Speeding up the low-carbon economy transition can support financial institutions’ efforts to mitigate climate risk

Financial institutions’ response to climate change by mapping out their risk from physical and transition risks is important. However, the speed of changes that financial institutions can make to limit their risk is constrained not by the risk metrics they look at but how quickly economic and social changes occur. To make the most impact on decarbonization, financial institutions have to look at both the climate risks they face and the opportunities they can gain by scaling up financing the low-carbon economy.

• Regulations like Malaysia’s new policy on climate risk management and scenario analysis have been important tools to mitigate climate risk in the financial sector
• Financial institutions will clearly be harmed by too slow progress on climate change but need more than only a risk-focused approach to increase their contribution to climate change mitigation
• The faster that low-carbon sources of energy become widely accessible, the faster the ‘speed limit’ is for decarbonization of financial institutions’ loan portfolios.

Regulatory action on responsible finance has been an effective way to increase consideration of ESG risk throughout the financial sector. It will continue to be a critical part of the financial sector’s response to ESG risks, especially those such as climate change that are systemic. On its own, it provides guidance on the range of actions that financial institutions can take to see whether they are moving too slowly or too rapidly in their responses.

Although regulators are concerned about individual financial institutions, with climate change, the risk they are most concerned about is the systemic dimension. What sets climate change apart from other ESG issues is that central banks post-2008 have put financial stability at the top of their agenda.

On November 30, Malaysia’s Bank Negara issued a Climate Risk Management and Scenario Analysis policy that will have phased-in impact during 2023 and 2024 on banks, insurers and takaful operators. The regulation combines climate-related risk management with scenario analysis and disclosures (linking with previous guidance materials from the Joint Committee on Climate Change for Malaysia’s financial institutions about how they can follow the recommendations from the TCFD for their disclosures).

In many ways, regulators’ actions are driven by a recognition that there isn’t a single, easy-to-measure way to track the build-up of climate-related financial risks. In order for regulators to fulfill their mandate (and relatedly for banks to undertake comprehensive climate risk management), they need much more information about what sources of risk are building up.

This leads into the question about the speed of financial institutions’ responses once they have the information they need. The earlier reference to speed suggested it could be either too slow or too rapid, although these risks are asymmetric and are not clear just looking at the risk side of the equation. Too slow a response to climate risk will ensure that the physical impacts are more severe while increasing the possibility of greater unanticipated negative consequences.

This is clearly a much greater risk than too rapid a response. However, if a risk-driven approach focused on sources of systemic risk becomes the primary response from the financial sector, it could be too rapid. This was a concern expressed in the Bank of England’s stress test of a too fast phase-out of existing energy sources, faster than clean sources come online, but it shouldn’t be mistaken as a trade-off for financial institutions because the ‘speed limit’ is determined by their efforts to support broader decarbonization efforts in the economy.

The faster that low-carbon sources of energy become widely accessible, the faster the ‘speed limit’ is for decarbonization of financial institutions’ loan portfolios. Taking a risk-oriented approach to managing climate-related risks will only allow action up to the speed limit determined by broader decarbonization of the economy. Financial institutions that see the risk of delay as substantial will also need to find other ways to accelerate their role in decarbonization if they want to lift the speed limit of portfolio decarbonization.

For example, financial institutions can look towards opportunities found from other parts of sustainable finance, where financing for decarbonization may unlock lower-cost sources of financing. These opportunities often are not covered in depth by risk-oriented policies. The Bank Negara Malaysia policy on risk management and scenario analysis for climate risks raises the issue with one specific consideration of a Just Transition.

The policy acknowledges that “it is important for financial institutions to manage the risks of economic dislocation and the associated reputational risk” and it suggests a few ways for them to do respond and “promote a just and orderly transition”. For example, banks can allocate funds to assist customers in building resilience against climate change, incentivize customers with lower pricing when transition milestones are achieved, and engage customers and counterparties in developing a transition strategy.

These actions will help reduce risks from dislocation, but provide a weaker motivation towards proactively increasing investments in decarbonization and in supporting the Just Transition. Other regulatory guidance, such as the Securities Commission’s SRI Taxonomy released a few days after BNM’s policy document, cover a wider range of environmental and social outcomes that could be complementary to financial institutions’ management of climate-related risks.

For example, the voluntary, principles-based SRI Taxonomy could offer a framework to define what investors may place value on in the context of environmental and social objectives that is more balanced between mitigating risks and finding new opportunities, including in decarbonization and the Just Transition.

The good news from the perspective of financial institutions, regulators and investors is that the policies and regulatory guidance are complementary. Financial institutions that better manage climate-related risks will be less susceptible to the effects of individual climate-related risks. That puts them in a stronger position to take advantage of opportunities for decarbonization and investment in the Just Transition.

Expanding those opportunities in decarbonization and a Just Transition, and especially using them to expand or maintain their own access to investment, can have the overall impact of raising the ‘speed limit’ for financial institutions’ efforts on risk-oriented climate risk mitigation. Having addressed the wider impacts of the climate transition allows financial institutions to more quickly reduce over time their exposure to the highest emitting sectors.

Want to learn more about responsible finance in Islamic markets & Islamic finance? Subscribe to RFI’s weekly email newsletter today!