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Creating a governance framework for climate risk

Sonia Shah Sonia Shah

Financial services firms have until the end of 2021 to implement the PRA’s Supervisory Statement 3/19 on managing climate risk. Sonia Shah and Cindy Niffikeer explore the role of the board and how governance can support effective risk management.

Good governance starts with the board.

Climate risk management is an emerging field, and it's important to keep the board informed on new developments, with the right information and tools to make informed decisions. Providing up-to-date terms of reference is a good starting point, but workshops to expand the knowledge base can also be beneficial.

With the support of appropriate risk assessments and relevant data, the board will be responsible for setting the risk appetite and deciding on a strategic approach for the firm.

Developing a strategic approach to climate risk

The board's strategic approach to climate risk must consider both physical and transitional causal factors. The physical risks stem from climate change itself, while transitional risks stem from regulation or legislation aimed at reducing environmental change.

In terms of time horizons, physical risks will take longer to crystallise, with long-term outlooks sitting at around 30 years and medium-term risk at around 10-15 years. Transitional risks are more likely to be felt in the short term, generally around the 5-10 year mark.

This is significantly longer than a standard five-year risk outlook and it may be challenging for boards to balance short-to-medium goals and expenditure against the long-term outlooks. The strategy should include future milestones to review the strategy and risk management approach.

Setting the tone

The board has a key role to play in setting the tone and building awareness for climate risk management. One of the immediate hurdles is differentiating the financial risks due to climate change from broader ESG risks.

The regulators are specifically focused on the financial risk due to climate change, referred to as 'climate risk', and mitigating the systemic risk it poses to individual firms and financial stability. While this is well established for people actively following, or participating in, industry-wide discussions on the topic, it may be a barrier to developing broader organisational awareness.

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Emerging climate risk management skill sets

With board-level buy-in, firms can begin to roll out training and awareness programmes across the rest of the organisation or specific operational teams. This will be informed by the firm’s preferred risk management approach, ie, cross-cutting or principal risk, with the former requiring a greater working knowledge across a wider resource base.

Firms must also make sure all training and awareness programmes incorporate new flexible working patterns. Line managers need to be on board to make sure the right culture is embodied by the wider team. The firm’s people should also be aware of the impact of reputational risk. These are hidden financial risks that should be highlighted during the awareness training so that key employees are fully aligned with the strategy.

The Climate Financial Risk Forum (CFRF) highlights four key areas of focus to culturally embed climate risk management through training and awareness programmes:

1 Establishing a clear link between the firm’s overall purpose and its climate risk management strategy

2 Identifying key personnel who will contribute to climate risk management

3 Understanding the role of each team involved in climate risk management to develop appropriate training and awareness initiatives

4 Applying new or existing tools to develop skill sets as new specialisms emerge and to shape new behaviours

Good governance from the top down can build awareness and set expectations, but it must be supported by adequate oversight at each organisational level.

Embedding accountability and responsibility

A dedicated senior manager must be given overall responsibility for climate risk management. The CFRF has emphasised the need for this to sit with a senior management function (SMF) with responsibility for other financial risks, potentially the Chief Financial Officer or Chief Risk Officer. Again, this reflects the distinction between financial risks due to climate change and environmental, social and corporate governance (ESG), and will also help to develop awareness of the difference between the two.

Firms should establish working groups or committees, chaired by the senior manager, to develop and implement the risk management approach. This should include teams or individuals across all three lines of defence, with clear responsibilities and accountabilities for climate risk, include demonstrable key risk and performance indicators.

Reporting and ongoing monitoring

As discussed in our previous article, it can be challenging to establish the right tools and metrics for ongoing monitoring. But adequate management information (MI) is an integral part of any governance framework and allows boards, and other senior management, to make informed decisions and to identify if controls are working effectively.

Once tools are in place to collect the right data and metrics, a reporting framework should be established to make sure right information is available in an accessible format. As firms’ climate risk management models mature, this data will be used for scenario testing to shape future processes, so it’s important that the data is accurate and robust.

For support in creating a climate change risk governance framework, contact Sonia Shah.

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