As Extinction Rebellion supporters around the world emphasise the urgency to tackle climate breakdown, the heads of the UK and France’s Central Banks, Mark Carney and François Villeroy de Galhau, warn about the dangers of climate change on the economy.
Banks are shifting away from viewing climate change risks solely as a corporate social responsibility issue, as they understand their financial implications. Financial regulators, such as the Prudential Regulation Authority, issued recommendations on voluntary disclosures on banks’ approach to managing financial risks from climate change.
Perhaps one of the most important developments in this respect is the industry-led Task Force on Climate-related Financial disclosures (“TCFD”). The Financial Stability Board established TCFD to help investors, lenders and insurance underwriters to understand how to identify and assess climate-related risks and opportunities. To this end, the panel of experts in TCFD developed a framework for voluntary disclosures, which relies on four pillars:
- Governance: Does the board have oversight of climate-related risks?
- Strategy: What is the impact of climate-related risks on the company’s strategy and financial planning?
- Risk Management: How does the firm identify, assess, and manage climate-related risks?
- Metrics and Targets: What are the metrics and targets used to assess and manage climate-related risks?
Financial risks from climate change arise as physical and transition risks. Physical risks relate to extreme weather events and long-term shifts in climate that can damage the value of banks’ assets. Transition risks can arise from the shift to a low-carbon economy underpinned by climate policy developments and technological changes. As we can see in Chart 1, there is a transition-physical risk trade-off; lower transition risks lead to high levels of physical risks and vice-versa. This is a balancing act for companies, which need to act fast to curb physical risks, but not too fast, as an abrupt transition could be detrimental to the economy.
Chart 1. Possible carbon emission pathways and climate-related risk factors
Source: PRA, “Transition in Thinking: The impact of climate change on the UK banking sector”, September 2018
One of the central TCFD recommendations is the disclosure of climate scenario analysis. Scenarios are hypothetical constructs that allow firms to consider how climate-related risks, both physical and transition, may affect their financial performance over time. Scenario analysis can focus on exposure to physical and/or transition risks.
Exposure to physical risks: Firms are expected to identify physical risks that they are exposed to in the short term (before 2030) and in the medium term (between 2030 and 2050).
Exposure to transition risks: A typical transition risk scenario is the so-called 2°C scenario. This scenario helps investors evaluate the implications for individual firms of holding the global average temperatures below 2°C above pre-industrial levels, as reflected in the Paris Agreement.
Collectively, this scenario analysis helps companies to understand and plan for likely risks and eventualities. The disclosures also help their investors understand and challenge the risks companies are taking. Together, this should help the world become more robust to these challenges.
Among the global systemically important banks (“G-SIBs”), all European and the majority (67%) of UK banks state that they have conducted climate scenario analysis (Chart 2). Furthermore, the majority of G-SIBs declared themselves committed to aligning their disclosures with the Task Force’s recommendations.
Chart 2. G-SIBs that have conducted climate scenario analysis according to TCFD recommendations
Disclosures according to TCFD recommendations provide necessary information to investors that allows them to correctly value assets. The financial crisis of 2007-2008 is an example of how a lack of transparency and poor corporate governance practices can impact asset values. These disclosures are not and should not be another box to tick, but a long-term strategy that will benefit banks and the economy as a whole.
If the worst predictions about climate change come to pass, or even the most realistic scenarios occur, it seems many banks have left themselves open to significant unmanaged risks. That will prove a major concern for their investors.
[i] Partington, Richard (2019) Mark Carney tells global banks they cannot ignore climate change dangers, The Guardian. Available at: https://www.theguardian.com/environment/2019/apr/17/mark-carney-tells-global-banks-they-cannot-ignore-climate-change-dangers
[ii] PRA, (2019). Supervisory Statement SS3/19. Available at: https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/supervisory-statement/2019/ss319.pdf?la=en&hash=7BA9824BAC5FB313F42C00889D4E3A6104881C44
[iii] Task Force on Climate-Related Financial Disclosures, (2017). Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures. Available at: https://www.fsb-tcfd.org/publications/final-recommendations-report/