Climate Risk Management in Financial Industry
Bank of England releases a consultation paper on climate risk management in financial industry, aimed at providing guidance on climate risk management for banks and insurance companies.
Bank of England believes that effective risk assessment and risk management capabilities will help banks and insurance companies resist climate risks.
Related Post: UK Financial Conduct Authority Releases Climate Adaptation Report in Financial Industry
Climate Risk Impact in Financial Industry
Climate risks are typically divided into physical risks and transitional risks, which have the following characteristics:
- Climate risks may affect the overall system of the financial industry, and these impacts are nonlinear and irreversible. Over time, climate risks may surpass critical points and continue to expand.
- Climate risks in uncertain, and although the market has clear classification methods for physical and transitional risks, the actual risks that occur cannot be accurately predicted.
- The development of climate risks depends on current actions. After the occurrence of climate risks, it is difficult to reverse them by reducing carbon emissions. If current actions are taken, more future risks can be reduced.
For banks, climate risk can reduce borrowers’ repayment ability, lower the value of collateral assets, and affect the bank’s regular business activities (credit risk, operational risk). For insurance companies, climate risk can lead to an increase in claims and may affect the assets held by the insurance company (underwriting risk, market risk).
Previous investigations by the Bank of England into banks and insurance companies have shown that the ability of these financial institutions to identify and manage climate risks is still in its early stages. For example, most financial institutions have not yet established climate risk indicators or defined climate risk preferences. In terms of scenario analysis, financial institutions lack climate data from enterprises and rely more on qualitative analysis.
Consultation Paper on Climate Risk Management in Financial Industry
The consultation paper on climate risk management in financial industry refers to the Supervisory Statement SS3/19 issued in November 2024, which sets out requirements from the perspectives of governance, risk management, scenario analysis, and disclosure. The consultation document categorizes the above requirements into the following aspects:
- Governance: Financial institutions need to provide climate risk information to their boards of directors to ensure that they set climate risk preferences and regularly review climate risk management practices and strategies. The board of directors needs to clarify the relationship between financial institution business strategies and climate change and define climate risk indicators at both the company and business levels.
- Risk Management: Financial institutions need to identify and assess material climate risks and regularly evaluate their climate risks with stakeholders such as customers, counterparties, and investees. They also need to develop internal risk reports and disclose the impact of climate risks to their boards of directors.
- Climate Scenario Analysis: Financial institutions need to use climate scenario analysis to assess climate risk exposure and apply it to investment decisions. They also need to understand the limitations and uncertainties of scenario analysis and continuously update scenario assumptions that are suitable for the company’s actual situation.
- Data: Financial institutions need to identify and evaluate data gaps, invest in data tools, frameworks, and capabilities to reduce the negative impact of data. When using third-party data, they should establish effective supervision and management systems.
- Disclosures: Financial institutions are required to use internationally recognized sustainable disclosure standards such as the International Sustainability Standards Board Standards (ISSB Standards) to disclose information.
- Banking-specific issues: Banks need to assess climate risk related capital and incorporate it into credit risk management to address liquidity and funding risks.
- Insurance-specific issues: Insurance companies need to incorporate climate risk into risk management framework and integrate climate scenarios into risk and solvency assessments, reflecting climate risk on balance sheets.
Reference:
Enhancing Banks’ and Insurers’ Approaches to Managing Climate-related Risks
