Climate change and risk management have become hot-button topics for financial institutions in recent years as a result of the rising concern by policymakers, international organizations, financial regulators, and so many others. There has been a big push in recent years for a more environmentally friendly world as we see changes in organizational resources and operations, investor expectations, environmental activists, and even the expectations of the current administration. With all the focus on environmental safety, considering the impacts and learning how to manage the risk is inevitable for financial institutions.

What is Climate Change?

Climate change is considered to be a change in global or regional climate patterns — more specifically, a change in global or regional climate patterns from the mid-20th century through today. It has been largely attributed to an increase in atmospheric carbon dioxide levels, which are produced by fossil fuel usage. It can be a controversial topic among various groups, but whatever side of the fence you stand on when it comes to climate change, banks face climate-related financial risks and managing that risk can be critical.

What Type of Risks Should Financial Institutions Consider?

According to the varying regulatory agencies, financial institutions and the overall financial system of the United States are faced with emerging risks, both physical and transition, from contributing factors such as climate change and the transition to a low-carbon economy. The harm to people and property which arises from acute, climate-related events (flooding, hurricanes, heatwaves, etc.) is considered a physical risk. Stresses to financial institutions as a result of the shifts in policy, the adjustments in consumer or business sentiments, or the changes in technology in order to limit the impact of climate change are considered transition risks. In other words, a transition risk is the risk of the transition to a more environmentally friendly process or way of conducting business and operations. Other risks that financial institutions should consider as it relates to climate change and the environment include credit risk, market risk, liquidity risk, operational risk, and reputational risk. Banks must consider the various areas of risk, especially as they consider the safety and soundness of their institution.

Principles for Managing Climate-Related Risk

While there currently isn’t specific regulatory guidance for achieving compliance and managing the risk related to climate, we are likely to see this in the near future. Regulatory agencies have addressed the issues, have requested feedback for managing the risk, and are looking at implanting regulatory requirements for large financial institutions. This would include banks with over $1 billion in assets. The OCC (Office of the Comptroller of Currency), along with other regulatory agencies, have released guidance, requests for information, and a set of principles by which financial institutions should consider in managing climate-related risks. The information released by the OCC includes a set of general principles as well as the 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. The general principles provide guidance for developing an effective framework that is essential to the bank’s safe and sound operations. The principles outline expectations for the board and senior management oversight, guidance for developing a written program, and areas of consideration for planning which should take into account the bank’s overall business strategy, risk appetite, and financial, capital, and operational plans. It is also important that management is involved in the oversight of 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. An important approach for identifying, measuring, and managing climate-related risks is the development of climate-related scenario analysis.

In order 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 are able to identify emerging risks in order to develop and implement the appropriate strategies to mitigate and manage them. 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 in subsequent guidance, 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 isn’t currently a specific set of guidance that financial institutions must abide by when it comes to climate risk, compliance, and management, this is an area which all banks should begin considering from a safe and sound banking standpoint. It looks like the future guidance related to climate risk will only apply — or be required by — large financial institutions; however, the guidance and risk considerations should be contemplated by institutions of all sizes. Risks can impact even smaller institutions; therefore, taking a proactive approach rather than a reactive response is always the best plan of action. It is important that financial institutions stay informed on 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.