The growing importance of climate and environmental risks in the financial sector cannot be overstated. As the world grapples with the impacts of climate change, financial institutions are increasingly recognising the need to integrate climate and environmental risks into their risk management frameworks. Effective risk identification and management strategies are crucial for mitigating potential negative outcomes, such as financial losses or threats to continuous operations.
Understanding Climate and Environmental Risks
Climate risks can be broadly categorised into physical, transitional, and liability risks.
- Physical Risks: These refer to the financial impact of a changing climate, including more frequent extreme weather events and gradual changes in climate, as well as environmental degradation such as air, water, and land pollution. Physical risks are categorised as “acute” when arising from extreme events like droughts, floods, and storms, and “chronic” when arising from progressive shifts like increasing temperatures, sea-level rises, and biodiversity loss.
- Transition Risks: These refer to financial losses that can result from the process of adjustment towards a lower-carbon and more environmentally sustainable economy. This could be triggered by abrupt adoption of climate policies, technological progress, or changes in market sentiment.
- Liability Risks: Physical and transition risks can trigger further losses stemming from legal claims on the institution and reputational loss for failing to adequately manage climate-related and environmental risks.
Examples of environmental risks relevant to financial institutions include water stress, biodiversity loss, and deforestation.
The Regulatory Landscape
The regulatory framework for climate risk management in financial institutions is evolving rapidly, driven by the increasing recognition of climate change’s impact on financial stability. Key regulations and guidelines include:
- Task Force on Climate-related Financial Disclosures (TCFD): Established by the Financial Stability Board, the TCFD provides recommendations for companies to disclose climate-related financial risks and opportunities. It focuses on four key areas: governance, strategy, risk management, and metrics and targets.
- EU Taxonomy: This is a classification system established by the European Union to help investors and companies identify environmentally sustainable economic activities. It sets criteria for determining whether an activity contributes to environmental objectives such as climate change mitigation and adaptation.
- Principles for Climate-Related Financial Risk Management: Issued by federal bank regulatory agencies, these principles provide a high-level framework for managing exposures to climate-related financial risks. They address governance, policies, procedures, strategic planning, risk management, data, risk measurement, and reporting.
Compliance with these regulations is crucial for financial institutions to ensure they are adequately prepared to manage climate-related risks. Reporting requirements help institutions maintain transparency and accountability, fostering trust among stakeholders and investors.
Risk Identification Framework
Effective risk identification is the cornerstone of robust risk management. Financial institutions employ various techniques to identify climate and environmental risks, including:
- Stress Testing: This involves identifying risk scenarios using historical data and industry trends. Metrics are defined to measure the impact of these scenarios on the institution’s financial health. Stress testing helps institutions understand their vulnerabilities and prepare for potential adverse events.
- Scenario Analysis: This technique quantifies potential impacts of different climate-related scenarios, assesses reputational damage, and develops mitigation strategies. Scenario analysis provides a forward-looking perspective, allowing institutions to evaluate the resilience of their strategies and risk management practices.
Data collection and analysis are fundamental to these techniques. Accurate and comprehensive data enable institutions to build a thorough picture of the risks they face, influencing stakeholders and improving decision-making. By integrating these frameworks into their risk management processes, financial institutions can create a risk-aware culture that fosters informed decision-making and enhances strategic planning
Integrating ESG into Risk Management
Integrating environmental, social, and governance (ESG) factors into risk management frameworks is crucial for building a resilient and sustainable financial institution. Tools and methodologies such as risk assessment models and sustainability metrics can aid in this integration.
In conclusion, climate risk management is essential for safeguarding financial stability. Financial institutions must adopt robust risk identification and management strategies to mitigate the impacts of climate and environmental risks.
How ARQ Can Help
ARQ offers expertise in assessing climate and environmental risks, helping companies prepare for and manage these risks effectively. Our key services include:
- Climate and Environmental Risk assessments.
- Assessing and reviewing stress testing.
- Training programs and workshops.
For more information, please speak to Martina Cutajar – Senior ESG Advisor – Risk and Compliance.
Manfred Galdes
Managing Partner
A lawyer by profession, Manfred Galdes is the managing partner at ARQ. He has spent over twenty years of experience practising in the area of regulatory and AML compliance, having held leading roles both in the private and public sector. A lawyer by profession, Manfred Galdes is the managing partner at ARQ. He has spent over twenty years of experience practising in the area of regulatory and AML compliance, having held leading roles both in the private and public sector.
