Need for climate risk management | Daily News
Climate change as a source of financial risk

Need for climate risk management

The Network for Greening the Financial System (NGFS) has come out with their report. In October they had said, “climate-related risks are a source of financial risk. It is therefore within the mandates of central banks and supervisors to ensure the financial system is resilient to these risks.”

The legal mandates of central banks and financial supervisors vary throughout the NGFS membership, but they typically include responsibility for price stability, financial stability and the safety and soundness of financial institutions. Even though the prime responsibility for ensuring the success of the Paris Agreement rests with governments, it is up to central banks and supervisors to shape and deliver on their substantial role in addressing climate-related risks within the remit of their mandates.

The NGFS recognises that there is a strong risk that climate related financial risks are not fully reflected in asset valuations. There is a need for collective leadership and globally coordinated action and, therefore, the role of international organisations and platforms is critical.

The NGFS is planning to develop:

(i) a handbook on climate and environment-related risk management for supervisory authorities and financial institutions;

(ii) voluntary guidelines on scenario-based risk analysis;

(iii) best practices for incorporating sustainability criteria into central banks’ portfolio management

(Particularly with regard to climate-friendly investments).

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Climate change is one of many sources of structural change affecting the financial system. However, it has distinctive characteristics that mean it needs to be considered and managed differently.

These include:

* Far-reaching impact in breadth and magnitude: climate change will affect all agents in the economy (households, businesses, governments), across all sectors and geographies. The risks will likely be correlated with and potentially aggravated by tipping points, in a non-linear fashion. This means the impacts could be much larger, and more widespread and diverse than those of other structural changes.

* Foreseeable nature: while the exact outcomes, time horizon and future pathway are uncertain, there is a high degree of certainty that some combination of physical and transition risks will materialise in the future.

* Irreversibility: the impact of climate change is determined by the concentration of GreenHouse Gas (GHG) emissions in the atmosphere and there is currently no mature technology to reverse the process. Above a certain threshold, scientists have shown with a high degree of confidence that climate change will have irreversible consequences on our planet, though uncertainty remains about the exact severity and time horizon.

* Dependency on short-term actions: the magnitude and nature of the future impacts will be determined by actions taken today, which thus need to follow a credible and forward-looking policy path.

This includes actions by governments, central banks and supervisors, financial market participants, firms and households.

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The NGFS, as a coalition of the willing and a voluntary, consensus-based forum provides six recommendations for central banks, supervisors, policymakers and financial institutions to enhance their role in the greening of the financial system and the managing of environment and climate-related risks.

Recommendation n°1: Integrating climate-related risks into financial stability monitoring and micro supervision. Important steps in this regard include:

a) Assessing climate-related financial risks in the financial system by: mapping physical and transition risk transmission channels within the financial system and adopting key risk indicators to monitor these risks conducting quantitative climate-related risk analysis to size the risks across the financial system, using a consistent and comparable set of data-driven scenarios encompassing a range of different plausible future states of the world; considering how the physical and transition impact of climate change can be included in macroeconomic forecasting and financial stability monitoring.

b) Integrating climate-related risks into prudential supervision, including: Engaging with financial firms:– to ensure that climate-related risks are understood and discussed at board level, considered in risk management and investment decisions and embedded into firms’ strategy;– to ensure the identification, analysis, and, as applicable, management and reporting of climate related financial risks.

Setting supervisory expectations to provide guidance to financial firms as understanding evolves.

Recommendation n°2: Integrating sustainability factors into own-portfolio management.

Recommendation n°3: Bridging the data gaps. The NGFS recommends that the appropriate public authorities share data of relevance to Climate Risk Assessment (CRA) and, whenever possible, make them publicly available in a data repository. In that respect, the NGFS sees merit in setting up a joint working group with interested parties to bridge the existing data gaps.

Recommendation n°4: Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing.

Recommendations n°5 and 6 do not fall directly within the remit of central banks and supervisors but point to actions that can be taken by policymakers to facilitate the work of central banks and supervisors. Parts of these recommendations may also be applicable to the private sector.

Recommendation n°5: Achieving robust and internationally consistent climate and environment related disclosure.

Recommendation n°6: Supporting the development of a taxonomy of economic activities.

(i) Contribute to the transition to a green and low-carbon economy and (ii) are more exposed to climate and environment-related risks (both physical and transition). 


 

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