In the ever-evolving financial landscape, climate change has emerged as a formidable geopolitical risk, ushering in an era where banks worldwide are keenly monitoring and managing what is now termed as 'green swan' risks. This concept refers to the unforeseen and potentially severe financial risks associated with climate change.
As we delve into this intricate subject, it's important to acknowledge the insights of Frank Elderson, the vice-chair of the supervisory board at the European Central Bank (ECB). During a recent conference in Frankfurt, Elderson emphasized the growing significance of the physical and transition risks linked to climate change for the banking sector. He suggested that these risks are becoming increasingly material and will require robust management strategies.
To tackle this, the ECB has embarked on an ambitious project: a climate-related stress test that spans a 30-year horizon. This test aims to assess the potential impact of climate-related risks on the European banking sector. It involves a meticulous process of mapping climate projections and expected developments against the geographical locations of firms' physical assets. The ultimate goal is to estimate the repercussions of severe climate events on these assets and, by extension, on banks' portfolios. This initiative is part of a broader collaborative effort among central banks to develop joint climate stress-test scenarios.
Further, in line with its 'Guide on climate-related and environmental risks' issued in November 2020, the ECB has urged banks to conduct self-assessments and draft action plans to align their practices with the supervisory expectations. This initiative has seen widespread participation, with over 112 institutions, representing 99% of total assets under direct ECB supervision, submitting their self-evaluations and finalizing action plans.
As we move forward, it's crucial for banks to integrate climate change considerations into their risk frameworks more comprehensively. Elderson highlighted that many banks are still in the nascent stages of this integration, and there's a pressing need for them to enhance their capacity to manage these risks. He stressed that these risks could drive other forms of risks, including credit, market, operational, and liquidity risks.
The ECB's stress test is set to be a game-changer. It will not only evaluate the resilience of banks' balance sheets to climate change risks but also enhance the climate dimension of their risk management tools. Additionally, this exercise will significantly improve data availability and illuminate the supervisory reporting needs around these types of risks.
Globally, other supervisory authorities, including those in Australia, Brazil, Canada, France, Hong Kong, and Singapore, are also conducting or planning climate-related stress tests. The UK's Bank of England launched a similar test in June as part of its biennial exploratory scenario testing.
The focus on climate and environmental, social, and governance (ESG) factors is intensifying in the financial sector. However, challenges remain, particularly in making direct comparisons between banks due to the evolving nature of disclosures. This dynamic landscape demands a nuanced understanding of the nature and magnitude of climate-related risks banks face.
For treasuries, the success of an ESG program can be measured in terms of issuing appropriate financing instruments and gaining meaningful external recognition for short-term achievements. It's about embedding long-term goals into a company's overall ESG strategy, ensuring transparency, and aligning with the expectations of regulators, investors, and rating agencies.
In this context, banks' treasury departments play a pivotal role. They are not only responsible for issuing ESG-compliant financial instruments but also for aligning these issuances with a coherent overall ESG strategy. This involves a holistic approach that encompasses governance, risk, performance metrics, and reporting.
As we venture deeper into this new era, the emphasis on ESG compliance is becoming increasingly pronounced. Financial institutions are now expected to demonstrate their commitment to ESG strategies in all aspects of their operations. The pressure is on to align with ESG standards both internally and externally.
In summary, the journey towards integrating ESG considerations into financial operations is complex and multi-faceted. It requires a concerted effort from banks to not only understand and manage the risks associated with climate change but also to align their strategies and operations with broader ESG goals. As this journey unfolds, banks and financial institutions will play a crucial role in steering the global economy towards a more sustainable and resilient future.
Source: The Banker, MMCG, Heather McKenzie