Despite the unprecedented economic crisis triggered by covid-19 pandemic, financial regulators and supervisors do not lose sight of what many of them now consider a major long-term threat for financial stability: climate change and environmental degradation. Recent publications by the NGFS, ECB and ACPR expand the very young but rapidly growing body of materials and resources to address financial risks related to changing climate and environmental degradation.

The two recent NGFS publications are both meant to provide a snapshot of current practices. One focuses on financial institutions and the other on supervisors. The recommendations issued by NGFS are non-binding, their purpose is to share best practices and guide development of internal practices as harmonized as possible. ACPR recommends several good practices for French banking institutions in terms of governance and management of climate-related risks. The ECB is currently in the public consultation phase for its guide on climate-related and environmental risks.

 

NGFS guide for supervisors about integration of climate and environmental risks into prudential supervision

The NGFS “Guide for Supervisors: Integrating climate-related and environmental risks into prudential supervision” provides five recommendations for supervisors about how their work can integrate climate-related and environmental risks. As such, the guide provides examples of supervisory practices with the purpose of informing prudential supervisors about the best practices of their peers while giving banks and insurers view about how their supervisors expect them to address climate-related and environmental risks.  The recommendations are intended for NGFS members as well as for other banking and insurance supervisors.

The first recommendation asks supervisors to assess how economies and financial sectors within their jurisdiction can be impacted by climate-related & environmental risks and how material could these risks be. Such considerations are based on two[1] key concepts: physical [2]risks and transition [3]risks.

The second recommendation suggests that, having identified the abovementioned risks within their jurisdictions, supervisors should themselves develop a clear strategy to address these risks. Such strategy should include allocation of adequate resources and commitment from the top. Moreover, given that the topic is relevant for several departments operating within the current structure of central banks and supervisors, an establishment of clear internal organization is necessary.

The third recommendation relates to the identification of the exposure of supervised entities to climate-related & environmental risks and to the assessment of their potential losses in the case of materialization of these risks, such as stress testing exercises. The work in this regard is in an early stage as it requires assessment of different determinants of both physical and transition risks, which is in turn requires overcoming of significant data gaps, in terms of both quantitative and qualitative data. The NGFS recommends further development of scenario analysis and stress testing, while providing illustration of latest practice by some of its members.  Supervisors are themselves active in this regard: the Prudential and Regulation Authority (PRA) will assess both physical and transition risks in 2021 Biennial Exploratory Scenario and these two risks also feature in the stress test conducted this year by ACPR and Banque de France.

The fourth recommendation asks supervisors to set supervisory expectations in order to provide supervised financial instructions with a clear understanding of what is expected from them in terms of climate-related & environmental risks. This process is ongoing in some jurisdictions and typically involves expectations in five areas: governance, strategy, risk management, scenario analysis & stress testing and, finally, disclosure. The general observation within the NGFS is that new legally binding requirements related to climate or the environment have not been set by supervisors. Nevertheless, some supervisors either clarified how existing legal requirements could in the future be adapted to such considerations while other supervisors issued sets of good practices.

The final recommendation requests supervisors to ensure that financial institutions under their supervision adequately manage climate-related & environmental risks. There is still a long way to go to reach this objective. While existing supervisory toolbox can be adapted in the future, supervisors have not yet imposed additional requirements (neither in terms of capital nor solvency) relative to these risks, since further research is still required to elucidate their nature, transmission channels and magnitude of their impact in case of materialization.

 

NGFS report about how financial institutions assess risk differentials of green, non-green and brown financial assets

The second report released concomitantly by the NGFS as “A Status Report on Financial Institutions’ Experiences from working with green, non green and brown financial assets and a potential risk differential” takes the opposite perspective: that of supervised entities. It provides a snapshot of how financial instructions are currently able to track the risk profiles of green, non-green and brown financial assets (bonds & loans), develop dedicated risk metrics and carry out an analysis of potential risk differentials depending on asset coloration.

In theory, assessing the potential risk differentials between green & brown assets has strong justification: if (and when?) research could establish a consistent link between brown loans or bonds and higher default rates (higher levels of risk), financial institutions holding such assets would have to take measures to protect[4] themselves from the increased risk of default while regulators would be justified in increasing regulatory capital requirements that financial institutions have to hold against these assets. In practice, attempting to do so is currently not feasible with enough track record and stability for a variety of reasons discussed below.

Based on an anonymous survey of 49 banks, the survey found that no strong conclusion has been reached about the existence of a risk differential between green and brown financial assets. This result is not surprising given 1) the absence of common classification for “greenness” and “brownness” of financial assets and economic activities and 2) the limited availability of relevant data at a sufficiently granular scale. The survey showed that financial institutions deal with the absence of an official taxonomy be using either national or international classifications or voluntary principles or by developing their own internal taxonomy. Moreover, surveyed financial institutions cited “lack of harmonized client data” (an issued further aggravated by lacking legal disclosure requirements at company level) and ‘lack of internal resources” (adaptation of IT systems, internal build-up of expertise) as additional challenges in assessing potential risk differentials between different colors of financial assets. Furthermore, the survey indicates that financial institutions face several challenges when classifying the color of different types of assets: for instance, in the case of loans for general corporate purpose financing. Technical appendix II of the NGFS Status Report[5] provides a case study to illustrate how an internal taxonomy can be integrated into ordinary credit risks assessment. Please note, though, that Natixis Green Weighting Factor unique mechanism to internally, and analytically, adjust its capital allocation to the greenness/brownness of its financings is, among other things, addressing this feasibility challenge and the bank is progressively building the data sets needed to perform such systematic and dynamic analysis.

Considering the abovementioned complications, the NGFS concludes that adjustment factors should in any case play a limited role from a prudential perspective because the environmental risk profile of each individual asset should ultimately be reflected in the existing mechanisms of Pillar 1 (both standardized and internal ratings-based approaches).  Probability of default (PD) calculations should therefore be fine-tuned to integrate such risks.

Moreover, the survey also laid bare the diverging views amongst financial institution with regards to what methodologies are appropriate for assessing the riskiness of green & brown assets: some share the view that existing methods and models are compatible with the task while others argue that the timeframe for climate-related & environmental risks is much longer than periods considered in existing approaches and therefore requires the development of long-term forward-looking studies such as scenario analysis and climate stress tests. Nevertheless, these types of analyses are still very new and relatively underdeveloped, meaning that much further development is expected in this area. To address this issue, the NGFS is currently developing a set of global and regional scenarios to provide common building blocks for future scenario analysis.

 

ACPR recommendations for French banking institutions about governance and management of climate-related risks

Following a consultation process with the French banking industry, the French Prudential Supervision and Resolution Authority (ACPR) published last week its recommendations pertaining to the French banking sector’s governance and management of climate-related risks. Unlike the NGFS publications which consider a broader category of environmental risks, the ACPR recommendations relate specifically to physical and transition risks resulting from climate change.

Detailed under four principles, the French banking supervisor describes a set of good practices observed amongst ninebanking institutions, with the aim to improve the industry’s management of this increasingly recognized risk. While the good practices and approaches suggested in the ACPR’s report are merely indicative and hence non-binding, they can help financial institutions to prepare in anticipation of future regulatory developments: the European Banking Authority is mandated to issue[6] a report assessing the possibility of including ESG risks in the Supervisory Review and Evaluation Process. Several points listed below are worth highlighting.

 

Banking institutions participating in ACPR’s survey used for the collection of good practices regarding climate-related and environmental risks

Source: ACPR (2020)

 

The ACPR encourages banks to embed climate risks in their strategic planning which is in line with the expectations set by the NGFS but goes a step further by providing guidelines on how this strategic planning can be implemented. Institutions should name one or more members of their executive committee responsible for Climate issues and discuss the strategic implications of climate with the board of directors on a regular basis. The time horizon of strategic planning should take into account the specific features of climate change risks and banks could make reference to the calendars and trajectories described in international agreements. The ACPR in particular suggests that incentive scheme of top management in charge of climate risk issues could take into account dedicated KPI on the implementation of the climate strategy. The ACPR also suggests the use of scenario analyses to clarify and inform financial planning with regards to climate risks.

The ACPR report highlights the importance of effective management of climate risks by banking institutions, arguing for a clear allocation of responsibilities across business lines. The supervisor also notes that banks should allocate responsibilities with regards to climate risk management control and expects a Climate risk officer to be identified in order to raise awareness about the topic at the top management level.

The ACPR underlines it is essential to manage the financial risks associated to climate, by developing the right set of both qualitative and quantitative tools. In particular, it notes that the risk appetite framework could be enriched to incorporate climate risks. In this regard, please note that Natixis has included the “dark brown” share of the bank’s RWA in its Risk Appetite Framework as an indicator of climate transition risk. The supervisor notes that banking institutions do not include data about climate change risks within their centralized databases as relevant climate data are either unavailable or fragmented. In this regard, ACPR encourages identification, collection and centralization of the necessary data by supervised banking institutions. Again, with the implementation of its Green Weighting factor, Natixis is in the process of integrating its color rating into all of its front to back to accounting systems.

Moreover, the ACPR focuses on the need for a dedicated disclosure of their climate-related strategy, organization and risk management mechanisms, very much in line with the TCFD guidelines. In line with these expectations, the BPCE group intends to publish its first TCFD report in 2021 on its 2020 activity.

 

ECB guide on climate-related and environmental risks: a public consultation phase

The ECB published a guide (containing 13 expectations) explaining how the central bank expects banking institutions to manage risks related to climate and the environment and how these risks should be disclosed under prudential framework currently in place. The guide is now open for public consultation until 25 September 2020.

It is particularly worth highlighting that banks are expected to incorporate climate-related and environmental risks into their existing risk framework for risk management (which has to be done over a sufficiently long-term horizon) and to quantify these risks within their overall process of ensuring capital adequacyfrom an economic and a normative perspective". It is expected that climate risk should be incorporated into the Internal Capital Adequacy Assessment Process (ICAA) and therefore reflected in Pillar 2 capital add-ons. In this regard, Natixis anticipated future development of the prudential regulation to include climate-transition risk in particular as reflected in the development of our Green Weighting Factor, an internal mechanism by which we link the analytical capital allocation of each transaction to its level of impact on the environment.

Moreover, the ECB recalls[7] that difficult quantification or unavailability of relevant data are not to be used as an excuse to exclude climate-related and environmental risks from the assessment. To overcome these challenges, banks are expected to make active efforts to develop or apply appropriate tools and methods, taking into account the ongoing work and latest publications of international networks and standard setters, for instance the NGFS.

 

Natixis comments on prudential measures suggested in abovementioned publications

Natixis welcomes steps taken by the ECB and the recommendations provided by the NGFS to take environment-related risks into consideration in the prudential framework. We believe that the phased approach which is considered by the ECB is the right way to encourage financial market participants to start integrating ESG-related risks (and not only climate-related risks) in their risk management processes: addressing the issue via the Pillar 2 first, before eventually establishing Pillar 1 requirements.

Regulators and supervisors must however acknowledge that banks still face strong challenges to be able to include ESG factors in their risk management processes. In particular, we must avoid a market where each bank has its own definition of what ESG factors are and what do they mean, and we therefore need a common set of rules to evaluate ESG-related risks. The EU taxonomy has determined a set of useful climate and other environmental metrics, but it is focused on positive environmental impact, in other words “green only”. For risk management purposes, European authorities will need to develop a more granular taxonomy covering all activities and all types of environmental and social impacts (several shades including negative impacts, so-called “brown” activities), may it be through the EU Taxonomy Regulation or through another mean.

We also note that is reasonable for the ECB to focus for the time being mainly on climate-related and environmental-related risks in its guide, in particular for what concerns the development of prudential processes. This is the right start for pragmatic reasons: as far as social factors are concerned, the impact of activities of financial institutions is still extremely difficult to assess and we anticipate that the development of a common taxonomies and methodologies will take some time.

 

Further reading:

NGFS (2020), Guide for Supervisors: Integrating climate-related and environmental risks into prudential supervision. Available here: https://www.ngfs.net/sites/default/files/medias/documents/ngfs_guide_for_supervisors.pdf

NGFS (2020), A Status Report on Financial Institutions’ Experiences from working with green, non green and brown financial assets and a potential risk differential. Available here:
https://www.ngfs.net/sites/default/files/medias/documents/ngfs_status_report.pdf

ECB (2020), ECB launches public consultation on its guide on climate-related and environmental risks, Available here:
https://www.bankingsupervision.europa.eu/press/pr/date/2020/html/ssm.pr200520~0795c47d73.en.html

ACPR (2020), Governance and management of climate-related risks by French banking institutions: some good practices, Available here:
https://acpr.banque-france.fr/en/governance-and-management-climate-related-risks-french-banking-institutions-some-good-practices

 


[1] While “liability” risk used to be presented as a third category referring to climate-related legal proceedings (potentially threatening private companies, investors but also governments), the recent work of NGFS and its members tends to treat this category as a subset of either physical or transition risks.

[2] Physical risks refer to economic damage and financial costs inflicted by climate change and environmental degradation, either in an “acute” form of single impactful events or in a “chronic” form of slowly changing climate patterns

[3] Transition risk refers to re-pricing of assets along the pathway towards a low-carbon economy. This adjustment process will have impacts across all sectors of the economy as the decarbonization and movement towards circular economy will affect value of financial assets and corporate profitability. The pace of change is in itself a source of risk as too slow transition increases likelihood of future occurrence of physical risks while also risking the lock-in of carbon intensive assets which eventually become stranded, yet a too abrupt transition can also threaten financial stability.

[4] Through closer risk monitoring and / or by setting aside more economic capital (economic capital is defined as “amount of capital needed to cover a financial institution´s risks in a going concern”, (NGFS, 2020)).

[5] Pages 25 and 26

[6] By June 2021

[7] Also stated in the ECB Guide to the ICAAP


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