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Financial services firms need to act now on climate change risk to ensure a sustainable future

Gaurav Bedekar
September 25, 2020

The orange skies and blazing fires on the west coast of the US are a stark reminder of the devastating impacts of climate change. Climate change impacts every living being on earth. It is a key concern for global regulators and industry stakeholders to ensure that businesses account for this key consideration in their operating environments. The right actions must be taken in anticipation to mitigate the impact of companies on climate change and vice versa.

Globally, most international and government bodies have publicly opined that most industries would face a moderate to severe impact of climate change events soon. The banking and financial services industry too is unlikely to be immune. The Basel Committee on Banking Supervision (BCBS) has stated, “Climate-related financial risks could potentially impact the safety and soundness of individual financial institutions and have broader financial stability implications for the banking system.”

Banking and financial services companies are impacted in several ways, such as:

  • Potential economic costs and financial losses resulting from the increasing severity and frequency of extreme climate change-related events
  • Negative financial impact such as reduced economic activity, lower income and savings, and increased stress on financial assets and markets
  • Direct economic benefits and financial incentives from carbon reduction, and projects aiming to reduce deforestation and promote sustainability.

Regulators are enforcing aggressive action on climate change

Globally, the financial services industry regulators have been at the forefront of several initiatives to mitigate climate change concerns and adopt remediation actions as part of business practices and processes.

Along similar lines as the 2008 crisis, which led to an exponential intensification in the regulatory focus, activity, and mandates around risk management, climate change is set to emerge as an organizational imperative and a prerequisite for international business and trade.

Recently, the Financial Stability Board led Task Force on Climate-related Financial Disclosures (TCFD) and the Basel Committee on Banking Supervision (BCBS) have been focusing on regulatory initiatives on climate-related financial risks and developing effective supervisory practices.

The BCBS recently recommended monitoring climate risks as part of financial-stability assessments and improving data collection and corporate disclosures. Going forward, the Basel committee is likely to impose higher risk weightings for loans to companies that do not conform to climate change mandates.

Various regulatory bodies such as the European Banking Authority (EBA), the UK Prudential Regulation Authority (PRA) and France’s Prudential Supervision and Resolution Authority (ACPR) have recommended that climate change risks should be clearly identified, modelled, and integrated into the risk management strategy, policy, models, systems and data at banks and financial institutions.

The recommendations are not binding at present. However, a multitude of international bodies could move forward in a coordinated manner to develop the structure and model of a green economy. Such a model can then become a global standard for industry and business.

Businesses need to adopt climate change into their organizational strategy and roadmap

Climate change has already been included as a key consideration by regulators and businesses in several countries. It is necessary for organizations to ensure the development and resilience of complex adaptive systems that can enable the systematic integration of sustainability considerations into financial and economic decision making without impacting organizations’ goals and financial health.

Climate change is set to be an integral part of the operational and transactional lifecycle at companies and businesses in the same vein as KYC, AML, fraud, customer protection, material transparency, product quality, accounting disclosures, and corporate governance.

  • The adoption and embedding of climate change initiatives in the organizational DNA including its business strategy, products, policies, processes, sales, marketing, and operations will be integral to market acceptance, business growth and success in the near future.
  • A comprehensive approach to assessment and analysis of financial, operational and business risk from climate change needs to be structured, refined, and integrated into an institution’s internal risk management procedures and regulatory practices.
  • Organizations are evaluating a number of models and methodologies in this regard ranging from a scorecard-based approach, simulation analysis of the carbon impacts, risk measurement through metrics such as climate value-at-risk (climate VaR), multi-scenario analysis to assessing the impact on asset pricing or credit risks. Greater focus is also being put on long-range forecasting techniques and valuation models such as leveraging carbon delta estimates of future cash flows generated by each firm for use in impact analysis.

Embrace technology to understand and address the impact of climate change

Technology is set to be an enabler, catalyst, and deciding factor in application of climate change models and initiatives. Many organizations are leveraging cutting-edge technology solutions and tools such as cloud platforms, natural language processing, big data analytics, artificial intelligence, and robotic solutions.

  • For instance, RMS, a leading catastrophe risk solutions company offers a suite of climate risk models for natural disasters, such as hurricanes/typhoons, extra-tropical cyclones, floods, severe convective storms, winter storms, and wildfires, to enable analysis and business impact assessment from current climate change events. Closer to home, Gurugram-based Blue Sky Analytics is leveraging AI in its platform to analyze high volumes of satellite data, ground-level sensor measurements and ancillary public datasets to deliver real-time, high-resolution data for environmental monitoring and climate risk assessment.
  • The fintech solution market has seen significant evolution and business success by leveraging innovation, technology and analytics to enable the adoption of risk, regulatory and digital requirements by banks and institutions. Similarly, the startups and new product ventures in the environmental protection and engineering space are likely to redefine and radically impact the approach, speed, and adoption of climate change initiatives by business globally.

Given the accelerated government, regulatory, institutional, and social attention and traction on climate change initiatives, it is essential that all aspects of climate change are taken into account when defining and developing the organizational strategy, roadmap, and policies.

Climate change initiatives should be seen in the light of a forward-looking, next-generation industry and business template which has a significant role to play in broader societal changes such as a better integration of sustainability into financial and economic decision-making and the creation of a just and equitable society.