The financial sector must transform its management of climate risks, as changes in climate policies, new technologies and growing physical risks prompt reassessments of the values of virtually every financial asset. Our latest report explores how banks can integrate climate risks into their efforts to optimise risk-adjusted performance.
Mitigating climate change is not just an environmental responsibility – it is also an economic necessity. Rising sea levels and greater storm surges are expected to cost coastal urban areas over US$1 trillion each year by 2050. The longer we delay meaningful mitigation, the greater the disruption of climate change will be.
Governments globally are making concerted efforts to mitigate the impact of climate change. The 2015 Paris Agreement provides the overarching international framework towards limiting future warming to no more than two degrees above the pre-industrial average. Delivering this commitment will be a significant undertaking. The OECD estimates that US$6.9 trillion of investment would be required each year to 2030 to meet the Paris Agreement goals. Government purses alone will fall short: their development budgets to finance infrastructural shifts will not be enough to transition economies to the new low-carbon standards. Private finance must be mobilised – and banks will be called on to enable and safeguard this transition.
Given the sheer sums of capital required and the exposures to climate risks already locked into financial markets, banks face significant financial and nonfinancial risks from both climate change itself (physical risks) and associated mitigation measures (transition risks). The very mix of banks’ existing risk taxonomy – that is, what is considered credit risk, market risk, and operational risk – is set to be redefined.
Already, financial regulators are placing greater demands on banks to demonstrate effective management of climate risks. Pressure is also being applied to improve how firms report climate risks.
However, banks will have to overcome a number of hurdles. It remains uncertain how the risks emerging from the transition to a low-carbon economy will unfold over time. Allowing banks’ ability to respond effectively will require greater consistency, sophistication and availability of climate risk data – which may not be feasible under the current voluntary disclosure regime.
Knowing when to act will be challenging too. Many of the financial risks associated with climate change are unlikely to manifest within banks’ typical financial planning cycle (of around four years). And the degree to which banks need to seek immediate action depends on the “stickiness” of their balance sheets to climate risks.
What is clear is that the impact of climate change will only grow as more of the risks and opportunities manifest. Managing it effectively should be an integral part of banks’ effort to optimise risk-adjusted performance. Doing so requires banks to incorporate climate change considerations into their risk appetite, senior manager responsibilities and strategic planning in an explicit manner. This starts with establishing an appropriate governance process to approve the inclusion or exclusion of climate risks in their existing risk management framework.
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