been published”.

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Green and Brown Metrics These represent the share of green or brown activities within a portfolio expressed as counts, percentages, and currency values. Brown financing is financing (lending, investing, underwriting) or advisory activities associated with businesses that add to greenhouse gas emissions. In contrast, green financing is financing or advisory services to low carbon assets or activities. It also encompasses other green activities like green bonds. Table 15.3 represents a sample of metrics reported on climate progress along with the pros and cons of those metrics. Table 15.3: Types of climate metrics and their pros and cons. Climate Progress Metrics Categories of Metrics

Specific Types Of Metrics and application

Description and Examples

Pros

Cons

Cross-sector portfoliolevel assessment of investees’ exposure to GHG emissions such as financed emissions (a bank’s scope  emissions)

Metric works across sectors and asset classes, thus enabling portfoliolevel reporting

Emissions data availability

Corporate accounting Connecting the dots between portfolios and GHG emissions in the real economy

Corporate-level tracking of annual GHG emissions related to a company’s operations

Broad information on carbon emissions of sectors and portfolios

Inability to track “green” activities directly (except through avoided emissions accounting)

Project accounting Project finance screens (e.g., lifetime GHG emissions >  Mton)

Estimating net GHG emissions or emission reductions from projects relative to a baseline scenario

Lack of accounting standard and agreement on some measurement issues

Greenhouse Gas Accounting

Green and Brown Metrics

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Table 15.3 (continued) Climate Progress Metrics Categories of Metrics

Specific Types Of Metrics and application

Description and Examples

Pros

Cons

Financed emissions Public communication and reporting, particularly for assets with known use of proceeds

(Generally) portfolio level aggregation of GHG emissions associated with a portfolio’s underlying entities or projects, allocated proportionally, based on financial stake in the underlying entity or project

Directly measures contribution of each transaction (if proportional, i.e., for financed emissions)

Data availability and confidentiality issues outside listed companies and projects

Difficult to apply to off- balance sheet services Green/ Brown Metrics

Exposure-based Tracking both “green” and “brown” financing in the context of portfolios Tracking and reporting for any transaction or asset type, including services

Metrics that measure Ability to track both climate progress of a “green” and project, activity, or “brown” asset class in terms of exposure in financial terms such as dollars invested in green energy, counts such as number of energy star buildings in a real estate portfolio, or percentages such as % car loans to hybrids. Metrics could also be ratios such as dollars invested in hybrids or total dollars invested in cars Taxonomies distinguishing between activities and technologies that are climate solutions (“green”) and climate problems (“brown”)

Controversial technologies and taxonomies (e.g., are natural gas, nuclear, CCS, biofuels “green” or “brown”?)

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Table 15.3 (continued) Climate Progress Metrics Categories of Metrics

Specific Types Of Metrics and application

Description and Examples

Pros

Cons

Exposure metrics easy to track

Lack of standard taxonomy

Applicable to offbalance sheet services and onbalance sheet assets SectorSpecific Energy and Carbon Metrics

Sector-specific physical unit metrics expressed in absolute units (e.g., kWh generated) or intensity units (kWh/ft) Measuring sector level climate performance Comparing portfolio performance to economy-wide averages Physical unit-based (e.g., kWh, ft, km, etc.)

Metrics that are specific to a sector and expressed in absolute units (e.g., kWh generated) or intensity units (kWh/ft). Metrics can also be expressed in ratios such as KWh from green energy or total Kwh generated from power generation

Sector- and asset specific indicators can provide nuance and context

Only applicable for a number of key sectors

Measuring sector level climate performance

Sector-specific physical unit metrics expressed in absolute units (e.g., kWh generated) or intensity units (kWh/ft)

Benchmarks possible for transition (e.g., °C scenarios)

No obvious way to aggregate data across sectors or assets and/or transactions

Comparing portfolio performance to economy-wide averages Adapted from: Portfolio carbon initiative – Exploring metrics to measure the climate progress of banks – ES1 and ES2.

Green and Brown Metrics

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There are two areas that are currently less explored. The first is gauging the effect of expected impact both on liquidity as well as on future economic scenarios due to climate change. The aforementioned are considered for measuring expected credit losses (ECLs). ECLs are critical data points for banks from a risk management angle. The second is the linking of outcomes to actions. This area is not clearly identified and documented. From a disclosures perspective, the information is more on exposure levels, not so much on how risk appetite and the climate strategy of the bank translates into business outcomes. This linkage and insight, like changes to the business model, portfolio realignment, risk profile, etc., would help banks to understand and use the effort that goes into planning and preparing disclosures. As a practitioner, I am a strong proponent of deriving and using insights from the enormous effort that goes into compiling data and preparing disclosures. It would be a sub-optimal utilization of effort if not used for building business resilience and growth. The benefits of better disclosures, as rightly articulated by the Task Force on ClimateRelated Financial Disclosures (TCFD), are better risk assessment, optimal capital allocation, and more informed strategic planning.

Chapter 16 Operating Model for Climate Change Risk Management at Banks: Some Pointers It is the management’s responsibility to create a facilitative intolerance to non-compliance. –Saloni Ramakrishna

Climate change risk management is the new paradigm, the new frontier that banks are in the process of understanding and blending into their operations. What makes this task challenging is the fact that the subject is dynamic, evolving across multiple interconnected dimensions, and is multilayered. While the final edifice is some distance away, laying a strong operational framework foundation will stand banks in a good stead. The tough task ahead is to translate the intentions, expectations, and rhetoric to “workable” operational framework. Given the high visibility, through supervisory oversight and disclosures/reporting requirements, as well as investors/customers scrutiny, and its centrality to resilience as well as growth of the bank going forward, it becomes important to put in place a sound operating model. Creating a working model of a discipline with multiple moving parts that embed the uncertainties of climate paths is no easy task. A better approach is to start by leveraging the experience/wisdom of building the operational framework of ERM and extending it, to the extent possible, with climate change risk related nuances. The framework can then be grown organically as newer insights and requirements enter.

Operations Framework

Structural Framework

Strategy & Governance Framework

Figure 16.1: Foundational blocks of climate change risk management operating model.

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Climate Change Risk Operating Model The three interconnected core components of the operating model are represented in Figure 16.1. At the center is the strategy and governance framework as it sets the stage as well as the boundary of operations. The structures that provide a working model by translating the objectives, goals, and the directive into doable constructs are utilized through the structural framework. The actual actions expected, templates, linkages, and flow of operations are encapsulated in the operations framework.

Strategy Framework

Climate Change Risk Management Operating model components

• Articulation of bank’s climate change risk management strategy • Policy framework inclusive of well documented and communicated governance constructs and risk appetite. • Reporting relationships

Structural Framework

• Model of operations • Accountability, responsibility constructs • Operational Plans

Operations Framework

• Data, information and workflows

• Communication and disclosure structures

Figure 16.2: Operating model components of climate change risk management.

Figure 16.2 represents the next level of detail with a quick overview presented below.

Strategy and Governance Framework This block seeks to articulate clarity of purpose and the governance constructs. It sets the scope and direction of climate-related financial risks management at the bank: – Statement of climate change risk management strategy, objectives, and scope setting – Policy framework covering governance constructs and risk appetite articulation. – Board and senior management responsibility and accountability

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Structural Framework Flowing from the strategy and governance framework, the structural framework primarily addresses three areas – Operating model – centralized, decentralized or hybrid model – Reporting relationships: – Where the climate change risk management team sits in the organizational structure, for e.g., operating within CSR (Corporate Social Responsibility) or ESG or CRO (Chief Risk Officer) organization. – Hierarchical or matrix reporting constructs – Delineation of accountability, responsibility, and documenting the operational map of managing climate-related financial risks: – Risk ownership – clear lines of who owns and oversees distinct parts of the risk processes – Responsibility and accountability structure – clearly defined and enforceable responsibility and accountability matrix across the different functions and functionaries of the bank

Operations Framework The operations are defined within the structural boundaries specified. The challenge is in creating and communicating a simple yet comprehensive operating model. The big ask here will be that it has inbuilt flexibility to grow as the understanding of climate change related risks grows. – Working model encapsulating design and execution of the interconnected operations including data and information flow – Communication management that is simple, non-jargonized (to the extent possible), perpetuated through easily accessible communication channels – Disclosures management blueprint

Next Level Detail and Some Pointers Strategy Framework This is tone setting at the top, clearly communicating to both internal and external stakeholders about the bank management’s approach to effectively manage climaterelated financial risks as well as intent to strongly align with the global initiative of moving toward a low carbon economy.

Next Level Detail and Some Pointers

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Below is an overview of the ECB’s supervisory expectations1 as outlined in the ECB’s Guide on climate-related and environmental risks: – When determining and implementing their business strategy, institutions are expected to integrate climate-related and environmental risks that have an impact on their business environment in the short, medium, or long term. – The management body is expected to consider climate-related and environmental risks when developing the institution’s overall business strategy, business objectives and risk management framework, and to exercise effective oversight of climate-related and environmental risks – Institutions are expected to consider how climate-related events could have an adverse impact on business continuity and the extent to which the nature of institutions’ activities could increase reputational and/or liability risks. Basel Principles 1 to 32 articulate the corporate governance umbrella for banks. It starts with an understanding of the “potential impacts of climate-related risk drivers on their businesses and on the environments in which they operate. Banks should consider material climate-related financial risks that could materialize over various time horizons and incorporate these risks into their overall business strategies and risk management frameworks . . . board and senior management should ensure that their internal strategies and risk appetite statements are consistent with any publicly communicated climate-related strategies and commitments” (Principle 1). Important themes here are ensuring that board and senior management: – “Understand” climate change risks and the potential impact they can have on the bank’s businesses. This is central to the risk response paths that bank will chalk out. Given that the board of directors come from different backgrounds, it will be important to familiarize them with both the big picture of climate-related financial risks in their areas of operation as well as the specifics of potential impact on the bank. Special training programs on overview of the subject and board oversight responsibilities are required. Once the basic understanding is in place, scenarios and heatmaps are good tools for updates. Given the dynamic nature of the discipline, this endeavor needs to be a periodically reoccurring activity, preferably at every board meeting. Initially it could be to explain the concepts but later cover the potential impact of scenarios given the various transition arcs. – Recognize “material risks” in the space across “various time horizons.” The two aspects here are identification of materiality and how they span across different time horizons. Unlike other risk categories that the bank and its board are used

 European Central Bank, The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks, November 2021.  Basel committee on banking supervision, Principles for the effective management and supervision of climate-related financial risks, June 2022.

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to, here they need to be cognizant of double materiality – financial materiality and environmental materiality. Each of these impacts the other at multiple levels and therein lies the complexity. Maintain “consistency” between the risk appetite statement and the internal strategies, with externally communicated climate related commitments.

Below is an indicative and non-exhaustive list of board and senior management responsibilities, actions, and governance constructs in the climate change risk domain – Board – Lead the cultural pivot to commit to sustainability goals as this requires a different organizational and economic paradigm. It is not about eliminating risk, which is neither possible nor desirable, it is about building a climate change risk aware organization. – Strategy approval for sustainable, innovative, brand enhancing initiatives. – Ensuring business model alignment with agreed climate goals. – Clearly articulate corporate governance framework as an overall cover for climate change management. – Periodic check to safeguard resilience of the organization and strategy to the risk of climate change as well as agreed ESG deliverables. – Regulatory and standards compliance oversight embedded in the bank’s charter and meticulously executed. – Clear communication that the board and senior management do not view risk as negative and defensive but more as a collaborator in building healthy growth. – Integration of sustainability goals and initiatives into policymaking goal setting, adoption, and strategy formulation. – Reward, recognition, and remuneration policies coordinated with climate objectives and targets. – Assignment of oversight responsibilities to specific members, committees/ sub-committees of the board for clarity of accountability and responsibility. – Crafting a risk appetite statement that unambiguously spells out the material climate related financial risks with clear definitions and thresholds for materiality. – CXOs and Senior Management – Designing realistic business strategies that align to sustainable growth goals set – Enterprise Risk Management framework extension as required with robust control constructs that address the risks of adverse climate change – Sustainability embedded product portfolio creation and structuring to generate and lead market demand – Clear risk appetite statement with KRIs – Sectoral inclusion and exclusion – Limits setting for climate vulnerable exposures – Value creation through well thought out and realistic transition plans towards a net zero economy

Structural Framework

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Developing and deploying climate change risk adjusted pricing models Building climate change induced impact into balance sheet planning process covering budgeting, forecasting, capital planning, and the like Establishing transparent and effective communication channels, both internally and externally. Oversight of reporting and disclosures constructs in line with the requirements

Structural Framework The statements of intent need to be translated into a well-designed structure that will enable smooth execution of the intent. Principle 2 and 33 of Basel Principles states that “Banks should clearly define and explicitly assign roles and responsibilities associated with identifying and managing climate-related financial risks throughout the bank’s organizational structure and ensure relevant functions and business units have adequate resources and expertise to effectively fulfil responsibilities regarding climate-related financial risk management” (Principle 2) and “Management of material climate-related financial risks should be embedded in policies, processes and controls across all relevant functions and business units” (Principle 3). Important themes here are – Clear definition and explicit assignment of roles and responsibilities. Given that the climate change risk area is itself an evolving area, this is difficult. Banks may, however, start with defining and assigning responsibilities across the three lines of defense, drawing from their ERM experience and refine it over time. – An acknowledgement by the Basel principles that adequate resources with required skills will be required to execute an effective climate change related program. Skills, knowledge and expertise assessment, recruitment, and training will be a core activity for banks to come up the curve. – Embedding of processes and controls across all relevant functions and business units – the emphasis here is not just about creating but also about embedding these across the organization. To make this possible it is imperative to have a joint/cross functional team across the main functions that works both on the designing and execution of climate change related structures. Listed below is an indicative and non-exhaustive list of structural and operational aspects that banks can consider either through individual functional scope or through joint constructs:

 Basel committee on banking supervision, Principles for the effective management and supervision of climate-related financial risks, June 2022.

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Joint operational team of risk, performance, compliance and balance sheet management – a collaborative and well aligned cross functional team is at the core of building and sustaining an effective climate change risk management program. This is because climate change affects all aspects of business, as stated earlier. – Draw up plans focusing on Impact of climate change related initiatives on – Risks – Financial risks – Non-Financial risks – Liquidity planning (both funding and market liquidity) – Opportunities – Agree on the structuring of climate change unit management and control – Drawing up reporting and responsibility matrix – Hierarchical reporting structures – Matrix reporting constructs – particularly in smaller organizations where climate change related risks are not a standalone function – Clearly articulated control framework and metrics both for existing and planned products and services – Pricing approach – Portfolio alignment and management in line with the strategic objectives and goals. – Monitoring mechanism and course correcting where required to ensure delivery of plans while ensuring the bank’s resilience Translate climate change insights into simple and unambiguous business language, such that the larger organization understands, appreciates, and actions on both the risks and the opportunities in a timely manner. Three lines of defense. As ECB suggests,4 “Facilitate co-ordination across the three lines of defence. Institutions are expected to assign responsibility for the management of climate-related and environmental risks within the organizational structure in accordance with the three lines of defence model.” – First line of defense – Front Office functionaries that are client facing like Line of Business (LOBs) teams, relationship manager’s network, etc. These are the point of contact with the customers. They do the initial assessment of climate-related risks through client onboarding, credit application processing, monitoring and engagement with clients on an ongoing basis. This is both for existing products and services as well as new product or services offering. They are also the touch points for capturing customer preferences in the climate change space. This helps banks for action on multiple fronts like

 European Central Bank, The state of climate and environmental risk management in the banking sector, Report on the supervisory review of banks’ approaches to manage climate and environmental risks, November 2021.

Structural Framework

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Gathering information required by the bank for disclosures purposes. Offer appropriate products that compliment those preferences. Sharing customer preferences with other functions particularly product development organization. Second line of defense – risk management function. The risk management functionaries work towards enhancing enterprise risk management (ERM) frameworks to cover climate change related nuances and components – Risk Organization and governance principles – Originations – Climate risk identification and assessment constructs – Modeling impact of climate risk drivers and methodologies for measurement of potential losses – Creating inclusive risk taxonomy – Risk review structures Third line of defense – Audit and independent review function Recasting audit function to cover focus on risks from adverse climate change on bank’s books. Principle 4 clearly states “the third line of defense, the internal audit function, should provide an independent review and objective assurance of the quality and effectiveness of the overall internal control framework and systems, the first and second lines of defense and the risk governance framework in the light of changes in methodology, business and risk profile, as well as in the quality of underlying data.”

Operations Framework These are the frameworks that bring the operational map to life. These are specific actions, templates, and processes that are to be followed to actualize the strategic objectives within the designated structural framework. There are two lines of intertwined operations here. The first is actions/responsibilities across functional groups and the second is the structures comprising of templates, workflows, controls, checks, and balances across the lifecycle of climate change risk management. All aspects of banking businesses are impacted by climate change and thereby its risks, albeit to varying degrees. All functional lines in a bank have a role to play in climate change risk management, in addition to the three lines of defense. Below is a non-exhaustive list of operations that banks can consider through their support function teams: – Support Functions – Corporate Planning and Development team – a critical support function that incorporates the risks and opportunities into planning, product/services development like green lending products, transition financing, sustainability

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bonds, carbon credits, and carbon offsets, etc., to achieve corporate objectives of net zero commitments Legal Team – anticipating and proactive correction of potential inaccurate or inadequate disclosure of material climate change risks, thus avoiding liability risk Technology Team – creating and maintaining a flexible, scalable climate information architecture is a critical prerequisite as transparency and lineage will be top of the table requirements CDO and their team – this team will be tasked to make available reliable data at the required granularity and detail. Designing and developing flexible data architecture to allow for extensions as new classes of data or more detailed data become available will be at the center of their operations HR and Talent acquisition team – recruiting skilled resources and upskilling is the main key to success in this space. Drafting the desired profiles for recruitment and developing fast and efficient training programs will be the primary actions here Compliance – tracking regulations, providing inputs to the climate change management team, and ensuring compliance will be the demanding activities for this team MIS (Management Information Systems) Teams – ensuring timely delivery of both internal and external reporting/disclosures as required, with support from the rest of the teams, will be the core activity here.

Operational Structures –

Climate Change Risk Register This is a critical asset and valuable corporate memory. Capturing climate risk exposures with time stamps is a valuable tool in identifying exposures that need active monitoring as well as tracking progress across time. In addition, it will be an important input for banks in assessing and tracking their path towards maturity in climate risk management. Once the first “master register” is created, it can be updated on a periodic basis. This becomes the library of climate change risks which the bank at the top level as well as different units across the bank can draw on or map to the specifics they come across. This register can be as detailed as required. The touchstone is the realistic assessment of bank’s ability to maintain it across time. The focus is on its utility and not on its complexity. The starting point of a climate change risk master register can be at a dimension level like geography, LOB, product class, etc. A simplistic representation of a climate change risk register is reflected in Table 16.1. For Geography A or B or . . . . X

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Table 16.1: Geography based climate risk register. Date MM DD YYYY

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Description Lead risk driver Materiality of of risk (physical, transition, risk liability)

Likelihood Impact scale (severity)

Time horizon

The other important registers are: Climate change risks – master control register – documenting the controls at the top level, as a library of controls, on similar lines as the risks master is the starting point of both capturing and cascading the information of controls in place.

Table 16.2 reflects a simple sample: Table 16.2: Controls master. Date – MM DD YYYY

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Control Control category (preventive, corrective, description reactive)

Mandatory Business Y/N Owner

Climate change risk to controls mapping – the next step is the mapping of controls to the risks. Table 16.3 captures the mapping of controls to risks

Table 16.3: Control to risk mapping. Risk type

–

Risk Priority description rating

Mapped control and its description

Control category (preventive, corrective, reactive)

Business owner

Processes, workflows, and the related templates for various operations – similar to the risks and controls capture, processes, workflows with details of originators, authorizers, etc. to be created and periodically reviewed for all important activities like – Data flows – Risk processes – Reporting/disclosure processes

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– –

External disclosures/reporting Internal disclosures/reporting

In summary, ensuring that each of the three structures, strategic, structural and operations, are aligned and form a sharing and learning cycle is primary to creating a working model of climate change risk management.

Part 4: A Glimpse into the Complex Universe of Multilayered, Interlinked Climate Change Risks

Practitioner’s Note Interlinks and Spillover Effects of Climate-related Financial Risks Sridhar Aiyangar

Context The transition to Net Zero and decarbonization is at the forefront of the strategic agenda across many industries and through various stakeholders, including regulators, consumers, and investors. This decisive shift in priorities portends a significant impact on individuals and the real economy, manifesting in many ways; from the way goods and services are produced, marketed, sold and consumed, to the impact on lifestyle and financial health. Climate risk can have a serious detrimental impact on financial stability, hence global financial regulators are implementing several initiatives and introducing various regulatory guidelines and related actions to influence the effective management and mitigation of climate risk. Before breaking down climate risk and understanding its interconnectedness, it is important to identify the two main forms in which climate risk manifests itself, viz. physical risk (by way of extreme and frequent weather events) and transition risk (arising from policy risks, legal risks, technology risks – mainly from low-carbon innovations disrupting established industries). A disorderly transition to a low-carbon economy (because of policies being delayed or divergence across countries) together with the manifestation of physical risks could lead to destabilizing effects on the financial system, including falling asset prices and increasing costs (insurance premium, carbon tax, disappearing fiscal funding sources, etc.) in a relatively short-term horizon. Hence, climate risk is one big part of the overall ESG agenda for all institutions. It is important to appreciate the enormity of this challenge as countries and companies set out target dates for achieving Net Zero.

What is “Net Zero”? and Why is it Important? In simple terms, net zero means that the amount of greenhouse gas produced/added should be no more than the amount of greenhouse gases removed from the atmosphere. Complete or gross zero would mean stopping all emissions, which is not realistically attainable, nor desirable till plausible and robust alternatives evolve. There is growing evidence that the planet has been getting hotter. This is leading to erratic weather patterns, that is increasing in both the severity and frequency of extreme weather events – such as heatwaves, floods, severe storms, melting of polar https://doi.org/10.1515/9783110757958-020

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ice, and rising sea levels. Absent emphatic actions, global temperatures are on track to increase by as much as 2.7°C by 2100, which could render parts of the planet uninhabitable. Emissions released by human actions are taking a catastrophic toll thrusting us toward an irreversible climate crisis. There is broad consensus, through the Paris agreement, that countries should aim to reduce greenhouse gas emissions, roughly halve CO2 emissions by 2030, and reach net zero by 2050. Many governments have set a target for achieving their net zero targets by 2050 to 2070. Addressing climate change impact is generally approached in two main ways: climate change mitigation and climate change adaptation/resilience. The former approach focuses on both decreasing and stabilizing the levels of heat-trapping greenhouse gases in the environment; the latter on adapting to the climate change already taking place and strengthening resilience. Mitigation methods include those that decrease the sources of greenhouse gas emissions (e.g., deploying renewable energy sources), preserve the “sinks” that absorb and store these gases (e.g., oceans and grasslands), and decrease the amount of CO2 released into the atmosphere (e.g., utilizing carbon capture and storage [CCS] technology). Adaptation strategies tend to concern foreseeing the negative impacts of climate change and undertaking appropriate action, e.g., building flood defenses, protecting coast lines, developing drought-resilient crops, etc. All these actions will require funding and hence governments will likely consider funding these by way of carbon tax, amongst others.

Interconnectedness of Risks While climate risks emanate primarily from physical and transition risks, they manifest in many forms and are often interconnected with other risk types in myriad ways. However, the second order effects, its spillover into real economy and the implications for consumers are less clear.

Spillover Effects into Real Economy Climate risk manifests through many risk types. As a practitioner, some of the ramifications I see due to the interconnectedness are: – Banks and insurance companies are likely to increase their interest and premium rates to fund the increased risks and costs arising from climate risk. – Companies in the energy, transportation, logistics, automobile, etc. sectors will increase their prices to comply with transition requirements and carbon emission standards.

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Increase in food prices mainly due to fall in production of agricultural products due to extreme weather patterns like flooding or drought. Companies will witness increased funding risk as traditional sources of funding may no longer be accessible. Mass migration of people due to physical risks resulting in scarcity of key resources. Adverse impact on living standards due to inflation and carbon taxes, as lifestyle changes will be required for transition to a green economy, e.g., transport choices, food choices, taxes, etc. Increased financial markets volatility due to many of the above factors. Erosion of wealth due to investment in companies that are slow to transition to a green economy. Increase in taxes to fund transition to a low carbon economy.

Managing Climate Risk Effective management of climate risk is critical as it has wide ranging implications, ranging from financial stability to impacts on the real economy, sovereign and corporate credit ratings, interest yields, share prices and inflation, to name a few. Nonetheless, as Ms. Saloni Ramakrishna, aptly highlights, every risk presents an opportunity and it’s no different for climate risk. Sridhar Aiyangar Views expressed in this article are personal. Sridhar Aiyangar Group Head, Balance Sheet & Liquidity Management Bank ABC

Sridhar is an executive leader with 30+ years of experience in capital, liquidity and portfolio management. He has wide-ranging experience covering financial markets, corporate treasury, finance and risk management with large MNC banks across multiple markets. He has developed and implemented several strategic balance sheet management initiatives to strengthen capital, funding and liquidity positions while improving returns.

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Section Abstract Objective – to provide a brief glimpse into the complex universe of multilayered, interlinked climate change risks. Multiple facets of the subject, their interrelationships, interlinks, risk spillovers, second order effects, how each impact climate change risk and vice versa, are explored, bringing home the fact that climate-related financial risks are deeply intertwined with both the financial world as well as real economy. Each influences the other both positively and negatively depending on the situation. Financial risks and their interaction and influence on climate change risk are looked at more closely than the others.

Chapter Abstracts –

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Chapter 17 provides an overview of the interlinked universe of climate change, real economy, and the banking system and how the connectedness amplifies risks manifold. Interlinks, the apparent, the not so apparent and the non-apparent, all play a significant role in creating/precipitating, aggravating both firm specific and systemic risks. A bottom-up view brings to fore the complex web of interconnectedness with intra-sector as well as inter-sector impact amplifying shocks across the system, proliferating as well as intensifying risks in physical as well as transition trajectories. Chapter 18 delves a little deeper into the connectedness and influence of climate change on the various risk categories of the bank. The first part looks at the four core risks of banks (credit, market, operational and liquidity) and how climate risk drivers (physical and transition), sometimes referred to as horizontal risks, impact all the core risks and more. The second part discusses briefly how climate risk is intertwined with non-financial risks of banks. Chapter 19 focuses on the direct relationship between capital and the risks that banks assume. It looks at how each influences the other in a pre-climate change and how it is likely to in post-climate change constructs. With climate change – a cause – which has a powerful influence on the consequences (financial risks of banks) – a fluidity is introduced into the entire risk crystallization and management of banks and thereby its capital adequacy. This external causation, on which banks have less control, will have a sizeable impact on their risk profile which in turn will influence the capital requirement.

Chapter 17 Interlinks – The Big Picture It helps to question the fundamentals and their relevance every once in a while to avoid the danger of the activity becoming the purpose. –Saloni Ramakrishna

Exploring the Interlinks that Create an Interconnected Web “Climate change poses a substantial threat to the global economy and makes transitioning towards a more sustainable and greener future a first-order challenge.”1 Both banks and regulators are concerned with climate-related financial risks. Banks’ concern is that both adverse climate change and steps to mitigate adverse change affect their books in a myriad of ways. Regulators’ concern is that these risks have both macro and micro-prudential implications that will impact financial services and markets alike. The vagaries of nature with its non-linearity, existence of tipping points (critical thresholds in a system that when exceeded, can lead to significant change in the state of the system, often with an understanding that the change is irreversible).2 made more complex with people/process intervention (positive or negative) and the multiple simultaneous interlinks across the three worlds, climate pathways, real economy, and financial services give rise to uncertainty of timing and the magnitude of impact. Figure 17.1 captures the big picture of links between the banking system and climate change. Interlinks, the apparent, the not so apparent, and the non-apparent, all play a significant role in creating/precipitating, aggravating both firm specific and systemic risks. It is an acknowledged fact that the interconnectedness of banks, particularly the global banks, played a significant role during the financial crisis during 2007–2009; the integration and intertwining of the financial system has multiplied manifold since then. Real economy (real economic transactions and non-financial elements of economy) has also become multilayered and complex. Add to this an all-enveloping layer of climate change, which itself is a host of interrelated factors. It is not difficult to visualize the “amplification” of risks if one part of the system experiences financial stress and how there could be a snowballing effect leading to a potential systemic risk. The risk spillover would be two ways from financial system to real economy and vice versa. As we march towards a carbon neutral future, hoping for an orderly transition, understanding the interlinks and factoring them into both the strategy and operations will be critical for banks.

 European Central Bank, Climate Change-Related Regulatory Risks and Bank Lending, Isabella Mueller, Eleonora Sfrappini, No 2670/June 2022.  IPCC, https://www.ipcc.ch/sr15/chapter/chapter-3/. https://doi.org/10.1515/9783110757958-021

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Banks sit at the heart of the global economy allocating capital and risk There are unprecedented levels of carbon in the atmosphere. Global temperatures have increased

An orderly transition minimises the financial risks associated with climate change

They require a strategic approach which considers how decisions today affect future financial risks

Climate change creates physical risks (eg. floods) and the move to a low-carbon economy creates transition risks (eg. policy and technology changes)

The financial risks from climate change have distinctive elements which present unique challenges

These physical and transition risks create financial risks manifesting as credit, market and operational risks

Figure 17.1: The big picture – Links between banking system and climate change. Source: Bank of England, Prudential Regulation Authority, “Transition in thinking: The impact of climate change on the UK banking sector,” September 2018.

Looking at just the bank’s exposure to climate in isolation paints an illusory picture. As discussed in Chapter 4, Climate change risks tend to be non-linear, subject to considerable ambiguities and tail-risk. The risk drivers, the transmission channels, and the amplifiers together have a geometric multiplicator effect on risk crystallization. The interconnectedness and mutual triggering of risks quickly cascades across the ecosystem. Figure 17.2, which is referred to in Chapter 4, succinctly captures the interconnectedness of the real economy and financial system, aptly titled “the economics of climate.” Physical Risks (Extreme weather events and gradual changes in climate)

Economy

Business disruption

Lower property and corporate asset value

Financial System

Market losses (equities, bonds, commodities)

Asset destruction

Transition Risks (Policy, technology, consumer preferences)

Migration

Lower household wealth

Credit losses (residential and corporate loans)

Reconstruction /replacement

Lower corporate profits, more litigation

Underwriting losses

Lower value Increase in prices of stranded energy with assets dislocations Lower growth and productivity affecting financial conditions

Negative feedback from tighter financial conditions

Operational risk (including liability risk)

Figure 17.2: Economics of Climate (adapted from the IMF – F&D Climate Change, Central Banks, and Financial Risk, December 2019).

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When digging a little deeper and taking a bottom-up view, the complex web of interconnectedness becomes more apparent with intra-sector as well as inter-sector impact within each of the subsystems, rising to the next level in progressive amplification as represented in Figure 17.3. It is the interconnected response, in the context of climate related financial risks, that brings out a more realistic understanding of the risks. The interplay between climate change, real economy, and financial system is what complicates financial outcomes of adverse climate change or disorderly transition to low carbon economy. Shock amplification happens through the system, proliferating as well as intensifying risks in physical as well as transition trajectories. Climate change Interconnected Web

Intra-SectorG-SIBS, D-Sibs … Financial Services Inter- Sector

Banking, Insurance, Capital Markets Amplified Combined impact Intra- Sector Households Real Economy

Inter-Sector

Households, Corporates…

Climate change

Figure 17.3: Intra and inter-sectoral links.

Each subsystem has many tiers within itself. As a sample, within financial services itself, there are different layers, each interacting internally within its own components as well as with one another, either directly or indirectly: – Layer 1 – Intra-organization: banks with strong integrated enterprise risk management (ERM), factor in the interplay across the traditional risks within their portfolios (particularly to corporates where the bank’s exposure can be across multiple facilities, each with exposure to different risk categories). But banks that do not factor this interplay of risks within their books will be challenged when they have to include the effect of climate change that influences the financial risks they carry in complex ways. – Layer 2 – Intra-banking system: within the banking system G-SIBs (global systemically important banks) and D-SIBs (domestic systemically important banks) are

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more interconnected through the major share of interbank transactions and therefore vulnerable to quick transfer of risks from one player to the other. Layer 3 – Intra-financial sector: add to this the impact of other financial services players like Insurance firms, capital market firms, trusts, pension funds, etc., and overlay them with other non-banking financial companies (NBFCs), and the many to many relationships across this ecosystem will become evident.

A special call out is to the interconnectedness, of and with, non-banking financial companies (NBFCs) including asset management firms. The challenge here is the lack of transparency of disclosures by most NBFCs about carbon footprint of their businesses. This is not to say that interlinks are not desirable. The network of interconnectedness between various parties in the economy is a complex universe. They facilitate the system, absorb shocks/anomalies until a critical tipping point, beyond which they fast track the spread of risks leading to contagion. Appreciation of the network and its interconnectedness is critical to managing climate change risk, as this serves as a conduit to systemic risk. The risks spread fast and furious across the system, multiplying vulnerabilities and losses. The extent of financial contagion, as long as the magnitude of negative shocks affecting financial institutions are sufficiently small, a more densely connected financial network enhances financial stability. However, beyond a certain point, dense interconnections serve as a mechanism for the propagation of shocks, leading to a more fragile financial system (Acemoglu 2015).3

An understanding of the interplay between adverse climate change or its mitigation effect and their impact on the banking business operations and their core risks, articulated by the Deputy Governor of Reserve Bank of India, is as follows: Rising frequency and severity of extreme weather events can impair the value of assets held by the banks’ customers, or impact supply chains affecting customers’ operations, profitability, and business viability, affecting assessment of credit risk. Shifts in investor preferences could lead to decline in valuation and increased volatility in bank’s investment books, requiring change in the provision for market risk capital. Increased demand for precautionary liquidity to respond to market volatility arising from extreme weather events may induce the need for higher liquidity buffers. Disruption in business continuity given the impact on the financial firm’s infrastructure, systems, processes, and staff.4

In its July 2022 report, on the macroprudential challenge of climate change, the ECB/ ESRB spoke of real economy impact of climate risk and financial interlinkages: “While reaching carbon neutrality will involve adjustments particularly in sectors most ex-

 Daron Acemoglu, Asuman Ozdaglar, and Alireza Tahbaz-Salehi, ”Systemic Risk and Stability in Financial Networks,” American Economic Review 105, no. 2 (2015): 564–608.  Keynote Address, Shri. M. Rajeshwar Rao, Deputy Governor, Reserve Bank of India, Thursday, 16 September 2021 at the CAFRAL Virtual Conference on Green and Sustainable Finance.

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posed to transition risk, cascading effects could engulf other sectors. As economies are interdependent, the impacts of the direct exposure of a sector or firm to transition risks may be amplified by second-round effects stemming from interconnections between sectors and countries.”5 Interconnectedness manifests itself in both direct and indirect modes, as depicted in Figure 17.4. While direct links and to some extent the indirect links have been factored into risk assessments from a financial impact perspective, the canvas has been deepened and widened with climate change related factors. It is the indirect channels, their interrelations, and their potential points of impact that require greater understanding for a more realistic risk assessment.

Direct Interconnectedness

Indirect Interconnectedness

• Direct link between firms/organizations through financial transactions, contracts and other agreed arrangements etc.

• Channels through which distress signals or sentiments of an entity/a market can negatively impact another entity/ market even when there is no direct link.

Figure 17.4: Interconnectedness modes.

It is not just assessment but also mitigation and management that are of concern. It is the visible and the invisible correlations that complicate planning. Climate-related financial risks are complex as they are likely to create huge, correlated risk that is extremely hard to diversify. – Losses and their correlation from physical risks can happen or increase quite unexpectedly and simultaneously. As an example, geographic diversification of the portfolio does not automatically result in risk diversification as two different climate disasters could hit different geographies at the same time, thus leading to losses. – Transition risks can also materialize as highly correlated losses. As an example, different industries can lose value simultaneously as there is transition to low carbon alternatives. This will result in stranded assets and crisis selling. – The third dimension is when there is a multiplier effect of correlation between physical and transition risk drivers. As an example, physical losses impact transi-

 ECB/ESRB Project Team on climate risk monitoring, The macroprudential challenge of climate change (July 2022).

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tion efforts, thus delaying/derailing transition efforts, moving them from planned to disorderly transition trajectories. Ability of the traditional risk transfer vehicles like insurance and capital markets to absorb the heightened correlations is yet to be gauged.

An appreciation of the complexities that this intertwined web brings to the risk management universe enables banks to safely navigate the involved ecosystem: “The materialization of physical and transition risks depends on multiple non-linear dynamics that interact with each other in complex ways and are therefore subject to deep uncertainty.”6 The effect of this interaction impacts the various risk categories that banks work with. The challenge is the unpredictability of the timing, likelihood, frequency, and severity of the impact. Most banks have committed to transition greenhouse gas emissions from their lending and investment portfolios to align with the 2050 net-zero plans. These commitments will have a significant impact on how banks finance, manage, and monitor carbon intensive, carbon light or green ventures (clean energy products, firms working on carbon-capture technologies, etc.). While doing so, multidimensional analysis of risk will be required. This is an evolving science. For now, forward looking methodologies like scenario analysis and stress testing are the go-to tools that try to capture the interplays.

 Reserve Bank of India, Discussion Paper on Climate Risk and Sustainable Finance (n.d.).

Chapter 18 Interlinks with Financial and Non-financial Risks of Banks Never be afraid when people can’t see what you see. Only be afraid if you no longer see it. –Jeronicus

In Part 1, an overview of risk and risk management along with the different flavors of risk that banks work with was discussed. Broadly, these are under two super umbrellas – financial and non-financial risks. There are two sets of risk categories that move from one umbrella to the other depending on whether the discussion is about the capital management view of risks, in which case operational risk falls under pillar 1 risks and liquidity risk under pillar 2 risks, or the traditional view of risk categories, in which case liquidity risk is seen as a financial risk and operational risk as nonfinancial risk. Irrespective of where they are placed, credit, market, liquidity, and operational risks are the four main risks of banks. A simple articulation of the four core risks, in the words of J. Kearns, Head of Financial Stability, is: Banks’ core business is lending money to customers and so they face credit risk with the uncertainty about whether customers will repay those debts. They face market risk with the potential for losses as a result of (unexpected) movements in financial asset values, such as commodities, exchange rates or interest rates. Banks face liquidity risk from the mismatch of long-dated, illiquid assets – mostly loans – and short-term, liquid liabilities, in particular deposits and money market funding. The fourth of [the] core risks for banks is operational risk, which is the risk of loss from inadequate or failed internal processes or systems, and human error.1

Climate change risks (physical and transition risks – sometimes referred as horizontal risks as they are across all four core risks) at this point are not treated as a separate category of risk by themselves but are seen as manifesting themselves as either direct impact on banks’ financial and/or non-financial risks or indirect second order impact and spillover effect between them. Understanding the interlink and the impact that climate change risks have on the traditional risks is core to how banks manage their risks, going forward. Direct and indirect links were briefly looked at through Figure 17.4 of Chapter 17. The next level of detail throws light on how each of those can translate into financial

 Jonathan Kearns (head of financial stability), “Evolving Bank and Systemic Risk” (December 16, 2021). https://doi.org/10.1515/9783110757958-022

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risks. Figure 18.1 looks at a sample of direct contracts or relationships that banks have. While the credit exposures in a climate change risk situation could lead to heightened credit risk, the other two could well create an operational/business continuity situation if disrupted.

Credit Exposures between Banks

Direct Financial Interconnected ness

-

• Interbank Lending/ Borrowing • Investments in Securities • Derivatives • ……

• Payments • Clearance and Settlement systems • Arrangements to access the above systems • …….

Financial Market Infrastructure Links

Third Party Relationships

• Vendors • Security Service providers • Network / connectivity providers • ………..

Figure 18.1: Examples of direct financial interconnectedness.

A look at the sample of indirect connections (Figure 18.2) shows that these could lead to all four core risks of the bank.

Financial Risks Irrespective of the channels through which climate change risk drivers, physical or transition or a combination of both, manifest, they are deeply linked and impact the core risk categories of banks in a variety of ways. Table 18.1 captures a summary view of how physical and transition risk paths impact the core risks of banks.

Financial Risks

Exposure to Common Assets

Indirect Financial Interconnectedness

233

• Concentration of holdings of common assets • Supply & Demand dislocations • ,,,,,,,,,

• Particularly due to distress/ Fire Sales • Negative Price fluctuations due to • Negative market sentiments • Capital constraints • Information spill overs across markets • …….

Mark to Market Losses

Shadow Banking

• Money Market Funds • Mutual Funds • Pension Funds • Hedge Funds • ………..

Figure 18.2: Examples of indirect financial interconnectedness.

Table 18.1: Impact of climate risk drivers on bank’s core risks. Physical Risk

Transition Risk

Credit Risk

Higher default rates and loss-given default from borrowers who face physical losses from climate-related shocks, water stress, or chronic or long-term productivity losses (e.g., real estate losses due to hurricanes; agricultural loan losses due to drought).

Higher default rates and loss-given default from borrowers who face transition risk (e.g., coal mining, oil, and gas exploration companies; or borrowers in communities where the economy is dependent on the fossil fuel industry).

Market Risk

Losses to assets due to changes in market prices caused by climate-related issues (e.g., exposure to agricultural commodity prices rises because of crop damage).

Losses to assets due to changes in the price of carbon (whether an explicit or implicit price and whether the change occurs via government regulation or by market forces), competition from cheaper technologies, or investor-driven reallocations of capital or shareholder engagement or consumer shifts. These include stranded asset risks.

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Chapter 18 Interlinks with Financial and Non-financial Risks of Banks

Table 18.1 (continued)

Liquidity Risk

Physical Risk

Transition Risk

A bank’s cost of capital may increase if a significant number of shareholders and bondholders withdraw financing because of a bank’s climate-related risks or financing of carbon emissions.

A bank’s cost of capital may increase if a significant number of shareholders and bondholders withdraw financing because of a bank’s climate-related risks or financing of carbon emissions.

Losses as climate-related physical losses impair the value of long-term assets and/or disrupt short term funding sources.

Losses because changes in the price of carbon impair the value of long-term assets and/or disrupt short term funding sources.

Operational Losses to a bank’s operations and property, Risk plant, and equipment because of increased frequency and severity of climate-related shocks; losses due to disruptions to physical infrastructure (electric grid); losses to a bank because of disruptions to financial system infrastructure (e.g., payments systems, financial market utilities). Source: Coalition of financial reform and environmental groups, with American for Financial Reform Education Fund, Recommendations for Supervisory Guidance from Bank Regulators, September 2021.

Credit Risk Credit risk, as discussed in Part 1, is the risk of banks facing losses due to delayed or defaulted payments (interest and/or principal amount due) by their counterparties. Credit risk, broadly, is arrived at as a function of probability of default (PD) and loss given default (LGD). The aspects considered are the liquidity (as represented by its cash flow), solvency (as represented by its financial wealth and capital), and potential of recovery in case of default (as represented by its collateral – its quality and value). Adverse climate change impacts all the mentioned aspects, leading to higher PDs and LGD. Both physical risks and transition risks impact the cash flows as well as the collateral and capital, thus aggravating the credit risk of the firm (Figure 18.3). Higher probabilities of default and greater loss given default are a reality in a climate change risk situation whether physical or transition risk or both. This is due to the negative affect on the value of the assets or operations of their clients, thus impacting their profitability and viability. The result would be deferred payments and/ or defaults by the clients, which is a big credit risk for banks. The important insight here is that this climate overlay, a factor that is external to the client, has not been part of traditional assessment of credit risk.

Transition Risks Cost of adoption of newer technologies, increased costs due to transition drivers

Direct damage and/ or write off of assets in high physical risk areas.

Physical Risks

Value

Transition Risks Lower to No value of stranded assets, reduction in value owing to newer policies

Depletion of Collateral

Figure 18.3: Climate Risks aggravate Credit Risk. Source: Adapted from Pierre Monnin CEP, “Integrating Climate Risks into Credit Risk Assessment,” 2018.

Physical Risks Supply chain, transport and related disruptions Leading to Lower production and lower sales

Lower Cash Inflows and higher outflows

Borrower’s ability to repay negatively impacted by increased costs and reduced revenue

Credit Risk

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“Losses can arise from both direct damage and from the effects that potentially higher maintenance costs, disruption and lower labor productivity could have on profitability and hence default risk.”2 Increase in higher operational and maintenance costs is an import point to note. Understanding potential credit risk not just under different scenarios at various levels but also across direct and indirect modes (second order) impacts that climate change risk brings will be critical. The paths that banks and their counterparties take towards their net-zero commitments will materially impact all aspects of lending processes as well as the risks assumed and materialized. The complexity of climate change related risk drivers (physical and transition) and their transmission channels (micro and macroeconomic) will add to credit risks in many ways. This is so because climate change affects all stages of the credit lifecycle – origination, underwriting, pricing, measurement, monitoring, recovery, and closure of individual loans as also portfolio management, reporting, and disclosures. Physical risks expose banks to physical damage and/or decreased value/productivity. This could be due to acute, chronic, or stealth sub-categories of physical risk drivers that were discussed in chapter four. The issue is not just about the occurrence of the events but also increased frequency, intensity, and duration of the adverse climate events that affects the extent of credit risk banks are exposed to. The other aspect of potential credit risk is through transition demanded of both banks and their customers to low carbon ecosystems. This could result in “stranded assets” because of alternate options and disruptive technologies not to mention shifting of investor and customer preferences. From a physical risk perspective, the challenge could take two forms: – Direct exposure through bank’s lending and investment portfolios – real estate, housing, tourism, agriculture, and related industries. – Indirect exposure – bank’s counterparties are dependent on raw material, third party suppliers or infrastructure that is exposed to climate change risks like carbon intensive power supply, telecommunications, etc.). Supply chain disruptions due to physical climate events is another source of risk. HKMA3 (Hong Kong Monetary Authority) has called out supply chain disruptions as a physical risk, highlighting the fact that in a connected business ecosystem a disruption in the movement of goods would lead to sizeable losses. From transition risk perspective it would also have both direct and indirect exposures. In fact, physical risks in the form of natural disasters have been thought of ear-

 Christine Lagarde, President of the ECB, Climate change and financial sector, February 27, 2020.  “Weather events such as heatwaves, floods, storms while change in average temperatures, precipitation and sea-level rise. Direct impacts of such events may lead to damage to property or reduced productivity and revenues, indirectly impacts may result in disruption of global supply chains.” Hong Kong Monetary Authority GS–1 Climate Risk Management V.1-30.12.2021.

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lier, at least in passing if not actively factored into credit risk models. It is transition risk that is a whole new paradigm for banks and is fast materializing given the netzero commitments of both banks and their customers. – The significant risk is banks being laden with “stranded assets” due to obsolescence or less/lack of demand of carbon intensive assets that are fast becoming non-remunerative given new green technology breakthroughs, fast changing policies that disincentivize fossil fuel intensive firms and products. – Regulatory directives, investor/customer sentiments are major factors that influence the liquidity and solvency of firms and their marketability. The risk of default will devolve rapidly due to asset value deflation or collapse. – Loans/investments with long maturities are more susceptible to transition risks. Term loans and related facilities granted a few years earlier for the then good fossil fuel-based projects are good examples of heightened risk. – Correlated losses, potential distress sales (fire sales) can result in huge losses for the counterparties through abrupt and severe price corrections. Identifying climate vulnerable as well as concentration pockets of sectors plus vulnerable geographic locations is critical to manage credit risks. Overlooking these important set of factors leads to other sub-categories of risks that are all interrelated and amplify physical or transition impact of climate change like concentration and underwriting risk. Concentration of portfolios exposed to climate related losses is a pattern and of concern to both the banks and the regulators. Per the ECB, more than 20% of potential losses are residing (or concentrated) within the holdings of 5% of euro space banks. Large borrowers, their concentration, their intra and interlinks are the other area of concern. Climate risk can result in fall of revenue and decline (sometimes very steep) in asset value, thus affecting the customer’s operations, profitability, value, and in severe conditions its very viability. The potential deterioration of borrowers’ ability to repay, leading to higher probability of default and loss given default and inability to service the debt as also depreciation of collateral, increases credit risk multifold. Given the size of the loan book of banks, the impact of climate on their credit portfolio will be sizeable.

Market Risk Market risks are risks emanating from and due to adverse and unexpected movement of prices or increase in volatility of the assets/investments that banks hold leading to potential of losses. Climate-related financial disruptions occur through macroeconomic transmission channels that affect markets (commodities, forex, equity, debt) through macro-economic

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variables like interest rates, inflation, price indices, etc. The investment portfolio of banks faces losses through their securities and commodities investments. This could happen through instruments/commodities directly affected by disruption caused by adverse climate events (physical risks). They could also be the result of negative price changes of carbon intensive assets when they are repriced, led by policy changes, or change in market sentiment. The challenge that might confront banks is that the insurance and hedging instruments might get repriced unfavorably or become unavailable. Repricing of, say, sovereign debts due to adverse climate events (physical risk) or of securities and related due to newer climate policies (transitional risk) are events that could aggravate climate induced market risks. Higher leverage of borrowers and banks with higher level of climate risk adds additional risks to the financial markets: “Financial markets losses from abruptly repricing climate risks could affect investment funds and insurers as well as trigger corporate defaults and credit losses for banks.”4 Due to adverse climate change and changing investor/customer preferences, decline in valuation and increase in volatility of investments increases market risk manifold. Climate change, through shifts in investor preferences or through adverse effects on underlying economic activity, can induce decline in valuation or increased volatility in market instruments that banks have invested in, thus multiplying their market risk. The mark to market requirement reflects the losses onto the bank’s books almost immediately. The interplay between real economy and financial markets is most clearly visible here.

Liquidity Risk Liquidity risk, as discussed in Part 1 of the book, has two components – funding liquidity and market liquidity risks. Basel defines them as “Funding liquidity risk is the risk that the firm will not be able to meet efficiently both expected and unexpected current and future cash flow and collateral needs without affecting either daily operations or the financial condition of the firm. Market liquidity risk is the risk that a firm cannot easily offset or eliminate a position at the market price because of inadequate market depth or market disruption.”5 Climate change impacts both components. Increased demand for liquidity, at unplanned timepoints, owing to extreme weather event/s or challenges in liquidating assets given the changes in the market, will increase liquidity risk, both in terms of availability and excessive cost. Banks hit by deep or sudden credit and/or market risk would be unable to refinance themselves in the short term.

 European Central Bank, Press release dt July 26, 2022, Climate shocks can put financial stability at risk, ECB/ESRB report.  Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision, September 2008.

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Enhanced climate risk can manifest itself as liquidity challenges, in multiple ways: – Short term financing may be affected both in terms of availability of funds and the cost of funds owing to adverse climate events – Long term assets, owing to longer maturities with associated uncertainties of climate trajectories, will pose heightened liquidity risk – Stranded assets may dry up liquidity faster than anticipated Collectively, the above can precipitate liquidity risk that may be both quick and huge. This could arise from operational exigencies necessitated by extreme weather events or from difficulties in liquidating assets at a fair price all the way to not being able to liquidate them at all. There is also the threat of expected cash inflows not happening at a given level of contractual obligation owing to higher level of climate induced credit risk. All the above lead to sudden and huge demand for liquidity which will be required both to meet the maturing liabilities and maintenance. Liquidity and funding risks will be impacted by adverse climate change, hence the need to be part of its assessment, especially in the short to medium term, as they can very quickly cause negative cash outflows. Banks may not be able to roll over short term wholesale funding, due to negative investor sentiment regarding bank’s climate/carbon exposure, and may be challenged in finding a substitute fund, and, even if they do, they must do so at a rate disadvantage. Asset liability mismatch with huge uncertainty of long-term flows owing to climate change is a real risk for banks. At the extreme it can lead to a run risk.

Operational Risk Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”6 Climate change induced business disruption that impacts infrastructure, staff, processes, systems will shoot up the bank’s operational risk. If their data centers or offices are hit by physical risk events, banks’ business continuity will be affected across their value chain (both upstream and downstream activities), potentially exposing them to both operational and reputational losses. Business disruptions, systems failures, damage to physical assets, workplace safety, products, and practices are all “real” climate induced operational risks. Some of the ways the risks manifest are

 Basel Committee on Banking Supervision, OPE 10, Calculation of RWA for Operational Risk (version effective December 15, 2019).

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Physical Infrastructure – damage or destruction of bank branches, data centers, other buildings, transport vehicles, etc. Utilities – connectivity, power, and water supply Disruption of supply chains – impairment of operations and transactions of its customers and its own transactions Technology obsolescence – change towards “greener” technologies. Change in practices and processes – to accommodate net-zero objectives Staff movement and safety concerns Physical risks could threaten banks’ operations and business continuity through disruption of infrastructure, data centers, staff movements, processes, and systems due to physical risk drivers. Alternatively, owing to transition or net zero commitment, some of the technologies or systems used must be decommissioned, replaced by new and not well tested technologies, or have operations relocated, etc. All of this could lead to heightened operational risks, not to mention business risk owing to additional capital expenses (CAPEX) and operational expenses (OPEX) that climate change initiatives necessitate.

Non-Financial Risks Legal Risk An introduction to legal risks or liability risks was made in Part 2 of Chapter 4. This class of risks expose banks to claims from different stakeholders, who have suffered climate-related losses, which they were not made aware of while entering contracts. They will seek to recover those losses legally, thus increasing bank’s legal risk. Liability risk is emerging as a distinct risk category of climate change, with rapidly increasing climate-related legal actions. Banks’ own actions could lead to legal/liability risk if they omit, misstate, obscure, or withhold information that could influence the decisions of customers (on both sides of the balance sheet – borrowers or depositors for example). Banks’ products/services – Miscommunication, mis-leading communication or not communicating the apparent or embedded climate risks, which could potentially impact the customers negatively, will expose banks to claims/legal action/lawsuits, from different stakeholders who have suffered losses due to such non-disclosure of the risks involved in climate related products or services of the bank leading to legal risks (liability risk). Borrower contracts – Specific to the lending portfolio, banks might find themselves exposed to lender’s liability litigation. Understanding of climate change risk and its channels of propagation are still at a very nascent stage. Vast majority of borrowers are unaware of the embedded risks in the businesses. The expectation would be that banks make borrowers aware of the potential climate change risks. Lender liability law expects that lenders will treat their borrowers fairly, and when they do

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not, they can be subject to litigation under a range of legal claims. The damages can be a variety of losses like loan cost, finding a replacement loan cost, loss due to the time lost, opportunity loss, profit loss, etc. In addition to the above, banks will also have credit risk (losses) on their books, if the borrower is unable to repay the loan. The Basel Committee on Banking Supervision sums up legal risk as “Corporates, as well as banks, may also be exposed to an increasing legal and regulatory compliance risk as well as litigation and liability costs associated with climate-sensitive investments and businesses. Furthermore, climate-related lawsuits could target corporations, as well as banks, for past environmental conduct whilst seeking to direct future conduct.”7 It is important to note that banks could also be targeted for past conduct as well.

Reputation Risk Any negative perception of shareholders and/or customers about the bank’s alignment with the transition to the low carbon economy will lead to reputational risks (transition risk) which will translate quickly into business risks that impact the books of the banks in question, hitting both the Income statement and the balance sheet. This can take the following forms:

Direct Impact –

–

Investors – source of capital. The direct outcome of not having sound reputation of their role in actively containing proliferation of carbon emissions is the potential of higher cost of capital. This is because different classes of investors (Tier 1, Tier 2, and Tier 3 capital providers) may prefer banks with lower climate change related risk or are more active in sustainable financing. Customers – source of revenue. Depositors, customers, and counterparties are highly likely to move away from banks that are not seen as active contributors in the move to a low carbon world.

 Basel Committee on Banking Supervision, Climate-related risk drivers and their transmission channels (April 2021).

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Indirect Impact –

Reputation may take a hit in an indirect way as well, if the bank is seen as supporting or providing financing to firms that are seen or held for negative climate impacts. Given the current social activism and widespread education on the subject, banks will do well to understand the approach and stance of their borrowers towards a net-zero path. Banks face reputational risks, under the climate risk umbrella, from multiple points: through their lending or investment portfolios, if not actively supporting climate friendly initiatives, through their association with fossil fuel intensive firms, if seen as passive in acting upon the mitigation of transition and physical risks, to mention a few.

Regulatory Risk Regulators themselves are coming to grips with managing the climate risk of banks. They are concerned both with systemic risk as well as individual banks’ wellbeing. Regulators seek to balance and align short term profit optimizing objectives of organizations with long term interests of society by formulating regulations towards a low carbon path. There are three principal approaches that regulators are using or proposing to use to manage climate change risks as summarized by the Reserve Bank of Australia: – “seeking to understand the effects of climate change on banks – strengthening disclosure and management requirements; and – addressing climate-related risks in regulatory policy and capital frameworks.”8 There is and will be an expectation that banks provide the required information, carryout scenario, and stress tests as well as respond to surveys and questionnaires so that regulators understand bank level and sectoral level exposure to climate risk as well as economy level climate vulnerabilities. Banks face regulatory risks in diverse ways: – Direct costs as they undertake transformational changes to comply with regulatory and other disclosure demands that they must respond to – Effect of climate-related regulations on banks’ lending patterns and portfolios – Indirect passing on of the regulatory risk of its borrowers – either through reputational impact or credit risk impact or both

 Reserve Bank of Australia, Financial Stability Review, April 2022.

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Other Risks Business and strategy risks are the other major risks that are deeply intertwined with climate change risks. In summary, the intertwining of climate-related financial risks with the different classes of risks that banks have been working with is multithreaded and multilayered. In a simple example, reputational risk can transform into credit risk flowing into liquidity risk leading to regulatory risk through the disclosure route or the other way around very quickly and sometimes simultaneously. It is this complexity that will change the approach to risk management going forward.

Chapter 19 Capital and Climate Change Risks – the Links What matters is how much money you made when you were right and how much you lost when you were wrong. –Rakesh Jhunjhunwala

Capital is a core element of the safety and soundness of a bank. Banks are in the business of risk taking and are likely to face losses when some of those risks materialize. They need to absorb those losses while protecting their depositors through a robust capital base and sound business practices. Capital, therefore, at least in theory, must have a fair relationship to the risks bank take. A conservative bank might think of higher capital and lesser risk – but that would result in lower and slower growth. The opposite end of the spectrum of higher risk and minimum required capital could be a challenge too. In principle, capital is a buffer that absorbs some BAU (Business As Usual) losses and supports the stability and viability of the bank. Capital is part of the regulatory toolkit. Regulators control capital to an extent by setting and monitoring minimum capital requirement standards as a function of bank’s risk weighted assets of credit, market, and operational risks (pillar 1 requirements) as well as capital adequacy assessment of the rest of the risks (pillar 2 requirements through Internal Capital Adequacy Assessment Process (ICAAP)) as also monitored through market disclosures (pillar 3 requirements). As the Bank of England states, these requirements are set “to ensure firms have sufficient resources to help absorb financial losses over time. This supports their safety and soundness and contributes to protecting depositors and insurance policyholders.”1 However, given the small percentage of total business, it is not a support during a total collapse as seen during the 2007–2009 financial crisis. With this experience regulators guided banks to build up buffers both for capital and liquidity. These buffers stood banks in good stead during the Covid and post-covid times (2019 and forward). Regulators are looking at how climate risks are captured in the current capital framework and the gaps therein. Table 19.1 reflects Bank Of England’s capture of these themes. Capital adequacy is a critical aspect in the context of the additional layer of risks that climate change adds. That is because adverse climate change will impact both the financial (credit, market, liquidity) as well as non-financial risks (operational, legal, reputational, regulatory, etc.). The regulatory capital is based on the risk weighted assets and the risk weights are based on the perceived/quantified risk based on a set of rules and algorithms.

 Bank of England, Climate-related financial risk management and the role of capital requirements, Prudential Regulation Authority, Climate Change Adaptation Report 2021. https://doi.org/10.1515/9783110757958-023

Chapter 19 Capital and Climate Change Risks – the Links

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Table 19.1: Illustration of climate-related financial risks captured in the banking regime, and possible gaps. Capital

Where captured (illustrative)

Possible gaps (illustrative)

Pillar  Capital models: Existing risk types (notably (minimum) credit and market) allow for elements of climate risk drivers to the extent that they are captured by firms under the relevant time horizons. Credit ratings: There is reliance on internal and external credit ratings, which are designed to incorporate future risks and increasingly include climate. Accounting treatment: The accounting values are the starting point for calculating capital to measure banks’ own funds against the Pillar  requirements. Where climate-related financial risk is considered material, firms must consider climate-related matters in preparation of their accounts. Loans (and the impact of climate-related financial risks on loanlosses) and the fair value of instruments that are marked-to-market are likely to be most impacted, where the climate-related financial risks are material, as these positions include a forward-looking element.

Capability gaps: – Data limitations for modelling risk: lack of taxonomy and disclosure standards pose challenges. Current level of disclosures, particularly for indirect emissions from the value chain (i.e. scope ) emissions, are poor. – Modelling variation: PRA analysis found significant variation between firms in translating climate science into targets and scenarios, on modelling climate-related market risk and capital modelling. – Lack of clarity on future outcomes: the scale and timing of both transition and physical risks, which are fundamental to estimating capital requirements, remain uncertain.Possible regime gaps: – Time horizon of  year (for the majority of capital requirements) which might result in future climate-related financial risks remaining uncaptured. – Reliance on historical data, which is not representative of future climate-related financial risks. – High-level ‘bucketing’ of assets, which overlooks climate-related financial risks that heavily impact certain sectors or geographies.

Pillar A Currently, firms should capture material (minimum) climate-related financial risks if they are exposed to these risks and they are not (fully) captured in Pillar .

Capability gaps: – Same as under Pillar , although data and modelling gaps are likely less material (e.g. the operational risk methodology for Pillar  is an example of an approach where perfect data is not necessarily required).Possible regime gaps: – Current methodologies prescribed by the PRA use a time horizon of  year, and there is no specific climate module. However, in principle under Pillar A there is more flexibility with regards to time horizons than under Pillar .

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Table 19.1 (continued) Capital

Where captured (illustrative)

Possible gaps (illustrative)

PRA Buffer PB is designed to reflect risks that firms become exposed to in the future over a three to five year time horizon under a severe but plausible stress.The Annual Concurrent Stress (ACS) test’s severity (in the stressed scenario) could be argued to already capture at least some of the possible climate-related losses.

Possible regime gaps: – Currently, no explicit module for climate in scenarios and buffer setting. – Currently, time horizons are longer than for minimum requirements, but still relatively short (– years). – Risk Management and Governance (RMG) scalars could, in principle, be used for modelling/risk management deficiencies, as described earlier in the report. However, introducing separate climate-specific elements to the methodology may require further policy changes

Combined Buffer

Possible regime gaps: – No current explicit consideration of climate related financial risks or tools designed specifically to address this risk. – Systemic buffers take account of firm’s systemic impact but not specifically in relation to climate-related financial risks. – CCyB is cyclical in nature whereas climate related financial risks are mostly not.

Climate-related financial risks are not currently explicitly captured within the macro-prudential regime

Source: BOE, Climate-related financial risk management and the role of capital requirements, Prudential Regulation Authority, Climate Change Adaptation Report 2021, October 28, 2021.

The bank’s capital is intertwined with the risks it assumes, at least to the extent of minimum capital adequacy requirement. These risks and their interconnection with climate change mitigation has been discussed in Chapters 17 and 18 of this part. It follows, therefore, to accept that climate change risks have added a new dimension to risks that banks carry. By extension, therefore, capital should be able to capture and reflect the newer risks and the increased riskiness of its businesses. Both regulators and banks are grappling with the evolution and ramification of this nascent discipline and the tools to manage them including usefulness of capital as one of the critical tools. The Bank Of England opines “that regulatory capital is not the right tool to address the causes of climate change (greenhouse gas emissions) but should have a role in dealing with its consequences (financial risks). Further work is required to identify whether changes in the design, use or calibration of the regulatory capital framework are needed to ensure resilience against those consequences.”2

 Bank of England, Prudential Regulation Authority, Climate-related financial risk management and the role of capital requirements (October 2021).

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Two of the key findings of BOE report requires a special mention in the context of this book with its focus on climate change risk management. – Capital can be used for the consequences, not the causes of climate change – “Climate-related financial risks are partially captured by current frameworks, but there are gaps” (“Climate-related financial risk management and the role of capital . . .”) Proceeding from point two above, the climate change risks that affect the financial risks are partially captured through:

Current Capital Structure –

–

Pillar 1 – Credit Risk – arrived at as a function of probability of default (PD), loss given default (LGD), and the collateral (mitigants). This is usually the largest component of capital requirements. Crystallization of climate change risks could lead to potential worsening of all the three components that will increase the RWA due to reduction of value (both of collateral and primary assets and therefore RWA and capital required will go up. – Market Risk – arrived at as a function of volatility of market variables, their correlations on banks exposures. Interest rate, equity (both general market risk and specific risk), commodities, etc. Crystallization of climate change risks would increase both the volatility and uncertainty resulting in higher capital. The current limitation, however, is that market risk models calibrated to historical data do not allow for changes to correlations and/or volatility of assets due to the crystallization of transition risk – a gap as pointed out by the Bank Of England. – Operational Risk – the new “Standardized” approach for capital assessment of operational risk will be a function of a measure of the bank’s income (called the Business Indicator Component (BIC) and a Loss component (LC)). An internal loss multiplier (ILM) is derived from LC – a measure of the bank’s historical losses. Going forward, climate change will impact both aspects, the income and loss. The gap would be that historical operational (internal) losses will not be reflective of the losses bank operations would take through a hit of potential climate change risks. Pillar 2 – addresses all other material risks that are not fully captured in pillar one. This is a core component of capital adequacy arrived at through internal capital adequacy assessment process (ICAAP). Crystallization of climate change risks are likely to put pressure on liquidity, reputation risk as well as pointing to the potential of higher liability risk. All these will lead to worsening of non-financial risks and thereby the capital required to cover pillar 2 risks. The challenge for now is that there are no “standard” ways of computing the climate impact on capital.

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Capital Buffers – there are different buffers that banks must hold, subject to the scope, like capital conservation buffer, counter-cyclical capital buffer, sectoral capital requirements, additional buffers for systemically important banks (G-SIBs & D-SIBs), etc.

Regulators may set new capital buffers to improve the resilience of banks to climaterelated financial risks. This would help absorb losses in times of climate induced financial challenges and tide over stress situations, particularly the unexpected and unplanned ones. Regulators, global organizations, and influencers are all working on how capital component can be recast for it to capture the required capital cushion where risks are more realistically reflected and supported. There are a range of options where regulators may consider starting from a broad-brush capital buffer to a fine-grained risk weight adjusted to reflect the acute physical or transition risks that banks/sensitive geographies, products, carbon intensive portfolios of the banks may have. Capital surcharge is also spoken of by regulators. Overall, a more fine-tuned capital construct is to be expected sooner than later. A couple of the directions of these endeavors are as follows: – Increasing the risk weights for the fossil intensive exposures – a lever that regulators may resort to, in the short term, are valuations and haircuts in RWA computations/collateral value computations. The challenge is that the financial risks from adverse climate change (particularly the chronic physical risks and transition risks) do not materialize in the short-term liquidation horizon. For example, the People’s Bank of China (PBC) intends to consider calibrating risk weights based on its assessment of “green” and “brown” assets. – Adding on capital buffer to cover the range of climate-related financial risks – for example, the UK’s Prudential Regulation Authority (PRA) stated that banks could face pillar two capital add-ons if their responses to climate change ae deemed insufficient.3 The ECB is also of the opinion that pillar two capital requirements can be used to address climate risk of banks.4 It is important to note that climate risk drivers (physical and transition) have both macro and micro-prudential implications. Micro-prudential risks impact the individual banks in the form of impact on financial and non-financial risks, based on their business model (portfolios, products, customer segments focused on), and geographic location/s. This is where a fine-tuned climate risk nuanced risk weights are likely to be effective. Macroprudential risks, on the other hand, are concerned with the entire financial system.  Bank of England, Climate-related financial risk management and the role of capital requirements, Prudential Regulation Authority, Climate Change Adaptation Report 2021.  I. Baranović et al., The Challenge of Capturing Climate Risks in the Banking Regulatory Framework: Is there a Need for a Macroprudential Response? ECB Macroprudential Bulletin, 19 October 2021.

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Regulators are likely to incorporate climate-related financial risks as part of ICAAP iteratively and progressively, as data, methods, and metrics to measure the risk become slightly more mature. In the meantime, some regulators have been more active than the others on the question of capital. Should there be a capital cushion for climate change risks is not the question – there has to be. The question is really in what shape and form will the regulators structure it. If these risks are seen as impacting the traditional risks, as mentioned in the previous paragraph, then factoring in the climate variables into RWA computations to acknowledge its impact on the bank’s book as well as creating a capital cushion will be a way forward for now. Credit risk and partly market risk can take the inputs from the vulnerability index created by independent providers as well as the credit ratings that have factored in environmental/climate impacts into their ratings. A related issue that will weigh on regulatory approach to capital will be the cognizance of the fact that banks with higher climate risk exposure have higher leverage and this is equally true of sectors/industries that are susceptible to climate change risks. Fossil fuel intensive firms/industries, owing to their high exposure to climate change risks, have higher leverage which makes them more vulnerable to shocks. This adds to bank’s leverage. This makes both the borrower and the bank more prone to shocks. The route could be any of the three pillars of capital adequacy – a direct buffer, ICAAP or through disclosures. That is not the focus; the focus is the fact that climate change brings into the bank’s fold a complex set of interwoven risks and outcomes that demand on the one hand different but agile business models and on the other a risk plus capital management framework aligned to mitigate as well as cushion adverse impact when they arise. As measurement techniques for climate change become more mature, a more robust capital adequacy framework can be evolved by regulators in consultation with banks. The capital treatment options are also discussed in Chapter 20 in terms of going forward options. In the meantime, stress testing and scenario analysis are the instruments, especially for medium- and long-term assessment of the resilience and sustainability of banks. In the interim, it will stand banks in good stead to understand the interlinks of capital and the risks, inclusive of climate change risks, that they carry on their books (both current and proposed) and plan their capital structures with the required buffers – a guesstimate at this point and yet a useful exercise. It is so because capital building (a tier one component) is a time-consuming process. In summary, the approach to capital will potentially change in more ways than one.

Part 5: Going Forward

Practitioner’s Note Finding the Right Balance of Approach to ClimateRelated Financial Risks Tsuyoshi Oyama Decarbonization is the global trend. However, the world is a dynamic place with newer realities/challenges being added to its canvas. The worsening situation in Ukraine has caused the price of natural gas to skyrocket, and some are worried about a “rollback” of decarbonization. The good news is that the movement to promote decarbonization appears to be rather accelerating. For example, in the first half of 2022, we have seen more regulatory/supervisory/ disclosure guidance on climate-related risk issued by international organizations (FSB, BCBS, ISSB), European authorities, and U.S. authorities than ever before. Ms. Saloni Ramakrishna, deftly traces and features the highlights of the important guidelines across the book and their stated roadmaps in Part 5, the “Going Forward” section. There is a shift from the conventional “high-level” content to specific practices from the practical perspective of financial institutions. Among them, the report published by NGFS analyzed the degree to which climate-related risks can be recognized quantitatively, implying the future bank capital regulation vis-à-vis climate-related risk. There have also been many discussions in the macro-prudential area, including stress testing focusing on climate-related risk conducted by the BOE and the ECB and the ECB/ESRB report on the challenges of addressing climate change risk from a macroprudential perspective. At the same time, as Ms. Saloni Ramakrishna rightly points out, there are challenges to overcome before attaining the net-zero GHG target by 2050 through banks’ cooperation. For banks that have to measure their scope 3 GHG, collecting the data of GHG emissions of their clients is the primary issue. Depending on the external vendors’ solution, which usually assumes a “structural model” as an answer, but this should be supplemented by banks’ analysis using their clients’ financial data, such as the cost-tosales sensitivity to oil price changes obtained by the “reduced-form model.” Considering the diversity of each company’s businesses producing GHG even with the highly granular industry classification, methodologies need to be developed to estimate individual company level’s GHG footprint, including in the cases of SMEs. Another fundamental issue is how to achieve a “just” transition. GFANZ has already pointed out potential conflicts with achieving other SDG/ESG targets, including reducing poverty. The challenge is to transition to a decarbonized society in a “just” way that minimizes these conflicts. In Japan, for example, with a time horizon of 30 years, we have other significantly essential issues such as “declining birthrate and aging society,” “major earthquakes,” and “fiscal sustainability.” Focusing only on climate change while https://doi.org/10.1515/9783110757958-024

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ignoring other important issues may lead to biases in policy responses (misallocation of policy implementation resources) and unexpected policy outcomes. Similarly, we should pay due attention to the risk that the climate change response could invite unintended consequences through its correlation with other issues. A typical example would be increased reliance on nuclear power generation as a result of aiming to reduce GHG as part of the climate change response. Under current technological constraints, there appears to be a trade-off between climate-related risk and the risk of nuclear power plant dependence. Suppose the society’s appetite for the risk associated with nuclear power plant dependence is not thoroughly assessed before proceeding with climate change responses. In that case, the result may be a biased policy outcome that ignores the possible low appetite for the nuke risks. With all the above issues in mind, my top three suggestions for financial institutions are: 1. Focusing on GHG emissions of individual clients for sharing and enacting the same passion for decarbonization rather than focusing on estimating industry based GHG emissions just for reporting purposes. 2. Becoming sensitive to all SDG (Sustainable Development Goals) related serious risk events which are likely to materialize over the coming 30 years and apply similar risk management methodologies developed for climate-related risk to them. 3. Becoming aware of the right balance between climate-related risk and others. Tsuyoshi Oyama

Mr. Tsuyoshi Oyama, an MS in finance from George Washington University, is the CEO of RAF laboratory Co., Ltd. Before working as a partner at Deloitte Touch Tohmatsu and as a CEO of Promontory Financial Japan for more than ten years, he has been a regulator of repute having worked 23 years at the Bank of Japan. He held various positions, including Deputy Director-General in the Financial System and Bank Examination department. Author of books like Post-crisis Risk Management and Basel III Impact, Tsuyoshi leads risk management advisory for major banks in Asia/Pacific region.

Section Abstract

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Section Abstract Regulators are one of the most important stakeholders in the space as their ability to shape the industry’s response is substantial from a bank’s standpoint. In this chapter, regulatory stance, regulators’ direction, and their go forward plans are briefly looked at. The stated next steps of other important narrative shaping groups such as TCFD, NGFS, ISSB, and other standard setting bodies are briefly studied. What is next in the climate-related financial risk space, as per banks’ own forward looking views, is also explored.

Chapter 20 Going Forward If you work hard enough at it, you can grind even an iron rod down to a needle. –Chinese Proverb

The Big Picture

Banks, Investment and Insurance firms, Investments/Flow of funds to Sustainable activities Risk Management and Stewardship

Global Organizations Taxonomy, Data and Scenario frameworks

Disclosure Charters

Regulators Monetary and Financial Stability Financial Regulation

Real Economy Transition, Business Activities and Operations Innovation, Research and Development

Government and Policy Makers Climate Policy International Negotiations (Paris Agreement, G20 etc.)

Figure 20.1: Climate action role holders (adapted from The Bank of England and Climate Change, Briefing to Bank of England Agency contacts, March 4, 2022, with author extensions).

Figure 20.1 captures the climate action role holders and their headline contribution to climate action. Multiple aspects will impact the forward actions of different stakeholders. There is a high degree of uncertainty of how and when climate-related risks will materialize. The complex and potential non-linear interactions between climate paths, policy, real economy, and financial system make it an involved exercise. Physical risk drivers that are likely to evolve over longer time horizons challenge the planning skills of banks. The current regulatory Basel framework also uses a twelve-month time frame to measure capital adequacy. These need to be worked on to include the long-term nature and other nuances of climate change risks. Governments and policymakers are the leaders and are tasked to set the tone and direction towards a low carbon economic transformation path. Through a combinahttps://doi.org/10.1515/9783110757958-025

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tion of measures like proclaimed policy actions, for example, carbon taxes, subsidies, guarantees on the one side, and emission reduction targets on the other, governments can enable an orderly transition to low carbon economy. Real economy changes are consequences of the interplays and correlations between the various components of adverse climate change, its mitigation and adaptation measures. For regulators and banks, currently, scenario analysis is the go-to tool to gauge the potential impact of climate change. However, the translation of these scenarios to financial risks have some important issues, which are to be kept in perspective, for example: – Data that is incomplete, unverified, in some cases unreliable and in other cases unavailable, so are proxied, which, while understandable during the learning phase, are only indicative. – Dependence on a broad array of simplified assumptions that influence the outcomes on which the stakeholders will act. – Unpredictable climate paths. – Uncertainty of the future of green technologies development. – Unknown geopolitical realities that will influence climate-related government policies. – Imprecise understanding and therefore inability to model the interlinks and correlations between the various layers. All aspects need to be tackled at multiple levels, in collaboration. Common directional alignment amongst various stake holders, viz., governments and policymakers, regulators and global organizations, the financial industry, other market participants, and society at large is required for this mammoth initiative. A call out for three specific aspects that require a greater focus going forward (in addition to others), that will allow for a smooth and sustainable transition, is mentioned below. These aspects, like others, have to be worked on at different levels but in a coordinated way.

Climate Information Architecture (CIA) Climate information architecture is a critical part of success in this space. Tying in reliable taxonomy aligned data at the right grain and detail, harmonized, comparable processes and disclosures should be an aspirational goal as this would not only enable meeting the various business and disclosure requirements smoothly but also facilitate better market pricing, making informed investment decisions, as well as improving sustainable finance growth.

What Next – Regulatory Perspectives

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Data Democracy Making available freely accessible quality data from trustworthy sources will be a great accelerator. Today, the larger part of the data available has two limitations, one that a major part of it must be paid for and two that these data sources have their own set of assumptions which may not be compatible when used together.

Climate Pricing This issue has to be tackled both at factors influencing market pricing as well as at individual financing by banks and other funding agencies. Dwelling on the theme, the ECB mentions that “Market pricing of Transition Risk is complicated by its long term nature and lack of data, Correct pricing of climate risk reduces the risk of sudden reassessment and thus the costs related to the transition . . . The costs associated with physical and transition risks vary depending on the trajectory chosen for reducing carbon emissions.”1 It is this complex canvas that stakeholders need to work on and progress to the desired goal of a low carbon economy. While “why and what” has to be done is fairly clear, at least at the headline level, the real questions are all related to “how,” which will evolve through trial and error.

What Next – Regulatory Perspectives At the top level, regulators are working towards embedding climate risk assessments into financial stability and prudential frameworks. The objective of regulators in the climate change space, as BOE points out, is to play a leading role in ensuring: “the financial system, the macroeconomy, and the Bank itself are resilient to the risks from climate change and supportive of the transition to a net-zero economy.”2 Regulators understand the complexities involved and are approaching it gradually. Current focus is to analyze the impact of physical and transitional risk drivers, and their potential effect on financial institutions they supervise. While the primary focus of prudential regulation is to ensure financial stability and safety of individual banks within their jurisdiction, they do influence the sectors and businesses to which credit flows.

 European Central Bank, Financial Stability Review, May 2019.  The Bank of England and Climate Change, Briefing to Bank of England Agency contacts, March 4, 2022.

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FSB, in its final report, summarizes how macroprudential initiatives compliment the climate change risk management process as – “Potential macroprudential tools and policies, or tools and policies with a macroprudential dimension, could be complementary to address the systemic characteristics of climate-related risks that remain, including sources of tail risk, uncertainty around the timing of climate-related events and magnitude of impact, heterogeneity of exposures and impact across sectors, crosssectoral spillover of risks or risk transfers and second order effects.”3 There is a need for authorities to review prudential frameworks with a view to taking full account of the implications of climate-related financial risks for financial stability. Going forward, building on the work so far, some of the important areas of focus for financial regulators across prudential regulations (both Macro and micro-prudential areas) and monetary policies, as indicated through various documents, speeches and stances, are likely to be the following.

Approach to Capital Treatment Capital is intended to create capacity for absorbing losses arising from unexpected events. That capital management will be part of the regulatory treatment is a given; the question is what shape it will take. Different regulators might take different routes. The link between capital and climate change risks has been explored in Chapter 19. Taking that conversation forward, here is a look at some of the possible approaches to using capital as a tool under Basel’s three pillar structure and/or prudential regulations: – As part of Pillar 1 capital This may not be preferred as a direct approach, as they may prove to be sub-optimal at least in the short term. However, there are two ways in which pillar 1 capital could be influenced: – Through differential risk weights treatment for the preferred and nonpreferred sectors/industries, e.g. with green loans being assigned lower risk weights and thereby gaining capital advantage while brown loans have higher risk weights and therefore are at a disadvantage. However, the challenge regulators face is that the risk weights are standardized based on ability to compute tail risks and implicit value-at-risk. In the case of climate change risks, this means a reasonably good estimate of probability distribution of climate events, across the applicable term horizons, and related policy responses, not to mention the response of banks to the emerging risks.

 Financial Stability Board, Supervisory and Regulatory Approaches to Climate-related Risks, Final Report October 13, 2022.

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Through a more fundamental approach where climate change risk blended variables go into calculation of RWA like ratings, loss given default, etc. Here the climate risks are, to an extent, factored into individual client and exposure over facility’s lifetime.

– As part of Pillar 2 treatment This is evolving as the most preferred option. Here supervisors may consider add on capital to create sufficient loss absorbing capacity, if they assess (through stress testing, scenario analysis, and other tools as they evolve) that climate-related financial risks are not managed well by the banks. For example, the UK’s perspectives are on these lines, as are many of the other regulators, as this is perceived more effective than Pillar 1 changes. The challenge for the global banks may be that the requirements will vary across jurisdictions. Regulatory alignment on integration and treatment of pillar 2 expectations, as part of supervisory review process, will be required to overcome this challenge. Financial Stability Institute (FSI briefs No. 16), speaking of regulatory response, opines that “Given the longer time horizons and the higher degree of uncertainty associated with the materialization of climate-related financial risks, standard Pillar 1 instruments might be suboptimal in addressing such risks. In contrast, the intrinsic flexibility of the Pillar 2 framework makes it the natural candidate for ensuring that banks effectively manage such risks and have sufficient loss-absorbing capacity against them.”4 Sectoral concentrations can be addressed here or under systemic risk buffers. – As a capital buffer A buffer dependent on the quantum and direction of climate change risk response that banks take towards a low carbon economy. Some form of objective approach will need to be the basis – for example the orderly transition versus disorderly transition routes taken. In the latter case the potential losses will be higher, requiring a higher buffer. – Systemic risk buffer (SyRB) A macroprudential intervention, this can be seen as a variant of capital buffer that is focused on addressing potential systemic risk. This could be across all banks, a group of banks, or across sectoral or geographical exposures that are vulnerable to climate change risks. The latter approach could have the twin benefit of enhancing resilience against climate-change risks as well as motivating banks to programmatically reduce exposures to the identified sectors. The ECB and ESRB5 are looking at this option.

 Rodrigo Coelho and Fernando Restoy, Financial Stability Institute, FSI Briefs No. 16. The regulatory response to climate risks: some challenges (February 2022).  European Commission, Proposal for a Directive of the European Parliament and of the Council, 27.10.2021.

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OECD’s framework, for both sectoral as well as geographical concentrations, can come in handy in the case of large exposures as it looks for reporting of carbonintensive large exposures of individual, group or interconnected companies. What makes this segmented, focused method preferable is that it avoids a one size fits all approach which is fraught with inefficiencies, as FSI cautions, saying, “applying the current macroprudential framework to contain systemic climate-related financial risks is likely to be ineffective and potentially counterproductive for financial stability. The same could be said of the introduction of a green supporting factor.”6 – Pillar 3 requirements of disclosures There is a link between the detail of regulation, its’ follow up by regulators, and submission of disclosures by firms. Banks under more stringent or focused regulators have better and more detailed disclosures. It is not surprising, therefore, that the banks in European Union and United Kingdom (where climate disclosures SDRs (Sustainability Disclosure Requirements) will become mandatory in UK from 2025) are ahead in the submission of disclosures with a reasonable amount of information. The two important themes (amongst others) that regulators and global organizations will focus in this space are: – Climate change related data, metrics, goals, and disclosures are all a continuum – each is dependent on the availability and dependability of the others. Enriching and keeping this multi-way information sharing wheel moving smoothly will be a task that regulators and global organizations are expected to spearhead. – Harmonizing disclosures – the effort is on standardization. In parallel there is a healthy debate between the various stakeholders on the approach to disclosures at two levels: – A standalone approach – the road to a consistent, comparable reliable climate disclosures across companies and thereby banks is some way off yet. TCFD and ISSB continue to work for arriving at a global sustainability disclosure and reporting standards. This effort, by itself, is considerable and demanding from the global organizations. From banks’ and corporates’ point of view, this approach will entail a distinct set of information which they may have to work from the ground up. This exercise would be costly, time consuming and potentially incomplete and error prone to start with. – Incremental approach – a lot of data is collected from companies today. A valid question is if this can be leveraged for climate change risks with the additional data that is required that is missing be asked of instead of evolving a completely new set of data asks. A pertinent reference to this aspect is drawn by commissioner Hester M. Peirce.7

 Rodrigo Coelho and Fernando Restoy, Financial Stability Institute, FSI Briefs No. 16. The regulatory response to climate risks: some challenges (February 2022).  US Securities and Exchange Commission, commissioner Hester M. Peirce, We are Not the Securities and Environment Commission – At Least Not Yet. March 21, 2022.

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The next phase of BCBS (Basel Committee of Banking Supervision) work in this space would be to look at alignment of climate -related financial risks with the Basel framework, identify gaps, and evolve measures to address those gaps.

Granular Taxonomies A starting point for realistic prudential measures is the availability of standard granular taxonomies to assess the corporate exposures of banks and their vulnerability to climate change risks. The granularity is important to segregate exposures based on sectors, locations, and business models of the corporates. This is a demanding exercise. The EU is leading in this effort. With taxonomies gaining prominence, there is not only hope of a standardized approach identifying assets with sustainability benefits but also for risk management frameworks to align and leverage that content. Figure 20.2 reflects the potential leverage climate risk management can derive from the work on taxonomies. Alignment of banks with taxonomies will be an expectation that will be enforced. As the ECB states, a key theme for the regulators in the next phase will be moving from assessing the individual bank’s performance against supervisory expectations on climate risk management to actively supervising against their expectations.

Approach to Materiality There is a need to find a balance of exposures, data, and approach for climate risk and finance overlap. From “materiality” point of view, the debate is whether banks should be focused on the financial impact or should the materiality assessment look at both financial and non-financial impact. The latter would cover ESG (Environmental, Social and Governance) components which will bring to fore the multiple factors. These themes include. – Single Materiality – here, while sustainability factors are given due importance and are factored into business processes, from a materiality perspective, the focus is on the business outcome, which is the potential financial impact that banks are likely to have due to climate change risks. This is an approach favored by US. – Dual Materiality – here the potential impact on banks as well as by banks is in focus, on both financial and non-financial impact. This is EU (European Union) preference. Under this approach, there could be measures like mandatory allocation of a certain portion of loans to green loans, ensuring banks are not only mitigating risks but also making a positive contribution to climate change.

TAXONOMIES

Increase awareness of sustainability risks and communicate supervisory expectations through public statements, reports…

Financial sector regulation: Risk management requirements; Stress tests; Capital requirements etc.

Climate Risk Strategy & Risk Appetite

Climate Risk Identification & Assessment

Climate risk measurement &Disclosures

Figure 20.2: Pointers for climate change risk management from taxonomies. Source: Saloni P. Ramakrishna, Growth of Taxonomies and Climate Risk Management- a Practitioner’s view, Professional Risk Managers’ International Association Intelligent Risk, May 2023.

Channeling financial flows to investments with sustainability benefit

To enable investors to identify assets with sustainability benefits

Sustainability disclosure and accounting standards

264 Chapter 20 Going Forward

What Next – Influencers’ Roadmaps

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Refinement of Models, Methods, and Scenario Analysis A lot of work is happening on this front by all stakeholders including academicians. Regulators and global organizations will play a primary role in evolution and refinement of scenario analysis to capture the interconnectedness of related scenarios and share best practices observed, so every bank does not have to start from the ground level. Work on models will continue to happen across banks, rating agencies, software developers, and the academic community, amongst others.

Leading by Example In addition to all the above, regulators are actively embracing sustainability initiatives in their direct operations. As a sample: – The Central Bank’s investment wing is, and will be, investing in green ventures/ instruments. – Facilitating the green journey – issuance of green bonds by central banks whose proceeds are used to fund climate-positive initiatives. The “green bubble” is an area of concern for regulators where the potential of overinvestment and overvaluation in green assets leading to a disorderly correction is high. The big challenge regulators face is finding the right balance between the safety of individual constituents they supervise and the financial stability of the system. They need to balance disclosure obligations and supervisory action including adjustments to capital requirements. It is important to note that policy response to climate emergency falls within the realm of governments, because the main responsibility of regulators is to ensure financial stability, while supporting governmental policies towards a low carbon, low fossil fuel economy. In summary, new regulations, more standardized taxonomies, more detailed disclosures, more finegrained stress testing requirements, newer measurement and modeling designs are a given. So are newer technologies. Directional guidance towards an early, orderly economywide transition to climate friendly finance, through curated disclosures and inclusive risk management on the one side and encouragement of sustainable finance on the other, will be the hallmark of a regulatory stance for the coming years.

What Next – Influencers’ Roadmaps All the stakeholders (investors, consumers, regulators, governments, market, and others) benefit from reliable, well thought out, and well-structured disclosures to make informed decisions. While there are many information seekers, the providers are primarily finan-

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cial services firms, corporates, SMEs, businesses, and other counter-parties. Climate related disclosures are required not only from corporate/firms’ own operations but also from their supply and investment chains. This information is channeled either directly or through banks. Unified climate related disclosures with transparent standards for data, disclosures, and reporting is a goal that will benefit all. This is pivotal to enable collaboration, comparison, and benchmarking. As discussed in Chapter 7 (Part 2), Figure 20.3 captures some of the active global organizations that influence the approach and path towards low carbon economy.

Task Force on Climaterelated Financial Disclosures

TCFD

NGFS

Global Associations (Sample) Set Standards, disclosure guidelines, stress testing and modeling methodologies etc.

ISSB

GHGP

UNEP FI

Network for Greening the Financial System

International Sustainability Standards Board

Green House Gas Protocol

UN Environment Programme Finance Initiative

Figure 20.3: Sample of global organizations that play a significant role in climate change management.

These will be standard setting bodies in the important areas like disclosures (TCFD, ISSB), guidance on scenarios to be used (NGFS), measurement methods, e.g. financial emissions (GHGP, PCAF), carbon accounting policies, etc. In addition, they will be tracking progress in each of the initiatives they spearhead, as well as sharing with the industry their findings and best practices observed. Going forward, each of these (and similar) organizations will build on the work already done.

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TCFD and ISSB Disclosures – the objective here is to harmonize the various disclosure asks into a unified requirement, as far as possible, such that both banks and regulators save precious time, effort, and resources tracking and reconciling exposures to climate change and their riskiness. TCFD has been the forerunner in this space establishing the key framework for disclosures. Over the next several months, the Task Force will continue to monitor companies’ progress in disclosing climate-related financial information aligned with the TCFD recommendations and will prepare another status report for the Financial Stability Board in October 2023. Aligning financial and non-financial reporting and providing assurance by auditors is an objective being pursued by IFRS through ISSB (International Sustainability Standards Board) to set global sustainability reporting standards that will promote transparency, with comparability a step in the right direction. ISSB, with its proposed IFRS sustainability disclosure Standards (the Standard), building on the TCFD framework, is an important step towards creating a comparable baseline of investor relevant sustainability disclosures. ISSB was announced on November 3, 2021 and since then has been working not only on the standards but also to generate international consensus including from G20 and G7. The end goal is to develop a comprehensive global baseline of sustainability disclosures to meet investors’ information needs. In order to reduce the burden on firms, ISSB has taken some important initiatives. It has consolidated the effort of Value Reporting Foundation (VRF) and Climate Disclosure Standards Board (CDSB). This brings the existing industry specific standards of the Sustainability Accounting Standards Board (SASB) into ISSB’s fold. It is working with Global Reporting Initiative and is building on TCFD’s framework. Leading on from this, ISSB is working on the first two disclosure standards, s1 and s2. These are applicable for all financial reporting frameworks, but the decision of whether they will adopt the standards when they become effective rests with individual jurisdictions. The proposed standards were released for public comment on March 31, 2022. The first standard, IFRS s1, general requirements proposal, is expected to be the base of all the reporting under the standards. They will define the scope and objectives and provide core content, presentation standards, and functional requirements. The second standard, IFRS s2, climate proposal, relates to climate-related disclosures with climate specific reporting requirements. Over time ISSB will work on other standards. Overall, interoperability of the EU’s European Financial Reporting Advisory Group (EFRAG), SEC-US, and ISSB is being worked on. EFRAG and ISSB plan to use TCFD framework as the basis. Whatever the outcome, global alignment of standards will only be possible if governments and policymakers agree to adopt them. The adoption can be a core aspect of ability to implement the standards, which are dependent on multiple factors of individual jurisdictions including their specific priorities.

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NGFS The big contribution of Network for Greening of the Financial System (NGFS) is the development of credible climate scenarios that are being used by regulators to gauge the susceptibilities of the banks they regulate. The next objectives for NGFS,8 as stated in their September 2022 document, fall under two major buckets, strategic and technical. Figure 20.4 captures these. NGFS has clearly stated that it “will continue to develop the scenarios to make them more comprehensive and relevant for an increasing range of applications.”9 PCAF (Partnership for Carbon Accounting Financials) is an industry-led initiative to enable financial institutions to consistently measure and disclose financed emissions. Its twin objectives are to have a global GHG (greenhouse gas protocol) accounting reporting standard and to increase the adoption of the standard by financial institutions to 250 and beyond. IPCC (Intergovernmental Panel on Climate Change) is the United Nations body for assessing the science related to climate change. It prepares comprehensive assessment reports on the state of scientific, technical, and socioeconomic knowledge on climate change, its impacts, future risks, and options for reducing the rate at which climate change is taking place, both through mitigation and adaptation. This input is critical, going forward, to demystify as well as set a scientific basis to understand and project potential climate paths. The above give a bird’s eye view of some of the global organizations and their next steps/road map. Going forward, their actions and collaboration will shape the approach and narrative of climate change risk management.

What next – Banks’ Outlook The coming years are critical from climate action perspective, given that it will set the tone and direction the economy will take. Investors and customers will prefer banks and corporates that have a positive alignment with climate change initiatives and handle risks proactively. To do this in a constructive manner, standardized and decision useful information is core. The investments and funds to address climate change are huge to say the least. Banks by the nature of their business will be a big part of this funding. The caveat here is that banks need to be clear about their role in the overall climate change ecosystem.

 NGFS Scenarios for central banks and supervisors, September 2022.  NGFS Scenarios for central banks and supervisors, September 2022.

–

– Better represent acute physical risk

– Introduce short-term scenarios (in cluding higher frequency data) that could be best used for scenario analysis and stress-tests

– Broaden the user base of scenarios (beyond central banks/ supervisors to also private institutions, academics), and increase range of usage of NGFS scenarios

– Improve transparency and provide users with methodological guidance

Make NGFS scenarios a common standard

– Manage the trade off between usability and complexity of scenarios

Figure 20.4: Next objectives of NGFS. Source: Network for Greening the Financial System NGFS Climate Scenarios for central banks and supervisors, September 2022.

Update scenarios

Improve scenarios

– Improve usability and limit complexity of the scenarios ( off-the-shelf )

Strategic objectives

– Increase sectoral granularity and geographical coverage, especially in emerging economies

Technical objectives

Phase IV objective: improve the design of the NGFS Scenarios and promote their wide use by a broad range of stakeholders.

Next objectives for the NGFS Scenarios

What next – Banks’ Outlook

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Addressing this point, BIS officials rightly point out that the Financial Services sector has a key role to play in supporting the green transition. However, it is unrealistic to expect that it can drive the required reallocation of resources in the absence of adequate environmental policymaking in the real economy. Such unrealistic expectations could undermine financial stability and may derail the green transition itself, and set the financial sector up for failure . . . As a key channel for the reallocation of resources, the financial sector has an essential supporting role to play.10

It is important to understand that financial services have a “supporting role” in the overall plan of transitioning to a low carbon economy. However, from a climate change risk management perspective, the requirement is now and will keep growing. Banks know that they will be most challenged on the transition risks (both mitigating and adapting measures). This is confirmed by the representative response from 163 firms that BOE collected, as shown in Figure 20.5. This is because transition risks are the newest category of risks whose speed and direction are fluid. 117

39

7 Physical risks

Transition risks

Litigation risks

Figure 20.5: View of banks’ concern across different climate risk drivers. Source: The Bank of England and Climate Change, Briefing to Bank of England Agency contacts, March 4, 2022.

One of the big concerns banks have is mispricing of climate risks which could expose banks to big losses and with little lead time. The other concern is that these risks are global in nature and span over long periods of time which makes it difficult to gauge potential policy changes as well as changes across geographies, sectors, and industries. What complicates the canvas is that the impact will be different for different countries: for example, for commodity exporting countries like Canada, macroeconomic impact will increase the transition risk. The aspects that banks need to keep in perspective are likelihood, severity, stakeholder relevance, and materiality.

 Claudio Borio et al., BIS, Finance and climate change risk: managing expectations.

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Summing up the situation, Bank of Canada says, “Financial institutions and financial authorities are in the early stages of building their capacity to assess the risks tied to climate change.”11 The current “learning experience” of the pilots across various geographies will place banks in a better position to understand, assess, and measure their exposure to climate-related financial risks. The other takeaway is that it will help banks to spot and assess business opportunities. There is serious work happening across banks in the space both on climate change risk management as well as on the sustainable finance. Banks have been declaring their stance and progress in these areas through either their annual statements or through separate focused statements/declarations about their ESG/climate commitments. For example, ABN AMRO12 announced that it has embedded ESG Scores (contribution to climate commitments/goals like carbon emission) onto its trading platform to enable investment clients see the impact they are making with their investment, and also, where required, to make course correction. Embedding practical wisdom, Jamie Dimon, Chairman and CEO of JP Morgan Chase & Co., cautions “The fact is we’re long past debating whether climate change is real . . . But we need to acknowledge the solution is not as simple as walking away from fossil fuels. We need resources such as oil and natural gas until commercial, affordable and low-carbon alternatives can be developed to meet all of our global energy needs.”13 It is vital that banks maintain the critical balance between green and brown assets to ensure economic and financial stability. In this, they need to be supported both by regulators and policymakers, because of the stark reality highlighted by Jamie Dimon. Creating and making available credible low carbon alternatives will take time, which will require constructive collaboration across all stakeholders. The area requiring immediate focus from banks, however, is to refine their initiatives across the life cycle of climate change risk management. Different banks are at different points in this journey. Table 20.1 captures some of the good practices followed by banks in this space, as shared by the ECB. Going forward, the main themes banks look to focus on are: – Refining climate risk strategy, governance constructs, and risk appetite statements – this is an area where some initial work has been put in. Governance aspects will continue to be in focus from a supervisory review perspective. – Creating climate change risk enabled information architecture. This is at the very core of navigating the complex universe of climate change management. Regulators and global organizations will address this at a higher level. Banks on their part will do well to extend their existing ERM information architecture to subsume climate change risk related nuances.

 Bank of Canada, Assessing climate change risks to our financial system, January 14, 2022.  ABN AMRO Embeds ESG Risk Score to Address Demand for Sustainable Finance. May 17, 2022.  JP Morgan Chase & Co. Annual Report 2020, Chairman and CEO Letter to Shareholders.

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Table 20.1: Sample good practices in the climate change space. Institutions Leading the Way Towards Full Alignment with the Supervisory Expectations Areas of focus

A selection of observed good practices

Business strategy

Institutions are using state-of-the-art scientific transition pathways to develop targets to steer their strategy. Institutions do so, for example, by setting intermediate and longer-term targets using forward-looking tools to avoid the build-up of excessive transition risk in their portfolios. This target-setting process is fully integrated in the institution’s governance, risk appetite and risk management framework and reflected in the types of products and services offered to clients.

Governance

Institutions have developed advanced methods to collect granular data to quantify the risks stemming from climate change. With such methods, institutions collect client and asset-level data, such as data on actual greenhouse gas emissions, water consumption intensity, energy performance certificates, and fossil fuel dependency. These data are used to develop granular risk indicators, which are reported to the management body in a systematic manner. Such indicators are also integrated into institutions’ variable remuneration practices.

Risk management

Institutions are allocating economic capital specifically to the management of physical and transition risks and integrating this into their rating system for probability of default. Institutions assess capital adequacy using scenario analysis in their ICAAP, covering market, credit, and operational risks. Institutions are including C&E risks in their internal ratings-based models, for example by using qualitative variables or rating overrides in their PD rating systems. In such cases, risks may also be reflected in loan pricing via credit and funding cost price calculations or through expected profit margins.

Source: ECB, “Good practices for climate-related and environmental risk management,” November 2022.

Different aspects that will be the center of focus are granularity and detail of the data to be captured (both what is available presently as well as what is likely to come over time), aligning to the evolving taxonomy constructs, provision for data-sets to support the developing disclosure standards, etc. to name a few. Since effort across these initiatives is work in progress with different stakeholders, flexibility, scalability, transparency, and traceability have to be built in as fundamental architectural design principles. –

Defining and putting in place processes for materiality assessment. This is vital, given that risk management attention will need to be on the exposures identified

What next – Banks’ Outlook

273

as “material.” If found wanting in this area, supervisors will enforce actions through their supervisory review processes. For example, the ECB will action this through its SREP (Supervisory Review and Evaluation Process) if it detects that “the institution did not conduct a sound and comprehensive materiality assessment for C&E (Climate and Environmental) risks and its operational plan does not foresee any actions in this regard.” It will mandate that, “with respect to the identified weaknesses, the institution is required to: a) perform a comprehensive qualitative and quantitative materiality assessment of C&E risks, covering all risk categories it might be exposed to; b) explicitly monitor, with adequate metrics, the impact of physical and transition risks arising from climate change and environmental degradation. c) integrate material C&E risks in both the risk appetite framework and the three lines of defence model.” –

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Cataloging measurement methodologies used with a time stamp and adding the newer additions. In addition to stronger models and methodologies, the two areas with notable advancements would be in the areas of scenario analysis and measurement of carbon footprint of the businesses – financed emissions. Keeping collateral valuation current and adjusted to climate change related nuances is the other area of focus. Climate risk pricing – pricing can be used to rebalance portfolios by higher pricing to “brown” assets and offering near prime rates to the right “green” assets. The emphasis is on “right” because in a rush to the net zero goal post, special care needs to be taken not to bypass the fundamental prudence of lending and investing. Both costs and the credit risk will require careful scrutiny while arriving at the risk premia. The costs depend on multiple factors including the transition path chosen by the customer for its low carbon journey. Due cognizance should be given to risk mitigants that borrowers have in their transition trajectories, both in loan underwriting and pricing, with an advantage on price points for sustainable options by clients/customers. The aspect to watch out for is that potential of arbitrage exists if the measures are unevenly implemented. Putting in place effective processes for disclosures – for smooth operation of disclosures, it is essential for them to be part of the climate change risk architecture discussed earlier. With ISSB’s global standards (s1 and s2), and the need to align with regional (for example EFRAG, SEC) and local regulatory requirements, an intense effort will be needed in this space. Data, taxonomy, and reporting all need to come together to make this functional. The expectation would be disclosures in their annual reports, either as part of the financial reports or standalone climate reports, to focus on how changes in risk appetite and business strategy are impacting the two-way street of impact on climate on the one side and being impacted by climate change on the other. Disclosures will continue to be an area of sizeable effort, as

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banks continue to grapple with data gaps, scenario modeling complexities, and lack of standard taxonomies. Tracking performance against supervisory expectations – this will be another critical area that banks will be focusing on going forward, as regulators have set out expectations from their constituents in managing climate change. The European Central Bank leads the way and is assessing banks’ performance against each area spelled out. They have clearly stated, for example, that they “expect banks to progressively meet the supervisory expectations, by [the] end of 2024, in the climate and environmental risks outlined in 2020. Including integration in the internal Capital Adequacy assessment Process (ICAAP) and stress testing.”14

It would be sub-optimal for banks to look at the financial impact of climate change only as a risk management endeavor. Financing climate aligned credible businesses will benefit from transition, riding the wave so to say. Customers, market, and investor community are becoming more sensitized towards climate preservation which will impact the direction and volume of their spending and investments. Going forward, it is important to look at the value creation opportunities in the context of climate change risk management, like: – Revenue growth through new products and services in the sustainable space, with newer markets better aligned towards reduced fossil fuel usage. – Optimizing capital allocation. Banks can influence the course of the net zero journey by redirecting capital to credible, sustainable projects, technologies. – Better, low carbon focused, balance sheet planning. – Climate change risk sensitized pricing. – Proactively addressing liability risks that might materialize. The road ahead for banks is going to be an intensely involved one. Global banks and companies operating in multiple jurisdictions will be most challenged. This will be on several, related fronts as they need to work through data, systems, processes, controls, and governance constructs. The main mantra that will ensure harmonious evolution is to keep the big picture in context and approach climate change risk management in a wholistic manner, both while working on the blueprint as well as executing the individual pieces mentioned above.

 ECB sets deadlines for banks to deal with climate risks. Press release November 2, 2022.

Closing Notes Simple can be harder than complex; you have to work hard to get your thinking clean to make it simple. –Steve Jobs

When I started writing this book, I did not think that I would be referring to the global financial crisis (2007 to 2009) given that it is now a more than a decade and half old experience. However, the systemic risk and the financial contagion effect that created havoc across the globe then, stand as stark example of the magnitude of negative impact such a situation creates if not addressed in time, and the painful road to recovery. It was a systemic risk propelled by willful negation of the writing on the wall through a combination of factors like fear, negligence, greed, incompetence, delayed as well as uncoordinated responses and lack of required skill sets. Some of these causes are seen in the climate change risk management space. If the stakeholders do not manage these in a timely manner, resort to inaction, delayed, disorderly or noncollaborative, disjointed actions, it might lead to unwanted, and more importantly, irreversible negative consequences. In a fast-exploding climate change awareness scenario, it is an understatement to say the stakes are high. The demand for transparency, holding investors to responsible investing, and the actionable regulatory initiatives are all increasing at high speed. All will be better off by learning from history and not letting the pattern repeat in the case of the potential impact of adverse climate change or transition effects of moving to a low carbon economy. One thing that is clear, is that delayed action will lead to increased risk, not only to the banks but also to the economy. Like the BIS paper rightly says, climate related financial risks have unique features necessitating forward looking measurement and methodologies to assess the risk. Regulators themselves need to rise to the occasion and build the ability to have forward looking assessment of the future business environment, banks’ ability to manage those environments, and the potential risks that arise thereof. Major concerns are regarding the potential impact across sectors, cross-sectoral spillover of risks or risk transfers and second order effects. In a connected and fast changing universe (both physical and societal) with its complex inter-relationships that impact across multiple aspects, the effect of medium to long term materialization of climate change risks, specially chronic and stealth physical risks and acute events in far off geographical locations need to be factored in, at the minimum as a second-order effect. Given that climate change risks do not respect either borders or time, the likelihood, severity, and consequence is not known prior to action and therein lies the absolute importance of vigilant monitoring, course correction, and, if not feasible, cutting losses. I have discussed various aspects of climate change risk management across the book. In these closing notes, I will touch upon a few core themes, more as a practitioner myself. I will start off by saying that the focus needs to be as much about what https://doi.org/10.1515/9783110757958-026

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Closing Notes

needs to be slowed down (problem definition) as about what needs to be propelled and how (solution articulation and execution). Both aspects need equal and a balanced plan of action.

The Transition from Brown to Green Takes Time Banks can influence consumer/customer behavior both explicitly and implicitly and vice-versa. However, being realistic is very critical both in expectation setting and planning across the stakeholder community. Brown will not suddenly transition to green. The transition will move from shades of brown to shades of green over a period. As mentioned in Chapter 20, the financial services industry plays an important but clearly a supportive role. At this point, while the risks are fairly clear, it is the opportunity space that is hazy. This is more noticeable in the areas of structural opportunities, ability to identify credible high growth sectors/industries/corporates, and potential competitive advantage in medium to long term. There is great emphasis and huge investments by banks on green/sustainable financing. Cost of meeting disclosures expectations, talk of trillions of dollars.

Green Options are not Risk Free It is important to note that not all “green” options are risk free. This is especially so given that the associated technologies are still in their infancy. Sound fundamental risk assessment of viability across time (like how one would deal with term loans over long periods) is a must. Measuring climate risk is and will remain work in progress for some time. The transition from a “learning phase” to a “stable phase” will be an iterative process. At the core, climate change risks are high impact, low probability events (particularly acute physical risks). Risk amplification happens through a multiplier effect of perceived threat and people/organizations’ response, not to mention media coverage and the societal reaction to it.

The Balancing Act There are multiple benefits if the approach to and execution of the management of climate change risk is done right. Increase of stakeholder value (shareholder + other stakeholders), enhanced brand value, easier, preferential, and faster reach to newer markets, customers and investors, proactive management of risks including reputation and regulatory risks are some of the many positives if banks get this right. The flip side is that intense effort is required to lay a sound but flexible foundation. The demand will be both structural and cultural. The optimal way to address this mam-

Centrality of Climate Information Architecture

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moth project is to establish an objective data driven approach, not just to meet stakeholder expectations but also to grow a profitable and sustainable business going forward.

Rewiring Business Models Business models will undergo interesting changes. The important action is to embed climate change risk aspects in both the operative business models, viz. “Run-the-bank” and “Change-the-bank” models to cover the whole gamut of business operations like product planning, pricing, sales strategy, risk management, disclosures/reporting/MIS constructs, profitability and balance sheet planning, HR, and operations practices. Rewiring business models of banks and the way they think of a net zero journey to build its balance sheet with climate risk overlay will be a necessity. Support to clients in their transition journey, green guidelines baked into lending processes including selection of portfolios and activities to finance will be required to move to a sustainable economy.

Policy Setting by Governments Action in the financial sector cannot and will not be able to offset inaction in other areas. Capital requirement or other regulatory responses are not a substitute for policy initiatives from governments and policymakers that will be required for a wholistic approach to transit to low carbon economy. Banks are not and cannot be expected to be the climate police for their clients. Governments can set the tone by facilitating fiscal climate policies like a well calibrated set of taxes and associated actions; for example, carbon taxes, green premium, and emission trading schemes are some of the possible steps. Costs, availability of funds, and enabling a differential that will allow banks to continue to operate in a facilitative environment is critical.

Centrality of Climate Information Architecture I cannot emphasize enough the importance of this aspect as the bedrock of a sound climate change risk management framework. The architecture at the bank level needs to be a flexible, scalable, transparent and lineage traceable set of connected constructs/structures. At the next level, as the IMF rightly urges, there is an “urgent need to strengthen the “climate information architecture.” There are three building blocks needed to support it: (i) high-quality, reliable, and comparable data, (ii) a har-

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monized and consistent set of climate disclosure standards, and (iii) a broadly agreed upon global taxonomy.”1 Central Banks need to be information leaders.

Cognizance of the Aggregation Effect The need for a wholistic approach is critical. There is always the risk that the left hand takes off what the right hand gives. One example of such a situation could be reduction in carbon exposure by financing electric car manufacturing firms on the one hand but offsetting that by an increase in lithium mining which is required for electric car batteries. This is where scope 3 emissions become important as they, along with scope 1 and 2 emissions, bring to fore the aggregated carbon footprint of the firm. This needs to be kept in perspective by banks while making lending decisions as financed emissions are computed as a function of all three scopes of emission. Some of the other pointers that banks will do well to look out or plan for are –

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Potential of rollover risk if a sound credit worthiness exercise has not been done as both the collection possibility as well as unburdening to other lenders will be quite weak if the loan is at risk. With policy makers and regulators seeking to impose a price on carbon, industries/counter parties that either require or sell carbon as part of their businesses will be placed in a hugely disadvantageous position to cope and transition to sustainable options. Early identification of customers in this segment will reduce risk. Proactively working on risk mitigation on the one hand and supporting customers to find a viable, feasible transition path on the other will be the call of the hour. Gathering data from counterparties about their exposure to and management of climate-related risks and opportunities will assist in assessing the viability of the project. Finding credible climate related opportunities in green, sustainable corporates/ businesses and technologies, understanding sector level opportunities as well as risks is a skill set that will stand banks in good stead both for building a strong portfolio as well as avoiding stranded assets. Innovation and creativity in planning and executing unique campaigns to promote new products and services targeting sustainability sensitive customer segments to create value, growth, and brand building. Creating ring fenced products and services for transition financing is a good strategy.

 Caio Ferreira, Fabio Natalucci, Ranjit Singh, Felix Suntheim, IMF Blog, How Strengthening Standards for Data and Disclosure Can Make for a Greener Future, May 13, 2021.

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As this book goes into print the world is challenged by high energy costs, inflationary trends after years of lull, tightening monetary policies, and intensive and intrusive sustainability expectations, not to mention geopolitical realities. These challenge climate commitments and proposed support to transition risks which have a direct social impact, especially on developing countries that will be harder hit because of potential economic headwinds. One of the big dilemmas is determining how much is too much intervention by regulators in different areas like reducing preferences in asset portfolios, adjusting collateral policies, better disclosures, etc. It is a hotly debated topic and requires mature deliberations. Standards and disclosure requirements will continue to evolve. it will take a while to arrive at a common baseline of disclosure/reporting standards that is consistent across geographies for similar sectors/industries/businesses, and probably longer for their implementation across jurisdictions. This will be one of the biggest hurdles to accountability. Convergence across data, metrics (that are transparent not only with respect to inputs, process, outputs, but also the impact on the low carbon goals), measurement methodologies, models, reporting constructs is an evolutionary process. Given this evolving landscape, it is indeed a challenge to turn net-zero pledges into specific timeline actions, particularly in the near term. Having said that, it will be important to make a start with near term milestones, interim targets, and goal posts: from now to 2030 and then on to 2050 will be more practical. Over time these can be refined to become credible, trackable, and achievable signposts towards a low carbon economy. The knowledge, competence and practical wisdom of all stakeholders is in simplifying the process, to the extent possible. First at the blue print stage and then at implementation, as a collaborative and coordinated process. Simplification will be a difficult journey but the outcome is a reward in itself to all the stakeholders. As I have said earlier, climate change risks are real and so is the fact that transiting to net zero ecosystem is in the interest of all stakeholders. The three central themes are timely, orderly and collaborative transition towards a net zero path. Time is of the essence; as Lee Iacocca said: “Even a correct decision is wrong when it was taken too late.”

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List of Abbreviations AI APRA BAU BCBS BES BIC BIS BOE BTAR C & E risks CFO CFRF CIA CGE Models CDP CDSB CIA CO2 COSO CRO CSR CVA CVaR D-SIBs EAD EBIT EBA ECB EFRAG EPC ERM ESG ESRB ESRS EU EU Taxonomy FDIC FP&A FRB FSB FSI FX risk G20 GAR GHG GRI G-SIBs

Artificial Intelligence Australian Prudential Regulation Authority Business As Usual Basel Committee on Banking Supervision BOE’s Biennial Exploratory Scenario Exercise Business Indicator Component Bank for International Settlement Bank of England Banking Book Taxonomy Alignment Ratio Climate and Environmental risks Chief Financial Officer Climate Financial Risk Forum Climate Information Architecture Computable General Equilibrium models Carbon Disclosure Project Climate Disclosure Standards Board Climate Information Architecture Carbon Dioxide Committee Of Sponsoring Organizations of the Treadway Commission Chief Risk Officer Corporate Social Responsibility Climate Vulnerability Assessment Climate Value at Risk Domestic Systemically Important Banks Exposure At Default Earnings Before Interest and Taxes European Banking Authority European Central Bank European Financial Reporting Advisory Group Energy Performance Certificate Enterprise Risk Management Environmental, Social, and Governance European Systemic Risk Board European Sustainability Reporting Standards European Union The EU (European Union) Sustainable Finance Taxonomy Federal Deposit Insurance Corporation Financial Planning and Analysis Federal Reserve Board Financial Stability Board Financial Stability Institute Foreign Exchange risk Group of Twenty Green Asset Ratio Greenhouse Gas Global Reporting Initiative Global Systemically Important Banks

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List of Abbreviations

HKMA HQLAs IAM(s) ICAAP IEA IIA ILAAP ILM IMF IOSCO IPCC IRENA ISO ISSB IT KPI KRI LC LGD ML NBFCs NFR NGFS NRDC OCC OECD OSFI PBOC PCAF PD PG&E P&L Statements PRA RAS RCPs REs RBI RIMS RWA SASB SDG SDRs SEC SME SSM SyRB TCFD UK UN

Hong Kong Monetary Authority High Quality Liquid Assets Integrated Assessment Model (s) Internal Capital Adequacy Assessment Process International Energy Agency Institute of Internal Auditors Internal Liquidity Adequacy Assessment Process Internal Loss Multiplier International Monetary Fund International Organization of Securities Commission Intergovernmental Panel on Climate Change International Renewable Energy Agency International Organization for Standardization International Sustainability Standards Board Information Technology Key Performance Indicator Key Risk Indicators Loss Component Loss Given Default Machine Learning Non-banking Financial Companies Non-financial Risks Network for Greening the Financial System Natural Resources Defense Council Office of the Comptroller of the Currency The Organization for Economic Co-operation and Development Office of the Superintendent of Financial Institutions Canada People’s Bank of China Partnership for Carbon Accounting Financials Probability of Default Pacific Gas and Electric Company Profit and Loss Statements Prudential Regulation Authority Risk Appetite Statement Representative Concentration Pathways Regulated Entities Reserve Bank of India Risk Information Management System Risk Weighted Assets Sustainability Accounting Standards Board Sustainable Development Goals Sustainability Disclosure Requirements US Securities and Exchange Commission Small and Medium Enterprises Single Supervisory Mechanism Systemic Risk Buffer Task Force on Climate-related Financial Disclosures United Kingdom United Nations

List of Abbreviations

UNEP FI USA USGCRP VaR VRF WACI WEF WMO

United Nations Environment Programme Finance Initiative United States of America U.S. Global Change Research Program Value at Risk Value Reporting Foundation Weighted Average Carbon Intensity World Economic Forum World Meteorological Organization

289

List of Figures Figure 1.1 Figure 1.2 Figure 1.3 Figure 2.1 Figure 2.2 Figure 2.3 Figure 2.4 Figure 2.5 Figure 3.1 Figure 3.2 Figure 3.3 Figure 3.4 Figure 4.1 Figure 4.2 Figure 4.3 Figure 4.4 Figure 4.5 Figure 6.1 Figure 7.1 Figure 7.2 Figure 7.3 Figure 7.4 Figure 8.1 Figure 8.2 Figure 9.1 Figure 9.2 Figure 10.1 Figure 10.2 Figure 11.1 Figure 11.2 Figure 11.3 Figure 11.4 Figure 12.1 Figure 12.2 Figure 12.3 Figure 12.4 Figure 12.5 Figure 12.6 Figure 12.7 Figure 12.8 Figure 12.9 Figure 12.10 Figure 12.11

Carnegie Mellon University’s Enterprise Risk Management framework 13 Desirable versus undesirable risk 14 Connected continuum of risk management processes 15 Risk categories 18 Major risk types banks work with 19 Pillar 1 and Pillar 2 risks 19 The different contours of operational risk 20 Representative non-financial risks 21 High level representation of ESG 35 Environmental concepts 37 Social concepts 38 Governance concepts 39 The Economics of Climate 44 Climate change risk drivers 45 The three classes of physical risk drivers 47 The three classes of transition risk drivers 50 Liability risk drivers 53 Broad segmentation of challenges 62 Different stakeholder segments in climate change ecosystem 68 Sample banking industry regulators in climate-related financial risk space 69 Sample of Global Association 73 Other significant players 77 Broad areas of Climate change management for Banks 87 Building blocks for creating a robust climate change risk management framework 90 Principles for effective management and supervision of climate-related financial risks 92 Principles for climate-related financial risk management for large banks (Office of the Comptroller of the Currency) 95 Broad set of components of a Climate change risk appetite statement 97 Cascading effect of climate change risk 104 Broad areas of Data Challenges 106 Key challenges for climate-related data 108 The proactive response to data challenges 110 Data categories 114 The three main components whose interaction results in Climate change risk 118 Conceptual risk assessment framework 121 Amplification of financial system vulnerabilities 125 Sensitive sector mapping 127 Broad steps involved in converting climate risks to financial risks 129 Data categories required for measuring climate-related financial risks 130 Financial risks from climate risk drivers 131 Transmission channels – climate risks to financial risks 132 Indicative models, data and navigation tools from NGFS 136 Sample Model for physical risk assessment 137 Scope 1, 2, and 3 emissions 143

https://doi.org/10.1515/9783110757958-029

292

Figure 12.12 Figure 13.1 Figure 13.2 Figure 13.3 Figure 13.4 Figure 13.5 Figure 14.1 Figure 14.2 Figure 14.3 Figure 15.1 Figure 15.2 Figure 15.3 Figure 15.4 Figure 16.1 Figure 16.2 Figure 17.1 Figure 17.2 Figure 17.3 Figure 17.4 Figure 18.1 Figure 18.2 Figure 18.3 Figure 20.1 Figure 20.2 Figure 20.3 Figure 20.4 Figure 20.5

List of Figures

Mapping of businesses to asset classes 145 Climate scenario lifecycle 157 Components and sequence of operationalizing climate related scenario analysis 165 NGFS scenario classes 166 Climate scenarios range 167 Impact assessment 174 Materiality of climate and environmental risks 177 Natural hazards transmission channels to NPL 179 Risk responses 181 Principles for effective disclosures in the climate-related disclosures space 190 Overview of disclosure obligations in the EU for financial services 195 Overview of EBA disclosures (Pillar 3) with examples 202 Green Asset Ratio components 203 Foundational blocks of climate change risk management operating model 208 Operating model components of climate change risk management 209 The big picture – Links between banking system and climate change 226 Economics of Climate 226 Intra and inter-sectoral links 227 Interconnectedness modes 229 Examples of direct financial interconnectedness 232 Examples of indirect financial interconnectedness 233 Climate Risks aggravate Credit Risk 235 Climate action role holders 257 Pointers for climate change risk management from taxonomies 264 Sample of global organizations that play a significant role in climate change management 266 Next objectives of NGFS 269 View of banks’ concern across different climate risk drivers 270

List of Tables Table 1.1 Table 1.2 Table P.1 Table 4.1 Table 4.2 Table 10.1 Table 11.1 Table 12.1 Table 12.2 Table 12.3 Table 12.4 Table 12.5 Table 13.1 Table 13.2 Table 13.3 Table 13.4 Table 13.5 Table 13.6 Table 13.7 Table 14.1A Table 14.1B Table 14.2 Table 14.3 Table 15.1 Table 15.2A Table 15.2B Table 15.3 Table 16.1 Table 16.2 Table 16.3 Table 18.1 Table 19.1 Table 20.1

Primary risk vocabulary and their dictionary meaning 10 The principal distinction between common terms that are mistaken as synonyms 11 Climate-change related impact on banking risk types 30 Impact of Physical risks on traditional risk categories 48 Impact of transition risks on traditional risk categories 51 Example of a possible corporate bank RAS 101 Sample of data gaps and actions 111 Comparison of models and methodologies 138 The Three scopes and category 15 emissions 144 Financed emissions metrics 144 Sample indicators used by banks 146 Double materiality overview 149 Challenges and barriers in the scenario analysis space 151 Key considerations in designing scenarios 158 Baseline scenario samples 162 Sample climate-risk variables 162 Stages in conducting transition risk scenario analysis 164 Sample of approaches taken by different regulators 168 Sample outputs 172 Design effectiveness 185 Implementation effectiveness 185 Heatmap of control effectiveness 186 Arriving at Residual risk 186 Alignment with supervisory expectation in climate and environmental risk space, a sample 192 Sample climate-related metrics 196 Sample Financial services organizations working with climate change related metrics 200 Types of climate metrics and their pros and cons 204 Climate risk register 217 Controls master 217 Control to risk mapping 217 Impact of climate risk drivers on bank’s core risks 233 Illustration of climate-related financial risks captured in the banking regime, and possible gaps 245 Sample good practices in the climate change space 272

https://doi.org/10.1515/9783110757958-030

About the Author Saloni Ramakrishna, a published author in risk management space, is an acknowledged financial industry thought leader. In this book she brings to bear her three decades of global experience and knowledge of financial services. The distilled wisdom of interactions with different stakeholders of the industry, and experience of technology power is reflected in the vibrant canvas of comprehensive yet practical approach proposed in the book that deftly addresses the nuances of the young and upcoming discipline of “Climate Change Risk” and its management. Ms. Ramakrishna contributes to the industry narrative through her books, blogs, columns, and articles. She has been invited to share her thoughts and views on industry trends surrounding climate change, risk,compliance, and data management, amongst others, by national and international banking and finance forums. Her ideas have appeared as articles, quotes, and interviews. She has presented papers at national and international seminars and conferences. A member of professional risk organizations GARP and PRIMIA, Ms. Saloni Ramakrishna is a Value Architect and Senior Director with Oracle. In her role she regularly interacts with top managers of banks, consulting professionals, financial services bodies, and senior regulators across multiple countries, enriching the industry dialogue.

https://doi.org/10.1515/9783110757958-031

About the Series Editor Moorad Choudhry is an independent non-executive director at Recognise Bank Limited, a non-executive director at the Loughborough Building Society and a non-executive director at the Wandle Housing Association. He is Honorary Professor at University of Kent Business School. He was latterly Treasurer, Corporate Banking Division at The Royal Bank of Scotland. Moorad is a Fellow of the Chartered Institute for Securities & Investment, a Fellow of the London Institute of Banking and Finance, a Fellow of the Global Association of Risk Professionals, a Fellow of the Institute of Directors and a Freeman of The Worshipful Company of International Bankers. He is author of The Principles of Banking (John Wiley & Sons 2012, 2022). Moorad was educated at Claremont Fan Court school, University of Westminster and University of Reading. He obtained his MBA from Henley Business School and his PhD from Birkbeck, University of London. He was born in Bangladesh and lives in Surrey, England.

https://doi.org/10.1515/9783110757958-032

Index absolute emissions 85, 144 academicians 265 accountability 11, 60, 63, 67, 102, 112, 181, 208, 209, 211, 279 acute physical risk 45, 59, 248, 276 adaptation XV, 36, 81, 149, 177, 193, 222, 258, 268 adverse climate change XI, XIII, XV, 3, 33, 37, 40, 41, 43, 44, 46, 47, 55, 58–61, 67, 68, 71, 97, 122, 124, 126, 151, 211, 214, 225, 227, 228, 234, 238, 239, 244, 248, 258, 275 agent based models 138, 141 aggregation 105, 113, 141, 142, 149, 190, 278–279 alternate energy sources 41 amplification 57, 125, 169, 177, 225, 227, 276 amplifiers XIII, 33, 55, 57, 129, 162, 226 assessment 15, 19, 42, 54, 64, 84, 85, 87, 88, 102, 106, 112, 117–148, 151, 153, 154, 156, 171, 173, 175, 181, 182, 184, 185, 188, 195, 200, 206, 212–215, 228, 229, 234, 239, 244, 247, 248, 249, 259, 263, 268, 272–273, 275, 276 asset management 68, 228 asset prices 149, 221 assets XII, 23, 24, 34, 39, 40, 44–50, 54–56, 58–60, 64, 71, 75, 93, 94, 97, 99, 103, 111, 116, 118–120, 122, 124–128, 130, 134, 135, 137, 141, 142, 144, 145, 170, 171, 179, 186, 191, 193, 196, 197, 203, 215, 228, 229, 231, 234, 236–239, 244, 247, 248, 263, 265, 271, 273, 278, 279 assumptions 110, 133, 135, 137–141, 151, 152, 157–161, 258, 259 attribution factor 144, 145 audit 155, 181, 184, 214 bank XI–XVI, 3–6, 9–26, 29–66, 68, 70, 71, 73–78, 81, 82, 84–89, 91, 93–103, 105, 106, 108–110, 112–131, 133, 135, 137, 141, 142, 145–149, 151, 153–156, 160, 161, 162, 166, 169–173, 175, 177–188, 190–193, 199, 200, 206–217, 222–228, 230–244, 246–249, 253–255, 257–263, 265–278 banking XII, 3, 4, 12, 13, 22, 29, 30, 32, 33, 36, 41, 42, 60, 62, 63, 66, 69, 70, 75, 83, 85, 89, 91, 98, 105, 106, 109, 123, 127, 145, 162, 171, 175, 186, 190, 191, 200, 209, 213, 214, 224–228, 245–246 basel 45, 48, 51, 55, 60, 93, 94, 98, 126, 135, 152, 172, 183, 190, 210, 212, 238, 257, 260, 263 baseline 74, 75, 91, 160, 161, 165, 193, 267, 279 https://doi.org/10.1515/9783110757958-033

benchmarking 71, 94, 107, 169, 266 biodiversity 37, 98 biodiversity loss 40, 59 black box 139, 140 black swan 25, 54, 162, 165 blueprint 82, 84, 88, 112–114, 192, 209, 274 board 59, 81, 83, 89, 91, 99, 102, 113, 154, 171, 179, 183, 188, 208, 210, 211 bottom up approach 85, 113, 125, 127, 141–142, 167–169 brown economy 50 brown metrics 62, 203–206 buffers 4, 19, 22, 71, 93, 228, 244, 246, 248, 249, 261 business as usual (BAU) 93, 152, 160, 244 business indicator component (BIC) 247 business model 16, 41, 50, 57, 59, 63, 71, 76, 87, 98, 102, 130, 155, 170, 172, 175, 200, 206, 211, 248, 249, 263, 277 business viability 124, 133, 228 capacity building 107–109 capital XVI, 4, 12–14, 19, 22, 25, 29, 31, 35, 36, 47, 57, 61, 71, 74, 88, 93, 96, 97, 115, 124, 133, 154, 155, 157, 167, 183, 186, 206, 223, 224, 228, 230, 231, 234, 241, 242, 244–249, 253, 260–263, 265, 274, 277 capital adequacy 19, 20, 154, 171, 190, 224, 244, 246, 249, 257 capital planning 12, 93, 212 carbon emissions 51, 61, 64, 99, 110, 116, 117, 120, 170, 222, 241, 259, 271 carbon footprint 41, 61, 63, 116, 117, 120, 142, 193, 199, 200, 228, 273, 278 carbon intensity 85, 103 carbon intensive businesses 76 carbon offsetting 41, 215 carbon price 145, 153, 157 carbon taxes 49, 71, 154, 221–223, 258, 277 catastrophe XI, 123, 133, 162, 177, 180 causal chains 55 causal pathways 43 central banks 24, 36, 44, 65, 70, 71, 74, 162, 226, 265, 268, 278 chronic physical risks 45, 59, 248 classification 6, 18–20, 122, 141, 153, 170, 186, 253 climate action 40, 58, 59, 67, 125, 257, 268

300

Index

climate and environmental risk management 98, 109, 127, 145, 175, 186, 191, 209, 213, 272 climate change XI–XIII, XV, 3, 8, 16, 29–48, 53–55, 58–61, 65–68, 70–73, 76, 78, 81, 82, 85, 87–89, 91, 97, 98, 100, 102, 112, 113, 118–120, 122, 124–126, 128, 129, 131, 141, 149, 157, 162, 165, 169–172, 179–183, 186, 188, 193, 195, 199, 206, 212–214, 222, 224–229, 234, 236–240, 242, 244, 246–249, 253–254, 258, 259, 262, 263, 266–268, 271–275 climate change risk XI–XIII, XV, 3, 4, 6, 8, 16, 18, 21, 25, 26, 29–34, 41, 43–45, 54, 55, 58–60, 62–78, 81–91, 93, 97–105, 107, 109, 112, 114–120, 122–124, 126, 128, 130, 131, 133, 145, 147, 149, 169, 170, 177, 179, 181, 182, 185, 190, 192, 193, 195, 207–217, 224, 226, 228, 231, 232, 234, 236, 240–249, 253, 257, 260–264, 268, 270, 271, 273–277, 279 climate change vulnerability 41 climate data 110, 112, 113, 116, 117, 126, 138, 139 Climate Disclosure Standards Board (CDSB) 195, 267 climate events 40, 47, 54, 116, 236, 238, 239, 260 climate information architecture (CIA) 215, 258, 277–278 climate paths 6, 87, 110, 120, 126, 150, 207, 257, 258, 268 climate ratings 107, 123, 139, 141 climate-related financial risks (CRFR) XIII, 33, 34, 42–57, 62, 64–66, 68–70, 84, 85, 87–89, 91–95, 98, 99, 102–106, 109, 110, 112–115, 117–148, 150, 152, 154, 155, 170, 172, 177–181, 183, 184, 186–188, 190, 193, 208–210, 212, 221–225, 229, 243, 245, 247–249, 253–255, 260–262, 271 climate-related risk indicators 99 climate-related risks 42, 43, 45, 48, 49, 52, 53, 55, 60, 64, 84, 93, 94, 99, 105–116, 122, 123, 125, 126, 131, 135, 151, 153, 155, 162, 170, 172, 175, 179, 180, 186, 188, 189, 191, 210, 213, 241, 242, 253, 254, 257, 260, 278 climate scores 107 climate screening 128 climate value at risk (CVAR) 103, 112, 141, 147 climate vulnerability assessment (CVA) 124–125 climatic patterns 40 collateral 21, 23, 47, 54, 56, 64, 99, 130, 182, 234, 237, 238, 247, 248, 273, 279 commodity prices 22, 23, 71

comparability 65, 105, 107, 200, 267 compliance risk 25, 51, 190, 241 contours of risk 9, 11, 20, 33, 135 control assessment 185 control effectiveness 183–187 control frameworks 178, 179, 181, 183, 213, 214 controllable 14 controllable risks 12 controls 4–6, 9, 12–16, 52, 75, 81, 85, 96, 100–102, 115, 119, 129, 143, 175–187, 211–214, 216, 224, 244, 274 corporate governance 38, 88, 91, 210, 211 corporate memory 16, 103, 112, 215 correlated losses 229, 237 correlation 8, 44, 87, 97, 131, 141, 149, 150, 162, 229, 230, 247, 254, 258 cost of carbon neutrality 108 counterparties 20, 39, 42, 43, 46, 49–51, 55, 56, 59–61, 63, 64, 71, 76–77, 94, 99, 100, 108, 110, 111, 113, 115–118, 120, 121, 123, 124, 126, 137, 141, 142, 154, 172, 177, 182, 234, 236, 237, 241, 278 counter-party credit risk 93 credit risk 4, 20–22, 31, 52, 55, 60, 88, 93, 97, 98, 106, 117–120, 124, 134, 135, 141, 170, 175, 179, 186, 190, 192, 228, 231–237, 239, 241–243, 247, 249, 273 credit valuation 135 creditworthiness 94, 124 crystallization 43, 44, 52, 172, 224, 226, 247 customer behavior 133, 177, 276 cybersecurity risks 4 damage function 118, 134 data architecture 112, 114, 192, 215 data categories 113, 114, 129, 130 data gaps 66, 107, 110, 111, 118, 150, 170, 192, 274 data providers 34, 78, 108, 112 data sets 110, 135, 272 data sourcing 110, 113, 115, 259 decarbonization 71, 142, 221, 253, 254 decision process 14 default risk 21, 22, 236 deferred payments 234 demand elasticities 135 depositors 20, 22, 240, 241, 244 design effectiveness 85, 184, 185 digitization 4, 62 disaster loss model 135, 137

Index

disclosures 25, 34, 41, 51, 53, 60, 62, 63, 65–66, 70, 73–75, 82, 84, 85, 105, 109, 113, 116, 117, 142, 148, 150, 173, 177, 188–207, 209, 212, 214–217, 228, 236, 242–244, 249, 253, 258, 262, 265–267, 272, 273, 276–279 disorderly transition 160, 170, 221, 227, 230, 261 disruption 24, 46, 49, 62, 122, 134, 228, 236–240 disruptive technologies 76, 236 distress sales 237 diversification 6, 11, 22, 98, 229 domestic systemically important banks (D-SIBs) 227 double materiality 63, 120, 148, 210 downside 3, 12, 14, 21 economic adjustment 49 economic costs 45, 46 economic life 60, 125 economics of climate 44, 226 ecosystem XIV, XV, 3, 12, 34, 37, 38, 40, 43, 45, 47, 49, 50, 58, 63, 67, 68, 115, 118, 122, 175, 226, 228, 230, 236, 268, 279 effective risk management 16, 175, 177 emerging risks 84, 105, 119, 190, 260 emission data 59, 106, 110, 116, 117, 166 emission metrics 88 emission targets 82, 88 energy efficiency 37, 61 energy intensity 120 energy performance certificate (EPC) 103, 110 enterprise risk management (ERM) 13, 17, 25, 89, 100, 112, 113, 128, 192, 211, 214, 227 environment XI, XII, XV, 6, 33, 37–40, 49, 54, 62–64, 74, 77, 88, 93, 115, 120, 124, 152, 153, 175, 177, 179, 182, 190, 210, 222, 275, 277 environmental aspect 37 environmental risk 37, 52, 98, 109, 127, 145, 175, 176, 186, 191, 209, 210, 213, 274 environmental social and governance (ESG) XI, 33, 35, 41, 263 environment protection 49 equity 4, 23, 55, 77, 144, 192, 237, 247 equity risk 22, 23 erosion 3, 47, 223 ESG factors 35, 39, 52, 128 ESG principles 36 ESG risks 21, 39, 200 estimates XV, 52, 53, 60, 87, 106, 126, 133–135, 137, 145, 151, 154, 155, 182, 200, 253, 260

301

European Systemic Risk Board (ESRB) 228, 253, 261 evaluation 4, 17, 120, 124, 152–154, 181, 200 evaluation process 14 exchange rates 22, 55, 231 execution process 14 expert judgement 117, 149, 184 exploratory scenarios 151, 156 exposure XV, 5, 9, 10, 12, 31, 40, 42, 46, 47, 55, 64, 66, 75, 88, 89, 91, 93, 94, 96, 98, 99, 105, 106, 113, 115, 117–124, 126, 129, 130, 131, 134, 135, 137, 141, 142, 147–148, 153, 154, 161, 162, 169, 170, 172, 175, 177, 178, 179, 182, 185, 186, 188, 190, 192, 200, 206, 211, 215, 226, 227, 229, 232, 236, 239, 242, 247, 248, 249, 260–263, 267, 271, 272, 278 exposure at default (EAD) 115 external factors 24 extreme event 16, 64 extreme weather 40, 59, 101, 223 extreme weather events 45, 46, 64, 182, 221, 228, 238, 239 feedback loops 44, 118, 150 financed emissions 75, 85, 88, 142, 144, 145, 188, 195, 198–200, 268, 273, 278 financial industry 3, 258 financial institutions XV, 12, 42, 46, 52, 65, 75, 82, 109, 117, 137, 142, 152–154, 198, 199, 228, 253, 254, 259, 268, 271 financial intermediaries 21 financial intermediation 3 financial models 118, 137, 153 financial performance 35, 135 financial risks XIII, 3, 5, 6, 18, 20, 21, 24, 26, 33, 34, 37, 40–59, 62–66, 68–70, 76, 84, 85, 87–89, 91–95, 98, 99, 102–106, 108–110, 112–115, 117–150, 154, 155, 170, 175, 177–181, 183, 184, 186–188, 190, 193, 208–213, 221–225, 227, 229, 231–243, 245–249, 253–255, 258, 260–263, 271, 275 financial services industry XI, XII, XVI, 4, 34, 68, 71, 73, 91, 276 Fintech 4 first line of defense 181, 213 forecast 64, 65, 131, 133, 135, 149, 150, 151, 152, 212 fossil fuel 31, 49, 60, 61, 76, 99, 116, 125, 186, 237, 242, 249, 265, 271, 274 framework XIII, XVI, 3, 6, 12, 13, 17, 29, 59, 65, 66, 72, 74, 81, 82, 84, 86, 88–90, 91, 94, 95, 99,

302

Index

100, 102, 112, 113, 121, 124, 128, 129, 135, 142, 148, 153, 162, 166, 172, 174, 175, 177–179, 181–183, 192, 193, 200, 207–215, 242, 244, 246, 247, 249, 257, 259, 260, 261–263, 267, 273, 277 frequency 45–48, 54, 87, 103, 111, 124, 126, 129, 135, 161, 221, 228, 230, 236 geographies XV, 3, 15, 23, 43, 56, 60, 63–65, 70, 72, 74, 94, 96, 119, 123, 126, 127, 130, 133, 141, 142, 167, 177, 179, 182, 184, 215, 216, 229, 248, 270, 271, 279 geopolitical risks 4, 25 GHG accounting 75, 142 global organizations XI, XII, XIV, XV, 36, 42, 85, 110, 131, 135, 151, 192, 248, 258, 262, 265, 266, 268, 271 global systemically important banks (G-SIBs) 74, 227 global warming 36, 43, 119 going concern 12 governance 15–17, 25, 33, 35, 38–39, 52, 63, 73, 86, 88, 91, 93, 105, 174, 181, 183, 188, 190, 195, 207, 208, 210, 211, 214, 271, 272, 271 governments XII, 34, 48, 49, 56, 60, 67, 71–72, 112, 115, 222, 257–258, 265, 267, 277 granularity 63, 105, 106, 108, 110, 113, 117, 141, 149, 154, 192, 215, 263, 272 green asset ratio (GAR) 106, 193, 198, 200, 202 green banking 63 green bubble 64, 120, 265 greener options 61, 76 greenhouse gas emission 36, 37, 40, 41, 74, 78, 103, 116, 120, 170, 188, 189, 203, 222, 230, 246 greenhouse gases 40, 61, 74, 142, 182, 221, 222, 268 green options 182, 276 green sector 88 green swan 54, 117, 162 green technologies 41, 60–62, 237, 258 green zone 88 gross 72, 135, 177, 221 guidelines 25, 66, 70, 98, 221, 253, 277 hazard XV, 9, 10, 11, 36, 118, 122, 123, 129, 134, 135, 153, 178 heatmap 147, 184, 185, 210 heterogeneity 56, 91, 107, 117, 123, 141, 260 high impact 133, 162, 276 hybrid 113, 167–169, 208

IFRS s1 267 IFRS s2 267 impact XI–XIII, XV, XVI, 3, 4, 6, 8, 10, 12–14, 16, 18–21, 23–26, 29, 30, 33–37, 39–44, 46–61, 63–67, 70–73, 76, 77, 81, 85, 87, 89, 91, 93, 94, 97–99, 102, 105, 106, 112, 115–120, 122–131, 133–135, 137, 141, 145, 148, 149–151, 153–155, 157–160, 162, 165, 167, 169–173, 175, 177, 178, 179, 182, 183, 186, 188, 189, 190, 192, 193, 195, 199, 200, 206, 210, 212, 214, 221–225, 227–234, 236–242, 244, 247–249, 257–260, 263, 268, 270, 271, 273–276, 279 implementation effectiveness 85, 184, 185 inaction XV, 10, 59–61, 102, 109, 275, 277 income 60, 241, 247 indicators 71, 78, 85, 98, 99, 110, 112, 113, 116, 124, 145–147, 177, 185, 186, 195 industry XI–XIII, XVI, 3, 4, 13, 29, 31, 34, 49, 62–64, 67–71, 73, 76, 91, 94, 98, 113–117, 119, 122, 123, 126, 128, 133, 135, 137, 141, 142, 149, 151, 175, 177, 182, 186, 191, 192, 195, 221, 229, 236, 249, 253, 254, 255, 258, 260, 266–268, 270, 276, 278, 279 inflation 55, 71, 133, 190, 223, 238, 279 infrastructure 46, 47, 61, 105, 190, 228, 236, 239, 240 inherent risk 183–185 insurance 36, 46, 51, 57, 68, 101, 115, 123, 177, 180, 182, 221, 222, 228, 230, 238, 244 integrated assessment model (IAM) 139 interconnection 118, 122, 228, 229, 246 interest rate risk 22, 23, 55 interest rates 22, 23, 55, 71, 153, 231, 238, 247 Intergovernmental Panel on Climate Change (IPCC) 72, 165, 268 interlinks XIII, XV, 18, 21, 26, 89, 129, 131, 134, 221–243, 249, 258 internal loss multiplier (ILM) 247 International Monetary Fund (IMF) 65, 78, 112, 131 interpretation risk 25–26, 66 invested assets 39, 46, 49, 55 investment 4, 22, 31, 49, 51, 56, 60, 61, 71, 74, 75, 78, 81, 118, 120, 122, 123, 124, 126, 128, 130, 148, 169, 186, 192, 200, 223, 228, 230, 236–238, 241, 242, 258, 265, 266, 268, 271, 274, 276 investor preferences 228, 238 key risk indicators (KRIs) 98, 99, 177, 185, 186

Index

learning period 131 legal risk 24, 45, 51, 52, 175, 221, 240–241 liabilities 23, 45, 48, 51, 53, 56, 63, 64, 119, 127, 137, 231, 239, 240, 241 liability risk 41, 44, 45, 51–53, 65, 98, 126, 181, 185, 191, 193, 210, 215, 240, 247, 274 likelihood 9–11, 42, 56, 87, 124, 126, 129, 135, 148, 183, 230, 270, 275 limit setting 123 liquidity 4, 22, 23–24, 30, 39, 55, 59, 61, 63, 93, 105, 118, 155, 157, 175, 186, 206, 213, 223, 224, 228, 231, 234, 237–239, 244, 247 liquidity buffer 93, 228 liquidity risk 6, 20, 22–24, 56, 93, 97, 129, 134, 155, 177, 190, 231, 234, 238–239, 243 listed equity 144 litigation risks 52 location 10, 47, 89, 108, 113, 115–116, 118, 122, 126, 129, 237, 248, 263, 275 loss component (LC) 247 loss given default (LGD) 135, 234, 237, 247, 261 low-carbon economy 48, 49, 60, 61, 68, 71, 76, 87, 117, 134, 172, 177, 192, 209, 221, 223, 227, 241, 257–259, 261, 266, 270, 275, 277, 279 low probability events 133, 149, 162, 276 macroeconomic 43, 55, 63, 71, 78, 82, 131, 190, 270 macroeconomic channels 55, 236, 237 macroprudential 190, 228, 229, 248, 253, 260–262 magnitude 10, 12, 25, 120, 135, 150, 166, 178, 225, 228, 260, 275 market disclosures 244 market risk 20, 22–23, 48, 56, 93, 97, 119, 134–141, 186, 228, 231, 233, 237–238, 247, 249 market value 103 material risks 15, 21, 126, 156, 210, 247 materiality 63, 120, 148, 175–177, 210, 211, 263, 270 materiality assessment 175, 263, 272–273 measurability 6, 10, 19, 121 measurable uncertainty 9 measurement 5, 6, 9, 15, 62, 64–65, 81, 84, 85, 106, 113, 114, 117–148, 152, 154–155, 183, 186, 214, 236, 249, 265, 266, 273, 275, 279 medium appetite 102 method XII, 19, 66, 85, 101, 113, 119, 123–125, 133, 141, 154–155, 222, 249, 262, 265, 266 methodologies 34, 62, 85, 88, 98, 106, 109, 111, 113, 114, 117, 118, 121–123, 129–134, 137, 138–142,

303

152, 154, 155, 172, 177, 181, 192, 214, 230, 253, 254, 273, 275, 279 metrics 62, 63, 66, 72, 73, 85, 88, 99, 103, 107, 108, 111, 117, 120, 130, 131, 141, 142, 144, 145, 161, 174, 175, 179, 188, 189, 195–200, 203–205, 213, 249, 262, 273, 279 microeconomic channels 55 micro-prudential 68, 190, 225, 248, 260 mitigant 57, 129, 135, 177, 182, 247, 273 mitigation XV, 15, 43, 52, 58, 74, 84, 85, 96, 100, 102, 115, 119, 126, 141, 142, 148, 149, 160, 172, 175–187, 193, 221, 222, 228, 229, 242, 246, 258, 268, 278 model risk 131, 133, 175 models 16, 20, 24, 41, 50, 57, 59, 63–65, 71, 76, 81, 85–87, 98, 102, 105, 107, 109, 112, 113, 117, 118, 123, 128, 130, 131, 133–142, 149, 150, 153, 155, 169, 170, 172, 175, 184–187, 192, 200, 206–217, 237, 247–249, 253, 258, 263, 265, 273, 277, 279 mortgage 22, 50, 54, 120, 125, 126, 133, 135, 144, 187, 192 multiplier effect 21, 62, 229, 276 national authorities 52 natural capital 35, 139 natural disasters 4, 13, 24, 56, 123, 135, 178, 236 net 25, 93, 135, 177 net zero 31, 40, 41, 58, 59, 63, 71, 72, 76, 88, 98, 102, 106, 142, 175, 192–194, 200, 211, 215, 221–222, 230, 236, 237, 240, 242, 253, 259, 273, 274, 277, 279 non-banking financial companies (NBFCs) 228 non-financial 13, 40, 43, 54, 190, 200, 225, 263, 267 non-financial risks 6, 18, 20, 21, 44, 54, 55, 56, 63, 88, 95, 117, 122, 129, 213, 224, 231–243 non-linear 44, 47, 64, 118, 133, 225, 226, 230, 257 normative scenarios 156 objective XIII, XVI, 3, 4, 6, 8–14, 18–20, 33, 36, 50, 57, 61, 68, 72–74, 76, 78, 84, 86, 89, 91, 96, 99, 100, 102, 106, 120, 123, 124, 128, 137, 152, 157, 161, 169–170, 172, 175, 179, 181, 184, 185, 190, 199, 208, 210, 211, 213–215, 224, 240, 242, 259, 261, 267–269, 277 obligations 20, 22, 23, 56, 194, 239, 265 open source 108, 115 operating model 24, 85, 112, 207–217 operational risk 6, 12, 20, 22, 24, 25, 56, 93, 97, 134, 175, 177, 190, 231, 234, 239–240, 244, 247

304

Index

operational structures 215–217 operations framework 208, 209, 214–215 opportunity 3, 4, 9, 12, 16, 41, 57–61, 63, 66, 74, 75, 93, 100, 122, 137, 173, 188, 189, 197–199, 213, 214, 223, 271, 274, 276, 278 opportunity loss 10, 241 ownership 100, 102, 112, 121, 209 pandemic risk 4, 25 Paris agreement 36, 74, 97, 99, 200, 222 Paris climate protection agreement 36 physical capital 47 physical risk 29, 30, 43–48, 52, 54, 56, 57, 59, 65, 67, 94, 97, 101, 103, 113, 116, 117, 119, 122, 123, 125, 126, 129, 130, 134, 135, 137, 146, 150, 161–162, 169, 178, 180, 185, 191, 192, 196, 221, 223, 229, 233–234, 236, 238–240, 242, 248, 257, 275, 276 Pillar 1 19, 20, 231, 244, 245, 247, 260 Pillar 2 19, 20, 231, 244, 245, 247, 261 Pillar 3 200, 201, 244, 262 plausible 58, 120, 131, 137, 149–155, 162, 221 policy 6, 17, 24, 25, 29, 31, 37, 39, 41, 48, 49, 54, 56, 58–60, 62, 64, 70–72, 78, 88, 93, 98, 112, 113, 117, 120, 122, 125, 126, 127, 141, 151, 153, 154, 159, 160, 170, 173, 179, 181–183, 185, 190, 208, 211, 212, 221, 237, 238, 242, 254, 257, 258, 260, 265, 266, 270, 277, 279 policy holders 244 policymakers XII, 33, 34, 36, 54, 56, 61, 67, 71–72, 76, 156, 188, 193, 257, 258, 267, 271, 277, 278 portfolio alignment 124, 173, 213 practitioner XI–XIII, XVI, 5–8, 29–34, 70, 81–86, 161, 206, 221–224, 253–255, 275 precipitation 45, 46, 236 preindustrial levels 36 price 22–24, 56, 64, 71, 116, 133, 149, 151, 153, 158, 170, 221–223, 237–239, 253, 273, 278 price corrections 237 price risks 4 principle XVI, 4–6, 12, 25, 31, 36, 38, 54, 70, 75, 77, 82, 84, 88, 89, 91–95, 98, 99, 105, 126, 134, 155, 169, 172, 177, 179, 181, 183, 188, 189, 190, 192, 210, 212, 214, 244, 272 principles for climate-related financial risk management for large banks 89, 94, 95, 99, 153, 179, 179 principles for the effective management and supervision of climate-related financial

risks 84, 89, 91, 92, 94, 105, 110, 155, 172, 177, 179, 183, 190, 210, 212 proactive XVI, 4, 12, 41, 52, 59, 68, 85, 88, 109, 110, 124, 149, 175, 179, 182, 184–186, 215, 268, 274, 276, 278 probability 9–12, 54, 120, 133, 141, 162, 260, 276 probability of default (PD) 135, 234, 237, 247 profitability 3, 105, 117, 175, 186, 228, 234, 236, 237, 277 proportionality 94 proxies 82, 103, 110, 114, 115, 129, 149, 186, 258 Prudential Regulation Authority (PRA) 244, 246, 248 qualitative 82, 98–104, 117, 123, 134, 141, 149, 186, 190, 192, 273 quantification 19, 63, 82, 121, 128, 130–134, 141, 150, 200 rating agencies 34, 78, 128, 265 real economy XIII, 6, 44, 57, 134, 221–228, 238, 257, 258, 270 real estate 46, 98, 125, 134, 135, 144, 182, 192, 236 regulated entities (REs) 93, 99, 182 regulator XII, XIV–XVI, 12, 19, 23, 26, 29, 33, 34, 36, 42, 43, 54, 60, 61, 65–72, 76, 81, 84, 85, 88, 89, 91, 93, 109, 110, 117, 124, 127, 137, 151, 156, 166–169, 173, 188, 190–193, 221, 225, 237, 242, 244, 246, 248, 249, 254, 255, 258–263, 265, 267, 268, 271, 274, 275, 278, 279 regulatory reporting 41 remediation 182–183, 187 renewable energy 49, 61, 71, 116, 222 repayment 4, 21, 40, 76, 77, 171 reporting standards 75, 111, 142–145, 195, 262, 267, 268, 279 representative concentration pathways (RCPs) 155 repricing 30, 238 reputational risk 4, 24–25, 45, 134, 241–243 residual risk 183–185 resilience 4, 8, 41, 89, 126, 137, 149, 151, 155, 166, 170, 173, 188, 189, 206, 207, 211, 213, 222, 246, 248, 249, 261 revenue 13, 77, 102, 135, 137, 236, 237, 241, 274 risk XI–XIII, XV, XVI, 3–6, 8–26, 29–34, 37, 39–78, 81–157, 161–163, 165, 166, 169, 170, 172, 173, 175–193, 195, 199, 200, 206–216, 221–249, 253–255, 257–265, 268, 270, 273–279

Index

risk appetite 12, 14, 15, 17, 76, 81, 84, 88, 89, 96–104, 115, 119, 123, 124, 160, 173–175, 177–179, 182, 184, 186, 206, 208, 210, 211, 271, 273 risk assessment 42, 64, 106, 120–126, 129, 134, 135, 137, 141, 148, 156, 206, 229, 259, 276 risk avoidance 12, 14, 85, 100, 179–180 risk capacity 96 risk categories 6, 8, 15, 18, 20–22, 24–26, 40, 43, 48, 51, 52, 56, 59, 63, 87, 93, 94, 97, 98, 100, 119, 122, 130, 141, 177, 179, 180, 185, 186, 190, 210, 224, 227, 230–232, 240, 273 risk classification 18, 122, 141, 170, 186 risk concentrations 94, 154, 175, 177, 182 risk culture 16 risk data 84, 105–116, 129, 186, 190 risk drivers XIII, 16, 24, 33, 42–46, 48, 49, 52–58, 60, 65, 81, 94, 105, 113, 116–120, 126, 128–131, 133, 134, 141, 149, 151, 155, 162, 175, 177, 181, 191, 193, 210, 214, 224, 226, 229, 232, 233, 236, 240, 241, 248, 257, 259, 270 risk hedging 12, 14 risk information management system (RIMS) 15, 17 risk management XI–XIII, XV, XVI, 3–7, 9–18, 25, 26, 29, 30, 34, 59, 62–67, 73, 74, 81, 82, 84–91, 93–96, 98–100, 104, 109, 112, 113, 115, 117, 121, 124, 127, 128, 133, 142, 145, 149, 153, 172, 173, 175, 177, 179, 181, 182, 186, 189–193, 200, 206–217, 223, 230, 231, 243, 244, 246–248, 254, 260, 263–265, 268, 270–272, 274, 275, 277 risk mitigants 177, 273 risk offsetting 135, 177 risk profile 19, 82, 91, 93, 94, 126, 155, 175, 177, 190, 206, 214, 224 risk register 30, 215, 216 risk response 17, 148, 179, 180, 210, 261 risk-return 4 risk tolerance 17, 96, 100, 102, 119, 123, 179, 184 risk transfer 12, 14, 57, 101, 115, 180, 230, 260, 275 risk transmission 43, 44, 55, 73, 126, 133 risk weighted assets (RWA) 71, 244 risk weights 31, 244, 248, 260 scalable 84, 112–114, 192, 215, 277 scenarios 23, 25, 54, 58, 64, 65, 74, 81, 82, 84, 85, 87, 93, 96, 99, 105, 117, 118, 120, 124–126, 129, 131, 135, 137, 138, 141, 148–174, 182, 188–190, 206, 210, 230, 236, 242, 249, 258, 261, 265, 266, 268, 273–275 scope 1 75, 85, 112, 120, 142, 143, 188, 189, 195, 278

305

scope 2 75, 85, 107, 110, 112, 120, 142, 143, 188, 189, 195, 278 scope 3 75, 85, 107, 110, 120, 142, 143, 188, 189, 195, 253, 278 scope 3 category 15 emissions 142, 143 scopes 1–3, 103, 106, 108, 116 scoring models 128 second line of defense 181, 214 sectors XI, XV, 29, 31–33, 43, 44, 46, 48, 49, 58, 61, 63, 70, 74, 76, 88, 94, 98, 99, 109, 110, 115, 119, 120, 122, 123, 126–130, 134, 135, 137, 141, 145–147, 149, 153, 154, 175, 177, 179, 182, 186, 190–192, 209, 213, 222, 228, 229, 236, 237, 249, 259–261, 263, 270, 275–279 sensitivity 57, 85, 108, 110, 113, 116, 124, 126, 137, 138, 151–154, 253 severity 43, 45, 46, 48, 54, 56, 124, 126, 129, 134, 135, 148, 161, 216, 221, 228, 230, 270, 275 shadow carbon price 198 shareholder’s stake 4 small and medium enterprises (SMEs) 76, 117, 200 societal activism 61 solvency 35, 93, 105, 175, 234, 237 source XII, 4, 5, 13, 23, 41, 49, 61, 63, 70, 73, 75, 76, 78, 108, 110, 113–116, 118, 123, 128, 130, 131, 142, 149, 165, 177, 184, 222, 223, 236, 241, 259, 260 sovereign 35, 56, 223, 238 spillover effects 54, 221–224, 231 stakeholders XI, XII, XV, XVI, 3, 6, 18, 34, 35, 38, 53, 58, 60, 63, 67, 68, 71, 76–78, 81, 82, 91, 95, 100, 103, 116, 161, 175, 187, 188, 192, 193, 195, 209, 221, 240, 255, 257–259, 262, 265, 270–272, 275–277, 279 standards 16, 17, 25, 32, 38, 43, 50, 62–66, 68, 70, 73–75, 91, 106, 107, 114, 129, 142–145, 177, 179, 192–195, 198, 200, 211, 222, 223, 244, 247, 255, 261–263, 266–268, 272–274, 278, 279 statistical methods 140 stock prices 22, 56 stranded assets 49, 56, 59, 60, 119, 125, 229, 236, 237, 239, 278 strategic objectives 13, 86, 96, 157, 213, 214 strategic risk 4, 6 strategy framework 209–212 stress test 54, 64, 65, 70, 74, 81, 84, 85, 99, 105, 124, 129, 137, 138, 148–174, 182, 186, 190, 230, 242, 249, 253, 261, 265, 274 structural framework 208–209, 212–215

306

Index

sub-types 20, 23 supervision 19, 68, 70, 74, 89, 91, 92, 94, 105, 109, 110, 155, 172, 177, 179, 183, 190, 210, 212 supervisory expectations 109, 191, 209, 263, 272, 274 supervisory oversight 207 supply chain 37, 46, 62, 101, 107, 110, 115, 116, 126, 228, 236, 240 support functions 214 sustainability XI, 3, 4, 8, 36, 41, 54, 58, 62, 63, 65, 66, 70, 74, 77, 93, 103, 111, 116, 124, 175, 182, 192, 193, 200, 211, 214, 249, 253, 262, 263, 265, 267, 278, 279 sustainability disclosure requirements (SDRs) 262 sustainability initiatives 4, 41, 265 sustainable development goals (SDG) 36, 254 sustainable economy 49, 50, 57, 71–72, 74, 277 sustainable finance 63, 68, 70, 75, 99, 188, 241, 258, 265, 271, 276 systemic risks 43, 60, 68, 127, 149, 224, 225, 228, 242, 261, 275 targets 40, 51, 64, 72, 75, 82, 88, 96, 98, 102, 103, 123, 124, 142, 154, 171, 177, 179, 188, 189, 195–198, 211, 221, 222, 241, 253, 258, 278, 279 taxonomy 34, 65, 72, 85, 200, 202, 214, 258, 263–265, 272–274, 278 technology 4, 13, 15, 17, 23, 24, 36, 41, 48, 49, 60, 61, 62, 76, 82, 101, 110, 112, 126, 151, 159, 215, 222, 230, 236, 237, 240, 254, 258, 265, 274, 276, 278 technology risks 4, 221 third-party 111, 131, 141 threat 3, 24, 40, 59, 62, 94, 173, 225, 239, 240, 276 thresholds 99, 103, 131, 148, 174, 177, 180, 211, 225 time horizon 40, 63, 65, 81, 87, 89, 120, 122, 129–131, 134, 138–141, 149, 150, 155, 161, 162, 172, 210, 253, 257, 261 tipping point 118, 133, 225, 228 toolkit XIII, 186, 244 tools 61, 64, 71, 78, 85, 93, 100, 112, 117, 121, 124, 128, 134, 136, 149, 150, 152, 154, 161, 186, 200, 210, 215, 230, 246, 258, 260, 261 top down approach 85, 113, 127, 141, 167–169 trajectories 58, 63, 77, 82, 120, 155, 200, 224, 227, 230, 239, 259, 273 transition risk 29, 30, 42–44, 48–60, 67, 75, 94, 98, 100–103, 110, 113, 116–120, 123–125, 129, 130,

134, 135, 140–142, 146, 147, 149, 150, 154, 155, 162, 163, 165, 183, 185, 192, 196, 200, 221, 222, 229–234, 236–237, 241, 247, 248, 259, 270, 273, 279 transmission channels XIII, 33, 34, 42, 43, 45, 48, 52, 55–58, 60, 81, 116, 129–132, 151, 175, 178, 226, 236, 237, 241 typology 126, 154–155 uncertainty 5, 9–11, 40, 62, 64, 66, 87, 118, 129, 133, 149, 152, 154, 156, 162, 172, 207, 225, 230, 231, 239, 247, 257, 258, 260, 261 undesirable risks 14 unexpected losses 12 upside 3, 4, 12, 14 usage 3, 63, 113, 115, 116, 120, 181, 195, 274 valuation 128, 135, 179, 228, 238, 248, 273 value 4, 6, 8, 9, 13, 14, 20, 24, 32, 39, 45, 47–49, 54, 56, 64, 65, 74, 75, 93, 103, 112, 114, 119, 120, 130, 134, 135, 141, 144, 162, 184, 203, 228, 229, 231, 234, 236, 237, 239, 247, 248, 276, 278 value at risk (VaR) 135, 260 value creation XII, 3, 17, 39, 179, 211, 274 Value Reporting Foundation (VRF) 195, 267 variables 55, 63, 71, 81, 85, 107, 122, 128–130, 137, 142, 153, 154, 158, 161–162, 171, 237–238, 247, 249, 261 viability 58, 63, 88, 120–122, 124, 133, 228, 234, 237, 244, 276, 278 viable cost 23, 56, 66, 93, 223, 228, 237, 238, 247 volatility 23 volatility risks 22–23 vulnerability 9–11, 16, 41, 50, 70, 105, 108, 113, 116, 118–119, 122–125, 127, 135, 137, 147, 151, 153, 170, 172, 177, 178, 182, 228, 242, 249, 263 vulnerable events 10 weather patterns 44, 47, 122, 221, 223 weather risks 47 weather variability 45, 116 weighted average carbon intensity (WACI) 85, 144 what if analysis 137 World Bank 78, 128, 131 zero appetite 102 zero-carbon technologies 49 zero risk tolerance 100, 102

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