Climate change and risk management have become a hot-button topic for financial institutions in recent years because of rising concerns from policymakers, international organizations, financial regulators, and many others. This push for a more environmentally friendly world is leading to changes in organizational resources and operations, investor expectations, environmental activists, and even the expectations of the current administration. With all this focus on environmental safety, it is inevitable for financial institutions to consider the impacts and learn how to manage the risk.

What Is Climate Change?

Climate change is a change in global or regional climate patterns, specifically, a change in global or regional climate patterns from the mid-20th century through today, largely attributed to increases in atmospheric carbon dioxide levels produced by fossil fuel usage. It can be controversial, but whatever side of the fence you stand on, there are climate-related financial risks faced by banks, and managing that risk can be critical.

What Type of Risk Should Financial Institutions Consider?

According to various regulatory agencies, climate change and the transition to a low-carbon economy have been identified as contributors to emerging risks facing financial institutions and the overall financial system of the United States. The agencies indicate that banks will likely be impacted by physical and transition risks associated with climate change. Physical risks are considered harmful to people and property arising from acute, climate-related events: flooding, hurricanes, heatwaves, etc. Transition risks are considered stresses to financial institutions because of shifts in policy, consumer or business sentiments, or technological changes to limit the impact of climate change. Basically, transition risk is the risk due to the transition to a more environmentally friendly process or way of conducting business and operations. Financial institutions should also consider credit risk, market risk, liquidity risk, operational risk, and reputational risk, especially as they relate to the safety and soundness of their institutions.

Principles for Managing Climate-Related Risk

While there isn’t currently specific regulatory guidance for achieving compliance and managing the risk related to climate, we will likely see this type of guidance in the near future. Regulatory agencies have addressed the issues, requested feedback for managing the risk, and are looking at implanting regulatory requirements for large financial institutions, including banks with over $1 billion in assets. The OCC (Office of the Comptroller of Currency), along with other regulatory agencies, has released guidance, requests for information, and a set of principles financial institutions should consider in managing climate-related risks. The information released by the OCC includes a set of general principles as well as specific areas of risk management.

The general principles touch on governance – policies, procedures, and limits; strategic planning; risk management; data, risk measurement, and reporting; and scenario analysis. These principles provide guidance for developing an effective framework essential to the bank’s safe and sound operations. The principles outline expectations for board and senior management oversight, guidance for developing a written program, and the areas of consideration for planning, which should consider the bank’s overall business strategy, risk appetite, and financial, capital, and operational plans. It is also important that management is involved in overseeing the development and implementation process for identifying, measuring, monitoring, and controlling climate-related financial risk exposure within the bank’s management framework. Sound climate risk management is dependent upon the availability of relevant, accurate, and timely data; therefore, management should incorporate climate-related financial risk information into the bank’s internal reporting, monitoring, and escalation processes to facilitate timely and sound decision-making across the bank. The development of climate-related scenario analysis is an important approach for identifying, measuring, and managing climate-related risks.

To ensure this framework is effective and successful, financial institutions should consider a risk assessment process as part of their sound risk governance framework. This will ensure that the board and senior management can identify emerging risks to develop and implement the appropriate strategies to mitigate and manage the risks. The guidance issued by the OCC suggests that financial institutions should consider incorporating climate-related financial risks when identifying and mitigating all types of risk. While the agencies will eventually elaborate on risk assessment principles, it is suggested that financial institutions consider credit risk, liquidity risk, other financial risk, operational risk, legal/compliance risk, and other nonfinancial risk.

Conclusion

While there is no specific set of guidelines for financial institutions to follow for climate risk, compliance, and management, this is an area that all banks should begin considering from a safe and sound banking standpoint. Future guidance will likely apply or be required of larger financial institutions; however, the guidance and risk considerations should be contemplated by institutions of all sizes. Risks can impact even smaller institutions, so taking a proactive approach rather than making a reactive response is the best plan of action. It is important that financial institutions stay abreast of the hot-button area of climate change and climate risk from a compliance and risk management perspective, as the society in which we are living continues to set a higher standard for an environmentally friendly world.