Climate emergency: financial institutions prepare for climate-related stress tests

Jonathan WatsonThursday 10 December 2020

Stress tests that focus on the impact of climate change are moving up every financial regulator’s agenda. These tests – which show what would happen in various hypothetical situations – are used by regulators to reveal whether banks, building societies and insurance companies hold enough capital to meet sudden and unexpected losses.

The change has come in recent years as the financial sector has realised that climate change is likely to play a major part in these disruptive scenarios.

According to a November report from the international Financial Stability Board (FSB), ‘three-quarters of financial authorities are now considering climate risks in their financial stability monitoring and some are starting to quantify those risks’.

You need to prepare, or you will be caught out at a stage where you will not be able to react, both at micro and macro level

Klaus Löber,
Senior Vice-Chair, IBA Banking Law Committee

The FSB is playing a key role in this. It set up the Task Force on Climate-Related Financial Disclosures (TCFD) in 2015 to develop consistent climate-related financial risk disclosures for use by companies, banks and investors when they provide information to stakeholders.

The European Central Bank (ECB) plans to conduct a stress test in 2022 on climate-related risks. In late November, it published a guide to climate-related and environmental risks which explains how the ECB expects banks to manage and disclose these risks under current prudential rules. Further details are due to be provided in 2021.

In addition, in its Strategy on Sustainable Finance, published in February, the European Securities and Markets Authority said that ‘more analysis will be done to analyse financial risks from climate change, including potentially climate-related stress testing in different market segments’.

In the UK, the Bank of England (BoE) plans to launch its climate stress tests for commercial lenders in June 2021. They had originally been planned for the second half of 2020 but were delayed due to the Covid-19 pandemic. According to BoE Governor Andrew Bailey, the exercise will consider three different scenarios over a 30-year period.

This year, the Australian Prudential Regulation Authority has said that it would be undertaking a climate change financial risk vulnerability assessment. The analysis will be carried out in conjunction with the Reserve Bank of Australia.

‘Despite all this work, we are still only in the initial stages’, says Klaus Löber, Senior Vice- Chair of the IBA Banking Law Committee and Head of Division at the ECB. ‘That requires significant shifts, reallocations and a change of emphasis. All provisioning for climate risk will affect your baseline, unless you are in the fortunate situation of offering highly specialised insurance products that other financial institutions need to buy.’

There needs to be a degree of global convergence when assessing the challenges posed by climate change, Löber says. ‘Institutions need to act globally, because you want to have some similarity of approaches to avoid having a very fragmented reaction from individual national regulators.’

The Covid-19 pandemic has served to sharpen banks’ focus on climate-related challenges. And more pandemics are probably on the way. For example, some 90 per cent of bats living in Southeast Asia are predicted to migrate to other parts of the world by 2050 due to their changing habitat. Scientists believe there are some 3,000 types of coronavirus circulating among these bats.

‘There is a good deal of research drawing a connection between the threat to biodiversity and pandemics’, says Jeff Twentyman, a partner at Slaughter and May and co-chair of UK Stakeholders for Sustainable Development, a multilateral association that works to deliver the UN Sustainable Development Goals in the UK. ‘The interaction between humans and wild animals increases the likelihood of pathogens transmitting to humans.’

Beatriz Paulo de Frontin is an environmental lawyer with Brazilian law firm BMA. ‘It is still too early to say how financial institutions are preparing to respond to further pandemics, as the Covid-19 pandemic enters a second wave’, she says. ‘Brazil has issued rules focusing [in particular] on ensuring liquidity in Brazil’s financial system and stimulating credit, by relaxing certain prudential requirements. These have proved to be successful so far.’

Brazil is an interesting case, de Frontin adds. ‘As a tropical country, it may suffer profound physical impacts due to climate change. Perhaps this physical risk is what motivates a very concentrated financial market to take initiatives that deal with climate change.’

Many of the discussions about climate-related stress tests focus on the scenarios that should be used for the exercise. ‘Is it a more immediate disruptive event or is it a slow but increasing scenario?’ says Löber. ‘Different scenarios can produce very different results. Depending on how you model the stress test, the results might be very difficult to compare.’

‘A lot of the sophisticated tiers of our economy are on this’, says Twentyman. ‘Business is really pushing the pace.’

Researchers working on TCFD’s 2020 status report used artificial intelligence to analyse reporting from 1,700 companies and found that ‘disclosure of climate-related financial information aligned with the TCFD recommendations has steadily increased’ since 2017, with the biggest growth seen in how companies ‘identify, assess and manage climate-related risk.’

In January, BlackRock CEO Larry Fink described TCFD as a ‘valuable framework’ for reporting on climate risk in his annual letter.

Despite this, the collective willingness among heads of banks to take the necessary measures may not be quite there yet. ‘From a Brazilian point of view, financial institutions are still catching up with the TCFD’s 2017 recommendations’, says de Frontin.

About half of the banks surveyed by PwC for a recent report said they had not yet conducted scenario analysis on their current portfolios – something that could help them track what their risk profiles would look like under varying degrees of global warming.

This is why there is a need for the public sector to continue to provide incentives for financial institutions to change their ways.

‘You can’t ignore this’, says Löber. ‘You need to prepare, or you will be caught out at a stage where you will not be able to react, both at micro and macro level.’

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