With rising global temperatures, comes an ever growing pressure on the financial services sector to respond and prepare for the far reaching effects of climate change.
The impacts upon the sector are already being felt, extreme weather events are creating significant losses for insurers and credit risks for banks. The pressures on businesses to demonstrate sustainable businesses and incorporate ‘green finance’ are forcing firms to adapt their business models. The FSB, PRA and FCA have also each had their say in how companies should be adapting and managing their exposure to climate change risks.
- How does climate change impact the financial services sector?
2. Transition to a low carbon economy
Although the impact of the transition to a low carbon economy, partly driven by the Paris Agreement, will be seen more directly within the fossil fuel and utility sectors, there will be a huge indirect effect on many others including energy-intensive sectors. In the financial services, the consequences will mainly be felt by financial institutions who have exposure to firms within these directly affected sectors.
How have the regulators responded to date?
Task force on climate-related financial disclosures status report
Recognising the criticality of climate change not only for the environment but also for businesses and the economy as a whole, the Financial Stability Board (FSB) created the Task Force on Climate-related Financial Disclosures (TCFD) in 2015. The TCFD’s final report was issued in 2017 with a number of recommendations to help firms identify climate related risks: through better disclosures, helping market participants better understand and assess their risks and exposures, as well as recognising opportunities and recommending areas of improvement.
The Prudential Regulatory Authority (PRA) consultation paper
In October 2018, the PRA issued a consultation paper seeking views on a draft supervisory statement on “banks’ and insurers’ approaches to managing the financial risks from climate change”. In line with the TCFD approach, the proposals aim to outline effective ways to address financial risks arising from climate change.
How banks and insurers should be managing financial risks
Governance: The consideration of financial risks arising from climate change should be part of firms’ governance frameworks and, in order to ensure adequate oversight, senior management and board members should be held accountable.
Risk management: Firms will be required to identify, monitor, measure, manage and report on their exposure to these risks through their risk management frameworks.
Scenario analysis: Firms will be expected to use scenario analysis in order to measure the potential impacts of climate change-related risks in the context of their strategic plans.
Disclosure: Firms should consider whether the existing Pillar 3 disclosure rules on material risks will suffice or whether additional disclosures need to be put in place in order to better inform market participants.
Following the consultation period, the PRA published on 15 April 2019 its feedback to the responses received and a final policy statement setting out the rules to manage financial risks arising from climate change.
What is the scope of application of final Supervisory Statement?
It applies to all UK insurance and reinsurance firms and groups, ie. those within the scope of Solvency II including Lloyd’s, managing agents and non-Solvency II firms, banks, building societies and PRA designated investment firms.
What are the next steps?
Firms are expected to have an initial plan in place to address the expectations by 15 October 2019.
The PRA aims to publish more detailed information in due course.
The PRA and FCA have recently created the Climate Financial Risk Forum (CFRF) to support the integration of climate-related factors into decision making. The outputs of this forum, along with other sources, will be taken into consideration when supervising these expectations.
The Financial Conduct Authority (FCA) discussion paper
In parallel to the PRA, the FCA also launched a discussion paper in October 2018 on Climate change and Green Finance. Recognising the growing demand for green products, particularly in asset management and retail banking, as well as the need to identify and manage climate related financial risks, the FCA identified four priorities which require regulatory development:
Pension investments – considering the long term nature of these investments, they will most likely be particularly affected by climate change.
Innovation – firms are encouraged to develop specialist green products whilst, at the same time, ensuring the good functioning of markets and outcomes for consumers.
Issuers of securities admitted to trading on a regulated market – entities falling under this category should give adequate and appropriate information to investors, allowing them to make informed decisions.
Public disclosure on climate related risks – financial services firms should report publicly on how they manage climate related risks. This requirement stems out of TCFD’s recommendations mentioned above. The disclosure aims to deliver transparency as well as to assess the areas with greater risk exposure and thus recognise any needs for further improvement.
The consultation period on this discussion paper closed on the 31 January 2019. At the time of writing, there is no specific information on the next steps.
The regulatory focus on sustainable finance and climate related-risks and issues will likely grow stronger in the coming months and years. Customers and the wider public express greater demand for ‘greener businesses’. The vast majority of the world’s public authorities, are committed to tackling climate change and the financial regulators have started setting their expectations around risk management and governance. All these elements are setting the stage for increased transparency, regulation and necessary adoption of new business practices. Firms will be required to take a more strategic approach and analyse how actions in the present can impact the future financial risks.
Particularly around governance, in line with the PRA’s recent policy statement, firms should identify and allocate responsibilities between Senior Management Functions (SMFs) for managing climate risks in their businesses. The SMFs Statement of Responsibilities will need to be updated accordingly, and evidence kept around the board and relevant sub-committees’ effective oversight of climate risk management and controls.
In respect of risk management and scenario analysis, one of the key challenges will be the lack of reliable data to build models for estimating future climate change impacts. Developing robust risk management frameworks around climate change, will require long term efforts and continuous improvement as firms learn from their individual experiences and peers. The sector must be ready as this ever-present issue becomes routed in business agenda and sustainable approaches become more critical to long term success.