The Basel Committee outlines how banks should address climate-related financial risks

• First guidance released for comment from the Basel Committee outlines how banks should prepare to integrate climate risks
• Basel Committee guidance covers issues related to governance, internal controls, risk management, monitoring & reporting, and scenario analysis / stress testing
• Expectations are high, particularly for larger banks, but every bank will be expected to manage climate risks that will escalate over time.

A recent study by Oxford University and 2 Degrees Investing Initiative has found that just within the oil & gas, coal, automotive, and power & energy sectors, companies’ misalignment with a transition to net zero by 2050 scenario will cost financial institutions $2.2 trillion. This estimate, which excludes many other sources of financial losses connected to climate risk, will rise by $150 billion every year that climate action is delayed.

Until now, there has only been a patchwork of guidance for banks and supervisors on how these risks should be integrated into banks’ governance, risk management, and disclosure frameworks. However, last week the Basel Committee on Banking Supervision (BCBS) released a draft for consultation containing 18 principles for banks and banking supervisors to incorporate in their responses to climate risks, and it shines a bright light in the direction that banks should start working. The principles incorporate concepts that should be familiar to those following the work of the Network on Greening the Financial System and regulators’ nascent efforts to evaluate climate-related risks.

Gathered together into one BCBS document, the ambition that banks and supervisors will require in order to implement it is notable and transformative for the banking sector. One of the key features of the Inevitable Policy Response that is useful as a way to look into the future of climate-related policies is that it doesn’t assume there will be a ‘big bang’ policy change to address climate change fully. Instead, policies evolve over time, and climate change policy will be no different, although wildly different outcomes will occur depending on the speed of the policy transition.

Based on the BCBS’s outlined principles for dealing with climate-related financial risks, the likely policy shift will be dramatic. The 18 principles highlight those topics that are at the forefront of regulators’ minds, with 12 focused on what banks should be doing and 6 reflecting those priorities onto the expectations for capabilities that supervisors will need to develop or continue to iterate and refine.

We outline below some of the key elements from the BCBS global blueprint grouped together into five thematic areas, where banks and investors with exposures to financial institutions should focus their efforts.

1. Corporate governance & internal controls: Banks are expected under this blueprint to understand how climate-related financial risks affect them in the short-, medium- and long-term. The governance expectations for financial institutions are much more robust than creating a sustainability department to focus narrowly on climate change mitigation financing such as renewable energy investments. Instead, boards are expected to have assigned responsibility to committees with relevant mandates and oversee the way that senior management integrates climate-related risk from top to bottom. The expectation set by the BCBS is explicit in assigning responsibility at the top level, including expecting awareness among front-line staff to be able to identify climate-related risks, a cross-cutting assessment by risk, and an approach to internal audit that adapts to changes in methodology & data quality.

2. Capital and liquidity adequacy: The BCBS principles call on banks to explicitly integrate the financial risks related to climate change — both physical and transition — into their capital adequacy and liquidity planning processes. Recognizing that the starting point for this work may be more limited based on both analytical frameworks and data availability, the BCBS guides banks to focus on building their risk analysis capabilities by identifying risk drivers that may impair banks’ liquidity and capital adequacy and key risk indicators and metrics to track over time. Notwithstanding analytical or data quality limitations, banks’ internal assessment processes should still focus on quantifying exposures, linking them to traditional types of risk, and then iteratively and progressively updating them over time.

3. Corporate governance & internal controls: Banks are expected under this blueprint to understand how climate-related financial risks affect them in the short-, medium- and long-term. The governance expectations for financial institutions are much more robust than creating a sustainability department to focus narrowly on climate change mitigation financing such as renewable energy investments. Instead, boards are expected to have assigned responsibility to committees with relevant mandates and oversee the way that senior management integrates climate-related risk from top to bottom. The expectation set by the BCBS is explicit in assigning responsibility at the top level, including expecting awareness among front-line staff to be able to identify climate-related risks, a cross-cutting assessment by risk, and an approach to internal audit that adapts to changes in methodology & data quality.

4. Capital and liquidity adequacy: The BCBS principles call on banks to explicitly integrate the financial risks related to climate change — both physical and transition — into their capital adequacy and liquidity planning processes. Recognizing that the starting point for this work may be more limited based on both analytical frameworks and data availability, the BCBS guides banks to focus on building their risk analysis capabilities by identifying risk drivers that may impair banks’ liquidity and capital adequacy and key risk indicators and metrics to track over time. Notwithstanding analytical or data quality limitations, banks’ internal assessment processes should still focus on quantifying exposures, linking them to traditional types of risk, and then iteratively and progressively updating them over time.

5. Scenario analysis: Finally, perhaps the most anticipated part of the BCBS’ guidance is related to scenario analysis. This is primarily relevant to larger, internationally active and more complex banks at least in terms of detailed quantitative scenario analysis. One element of the scenario analysis and stress testing related to it that remains challenging is to look at the intermediate climate scenarios — those that fall between an orderly transition (best case) and a hot-house world (worst case).

The challenge between these two ends of the spectrum is that each scenario is dominated either by transition risk (orderly transition) or physical risk (hot-house world). The BCBS’s view was that although some risks are already present, the bulk of material climate-related financial risks will occur in the future, depending on the climate pathway that is realized.

In reality, every plausible climate pathway will impose some combination of transition and physical risk, and the more severe the realized physical risks become, the more challenging it is to model how it will impact the realized transition risks in that scenario. This explains the rationale for making different degrees of rigor in scenario analysis required “in proportion to their size, business model and complexity across different time horizons” and recognizing that climate scenario analysis is “highly dynamic”.

Put another way, the biggest, most interconnected and international banks will have the greatest analytical burden to create and update their climate scenario analysis. Smaller banks will still be affected by climate-related financial risks, and still need to take the same forward-looking views of the possible climate risk trajectories, but shouldn’t be scared off by the complexity of what scenario analysis can be. They will need to work with the information they have to give reasonable evaluations of what different pathways would mean for them, and use that information — even if the outputs are largely qualitative at first — to inform their strategies.

Having the BCBS weigh in on how banks and supervisors should respond to climate-related financial risk is a big step forward, but it is not a discrete one-off change to banks’ governance, risk management or analytic capabilities. Throughout the 18 principles, there is a clear recognition that the tools we have today are not going to be sufficient for managing climate-related financial risks and their impact on the financial system.

Improving the data, analytics and the application of these tools will be a huge growth area in and around the financial sector, and one where banks and supervisors working alone are unlikely to be able to find all the right answers. The new guidance from the BCBS should be seen as a starting point for experts from finance, technology, climate science and other sectors to come together to continue to prepare the world’s financial system to navigate this upcoming transformation as smoothly as possible. There are trillions of dollars and millions of lives and livelihoods at stake.

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