Climate change: a key imperative for financial services

February 2021  |  FEATURE  |  BANKING & FINANCE

Financier Worldwide Magazine

February 2021 Issue

Despite the pressures of the ongoing COVID-19 pandemic, the financial services industry has been keen to progress the climate risk agenda. More needs to be done, however, to turn this enthusiasm into tangible action.

While on the surface it may seem that financial institutions (FIs) have less impact on the environment than, say, industrial manufacturers, they are in a unique position to influence the climate agenda. In their role as financial intermediaries, FIs have important relationships with, and investments in, companies whose operations may cause harm to the environment. FIs are evaluating these relationships to proactively identify, measure, monitor and control climate-related risks.

Moreover, according to the UK’s Prudential Regulation Authority (PRA), around 70 percent of banks recognise that climate change poses serious financial risk and jeopardises the stability of the financial system itself. “Attitudes toward climate change have been evolving within the financial services industry for some time now, but the tempo has quickened in recent years,” says Thomas W. McInerney, a partner at Bennett Jones. “What was once largely a theoretical or box-ticking exercise is giving way to increasingly substantive policy initiatives, like sustainability-linked loans and bonds.”

Physical risks can arise from events like storms, floods and droughts, while transition risks can arise from changes in environmental policy, such as the Paris Agreement, and technology, such as the growth of renewable energy. Transitioning to a greener, net zero economy could mean that some sectors face big shifts in asset values or higher costs of doing business, for example. FIs must also consider future liability risks, as people or businesses may seek compensation for losses suffered as a result of the physical or transitional impact of climate change. But climate issues can also have wider macroeconomic effects. A country whose key infrastructure is destroyed by a physical event may also see its productivity hindered and its economy deteriorate if workers are impeded from performing their tasks.

Regulatory developments

Climate change issues are global in nature, and demand a global response. Central banks, financial regulators and FIs themselves need to coordinate their efforts to reduce risks to the financial system. This includes supporting the Financial Stability Board’s (FSB’s) Task Force on Climate-related Financial Disclosures (TCFD), which encourages firms around the world to disclose more information on the financial risks arising from climate change.

“We are seeing a widespread push toward more fulsome TCFD reporting by financial institutions, particularly now in light of the recent announcements at the UK’s Green Horizon Summit,” says Ruth Knox, a managing associate at Linklaters. “This shift results from regulatory changes, such as those associated with sustainable finance and prudential regulation, but also pressure from investors and other stakeholders on the need to improve the climate risk management systems embedded within the organisation itself.”

Incorporating climate change considerations into an FI’s existing risk management framework should be the best way to ensure the organisation assesses the potential risks and impacts. This should encompass a range of risk categories, including market, credit, underwriting and so on, with relevant risk management tools and processes created to address each kind of risk.

To keep FIs committed to tackling climate change issues, boards are being urged to regularly review the response. They should also aim to be transparent about how climate change is incorporated into the decision-making process. For example, tying climate change-related targets into remuneration packages is one way to encourage and incentivise senior leaders to keep the issue on their radar.

Many central banks and financial services regulators are increasingly focused on how FIs manage and disclose climate change risks. Efforts are underway across many key regions, including the UK, the EU and Asia Pacific. The regulatory regime in the US, however, is less developed, with the country yet to introduce any regulation governing climate change issues in financial services. That said, there has been some recent movement in this area. In September 2020, the US Commodity Futures Trading Commission (CFTC) became the first US financial regulator to address climate change, concluding in its report ‘Managing Climate Risk in the US Financial System’ that “climate change poses a major risk to the stability of the US financial system”.

As the global economy continues to make strides toward mitigating and reversing the effects of climate change, cooperation between regulators and central banks will take on increased importance. More than 80 central banks and supervisors now belong to the Network for Greening the Financial System (NGFS), established in 2017 to “define, promote and contribute to the development of best practices to be implemented within and outside of the Membership of the NGFS and to conduct or commission analytical work on green finance”.

With investors and other stakeholders pushing for a response to climate change, many financial services firms are already taking steps to improve their environmental credentials, rather than wait for mandatory regulation. “Investors’ appetite for increased visibility into how environmental, social and corporate governance (ESG) factors are accounted for in their investments has created, and will continue to create, an opportunity for financial services firms,” notes Christopher Porter, an associate at Bennett Jones. “One need only see the extent of ESG-focused investment products available today, to see that such firms are not waiting for government regulation to capitalise on this trend.”

Previously, the adoption of climate change-related policies may have been driven solely by compliance concerns, but today there are larger forces at play, points out Ravipal Bains, an associate at McMillan LLP. “Asset managers are systematically integrating sustainability into their investment frameworks, considering environmental and social factors as a key part of their client mandates and increasingly engaging with management teams to analyse their sustainability plans and the impact on a firm’s long-term value. BlackRock, for instance, has been quite vocal about working climate risk into its risk management frameworks,” he says.

A number of FIs have also pooled their resources to launch collective efforts such as the Climate Action in Financial Institutions Initiative (CAFII), an organisation made up of 44 institutions as of January 2020, to create policies and drive change within the financial services community. “These collective bodies allow for the implementation of uniform strategies and objectives among institutions,” says Jason Kroft, a partner at Stikeman Elliott. “Some FIs have begun to include environmental and social risk management (ESRM) indicators in their due diligence, while others have decided to implement advisory teams to help clients capitalise on sustainable investment opportunities.”

The test of COVID-19

Of course, in 2020 FIs may have been forgiven for being preoccupied with the unique challenges created by COVID-19. But some observers point to the connection between the pandemic and the environment, in terms of evaluating FIs’ response to universal, widespread crisis. “Despite long and plentiful warnings from the scientific community about the risks of a pandemic, the financial community was unprepared for the crisis,” says Mr Bains. “So, not surprisingly, investors are increasingly treating the COVID-19 pandemic as a stress test of their preparedness for future environmental calamities.

“Banks will want to achieve a clear understanding of how regulators plan to achieve their climate goals over the medium-to-long term,” he continues. “Some have suggested that climate stress tests could feed into capital adequacy requirements for banks. FIs will also have to assess the risk exposure of their portfolios, as many traditionally capital-intensive sectors, such as the extractive industries, will undergo a transition.”

The pandemic is a practical example of a crisis without a fast, technological solution, and an economic fallout that demands significant changes to our lifestyle choices. FIs are being urged to draw lessons from the impact of the pandemic, and apply them to climate change initiatives. Regulators are doing the same. In Canada, for example, climate change has been a primary focus of the current federal government, which has used elements of its COVID-19 response strategy to advance its climate-related policy goals. When the federal government established the Large Employer Emergency Financing Facility (LEEFF) in March 2020 to provide bridge financing to Canada’s largest employers, aid was conditional upon recipient companies committing to publish annual climate-related disclosure reports, consistent with the TCFD.

To a greener future       

Though awareness of climate change has grown significantly in recent years, climate change itself is quickening its pace, with impacts more severe than expected. According to the World Economic Forum (WEF), the last five years have been the warmest on record, while natural disasters are occurring more frequently and with greater intensity.

There is a great deal of work to do in the financial services space and beyond to reverse the damage done to the environment, but it seems that FIs are acknowledging the importance of tackling climate change. According to the WEF’s ‘Global Risk Report 2020’, for the first time in the history of its Global Risks Perception Survey, environmental concerns dominate the top long-term risks by likelihood among WEF members. Furthermore, three of the top five risks ranked in the survey are also environmental.

Moving forward, FIs expect to face additional regulatory obligations as part of the movement to achieve climate change related goals. In the EU, for example, the Sustainable Finance package mandates new disclosures from asset managers on sustainability risks from March 2021, which also includes climate risks. “We know that the Non-Financial Reporting Directive is subject to a review on whether to require mandatory TCFD disclosures, and work is also being done on a unified reporting standard which factors in climate-related disclosures,” says Ms Knox. “We will also be keeping a watchful eye on the new US administration to see if climate risk management flows through into the requirements on disclosures from financial institutions in the US.”

For FIs, climate change risks require immediate attention. However, many also view the shift toward a sustainable economy as a strategic opportunity. “In Canada, this viewpoint is supported by the 2019 Final Report from the ‘Expert Panel on Sustainable Finance’, which carved a pathway for the scalability of sustainable growth markets and financial products,” says Victor MacDiarmid, an associate at Stikeman Elliott. “Many FIs have implemented policies or structures to facilitate sustainable investments, backed by larger firm-wide ambitions of achieving climate-related goals.

“These policies reconcile with general consumer sentiment toward adopting sustainable practices and pressure from governing bodies, alike,” he adds. “Although it is too early to see the wider effects of these policies, FIs have made it clear that they are willing to mobilise and bring new opportunities into the mainstream.”

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Richard Summerfield