Climate risk – Regulatory response gathers pace
It is widely accepted that climate change and how we respond to it has significant consequences, both for the global economy and for society in general. While banks and other financial institutions are increasingly dealing with the effect of both physical and transition climate-related risks on all aspects of their operations, regulators must concern themselves not only with the impact of these risks on individual institutions but also on broader financial stability. A recent report by the Financial Stability Board (FSB) sets out the agenda for regulators and the emerging new regime for financial institutions.
The battle against climate-related risks is made more difficult by the disparate and fragmented nature of approaches to mitigate these risks. Regulatory authorities worldwide have until now struggled to coordinate their approaches, which is hardly surprising given the lack of consensus on definitions and the opacity of information in the field. Moreover, individual regulatory authorities have different mandates and varying supervisory goals.
But regulatory authorities are stepping up to the challenge. Late last year the Financial Stability Board (FSB) issued its final report – Supervisory and Regulatory Approaches to Climate-related Risks – with the aim to assist supervisory and regulatory authorities in their efforts to “monitor, manage and mitigate risks arising from climate change and to promote consistent approaches across sectors and jurisdictions.”
Climate change and systemic financial risk
While concentrating on cross-sectoral and system-wide aspects of climate-related financial risks, the report formally recognizes the systemic risk that climate change is likely to pose to the financial sector, and recommends potential macroprudential tools to complement microprudential instruments.
The report focuses on three areas:
- Supervisory and regulatory reporting and the collection of climate-related data from financial institutions on which to base the identification and monitoring of climate-related risks
- System-wide supervisory and regulatory approaches to assessing climate-related risks, including the use of analytical tools such as climate scenario analysis and stress testing
- Evaluating the extent to which current policies and tools address climate-related risks and the adequacy of the tools in addressing systemic risks based on the work of standard-setting bodies and authorities
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Lack of climate risk data
The lack of consistent, comparable, granular and reliable climate data reported by financial institutions is a key challenge for authorities in their development of supervisory and regulatory approaches to climate-related risks, according to the report.
The FSB has also identified the key role of financial disclosures in mitigating climate-related risk. The past couple of years have seen a number of initiatives designed to make climate-related financial disclosures more comparable, consistent and useful.
New climate-risk disclosure regime approaches
March 2022 saw the publication by the newly established International Sustainability Standards Board (ISSB), under the IFRS Foundation, of two Exposure Draft standards on general sustainability-related and climate-related disclosures. Following public consultation, the aim is to issue the final standards at the end of Q2 2023. In its deliberations, the ISSB also decided to introduce a requirement to permit, but not require, preparers to consider the Global Reporting Initiative Standards and the European Sustainability Reporting Standards in identifying disclosures about sustainability-related risks and opportunities.
Until now, authorities have collected climate-related data for various objectives (depending on the scope of their mandate), including but not limited to:
- Microprudential objectives to assess firm-specific strategy and risks such as business model viability, exposure quantification, scenario analysis and stress testing, and capital adequacy assessments.
- Investor protection or market integrity initiatives to enable investors to better assess and compare climate-related factors associated with different investments, and to reduce the risk of greenwashing.
- Macroprudential objectives that assess sector-level or financial system-level risks including the monitoring of vulnerabilities and their implications to financial stability.
- Macroeconomic objectives that assess the impact of climate change on economic growth, productivity and inflation, as well as structural implications or other macroeconomic aspects.
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Climate-risk reporting requirements to increase
Based on the FSB recommendations, banks, asset managers, insurers and pension funds can expect regulators in several jurisdictions to expand the use of climate scenario analysis and stress testing for macroprudential purposes, with the objective of evaluating the potentially far-reaching impact of climate-related risks across the financial system.
Furthermore, the FSB recommends that authorities should begin by asking financial institutions to report qualitative information to their supervisors, supplemented with increasingly available quantitative information and move towards standardized regulatory reporting requirements “in a manner proportionate to the nature, size, and risk profile of a financial institution’s activities and that takes into account the balance of benefits and costs.”
Intuition Know-How has a number of tutorials related to the content of this article:
- Climate Risk – An Introduction
- Climate Risk – Banking & Decarbonization
- Climate Risk – Stress Testing
- Climate Risk Measurement – An Introduction
- Climate Risk Measurement – Approaches
- ESG – An Introduction
- ESG – Primer
- ESG Data & Ratings – An Introduction
- ESG Data & Ratings – Reporting Frameworks
