With their financing and investments, financial institutions play a key role in the transition to a more sustainable economy. However banks, pension funds, insurers and asset managers also run their own financial and operational risks in the field of climate change. Therefore, it is crucial that they integrate these risks into their risk management framework.
Pressure on financial institutions to shield themselves from climate risks is mounting. The European Banking Authority, for instance, plans to include these risks in capital requirements for banks. Other financial institutions must also brace themselves for more rigorous requirements.
However, increasing pressure from policymakers and regulators is not the only reason why financial institutions should tackle this topic. ‘Organisations that succeed in completely integrating climate risks into their business across the board, can go beyond compliance,’ says Julien Linger, financial risk management consultant at PwC. ‘They become frontrunners and from that position are able to capitalise on new commercial opportunities.’
The new publication ‘Integrating climate risks into the risk management framework’ provides financial institutions with a roadmap for managing climate risks. In addition, the publication sets out eight concrete recommendations for integrating climate risks within the risk management framework and thus boosting financial resilience.
For financial institutions, the first vital step is to identify and analyse climate-related risks, and take steps to mitigate and monitor them continuously. Climate risks can be broken down into physical risks and transition risks.
Physical risks include extreme weather events and critical climate change. This can lead to damage or a decrease in the value of business assets, for example in the agricultural sector. Financial institutions exposed to this through loans, investments and financial products may incur losses.
Transition risks relate to political and social developments associated with the climate transition. This can be legislation and regulations, but also changing consumer needs or new technology.
In the publication, PwC states that financial institutions should enrich their risk appetite with climate-related indicators. Climate risks in fact function as a driver of existing risks, especially in the areas of credit, markets and liquidity.
Stress tests should also be extended to include climate scenarios. Financial institutions must look further than just a rise in temperature; policy changes, technological breakthroughs and consumer preferences can also trigger shocks.
To adequately monitor climate risks, the availability of data (both quantitative and qualitative) is essential. Financial institutions must be aware of sustainability policies, but they must also know the figures. The availability of data, and the lack of unambiguous methodologies, are among the biggest challenges currently facing the industry.
Financial institutions will also need to take a close look at the due diligence process. They must have a clear view of the physical and transition risks to which customers are exposed.
Monitoring climate risks, and their impact on market position and investments, is an ongoing process. This requires a radical overhaul of the risk management framework and a rethinking of risk appetite. But for those financial institutions that can act quickly and thoroughly, the opportunities are there for the taking.
Partner, Sustainability, PwC Netherlands
Tel: +31 (0)65 378 26 45
Partner Advisory, PwC Europe
Tel: +31 (0)63 094 45 19