By Frankie Phua, Managing Director and Head of Group Risk Management, UOB
Since the former Bank of England Mark Carney’s clarion call in 2015 for the financial sector to recognize and act on climate risk, we have seen a dramatic response with climate change firmly entrenched at the top of global agenda. The string of climate disasters in recent years e.g., widespread floods in Europe and Asia in 2021 and wildfires in Australia in 2019-2020 has thrown into sharp relief the severe human and economic losses arising from climate change, helping to dispel climate skepticism.
Rising recognition of the systemic threat of climate change has compelled policymakers and regulators worldwide to take stronger and more concerted actions.
According to SBTi (SBTi, n.d.), 90% of global GDP is now covered by net-zero targets, up from just 16% in 2019 pointing to the enormous structural shift ahead and associated transition risk. From its inception in Dec 2017 involving just eight (NGFS, 2017) pioneer central banks and supervisors, NGFS has grown fourteenfold to 114 members as of April 2022.
With climate risk emerging as one of the supervisory priorities, more and more regulators have released guidelines on climate-related disclosure and risk management. As part of a holistic approach to address risks to the global banking system, BCBS recently published a public consultation on a set of principles for effective management and supervision of climate-related financial risks.
In ASEAN , Bank Negara Malaysia is in the process of issuing requirements and guidance on climate risk management and scenario analysis, coming on the heels of MAS ’s Guidelines on Environmental Risk Management in Dec 2020. One common expectation is for banks to build capability in climate stress testing, with ~20 exercises rolled out globally over the past few years.
Frankie Phua
Managing Director and Head of Group Risk Management, UOB
Unlike traditional credit stress test (typically 1-3 year horizon), climate stress tests are unique in their extended time horizon (30 years) to capture the long-run build-up of climate impacts. Instead of assessing banks’ capital adequacy, climate stress testing is intended as a “what-if” exercise to evaluate the impact on banks’ risk profile and business strategies, as well as resilience to financial losses under a range of climate scenarios.
As it is based on scenarios and parameters from preliminary research, it is therefore not an exercise to predict actual future impacts. Due to the uncertain trajectory of climate change and associated impact, regulators have required banks to run several climate scenarios representing different transition pathways, each with its accompanying climate-adjusted macroeconomic variables.
As climate change impacts various sectors differently, sector-specific pathways and variables also need to be developed. Furthermore, to probe the impact on top counterparties, granular bottom-up analysis is also required which entails detailed data e.g. financial performance, production output, business mix, carbon emissions. In particular, the effects of physical risks are difficult to simulate and necessitate intensive data collection effort (e.g. exact location and type of assets).
While it is easy to be overwhelmed by the sheer complexity and challenges, there are thankfully solutions that have emerged in the industry. NGFS has put together six harmonized sets of climate scenarios and pathways which greatly help banks overcome the unchartered territory of climate science and ensure consistency and comparability. These scenarios have been widely adopted by regulators, i.e. the orderly transition, disorderly transition and hot house world.
Unlike traditional credit stress test (typically 1-3 year horizon), climate stress tests are unique in their extended time horizon (30 years) to capture the long-run build-up of climate impacts.
As lack of reliable and comparable climate-related data remain a key impediment, NGFS has set up a workstream to bridge data gaps to support the need for more forward-looking and granular data (e.g. physical asset level data, physical and transition risk data and financial assets data).
Instead of waiting for a perfect solution, banks may in the meanwhile rely on external data e.g. carbon emissions and use industry proxies where data is unavailable.
In Singapore, the industry has come together to develop the ABS Environmental Risk Questionnaire, a standard template for banks to engage clients on both environmental and climate risk issues and to gather much-needed data, especially from small and medium enterprises.
Methodologies have also improved since the first UNEP FI -convened TCFD transition scenario analysis pilot in April 2018 with banks able to accelerate their capability-build by leveraging on external experts while drawing on internal sector expertise for any necessary customization and to validate assumptions.
Results of completed climate risk stress tests (ECB, HKMA, BOE) show potentially significant impact on profitability if banks fail to transition, with projected losses varying by geography and type of financial institution. Nonetheless, at present these exercises are exploratory in nature; they are not “pass or fail” exercises nor have direct implications on banks’ capital levels.
There are existing discussions on how wider environmental risk should be incorporated into the overall prudential framework with regulators such as EBA seeking opinions from stakeholders. In view of the longer time horizon and high level of uncertainty associated with climate risk, standard Pillar 1 instruments may not be appropriate to address such risks.
In comparison, the flexibility of the Pillar 2 framework makes it a better option for supervisory assessments on material idiosyncratic climate risks faced by banks particularly as climate stress testing