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How to manage financial risks due to climate change

Paul Young Paul Young

Climate risk is a growing area of concern within the financial sector. Sonia Shah and Cindy Niffikeer look at how to implement robust risk management processes for climate risk.

Last year, the Prudential Regulation Authority (PRA) released Supervisory Statement 3/19 asking firms to take a strategic approach to managing climate risk and reduce the financial impact. This applies to insurers, Solvency II firms, banks, building societies and designated investment firms.

The recent Dear CEO letter asked firms to establish an approach by the end of 2021 and highlighted that most are still at early stages of implementation, with a long way to go to meet the deadline. But climate risk is not exclusive to PRA-regulated entities, and firms across the financial sector are actively developing their risk management approaches.

Building an effective climate risk management approach

Climate risk is an emerging area of research, and finding the right approach will take time. In June, the Climate Financial Risk Forum (CFRF) released guidance to help firms build their risk management capabilities and develop best practice. The group is co-chaired by the PRA and Financial Conduct Authority (FCA), and consists of banks, insurers, asset managers and large non-financial institutions. The forum created four working groups to review risk management, scenario analysis, disclosure and innovation, and the guidance looks at each of these areas in turn. Their output is a fairly robust blueprint for best practice, and is designed to complement existing initiatives.

There are two approaches firms can take when addressing climate change risk. It can be viewed as a:

  • stand-alone risk with an independent risk management framework
  • cross-cutting risk which is embedded into existing risk management frameworks.

The preferred approach will depend on your unique risk profile and risk appetite, combined with a materiality assessment. The CFRF outlines an effective risk management approach, addressing the following seven areas.

1 Risk governance

Climate risk management and oversight is a board level concern, with clear roles and responsibilities from the top down. The Board is responsible for shaping your climate risk strategy and risk appetite statement, and it must offer robust challenge as needed. This includes an understanding of risk concentrations, emerging regulatory or legal expectations, extended time horizons and scenario analyses.

When establishing roles and responsibilities, your first port of call is allocating the Senior Management Function (SMF) to oversee climate risk management across the firm. The responsibility would be best placed with an existing SMF, holding comparable financial duties such as the chief financial officer (CFO) role. Working groups, headed by the SMF, can identify key roles across the first, second and third lines of defence to mitigate risks and action key controls.

2 Risk appetite

The risk appetite statement aims to reflect your broader business strategy and the sector in which you operate, including:

  • the extended time horizons for climate risk, including transitional and physical risks, and include potential future scenarios
  • key risks, demonstrated quantitatively and, if considered as a standalone risk, accompanied by a clear written statement
  • embedding the risk appetite across the business, with measurable key performance indicators within each department, will help your business maintain risk limits.

3 Risk management framework

Regardless of your preferred approach to climate risk management, it is important to recognise the impact across the business as a whole, with significant interdependencies.

To put this into practice, firms will need to review their existing policies and processes to reflect both transitional and physical risks. That may be easier said than done, and the ability to accurately identify, measure and assess these risks is a challenge in its own right.

4 Risk assessment

The CFRF has identified four key areas where climate change could materially crystallise as financial risks:

1 Underwriting risk

Insurers may suffer material losses due to physical risks, either through extreme weather events (acute risks) or gradual climate change (chronic risks). Transitional risks could also lead to losses due to pricing, valuations or a change in market demand.

2 Credit risk

As multiple sectors transition to low carbon alternatives, market demand may shift leading to an increase in counterparty risk. It may also give rise to concentration risk, where whole sectors of counterparties are affected ie, the transport sector.

3 Market risk

Physical and transitional risks can lead to a drop in asset value, particularly for bonds, commodities or loans.

4 Operational risk

Extreme weather events may lead to business disruption for the firm and its third parties. This may have a knock on effect on business continuity and operational resilience, which may prevent firms from fulfilling regulatory obligations.

5 Data and tools

Developing the right tools and metrics to measure and report climate risk is one of the biggest challenges. The PRA flagged this as an issue in its Dear CEO letter, and highlighted it as a key reason for the firms’ delay in implementation.

Firms can leverage both external tools and data sets, as well as internal tools and models, and customer information, as appropriate.

The CFRF suggest the use of hazard maps, expert judgement, catastrophe modelling, scenario analysis, questionnaires, ESG scoring and pre-existing market tools (amongst others) to assess risks. Used alongside risk and control assessments, these can begin to build benchmarks for the target end state and signal key milestones along the way. It’s also important to consider the assumptions on which the tools are based, and recognise their limitations.

6 Training and culture

As climate risk is an emerging specialism, developing the right skillsets and building awareness is essential to embedding risk controls across the organisation.

When rolling out your training programmes it’s important to establish alignment with your overall strategy and purpose, while making sure every operational team recognises the risks. This includes a physical breakdown of the risk appetite for each team, with appropriate metrics to monitor and track risk limits.

Consider how to identify these training needs and the available tools to deliver them.

7 Ongoing challenges

As discussed above, one of the most immediate challenges, is the current lack of data and tools. This effectively limits the degree to which firms can reliably measure, report and discuss climate risk, and makes it difficult to build effective models.

Similarly, the sector wide approach to climate risk is currently fragmented and could benefit from greater standardisation – which widespread adoption of TCFD guidelines could go some way towards remedying.

Longer than usual risk horizons may also prove challenging, and some firms may be unwilling to invest in mitigating risks with a 30 year outlook, against short term priorities.

What to do now?

Working across the seven key areas above, firms can establish a transition plan to meet the PRA’s expectations and implement an appropriate risk management approach. As a starting point, key actions may include:

  • defining your climate risk strategy and risk appetite
  • identifying your key stakeholders
  • undertaking a gap analysis against your existing risk management frameworks
  • establishing deliverables and key milestones.

Meeting the PRA's expectations on climate risk Find out more