Unit 5: Risk Management PDF

184 |Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management INTRODUCTION LEARNING OBJECTIVES The identification, disclosure and management of climate- On completion of this chapter, you will be able to: related ris...

184 |Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management INTRODUCTION LEARNING OBJECTIVES The identification, disclosure and management of climate- On completion of this chapter, you will be able to: related risks – and environmental and sustainability risks more broadly – have become priorities for policymakers, describe the nature and importance of key climate- central banks, financial institutions and finance related and environmental risks; professionals in recent years. Growing awareness of the explain the different types of climate-related risks scale and scope of physical and transition risks and their (physical, transition, liability) and their impacts on the impacts on countries, communities, economic activities finance sector; and entities - and financial institutions - has led to a describe the emergence of climate-related and rapidly developing regulatory agenda in this area. These environmental risks as priorities for central banks, are cross-cutting risks, which affect many other risks regulators and policymakers; and faced by financial institutions. In all scenarios, despite efforts to achieve the objectives of the Paris Agreement, examine approaches to identifying, disclosing and the impacts of climate-related and other environmental managing climate-related risks, the use of scenario and sustainability risks will increase due to global analysis, and the evolving regulatory agenda in this warming. area. In this chapter, we explore key climate-related and broader sustainability risks, introduce a range of approaches to identifying, disclosing and managing these, and discuss emerging regulation in this area. We examine the Task Force on Climate-related Financial Disclosures (TCFD) and the Task Force on Nature-related Financial Disclosures. Where there are risks, there are opportunities too, especially for financial institutions able to advise and finance clients’ and customers’ transitions to low-carbon, more sustainable business models. 185 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management 5.1 INTRODUCTION TO CLIMATE, ENVIRONMENTAL AND SUSTAINABILITY RISKS There is growing awareness of the current and future impacts of climate change and broader environmental and social sustainability risks. A decade ago, the World Economic Forum’s (WEF’s) top global risks included only one risk related to the environment. Today (2022), climate change – and specifically the risk of failing to act on climate change – is identified by business leaders, policymakers, academics and NGOs as the key risk faced by business, finance and society over the next ten years1. All of the top five risks identified as likely to materialise were related to climate change and the environment. In addition to climate action failure: extreme weather, biodiversity loss, natural resource crises and man-made environmental damage were recognised as key issues requiring attention by policymakers, regulators, business leaders and others. The table below shows how awareness of climate and environmental related risks has grown since the signing of the Paris Agreement in 2015: WEF TOP 5 GLOBAL RISKS: 2016 TO DATE 2016 2017 2018 2019 2020 2021 2022 Involuntary migration Extreme weather Extreme weather Extreme weather Extreme weather Extreme weather Climate action failure Extreme weather Involuntary migration Natural disasters Climate action Failure Climate action Failure Climate action Failure Extreme weather Human environmental Climate action failure Natural disasters Cyber-attacks Natural disasters Natural disasters Biodiversity loss damage Interstate conflict Terrorist attacks Data fraud or theft Data fraud or theft Biodiversity loss Infectious diseases Natural resource crises Human-made Human environmental Natural catastrophes Data fraud or theft Climate action failure Cyberattacks Biodiversity loss environmental disasters damage Source: Adapted from Certificate in Climate Risk Study Guide (Chartered Banker Institute, 2022). This underlines the extent to which climate, environmental and sustainability risks have become priorities for policymakers, regulators, business and financial institutions. As we will explore in this chapter, these are understood as significant, growing and cross-cutting sources of risk to customers, institutions and the economy overall in the short, medium and long terms, and are considered as potential threats to institutional and global financial stability. These are not completely ‘new’ or ‘emerging’ risks, however. The financial risks of climate- related events, such as the costs to insurers and asset owners following extreme weather events such as hurricanes, floods, or wildfires, have been apparent for some time, as reflected in the table above. Where there are risks, however, there are also opportunities for investors and lenders in areas such as green infrastructure and energy, clean transport and other climate change mitigation and adaptation technologies, and supporting organisations’ transitions to more sustainable, low-carbon business models. With an estimated $6 trillion of investment per year required to support the transition to a sustainable, low-carbon world, as we saw in Chapter 1, there are substantial commercial opportunities as well as significant risks for many businesses and financial institutions, which we explore elsewhere in this study guide. 186 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management As we briefly introduced in earlier chapters, risks posed to the financial sector, and to all economic sectors QUICK QUESTION: WHAT ARE SOME OF THE KEY CLIMATE- and society as a whole by climate change and other environmental and sustainability factors, can be classified RELATED, ENVIRONMENTAL AND SUSTAINABILITY RISKS in three ways: FACED BY A BUSINESS YOU ARE FAMILIAR WITH? HOW MIGHT THESE IMPACT BANKS, INVESTORS AND INSURERS Physical risks arising from the direct impacts of climate-related and environmental hazards on human EXPOSED TO THAT BUSINESS? and natural systems, such as droughts, floods and Write your answer here before reading on. storms. These impose direct costs on the businesses and communities impacted, and indirect costs through disruption of supply chains. Financial institutions are also impacted, for example through insurance losses and impairments to loans and investments. Transition risks arising from the transition to a low- carbon economy, such as developments in climate policy, new disruptive technologies, or changing investor and consumer sentiment. These can lead to increased costs to fund the transition to new, more sustainable business models. For some sectors and firms, the transition to net zero may lead to significant losses in economic value due to impaired or stranded assets. Liability risks arising from parties who have suffered loss or damage from the effects of climate change, environmental damage or negative social sustainability impacts and who seek compensation from those they hold responsible. Some categorise liability risks as a subset of transition risks, but for the purposes of this study guide we explore them separately, except where the context requires otherwise. 187 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management We explore each of these in detail in section 5.2. It is to co-ordinate and harmonise approaches to climate, environmental and sustainability risks through bodies such as important to understand, however, that in terms of the Financial Stability Board (FSB), which established the Task Force for Climate-related Financial Disclosures (TCFD), the these risks, every future scenario we face includes Network for Greening the Financial System (NGFS), and the Task Force on Climate-related Financial Risks (TFCR), which we significantly increased physical, transition or liability risks, introduced in Unit 3. We will also introduce the recently established Task Force for Nature-related Financial Disclosures or more likely a combination of these. If we fail to tackle (TNFD), which seeks to address a wider set of environmental and sustainability risks. global warming and other environmental issues, then physical impacts, including rising surface temperatures Climate, environmental and broader sustainability risks may be treated as stand-alone risks, that is, as risks in their own and sea levels, extreme weather events and a loss of right (for example, the direct costs of the physical impacts of climate change, and the costs of transitioning to lower- biodiversity – and the financial impacts associated with carbon, more sustainable forms of production and distribution). They are also cross-cutting (transverse) risks, which these – will continue to rise. The costs of legal action and impact many other types of risk faced by organisations, as set out in the table below: redress will also increase. Achieving net zero by mid- century moderates (without eliminating) climate and CLIMATE, ENVIRONMENTAL AND SUSTAINABILITY RISKS AS CROSS-CUTTING RISKS environmental hazards, but at the same time creates very substantial transition risks for most, if not all, economic CROSS-CUTTING CLIMATE, ENVIRONMENTAL AND SUSTAINABILITY RISK IMPACT AREAS activities and entities. As we saw in Chapter 1, it is estimated that, globally, financial institutions’ lending and Financial/Credit Market Operational Reputational Compliance/Legal investment portfolios overall are currently aligned with more than 3°C to 3.75°C of global warming, substantially Higher fossil fuel Increased cost in excess of the objectives of the Paris Agreement; this Loss of collateral/ Reduced input costs License to operate of regulation implies that most are currently exposed to significant asset value competitiveness levels of transition risk if we accept that policy, regulation Process called into question and regulatory Borrower’s inability to Product enforcement and societal action will successfully decarbonise the inefficiencies Talent acquisition repay loans obsolescence economy. Irresponsible and retention Third party civil Access to/cost of Missing actions product stewardship Consumer action These factors are increasingly driving assessments capital opportunities for of financial risk, including potential asset impairment new markets Equipment end-of- and sentiment Lender/investor and Reduced liquidity and stranding, at both the institutional and financial life obligations insurer liability system levels. Many of these risks are currently poorly understood and mispriced, and their probability and/ Source: UNEP FI (2016) – adapted by author or impact underestimated, resulting in significant over- exposure. In addition, the lack of consistent disclosure of these climate, environmental and sustainability risks has made it difficult for decision-makers, investors, and regulators to monitor, compare and contrast exposure to such risks and take appropriate action. In section 5.3 we will discuss how central banks and regulators are seeking 188 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Given the cross-cutting nature of these risks, and to chains. In the longer term, rising temperatures and sea Change (IPCC), global economic damage from the physical make sure the management of these is fully embedded levels may make parts of our planet uninhabitable. impacts of climate change is expected to reach $54 into financial institutions’ strategies and operations, trillion by 2100 with global warming of 1.5°C, and $69 appropriate climate, environmental and sustainability There are quantifiable direct costs associated with trillion with warming of 2°C4. risk governance and risk management structures need physical risks. A severe flood will damage property and to be developed. To be effectively embedded, these must infrastructure and disrupt supply and distribution chains The costs of physical risks caused by climate change, be supported by a culture of climate, environmental and trade. It will leave communities facing substantial particularly the increased frequency and severity of and sustainability risk awareness and management that clean-up and redevelopment costs. Insurers may cover extreme weather events, are significant and increasing, ensures (as we saw in earlier chapters) that: “… every some or all the direct costs, but economic disruption both to the individuals, firms and communities directly professional financial decision takes account of climate may continue for months or years. Local businesses affected and to the banks, insurers and investors change.” Education and training for risk professionals, and communities may face increased, ongoing costs to exposed to those risks. In fact, no sector or firm is and all finance professionals more broadly, plays an fund flood prevention measures. Businesses may decide immune to the physical effects of climate change, not important role in developing and sustaining such cultures. to relocate, with a loss of jobs and, potentially, knock- least because of the impacts of physical risks on complex This needs to go beyond sustainability specialists and on economic effects on other local businesses and global supply and distribution chains. In assessing the encompass all front-line risk owners (i.e. the majority commercial/residential property prices. Financial firms exposure of lending and investment portfolios to climate of finance professionals), as well as risk professionals that own assets in, lend to, or invest in the area may face risks, therefore, financial institutions need to consider themselves. impairments or losses. Insurance premiums may well not just the direct physical risks faced by office and rise, and in some cases, assets may become uninsurable, production facilities, but risks across what are often 5.2 CLASSIFICATION OF CLIMATE, ENVIRONMENTAL unless there is public sector intervention to share some highly complex value chains. Given the interdependency AND SUSTAINABILITY RISKS of the risk with insurers. and “just-in-time” nature of many of these, an event in one location can severely disrupt production and sales As we saw previously, climate, environmental and The financial implications of physical risks on the other side of the world, as the many examples sustainability risks can be classified as physical, transition In Chapter 2, we saw that 10 weather-related disasters of global disruption caused by the COVID-19 lockdowns and liability risks, and we explore each in turn below. alone were estimated to have cost more than $140 billion have demonstrated. Some (including the TCFD) categorise liability risks with in 2020. In 2021, extreme weather events caused total transition risks, but for the purposes of this study guide damage of $280 billion, according to Munich RE2 - an In November 2020, the Financial Stability Board (FSB) we treat the two separately. increase of 30% from the previous year and of 70% concluded that, whilst at present physical risks do compared with 2019. not appear to be having a significant impact on asset 5.2.1 Physical risks valuations (i.e. the physical risks of climate change are Physical risks relate to the material effects of climate Looking ahead, Swiss Re forecasts that the world already priced in), there is a considerable downside “tail change, some of which we are already experiencing. As economy could lose up to 18% of GDP by 2050 if no risk” – a risk that, whilst currently considered improbable, we saw in Chapter 2, climate change is increasing the climate action is taken, with economies in Asia being might in the future crystallise. Without robust climate frequency and severity of extreme weather events. In particularly impacted3. Limiting global warming to 2°C risk management, the FSB is concerned that physical many cases, the impacts of these are greater than in the above pre-industrial levels would still see global GDP and transition risks (the latter is covered in 5.2.2) could past because of the distribution of the growing global fall by 11%, and by 4% if warming is limited to 1.5°C. combine, leading to an amplification and acceleration of population, and the growth of complex, global supply According to the Intergovernmental Panel on Climate financial instability5. 189 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management The Task Force on Climate-related Financial Disclosures As we saw in Chapter 3 and throughout this study (TCFD) divides physical risks into: guide, global and national policy, regulatory and societal responses aimed at reducing greenhouse gas emissions Acute risks: with severe, short-term impacts such as a and achieving net zero by 2050 have accelerated since floods or hurricanes the signing of the Paris Agreement in 2015. Green and Chronic risks: with more gradual, longer-term impacts Sustainable Finance Professionals will need to consider such as rising sea levels or surface temperatures how effectively such policies are being translated into action, and therefore, to what extent physical risks such The former, as we can see in the aftermath of many as those discussed previously will crystallise – and what extreme weather events, lead to significant short- and the impacts of these will be on lending and investment medium-term costs for clean-up, redevelopment and portfolios, and risk appetite. It is important to remember, building more climate-resilient infrastructure, costs though, that even if the objectives of the Paris Agreement often borne by insurers and other parts of the financial are achieved, global warming will still increase from services sector. current levels, and the physical impacts of climate change will still become more marked, and more disruptive. Coastal communities, industrial areas and seaports are the most likely to suffer from climate change, and, as Uncertainty caused by differences in the development we saw in Chapter 2, rising temperatures and sea levels and implementation of national climate, economic and may make parts of our planet uninhabitable. This would energy policies creates additional risks. This uncertainty result in significant asset stranding, and in costs of is compounded by the complex, systemic nature of relocating and redeveloping existing facilities. According climate change and its links with broader categories to research by C40, even if global warming is limited to of environmental and social sustainability risks, as we below 2°C above pre-industrial levels, over 570 low-lying examined in Chapter 2. This means the precise impacts coastal cities will be at risk from rising sea levels by 2050. of climate change are extremely difficult to predict, This means that some 800 million people living in major and it is hard to state with certainty what the future low-lying cities - including Amsterdam, Miami, Osaka, will hold. As we saw in Chapter 2, however, the most and Shanghai and financial centres such as London and recent (2021/2022) IPCC reports make clear that global New York - will be significantly affected6. We must also temperatures are likely to rise by more than 1.5°C above recognise the impacts on many coastal communities pre-industrial levels by mid-century, and that some of in the developing world, whose people are the least the impacts of that warming are likely to be inevitable responsible for climate change but in many cases may and irreversible, including the warming of the oceans, the be amongst those most impacted by its effects. Not all melting of Arctic ice, and the rise in sea level. regions or areas, however, will necessarily suffer the same net effects of climate change or be impacted in the same ways. 190 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management 5.2.2 Transition risks Transition risks are those risks that arise from the QUICK QUESTION: WHICH PHYSICAL RISKS ARE HIGHEST transition to a low-carbon economy. The Task Force on FOR YOUR ORGANISATION? WHAT STRATEGIES COULD Climate-related Financial Disclosures (TCFD) divides these into four types, which we explore in turn in this section: YOU PUT IN PLACE TO MINIMISE AND/OR MITIGATE THESE RISKS? Risks from developments in climate policy, legislation and regulation; for example, the introduction of Write your answer here before reading on. carbon pricing may increase a coal or gas-fired power station’s operating costs, reduce its profit margin, and potentially lead to early decommissioning. Risks from new, lower-carbon technologies which substitute for existing products and services; for example, renewables replacing fossil fuels, or electric vehicles replacing petrol and diesel vehicles. Risks from changing consumer behaviour and investor sentiment, leading to changes in demand for products and services (for example, increased demand for plant- based foods and reduced demand for meat) and in investment demand (e.g. a fall in demand for assets heavily dependent on fossil fuels). Reputational risks where organisations (and, potentially, whole sectors) may suffer from their association with high-carbon methods of production and distribution, environmental destruction or causing social harm. This may lead to falling demand and revenues, and reduced attractiveness to potential employees and investors. 191 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management The implications of the global transition to net zero in valuations. Kodak and Blockbuster are examples of zero targets consistent with the objectives of the Paris are systemic for all sectors and all firms, for to achieve firms that failed to transform their business model to Agreement and other environmental objectives, these are the objectives of the Paris Agreement every economic adjust to such changes, and no longer exist. In both cases, not universal or binding on future governments should activity and entity will need to reduce (and/or offset) this was due to new, digital technologies superseding political priorities alter. The transition to a low-carbon greenhouse gas emissions to a greater or lesser extent. existing camera and video technologies. The transition world requires long-term commitments which many Consumer demand for high-carbon goods and services to net zero is already having a similar, disruptive effect, governments can find hard to make, given the relatively will fall substantially. Firms will also face increased costs especially on the coal mining sector in some countries short lifespan of many political administrations, at least in from carbon pricing and other forms of climate and and regions. The combined market capitalisation of the democratic countries. environmental regulation. Some sectors and firms will top four US coal producers fell by 95% between 2010 and face an existential threat unless they radically – and 2015, for example, with three of the top five US firms filing In the US, for example, the 2016-2020 Trump rapidly – transform their business models in response for bankruptcy7. administration was highly sceptical about climate change, to transition risks. This, of course, poses very real risks resulting in the US withdrawing from the Paris Agreement, to the financial institutions that lend to or invest in such Transition risks impact financial institutions, as well, as increasing investment in domestic fossil fuel extraction, sectors and firms. It also offers an opportunity to help they are exposed through investment and lending to and softening environmental protection regulation. These these sectors and firms finance successful transitions. a wide range of sectors and firms across the world, all changes in policy are estimated to have added some 1.8 of which will be affected (some positively and some gigatonnes of CO2e to the atmosphere by 20358 9. Under The nature of the transition to net zero itself impacts negatively) by the transition. Banks’ balance sheets may the Biden administration, the US has re-joined the Paris on the risks organisations face. An orderly transition, be substantially impaired by lending to high-carbon firms Agreement but now faces a greater risk of a disorderly aligned with the objectives of the Paris Agreement and and sectors. Investors’ and insurers’ portfolios may be transition, with less time available to achieve net zero. supported by national and sectoral plans and policies significantly reduced in value if they are aligned with In order to do so by mid-century, the US must reduce to achieve net zero by mid-century, does not reduce more than 1.5° or 2° of global warming (as is currently the annual greenhouse gas emissions by 5.4%, which seems the scale and scope of transition risks, but at least case for the majority). The risks to financial institutions unlikely at the current pace of change. makes them – and their financial implications - broadly are increased if there is a disorderly transition, for there predictable. A disorderly transition where governments will be little time to adjust portfolios, and high-carbon Political risks are related to market risks, such as changing and others are forced into taking swift action in response assets could be substantially impaired or stranded, with consumer behaviour. Campaigning by environmental to, or to avoid, catastrophic climate change could lead to significant consequences for financial institutions and NGOs and others often seeks to influence political views a ‘climate Minsky moment’. This refers to a rapid system- financial stability overall. (and hence policy and regulation), as well as to encourage wide adjustment and an abrupt re-pricing of high-carbon individuals to change their behaviour and use consumer/ assets that would have significant impacts on the many 5.2.2.1 Transition risks: political and regulatory financial pressure to promote change. An emerging organisations and communities and financial institutions Political and regulatory risks are closely linked (a change political risk for the finance sector is that, as the physical exposed to them. A disorderly transition would threaten in government may lead to new policy and regulatory effects of climate change become increasingly apparent, national and global financial stability. priorities) but are distinct. Rapid changes in the political support for alternative and more radical political climate, which may be related or unrelated to climate approaches may increase. This could target the financial There are already examples of how disruptive changes, change and the transition to a low-carbon world, increase services sector as being ‘part of the problem, rather than linked to policy, technology, consumer preferences and uncertainty to long-term lending and investment part of the solution.’ other economic factors, can indeed cause sharp changes decision-making. Whilst many countries have set net 192 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Regulatory risks are a subset of political risks; they regulation designed to mitigate the effects of climate 5.2.2.2 Transition risks: technology encompass changes to legislation and regulation that change and support the transition to a low-carbon Technology risks occur when new, lower-carbon (or other) could have a direct effect on the value of loans and economy is based on the internalising of externalities technologies replace existing products and services, investments, and on the activities of financial institutions related to climate change and environmental degradation. which may lead to the impairment or stranding of assets. more generally. These go beyond the regulatory risks A good example of this is carbon pricing, which we This is by no means unique to green and sustainable associated with the introduction and evolution of consider in Section 5.4.2. finance; the introduction of music streaming services led financial regulations designed to address climate change to sharp declines in the sale of CDs and in the value of and broader categories of environmental and social An analysis by the consultancy Vivid Economics and the record companies, for example. We noted the well-known sustainability risks, and include the following: Principles for Responsible Investment found that the examples of Kodak and Blockbuster previously. rigorous introduction of climate policy and regulation Climate change and environmental protection consistent with the objectives of the Paris Agreement What is perhaps unique to the green and sustainable regulations (and incentives) promulgated by a wide would reduce the valuation of the 1,400 publicly-listed finance sector is the potential scale of substitution and range of government departments such as agriculture, companies in the MSCI ACWI index by between 3.1 asset impairment and stranding because of the transition energy and transport and 4.5 percent ($1.6 to $2.3 trillion) by 2025. There to a low-carbon world. This net zero transition will impact Local (municipal) government regulations that may would be significant variation within this; the 100 on almost every economic activity, and every economic affect activities encouraged or disincentivised in local worst performing companies would lose some 43% of entity, to a greater or lesser extent – it is a ‘whole areas their value, approximately $1.4 trillion. The 100 best economy transition’. A successful transition from a high- performers, however, would benefit from gains of around carbon to a low-carbon world will mean the substitution Taxation regimes, especially the introduction of carbon 33% of their current value, equivalent to some $1.7 trillion, of a wide range of products and services built using taxes and other forms of taxation to incentivise demonstrating that there are opportunities to be gained existing technologies, including, but not limited to: low-carbon investment and consumption, and from transition, too10. disincentivise high-carbon alternatives energy Renewable energy, energy efficiency and other As we discuss elsewhere in this study guide, successfully tackling climate change and other environmental issues transport incentives and subsidies being introduced or withdrawn involves time horizons that are longer than those petrochemicals normally associated with many lending and investment Regulations designed to incentivise or disallow certain construction decisions. Regulatory certainty is an important part categories of activities of this; if firms, and their investors and lenders, do agriculture and food not have reasonable certainty that the policy and clothing Regulatory developments designed to encourage regulatory landscape (especially related to permitted sustainability and/or the disclosure of climate-related consumer appliances. activities, incentives and subsidies and taxation) will risks may also offer opportunities for financial institutions remain relatively stable over time, this increases risk and and Green and Sustainable Finance Professionals. therefore disincentivises investment. These can include offering capital relief for green and sustainable lending, or stimulating the growth of new markets and low-carbon industries through subsidies, as in the case of solar and wind power. In many cases, 193 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management This will have a substantial impact not only on the producers of high-carbon goods, but also throughout their supply and distribution chains. Whilst we might QUICK QUESTION: HOW VULNERABLE ARE SOME perceive that the transition to a sustainable, low-carbon world is proceeding slowly overall, in individual cases PRODUCTS AND SERVICES YOU USE TO SUBSTITUTION BY the effects of that transition may be dramatic. They can LOW-CARBON ALTERNATIVES? WHAT WOULD CAUSE YOU be especially sudden when prompted by changes in TO SWITCH? regulation, such as to prevent the sale of new petrol- or diesel-powered cars by 2025 (as in Norway) or 2030 Write your answer here before reading on. (in the UK). This is already having an impact on car manufacturers and their supply chains, as well as on many other parts of the automotive value chain, for example car dealerships and petrol stations. Financial institutions exposed through lending and investment portfolios to both electric and petrol/diesel powered vehicles are in turn also experiencing positive and negative impacts from the transition. 194 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management 5.2.2.3 Transition risks: changing consumer Finance itself can play a role in changing behaviour and preferences and social norms social norms within the financial services sector. One Risks from changing consumer behaviour and social way to do this is to encourage and incentivise firms to norms lead to changes in demand for products and decarbonise by divesting, or threatening to divest, from services (for example, an increase in plant-based foods firms or sectors perceived as being major emitters and a decline in meat consumption) and in investment of greenhouse gases. We briefly introduced Climate demand (such as a decline in demand for assets heavily Action 100+ in Chapter 3, for example, and will look at dependent on fossil fuels). These are linked to the this in more detail in Chapter 9. In 2020, the UK’s largest political, regulatory and technology risks previously pension fund, the National Employment Savings Trust discussed in this section, and to the reputational risks (NEST), began to screen out any company involved with discussed in the following section. The distinction coal mining, oil from tar sands and arctic drilling. In comes in the fact that changing consumer behaviour 2016, Peabody, then the world’s biggest coal company, (e.g. a reduction in demand for products containing announced plans for bankruptcy, claiming that a major palm oil from non-sustainable sources) and investor factor in its decision was the impact of the divestment sentiment (such as reducing investment in traditional car movement, which had made it difficult to raise the producers and increasing investment in electric vehicle capital it needed from banks and investors to continue manufacturers) may depend less on the observable operations. Financial institutions can also help shape impacts of climate change, changes in legislation and individuals’ consumption decisions and encourage more regulation and the transition to a low-carbon economy sustainable behaviour by, for example, integrating carbon overall, and more on consumer and investor perceptions tracking and scoring into retail banking and investment of the potential benefits, costs and impacts of certain apps and platforms, some examples of which we will behaviours. explore in later chapters. If changing perceptions lead to changes in consumer behaviour, this can positively or negatively affect demand for particular goods and services, impact the value of the organisations that provide them, and in turn affect the financial institutions exposed through lending, investment and other finance activities. If changing investor sentiment leads to a greater or lesser appetite for risks, in this case environmental and climate-related risks, this may in turn lead to changes in asset allocation, diversification or disinvestment from certain companies or sectors, or to greater or lesser decarbonisation of portfolios more generally. 195 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management 5.2.2.4 Transition risks: reputational Reputational risks arise where organisations (and, QUICK QUESTION: WHAT CHANGES (IF ANY) HAVE potentially, whole sectors) suffer from being associated YOU, YOUR FAMILY AND FRIENDS MADE TO YOUR with high-carbon methods of production and distribution and other environmental harms. These can lead to CONSUMPTION CHOICES TO REFLECT THE NEED TO REDUCE falls in brand value, reduced demand for goods and GREENHOUSE GAS EMISSIONS? services, decreased revenues, increased costs of crisis management and resolution, and reduced attractiveness Write your answer here before reading on. to potential customers, employees, and investors. Reputational risks may also arise in relation to a range of broader social sustainability factors, such as using child or forced labour. Financial services firms can find themselves suffering reputational (and financial) damage if they are seen to be supporting organisations and sectors that contribute to global warming or cause other environmental or social harms - even if their own operations, within themselves, are highly sustainable. Reputational risks also arise when organisations are accused of greenwashing, some examples of which were discussed in earlier chapters (such as Volkswagen installing ‘defeat device’ software in diesel vehicles). This may lead to activist and consumer campaigns and boycotts, with falling revenues and profitability. This is a significant issue in financial services since, despite increases in the capital they deploy to support green and sustainable finance investments and activities, many financial institutions still provide substantial investment to high-carbon sectors. As we noted in Chapter 1, for example, 60 global banks have provided financing of more than $4.6 trillion to fossil fuel companies since the signing of the Paris Agreement in 2015, according to the Banking on Climate Chaos 2022 Report11. Similarly, companies and financial institutions that are perceived to be lobbying to block or delay legislation or regulation designed to address climate, environmental and social 196 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management issues may also face reputational risks. In 2020, for example, the investment firm Storebrand publicly disinvested from Rio Tinto, ExxonMobil and Chevron after QUICK QUESTION: WHICH ORGANISATIONS ARE YOU learning they had lobbied against legislation aimed at supporting the transition to net zero in the US12. AWARE OF THAT HAVE BEEN TARGETED BY NGOS AND OTHERS FOR ALLEGED GREENWASHING? Climate activists, NGOs, journalists and bloggers are increasingly investigating and disclosing the financing Write your answer here before reading on. of oil, gas, coal and similar activities, especially where this stands in contrast to financial institutions’ public pronouncements on climate change and sustainability. Increasingly, signs of greenwashing from financial institutions can lead to mistrust, internally within organisations as well as externally. Hannah Duncan, a financial blogger, for example, writes: “Big banks and asset managers can invest billions into sustainability, but when they continue to finance fossil fuels, it means nothing…We've got to wake up to the reality. We cannot call ourselves sustainable if we're building new oil pipelines and cutting down forests. We finance people need a reality check.”13 With significant economic value attached to intangible assets such as brands and goodwill, reputational damage can impact revenues and profitability; it can also affect the value of an organisation and its attractiveness to lenders, investors and potential employees. 197 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management 5.2.3 Liability Risks The direct costs of legal action can be significant. The Litigation, therefore, can have an impact well beyond As noted previously, the TCFD and others treat liability costs arising from changes in legislation, regulation the direct financial costs involved. It can also be a driver risks (also referred to as “litigation risks”) as a subset of (or sentiment) as a result of such action, however, may of regulatory reform, and of corporate strategy and transition risks, since these – at least in part – arise from be much greater. For example, when a ‘polluter pays’ governance. As we explore in the case study on the next the development of stricter climate and environmental principle is established or upheld, this may lead to a page, claimants may seek to deploy litigation as a strategic legislation and regulation. For the purposes of this study re-pricing of assets and, in some cases, to significant tool, recognising the value of even unsuccessful litigation guide, however, we treat these separately, as this is a impairment or stranding. Firms and sectors can face as a mechanism that can be used to: broad and growing category of risk. As of April 2022, substantial long-term costs as a result of litigation. The Polish state-controlled energy group Enea, for example, raise the profile of a particular issue; almost 2,000 lawsuits relating to climate change and environmental issues have been filed in more than 40 was taken to court by ClientEarth (see the case study on obtain the defendant’s internal documents or jurisdictions, including the US, Australia, the UK, the EU, the next page over its decision to construct a new coal- information; New Zealand, Brazil, Spain, Canada and India14. fired power plant. The decision was declared invalid, and impact a corporation’s social licence to operate (for construction could not go ahead – imposing significant example, the “Make Big Polluters Pay” campaign17 Liability risks include costs that arise from: costs on Enea, and its investors and lenders, beyond launched by a coalition of environmental NGOs); the direct costs of the legal action itself, damaging the legal claims (litigation) prompted by poor company’s reputation with consumers and investors, raise potential defendants’ costs; and environmental management (for example, discharging and setting a precedent that would limit the likelihood of apply pressure on governments to introduce relevant chemical waste into a river); similar future projects by Enea or others going ahead15. regulation. claims against emitters of greenhouse gases and other Similarly, in January 2021, Royal Dutch Shell was ordered harmful pollutants; to pay damages to farmers in Nigeria following two legal challenges led by activists seeking to pressure oil pipeline spills that occurred more than a decade companies and governments to do more to prevent previously16. The resulting pollution had caused severe climate change and protect the environment; and environmental harm, devastating local farmers. The wider failures by companies and investors to take adequate implication of the case is that it may set a precedent that account of the risks of climate change and other oil companies and others have a Duty of Care, a legal environmental factors. prerequisite for claimants to sue for negligence. This could lead to many new cases arising, and to changes in operating models and the economic rationale for future investments. 198 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management 5.2.4 Climate, Environmental and Sustainability Risk In many traditional risk assessments, although climate, CASE STUDY: CLIENT EARTH Management in Practice environmental and other sustainability risks may form Risk is defined by the International Organization for part of the overall assessment process, the primary ClientEarth is an environmental law charity which focus is often on shorter-term, narrower, more easily Standardization (ISO) as “… the effect of uncertainty uses the power of law to tackle climate change. The quantifiable risks. As we have seen earlier in this on objectives…”, and risk management as “… the charity operates in three main ways: chapter, however, these risks, and especially the physical, identification, evaluation and prioritisation of risks, in order to minimise the probability or impact of negative transition and liability risks of climate change, can and 1. Shaping the law – for example, collaborating events18.” Risk is a central consideration for finance do have very significant short-, medium- and long-term with the Chinese government to build an professionals when considering lending, investment and impacts. Furthermore, they are cross-cutting (transverse) environmental legal system other financial decisions, for there are a wide variety risks that affect many of the other risk types listed 2. Enforcing the law - at the time of writing (February of risk factors that can have an impact on expected previously. 2021), the charity has 169 active cases returns. Some risks may materialise over the term of a 3. Increasing access to environmental law – for loan, investment or other financial activity, some may example, empowering local communities in West increase or decrease in materiality, and new risks may and Central Africa to enforce forestry laws emerge. When considering and monitoring the ongoing performance of lending, investment and other financial By using the law to fight climate change (among decisions, therefore, financial institutions and finance other environmental and social issues), ClientEarth professionals undertake detailed risk assessments in holds companies and governments to account for areas including: their actions. In 2017, the charity was named the “UK’s most effective environmental organisation” by country, political, and regulatory risk the Environmental Funders Network. credit risks ClientEarth is serious about green and sustainable financial risks finance, particularly in relation to climate change. legal risks The charity draws attention to banks and other financial institutions that it believes are not market risks deemed to be conducting business in a way that operational risks is aligned with their climate commitments. To date, technical risks ClimateEarth has reported four major UK companies and three insurers over failures to adequately climate, environmental and sustainability risks. address climate change risks in their annual reports. This puts pressure on firms – and their professional advisors – to improve their disclosure (and ultimately, management) of climate risks. Source: https://www.clientearth.org/ 199 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Financial institutions’ strategies and activities are both informed by, and respond to, the identification and assessment Risk Strategy: Provides an overarching approach of risk across all categories, including climate, environmental and sustainability risks. A strategic approach to risk for the acceptance and management of risks within management is developed through firms’ risk governance frameworks, risk management systems, controls and reporting, an organisation, and is usually approved (certainly in and the setting of appropriate risk appetites. As the chart below illustrates, these are interlinked, informing and financial institutions) by the main Board of Directors or reinforcing each other: a similar body. In terms of climate, environmental and sustainability risks, this means Boards should be aware of and consider the actual and potential impacts of physical, transition and liability risks and opportunities on their Regular & internal driven scenarios businesses, strategies, and financial planning over short-, STRATEGY & medium- and long-term time horizons. Strategic planning FORECASTING What-if analysis Risk Governance: Governance refers to the actions, policies, processes, procedures, structures and traditions by which authority is exercised and decisions are taken and implemented. Risk governance applies the principles of good governance to the identification, assessment, management, reporting and communication of risks within an organisation. It incorporates accountability, participation, and transparency in establishing sound mechanisms to make and implement effective risk-related decisions. A sound risk governance framework promotes clarity and understanding of the ways in which an organisation’s employees execute their responsibilities. GOVERNANCE Given the significant impacts of climate, environmental RISK APPETITE and sustainability risks and opportunities, and their cross-cutting (transverse) nature, firms’ risk governance frameworks must be designed to ensure that those risks Oversight Regulatory & climate- are appropriately assessed and evaluated at all levels of Policies and driven scenarios the organisation. procedures Setting climate risk Transparency limits & RARCC pricing Risk committees Capital allocation 200 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Risk Appetite: Defines the level(s) of risk an organisation is willing to take to achieve its strategic and commercial objectives. A clearly articulated risk appetite helps firms, QUICK QUESTION: ARE YOU AWARE OF THE RISK APPETITE and financial institutions especially, properly understand, monitor, and communicate the organisation’s overall STATEMENT OF THE FINANCIAL INSTITUTION YOU WORK approach to climate, environmental and sustainability FOR, OR FOR AN ORGANISATION YOU ARE FAMILIAR WITH? risks, both internally and externally. A properly WHAT, IF ANY, REFERENCE DOES IT MAKE TO CLIMATE, embedded risk appetite is a way of approaching risk ENVIRONMENTAL AND SUSTAINABILITY RISKS? within an organisation that is broadly understood by colleagues at all levels, not just directors, executives Write your answer here before reading on. and risk managers. As we have seen in this chapter and throughout this study guide and course, climate, environmental and sustainability factors are major drivers of risk and opportunity, and their cross-cutting (transverse) nature means they impact many areas of a firm’s risk appetite. 201 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Setting an appropriate risk appetite, and establishing robust risk governance frameworks, risk management CASE STUDY: ING’S APPROACH TO CLIMATE RISK MANAGEMENT systems, controls and reporting, are necessary conditions for ensuring that financial institutions ING is a universal bank based in the Netherlands, with strong European retail and wholesale banking franchises take account of, and can respond to, the risks and and operations in more than 40 countries. With total assets of approximately Euro 900 billion (2019) and 56,000 opportunities of climate change, environmental and employees, it is one of Europe’s larger banks. ING is a founder signatory of the UN Principles for Responsible broader sustainability factors. To fully embed climate and Banking and is seen as one of the European leaders in the financial sector’s response to climate change and sustainability risk awareness and management within sustainability more broadly. the organisation, though, firms also need to develop ING’s “Climate Risk Report 2020” is a good example of disclosure by a financial institution in terms of what is and embed strong risk cultures consistent with this disclosed, how it is disclosed, and transparency in areas where disclosure and measurement are difficult. The goal. As we explored in Chapter 3, at the organisational report is aligned with the TCFD’s recommended disclosures, and a summary table is provided in it to map these level, culture can be cultivated and sustained through against the contents of the report itself. the role of leadership (‘tone from the top’), appropriately aligned incentives and remuneration, and relevant Governance education and training. Regarding the last of these, the In 2018, ING formed a Climate Change Committee, chaired by the bank’s Chief Risk Officer,to ensure that climate Chartered Banker Institute, the Chartered Insurance risks and opportunities were included in risk management and decision-making at the executive level. Members Institute and the Chartered Institute for Securities and include ING’s Chief Financial Officer and senior executives from the retail and wholesale banking divisions. Investment have developed the benchmark Certificate The Committee is responsible for strategic oversight in this area, and for developing and overseeing policies, in Climate Risk to help risk and finance professionals performance objectives and monitoring in relation to climate risks and opportunities, supported by a Climate build and embed appropriate and robust approaches to Expert Group with membership from across the bank, including ING’s Sustainability Team. climate and sustainability risk management within their organisations19. Climate risk is embedded even more widely within ING’s “three lines of defence”. Primary responsibility for ensuring that environmental (including climate) and social risks are considered lies with front-line relationship managers and deal principals, with credit risk managers acting as the second line. In addition, climate and broader risks are considered by credit committees, including the Global Credit & Trading Policy Committee and the Global Credit Committee – Transaction Approval. In 2020, a Climate Risk Working Group was established to further develop ING’s climate risk capability and to accelerate the integration of climate risks and opportunities into risk management overall. Scenario Analysis ING has developed four, longer-term (to 2040) energy transition scenarios to help the bank explore possible changes in demand for fossil fuels, focusing on energy-intensive sectors of particular relevance to the bank. The scenarios, which are publicly available, are entitled: “Fast Forward”, “Wait and See”, “Green Liberalism” and “Inefficiency”. In applying these scenarios to examine the possible effects on ING’s strategy and portfolios, the bank has focused on what it describes as the two extreme scenarios: “Fast Forward” (policy and technology drive a rapid transition to near 2° of warming) and “Wait and See” (a far more cautious approach). 202 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Climate, environmental and sustainability risk The “Fast Forward” scenario has been used to investigate transition risks faced by ING in key sectors, and in its management is a rapidly evolving area, and there Climate Risk Report the bank publishes a simple heat map of its transition risk exposure under this scenario: is at present no universally accepted approach to it. Approaches depend on the size, scale and scope of High Risk Sectors Medium Risk Sectors Low Risk Sectors financial institutions, their capacity and capability in respect of risk management and sustainability, and the focus and extent of development of relevant national Coal Agriculture Real Estate and international regulatory regimes. This is an evolving Oil and Gas area of regulatory focus that will continue to have Automotive Telecoms Shipping and Aviation significant impacts on financial institutions’ strategies Electronics Rail and decision-making, and on the practice of risk and Construction (including Cement) Retail Renewable Power Generation finance professionals. Regulators play an important role Freight Transport in harmonising and standardising approaches, and in Metal Mining Natural Gas Extraction facilitating the development and sharing of best practice, Livestock Iron and Steel Financial Institutions as we will see in the following section. Aluminium Production 5.3 THE EVOLVING REGULATORY RESPONSE TO CLIMATE, ENVIRONMENTAL AND SUSTAINABILITY ING believes that its scenario approach helps the bank understand the range and scale of climate RISKS change. It acknowledges, however, that these high-level, longer-term scenarios are difficult to translate into actionable information for risk management and decision-making. The bank is, therefore, developing As we have explored in this chapter, physical, transition short- and medium-term (up to five-year) scenarios across geographies, sectors and products to better and liability risks impact a wide range of risks faced by all integrate climate risks and opportunities into its strategy and activities. organisations, including financial institutions. Whilst acute physical risks may impose direct costs in the short term, Stress Testing chronic physical risks, transition risks and liability risks In 2019, ING conducted an internal climate risk stress test, adapting its regular stress testing models can affect organisations’ business models in the medium for this purpose. Transition risks were assessed on a global basis; physical risks were assessed on ING’s and longer terms. All will impact on banks’, investors’ and Dutch mortgage portfolio only, including risks of flooding (which, as the Netherlands is a low-lying country, insurers’ lending and investment decisions, strategies are particularly significant). The stress test showed that climate risk was material for ING, and that it and activities. Financial institutions exposed to sectors could have significant impacts on commercial and residential real estate (because of the physical risk of and firms that are highly dependent on fossil fuels are flooding), and (as the transition risk heat map above sets out) on a number of high-carbon sectors. especially vulnerable to climate and environmental risks, particularly transition risks. As well as causing difficulties Source: ING Climate Risk Report 2020. Available at: www.ing.com/Newsroom/News/2020-ING-Climate-risk-report.htm [Accessed: for individual financial institutions, they can also threaten 19 January 2023] financial stability overall. 203 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management The prudential and systemic risks caused by climate, environmental and sustainability factors explain why it is in the interests of central banks and financial QUICK QUESTION: WHAT GLOBAL/INTERNATIONAL regulators to ensure that those risks – particularly climate-related risks at present – are identified, managed APPROACHES TO THE IDENTIFICATION, DISCLOSURE and disclosed by organisations, especially financial AND MANAGEMENT OF CLIMATE, ENVIRONMENTAL AND institutions. A coordinated, systematic approach to SUSTAINABILITY RISKS ARE YOU AWARE OF? climate, environmental and sustainability risks is essential from a regulatory perspective to identify and assess risks Write your answer here before reading on. to prudential and financial stability, and to help boards, investors and other decision-makers compare and contrast different strategies, activities and investments. Given the global and interdependent nature of the financial services sector, a harmonised and standardised (as far as possible) approach to climate, environmental and sustainability risk management is in the interests of firms, and of regulators. As we discuss in this section, a number of global regulatory bodies and policymakers, as well as national central banks and financial regulators, are therefore adopting similar approaches to the identification, management, disclosure and supervision of climate risks. Some global and national bodies are also now beginning to consider wider environmental and other sustainability risks, and we will also consider this briefly on the next page. 204 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Three key global regulatory bodies taking the lead in Thirdly, central banks and regulators also need discipline.” Such disclosures would also “… provide a source coordinating and harmonising responses to climate and to begin to consider wider environmental and of data that can be analysed at a systemic level, to facilitate other environmental and sustainability risks are: sustainability risks beyond climate change; this feeds authorities’ assessments of the materiality of any risks posed into the work of the TNFD. by climate change to the financial sector, and the channels the Financial Stability Board (FSB), which established through which this is most likely to be transmitted.” 21 the Task Force on Climate-related Financial Disclosures, 5.3.1 Financial Stability Board (FSB) examined in more detail in section 5.3.3; The Financial Stability Board (FSB)20 is comprised of central Whilst the TCFD has had strong support and the Network for Greening the Financial System (NGFS), banks, public international financial institutions (for encouragement from many central banks and financial which we explore in 5.3.2; and example, the World Bank) and international standard- regulators and its recommendations are now being setting organisations. It has a mandate to strengthen included within legal and regulatory disclosure the Task Force on Nature-related Financial Disclosures requirements in some jurisdictions, compliance is still financial systems and promote international financial (TNFD), which we describe in 5.3.4. mostly voluntary, that is, - encouraged, not mandated. We stability by coordinating the development of strong regulatory, supervisory and other financial sector policies, discuss this in more detail in 5.3.3. To help inform the priorities and work programmes of the FSB and the NGFS, both bodies have recently undertaken and to encourage consistency in the implementation of The FSB’s 2020 stocktake focused on central banks’ and “stocktakes” (reviews) to examine how central banks and these. regulators’ experiences of including climate risks in financial regulators are approaching the regulation and their financial stability monitoring. It found there was The FSB has played a key role in highlighting the risks of supervision of climate risks. Each stocktake, as we shall wide variance in terms of whether, and to what extent, climate change to international and national financial see below, had a different focus, but some common regulators considered climate risks. The FSB’s findings stability. In 2015, the FSB established a Task Force on themes can be drawn out: included the following: Climate-related Financial Disclosures (TCFD) – see section Firstly, climate risk is an emerging and evolving 5.3.4 - to develop recommendations for a consistent, Approximately 3/4s of regulators included or were regulatory priority, although there are considerable international approach to the identification, disclosure planning to include climate-related risks as part of their discrepancies between jurisdictions at present as to and management of climate-related financial risks. financial stability monitoring. the extent to which climate risk is currently embedded The TCFD would, in the FSB’s view, develop climate- Of those regulators that considered climate risks, most in regulatory and supervisory practices. related disclosures that “… could promote more informed focused on their impact on asset prices and credit Secondly, global co-ordination between central banks investment, credit and insurance underwriting decisions” quality. and regulators through bodies such as the FSB and which in turn “would enable stakeholders to understand NGFS is required to respond to the challenges of A minority of regulators that considered climate risks better the concentrations of carbon-related assets in climate change and support the transition to net zero. also considered their implications for underwriting, the financial sector and the financial system’s exposures Central banks and regulators need to work with a legal, liability and operational risks. to climate-related risks.” The FSB noted that disclosures wide range of market participants, data providers, the by the financial sector, in particular, would “… foster an A minority of regulators considered how climate risks scientific community and stakeholders if this is to be early assessment of these risks” and “facilitate market affect financial institutions and the financial system successfully achieved. could impact on the real economy22. 205 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management Whilst the results may appear surprising to those active rather than duplicating activities already underway Although there is a general and shared understanding in the field of green and sustainable finance, we should elsewhere. This includes working with bodies such as that climate change poses a challenge for central remember that climate risks (and still more so broader the Sustainable Banking Network (SBN), the Sustainable banks, the stocktake revealed that, in practice, many environmental and social sustainability risks) have Insurance Forum (SIF), the Sustainable Finance Network central banks were still at an early stage in considering only become a focus for central banks and regulators (SFN) and UNEP FI, amongst others. adjustments to their operational frameworks to in recent years. Much of the initial work on these has incorporate climate change-related factors. In addition, been undertaken to date by a fairly small number of The NGFS’s 2020 stocktake focused on the balance sheets the review found that, whilst more than half of the central institutions – albeit high-profile, influential ones. Through and operations of central banks as financial institutions banks surveyed considered stranded assets to be of the work of global bodies such as the FSB, and the NGFS themselves, how these could be impacted by climate concern now or in the future, a substantial minority did (discussed below), we can expect climate and other change and climate risks, and how this in turn could affect not - which was surprising given the potential impacts of environmental and social sustainability risks to become monetary policy. The results confirmed an increasing and transition risks, especially on economies dependent on priorities and key parts of central banks’ and regulators’ shared awareness of climate risks among central banks, fossil fuel extraction and processing. This may, however, supervisory activities in the coming years in those even if only limited, concrete actions had been taken to reflect the focus of the NGFS’ review on central banks’ jurisdictions where this is not already the case. date. The findings included the following: own balance sheets and monetary policy; some central banks had already taken steps to improve the resilience 5.3.2 Network for Greening the Financial System All central banks considered climate change to be of their balance sheets to climate risks as a result of (NGFS) a challenge because of its potential threat to the national political and economic policy decisions. economy and its impact on central banks’ operational Recognising the need for a wider global regulatory frameworks. The NGFS has also developed an expanding set of response to climate risk, and the need for greater global co-operation and harmonisation of approaches, The majority of central banks saw scope in their guidance and tools for sharing knowledge and best in December 2017 eight central banks launched the mandates to reflect climate risks. practice, both to help central banks address climate risks Network for Greening the Financial System (NGFS) at the in their own operations25 and to support and harmonise Most central banks were currently at a very early Paris “One Planet Summit”. By 2022, the NGFS had approaches to the supervision of financial institutions stage in determining their detailed approach to the grown to 114 members (central banks and financial in respect of climate risks. In terms of the latter, the management of climate risks. regulators overseeing economies accounting for the great NGFS’ work to develop climate scenarios to support majority of global carbon emissions) and 18 observers, The main incentive for central banks to adopt a more forward-looking climate risk assessment is particularly emphasising the importance of climate risk to the global proactive approach to climate risks was to support an notable, and is described in the reading on the next financial system and its regulators23. orderly economic transition to net zero. page (scenario analysis is described in more detail in the Central banks see international co-ordination of context of the TCFD in 5.3.3)26. The NGFS aims to share best practice between central approaches to climate risks as key24 banks and financial regulators and, in doing so, to: (a) accelerate and co-ordinate their work on climate and environmental risks, and (b) support the mainstreaming of green and sustainable finance. The NGFS works with a wide range of existing international and national regulatory bodies to feed into and build on their work, 206 | Principles and Practice of Green and Sustainable Finance Unit 5: Risk Management READING: NGFS CLIMATE SCENARIOS Disorderly: Action that is late, disruptive and Below 2°C: climate policies are introduced sudden. This representative scenario assumed immediately, although not to the same extent The NGFS Climate Scenarios have been developed climate policies were not introduced until 2030. as in the previous scenarios, giving a 67 % to provide a common starting point for analysing Since actions were taken relatively late and were chance of limiting global warming to below 2°C. climate risks to the economy and financial system. limited by available technologies, emissions While developed primarily for use by central Delayed Transition: global annual emissions reductions needed to be more rapid than in the do not decrease until 2030, and rapid climate banks and supervisors, they may also be useful Orderly scenario to limit warming to the same to the broader financial, academic and corporate action is then needed to limit warming to target. The result was higher transition risk. below 2°C. This leads to higher physical and communities. Hot House World: Limited climate action leads to transition risks. Initially (September 2020), eight scenarios were a hot house world with significant global warming Nationally Determined Contributions: developed. The set included three representative and, as a result, strongly increased exp