Building financial resilience: Integrating climate risk into the prudential risk framework
Bloomberg Professional Services
With climate-related events increasingly impacting financial stability, central banks and regulatory bodies are working hard to integrate climate risk considerations into risk management and regulatory reporting.
On the back of Bloomberg’s recent Toronto Sustainable Finance Forum, Dharrini Bala Gadiyaram, Global Head of Enterprise Risk Product at Bloomberg, shares some best practices for integrating climate risk considerations in risk management and regulatory reporting and how financial leaders can best prepare for the challenges ahead.
What do you think is the biggest challenge companies are facing in effectively measuring, managing, and mitigating climate risks?
Regulations related to climate stress testing and risk management, especially in Canada, have been evolving over the last 5-7 years and have not been a surprise to market participants. However, the primary challenges that financial institutions face in climate risk management lie in the effective incorporation of these risks into the traditional risk management pillars of credit, market, liquidity, and operational risks rather than looking at them as a separate pillar.
The introduction of regulations such as the Office of the Superintendent of Financial Institutions (OSFI) B-15 indicates that the quantification of climate risk has matured significantly, but there continue to be open questions about incorporating it into financial reporting and the implications it may have from an audit perspective.
Companies that invest across different sectors can be exposed to a large variety of physical and transition risks, and effective measurement of climate risk involves a significant investment in collecting the vast amount of data required. The move of climate disclosures from voluntary to mandatory is expected to accelerate collective solutions across the market to address these data gaps.
Disclosure requirements on material climate-related risks are on the horizon. How can financial leaders prepare?
Banks, insurers, investment managers and other financial institutions in scope for climate reporting need to enhance their climate risk programs and practices in order to meet the regulatory requirements. Many firms started this journey years earlier by initiating voluntary compliance with climate disclosures under the Task Force on Climate-Related Financial Disclosures (TCFD) framework. Regulators have been careful not to move too quickly due to the magnitude of changes, new datasets, and technology required.
“Climate risk needs to be incorporated as a factor enhancing decision-making in the other risk management pillars rather than instituting net new practices at these institutions.”
Dharrini Bala Gadiyaram, Global Head of Enterprise Risk Product at Bloomberg
Since climate risk is about the incorporation of long-term causality, the net new needs include forward projections of climate, macroeconomic, and company-level data, along with climate data science. Climate risk needs to be incorporated as a factor enhancing decision-making in the other risk management pillars rather than instituting net new practices at these institutions.
What are some best practices for integrating climate risk considerations into risk management frameworks?
Financial institutions need to recognize that climate risk management will continue to evolve rapidly as a discipline, filling gaps in the market around data availability and methodology consensus. It is important to build a framework that is agile enough to react to these evolutions.
Additionally, it is important not to look at transition and physical risk as independent pillars; transition risk factors such as carbon emissions, carbon capture storage costs, and energy technology costs need to be integrated with acute and chronic physical risk factors to arrive at a credible approach. Transition risk may be more aligned with datasets that financial institutions are used to dealing with, but datasets required for physical climate risk assessment are expansive and difficult to organize.
Frameworks such as OSFI B15 reflect this challenge—transition and market risk modules involve translating credit risk impacts, but physical risk only goes as far as exposure identification rather than translating to financial impact. For most banks, the first step in incorporating climate into risk management frameworks occurs through the lens of credit risk as a factor in making lending decisions.
What is the first step companies can take in building resilience against climate-induced financial risks?
The first step is risk identification —recognizing which geographical regions, customers, sectors, or sub-sectors may be most sensitive to physical or transition risk drivers. Most of the market is currently focused on this.
The next steps would be scenario analysis and setting limits similar to the standard risk management framework; this will require consensus on methodology and improving data availability, which will take a lot of work across the market. This process will be iterative to a certain extent because the methodologies that the market chooses to converge towards for translation to credit and market risk will also dictate what metadata is needed at the company level, asset level, and other sources.
Beyond this come mitigation strategies. When companies disclose significant risks, they will need to plan how to communicate this to regulators and investors alongside their plans to mitigate the risk. The design of effective mitigation plans involves incorporating climate risk in investment decision-making, as it could come in the form of capital allocation towards renewable energy sources or divestment from high-risk physical assets.