Climate risk-related weightings are seen as inevitable as investors and supervisors scrutinise sector’s climate policies.
With a group of investors representing US$4.2 trillion in assets under management calling this week for the world’s largest banks to demonstrate their climate credentials and central bank climate-related stress tests imminent or complete, banks are facing both supervisory and investor scrutiny.
The investors, including Aviva Investors, Fidelity International and M&G Investments, have written to 63 banks, including JP Morgan, Deutsche Bank, HSBC, ICBC and Standard Chartered, asking them to strengthen their climate and biodiversity strategies before the UN’s Kunming Conference (COP 15) and the UN Climate Talks in Glasgow this year (COP 26).
The investors asked banks to publish short-term climate-related targets covering all relevant financial services ahead of their 2022 AGMs; integrate the findings of the IEA Net Zero scenario and other 1.50 scenarios into their climate strategies; phase-out from coal by 2030 in OECD countries and by 2040 in non-OECD countries; and commit to protect and restore biodiversity.
“As a bank you are in a powerful position to drive the low-carbon transition and to address the worst consequences of climate change and biodiversity loss,” the letter states. Responses has been requested by 15 August, with investors warning that action will inform investors’ 2022 AGM voting and engagement activities.
Central bank stress tests
Banks’ exposure to not only the physical risks of climate change but also the transition risks of adjusting to a low-carbon and more environmentally sustainable economy has not been overlooked by supervisory authorities. Frank Elderson, Vice-Chair of the Supervisory Board and Member of the Executive Board of the European Central Bank (ECB), told a conference at Frankfurt in April 2021 that these risks would become “increasingly material” for banks in the coming years.
In November 2020, the supervisor published its final and amended guide on climate-related and environmental risks for banks, following a public consultation. The guide explains how the ECB expects banks to prudently manage and transparently disclose such risks under current prudential rules, and prepare to conduct self-assessments. In 2022, a full supervisory review of individual banks’ practices will be undertaken in a stress test followed by “concrete follow-up measures” where needed, says the ECB.
Writing in March 2021, Luis de Guindos, Vice-President of the ECB, described stress tests – which analyse how bank liquidity and capital would be affected under a number of severe scenarios – as an important tool, casting light on climate risks “that currently still lurk in the darkness”. While the primary responsibility for combating climate change lies with governments, central banks can play an important contributory role, helping to ensure the financial system is resilient to the transition to a low-carbon economy, he added.
“Stress testing shows the willingness and desire of regulators to address climate change risks,” says Pauline Lambert, Executive Director, Financial Institutions Ratings at German ratings agency Scope Ratings. “Hence, investors will want to see the banks involved demonstrate their ability to assess, manage and mitigate these risks. Climate change has become a supervisory priority and banks need to meet supervisory expectations. The stress test results will hopefully provide a picture of the magnitude of the risk for the industry. Investors are increasingly likely to incorporate these considerations into their investment decisions.”
Assessing physical and transition risks
Joint research by the ECB and the European Systemic Risk Board notes that central banks and supervisors have intensified their efforts to develop climate-related stress testing frameworks, across most Group of 20 countries and beyond.
In most cases, these initiatives cover both transition and physical risks and are focused on the banking sector, the research notes, although insurers and asset managers are sometimes also in scope. Most of the exercises conduct analysis in a combination of firm and sector levels and with a top-down approach. Additionally, most of the initiatives are in a “planned” stage with undetermined methodology and date of publication.
Most of the central bank stress tests are at relatively early stages of execution, says David Carlin, Task Force on Climate-related Financial Disclosures Program Lead for UNEP FI. “The tests have some components that are similar to traditional stress tests but at present are more about conducting long-term scenario analysis and determining management actions that are necessary. The exercises will help institutions to improve their risk modelling capabilities and think in a more long-term way.”
One supervisory stress test that has been completed is that of France’s financial supervisor, the Autorité de Contrôle Prudentiel et de Résolution (ACPR). It conducted a climate pilot between July 2020 and April 2021 that assessed both physical and transition risks. The time horizon over which the risks were assessed was 30 years, with the analysis of scenarios broken down by economic sector.
According to the ACPR, the exercise achieved its ambitions of mobilising French banks and insurers, with nine banking groups and 15 insurance groups involved, representing 85% of the total balance sheet of banks and 75% of the total balance sheet of insurers in the country. The exercise also raised awareness about climate risks among the participants, serving as a catalyst for debate and accelerating the mobilisation of teams and resource.
Like the Bank of England’s upcoming stress tests, Australia’s Climate Vulnerability Assessments and the ECB’s 2022 tests, the French tests were based on guidelines developed by the Network for Greening the Financial System (NGFS). “It is important that a growing number of supervisors take up this work in order to launch their own exercises and thus contribute to the development of a common base of knowledge and climate risk assessment,” says ACPR.
The pilot exercise revealed an overall “moderate” exposure of French banks and insurers to climate risks. “However, this conclusion must be put into perspective in view of the uncertainties concerning both the speed and the impact of climate change. It also crucially depends on the assumptions, the scenarios analysed and the methodological difficulties raised by the exercise,” said the supervisor.
Based on the current balance sheet structures, it nevertheless appears that considerable efforts must be made to help significantly reduce greenhouse gas emissions by 2050 and to contain the rise in temperature by the end of the century.”
Bill Coen, Chair of the IFRS Advisory Council, says financial authorities are likely to use the results of stress tests “primarily to gain insight into an individual bank’s ability to withstand severe but plausible events or conditions. Those results would help dictate specific actions and next steps to improve a bank’s resilience.”
Will central banks draw conclusions from evidence of banks’ climate exposures, putting pressure on them to exit loans and investments that represent risk to the financial system and the planet? At present, there is “scant good data” available that could help inform the calibration of climate risk-related risk weightings, he adds. “As a result, I suspect the introduction by the authorities of favourable or punitive risk weightings is not imminent. The focus will continue to be a supervisory response (versus a regulatory one, such as risk weightings). The type of questions the authorities are pressing their banks on include: How well is the bank managing climate risk? Has the bank’s board articulated a strategy with respect to climate risk? How does it factor related risks into its pricing and loan loss provisions? Does it have sufficient and capable expertise?”
Carlin notes that the question of risk weightings is complex and involves changing how risk is perceived across different assets, which is a reason why central banks are at present wary about imposing weightings. “But they are one of the surest ways of redirecting capital flows and changing a financial institution’s strategy,” he says. Given recent central bank pronouncements on the risk climate change poses to the financial system, Carlin believes it will be only a matter of time before central banks take more aggressive action.
Prashant Vaze, Senior Fellow, Climate Bonds Initiative in London, thinks there is room for capital weighting adjustments. “The stress tests are a welcome move. But they are only half the story. Seeing the consequences of climate-risk on future portfolio values is one thing, but the real prize is the short-term changes in incentives to make sure portfolio managers’ short-term decisions are aligned to long-term investor interests. This means adjusting the capital weightings to reflect high carbon risks on firms without credible net zero strategies, short-term goals and investment plans aligned to decarbonising their activities.”
There is evidence banks also see the writing on the wall. Huw van Steenis, Chair, Sustainable Finance Committee, UBS Group, recently wrote that stress tests could be “highly catalytic in repricing the cost of capital between high and low carbon companies”. The insights stress tests and other tools produce are likely to be used by boards and investors to change practices in asset allocation and risk management, he added.
This is part of the objective of stress tests, notes Hortense Bioy, Global Director of Sustainability Research at Morningstar. The stress tests could accelerate the shift to greener instruments by regulated firms such as banks, insurers and asset managers. “That’s part of the objective of the stress tests and the EU agenda – it comes back to disclosure. Banks will have to make sure that they get the right data from the companies and will have to divest from those companies that they can’t finance anymore.”
Lambert agrees disclosure is an important element, but says stress tests are only “one part” of the broader response to climate change risks noting that regulators such as the ECB and the Bank of England have already set out expectations. “The ECB expects banks to publish meaningful information and key metrics on climate-related and environmental risks that they deem to be material. Last year, the Bank of England noted that climate-related disclosures were limited by banks’ capabilities to assess these risks and therefore needed to materially improve to facilitate future disclosures. Through stress testing, banks will better understand materiality and at the same time will develop their risk assessment capabilities.”
Momentum is building behind climate-related stress tests and they are likely to become a tool for financial regulators and supervisors to ensure stability of the financial system as economies transition to net zero carbon emissions. This week, the European Commission announced plans to conduct regular stress tests as part of its recently finalised strategy for strengthening the EU’s sustainable finance framework. Pressure will continue to mount on financial institutions to take action to ensure ESG risks are addressed.