New reports shed light on how climate risks are taken into account by financial institutions and affect credit ratings.
The Network for Greening the Financial System (NGFS) has released two reports aimed at helping central banks and regulators in their oversight of the financial sector and central bank operations in relation to climate risk.
The first report is a follow-up to a status report published in May 2020, providing an update on existing analyses and practices in relation to green/non-green classification frameworks and the methodologies used by financial institutions (FIs), credit ratings agencies and supervisors to assess and quantify financial risk differentials.
The report – based on the experiences of 97 FIs – finds that there is still limited empirical evidence of ex-post green/non-green risk differentials and that conducting such analysis is not straightforward given persistent methodological and data-related challenges.
The report suggests a decisive shift by FIs – from a classification-based, backward-looking analysis of risk differentials at the asset or activity level – to a granular, risk-based forward-looking assessment of counterparties’ vulnerability to climate-related risks.
The report says the ability to assess counterparty transition readiness and quantify climate-related risk differentials on a forward-looking basis is critical to enabling FIs to price risks into their capital allocation decisions, steward their counterparties’ transition efforts, and green their own portfolios.
To improve the resilience of FIs to climate-related and environmental risks, supervisors should leverage scenario analysis and stress testing to further their understanding of potential risk differentials.
They should also examine the relevance and extent to which FIs must consider their counterparties´ transition plans, and further their understanding of the impact of environmental and climate-related risks on credit ratings and internal credit risk modeling at FIs.
The second report explores the challenges faced by credit ratings agencies in integrating climate-related risks in their assessments. These challenges primarily relate to the scarcity of consistent, high quality, granular and comparable climate-related data.
The report says there is still a lack of transparency surrounding the methodologies used by the rating agencies to incorporate climate-risk factors and how these factors contribute to the final rating.
In addition, credit ratings are forward-looking assessments of the creditworthiness of issuers over horizons that are typically shorter than those that are considered relevant for the implications of climate change.
Central banks are encouraged to apply their own analysis to complement traditional credit ratings while more work is being done to introduce appropriate modifications to their operational frameworks in order to properly address climate change related risks.