Climate risks may be under-estimated due to lack of internal scenario analysis by financial institutions, warn central banks.
Regulators must act to ensure financial institutions are taking full account of financially-material climate and sustainability risks, according to a new report on sustainable finance market dynamics by the Network for Greening the Financial System (NGFS).
Asset managers should view management of such risks as integral to the execution of their fiduciary duties, said the report, which provides central bank members of the NGFS with recommendations to support the mobilisation of sustainable finance.
“There is a need for regulators to require financial institutions to consider material climate and sustainability factors as financial factors,” said the report, published yesterday by the NGFS, a group of 89 central banks and financial supervisors formed to support the Paris climate goals.
Although some financial institutions are already applying forward-looking scenario analysis to better understand the impact of climate-related risks on cash flows and financial results, it is not yet common practice, the NGFS report noted, adding that a lack of internal capacity is leading many to rely on third-party advisory services.
“Until such capacities have been developed and become mainstream at financial institutions, the riskiness of polluting assets will not be properly understood or incorporated into risk and valuation calculations used to underwrite debt and equity,” it observes.
“They may even be under-estimated in highly exposed industries, leaving balance sheets impaired and at risk.”
The report noted the increasing guidance available to financial institutions, including a series of pilot projects offered by the UN Environment Programme Finance Initiative (UNEP-FI) to help banks, investors, and insurers to evaluate physical and transition risks using climate scenario analyses.
The NGFS cited also the growth of principles-based supervisory guidance on management of climate-related financial risks by central banks and other financial supervisors, as well as a growing consensus that the financial materiality of climate-related and sustainability risks is integral to the fiduciary duty of asset managers.
The report made further recommendations on disclosure, risk management and mobilisation of capital to enable the financial system to support the transition to a more sustainable and low-carbon economy.
On disclosure, the NGFS called for financial authorities to support global disclosure frameworks, including efforts to establish a corporate disclosure standard aligned with the recommendations of the Task Force on Climate-related Financial Disclosures, and the development of global sustainability reporting standards.
It also said multinational financial institutions should “adopt and promote” global voluntary sustainability standards and disclosure frameworks across jurisdictions.
To improve risk management, the NGFS called for greater transparency on the methodologies used by credit and ESG ratings providers.
The report said ratings firms should disclose “the criteria they use to assess the materiality of climate and sustainability factors, the manner in which these are measured and incorporated into ratings, and the weights they assign to them”.
On capital allocation, the NGFS said both national and multilateral development banks should “strengthen their support” for the mobilisation of capital towards green investments, particularly in developing and emerging markets.
The NGFS also released its ‘Dashboard on scaling up green finance‘, a set of 21 indicators tracking the greening of national financial systems. Presented at an aggregate level, the dashboard is intended for use at the jurisdictional level, and includes metadata to describe the country coverage and provide sources where these data can be found.
NGFS’s 2020 annual report was also published yesterday.
“With its new report, the NGFS gives examples of policies, regulations and guidance on how financial markets can support the transformation of our economies to align with the goals of the Paris Agreement with an increasing number of jurisdictions now committed to achieving net zero emissions by mid-century. As we are moving closer to the recovery of the pandemic, more than ever the time to act is now,” said Frank Elderson, Chair of the NGFS and member of the ECB’s Executive Board.