Climate Risks Will Soon Be an Essential Part of Risk Management Frameworks

Discussions about climate and environment related disclosures and regulations have discussed for some time. Recent developments suggest that governments are in the planning stages of creating regulatory frameworks that account for environmental impacts. This will mean new regulatory requirements, processes, risk models, and updates to risk management frameworks being used across the financial sector.

Federal Perspectives

There are two major developments which hint at the direction that the government will pursue in enforcing climate priorities through financial regulation and policies. The first development is Treasury Secretary Janet Yellen announcing the creation of a Climate Czar role in the Treasury. She also shared her perspective on the role regulations can play in tackling climate change and environmental protection. She stated that “I think we need to seriously look at assessing the risk to the financial system from climate change.”

There have been discussions about adoption tactics – from encouraging the the financial sector to ‘self-report’ and ‘self-regulate’ reporting related to the environment, to more stringent reporting policies. The Security Exchange Commission has also recently created a new senior policy advisor role dedicated to the climate as well.

The other major development which shows that climate policies are coming to fruition is the Federal Reserve Board officially announcing that it has joined NGFS (Network of central banks and supervisors for Greening the Financial System) as a member in December 2020. NGFS already had more than 80 financial supervisors and central banks from across the world as a member and has been dedicated to creating policies, frameworks, and recommendations that help include climate change related considerations into financial models and regulations.

Understanding the Risks Posed by Environmental Factors

The total implications of the risks posed by climate changes is too vast and still not fully understood. There are several different climate models which give different timelines and different severities of such changes. More importantly, the major changes are supposed to occur on a timeline that spans the next 100 years or so – they are not immediate concerns that need to be managed for enterprise risk managers.

What is thus important for risk managers is to identify the risks that will have the most immediate impact on their bottom line. These risks vary for different industries, but in the financial sector of the economy where BFSI organizations operate the most immediate risks can be identified as:

Credit Risks

Banks are very concerned about credit risks and climate change plays a major role in shaping this concern. A Deloitte study released in 2021 revealed that credit risks were the top concerns for financial institutions for 2021 and 2022. The increase in severity of climate events means unexpected shutdowns for businesses and can directly impact the bottom line of the borrowers, thereby increasing chances of them defaulting on payments.

Outdated Risk Assessments

There has been a dramatic increase in the number of extreme weather events around the world – more than 7000 in the last 20 years. The rate of these events has changed quickly, which means that the previous assessments of environment risks need to be updated. What happened in Texas recently is an example of such a failure; there were safeguards present to ensure that power generation would continue during expected extreme weather events. The freeze however was completely unexpected and thus ended up causing widespread losses of all kinds. An increase in these events may mean that businesses will need to safeguard against the events that were previously not expected in their regions.

Transition Risks

Transition risks are also closely tied to credit risks but need to be identifies separately because of their unique nature. The past two decades have seen a rise in global awareness of environmental concerns. This has created a strong demand to transition to a greener society by replacing materials that impact the environment negatively. This will shift business away from many existing businesses to new disruptive businesses.

Traditional car manufacturers are starting to lose customers to new companies manufacturing electric vehicles. Energy companies are losing customers to solar energy users. Plastic straw manufacturers are seeing their old customers opt for paper straws instead, and so on. These transitions are happening at different speeds in different areas and banks and financial institutions need to reassess their credit lines for each major industry.

Another major factor that needs to be managed is regulatory risk – state and federal governments world over are focusing on creating regulations that will significantly impact the way many industries operate.

Why Environmental Regulations Matter

The issue of climate change has been a hot political topic over the past few decades, but it is important to understand that the foreseeable regulations and rules will focus on environmental change impacts. Understanding how major events will impact global climate is already difficult. As the World Meteorological Organization’s bulletin explains, there are multiple models which give different estimates about the exact effects and causes of global climate change.

The rules and regulations which are being discussed right now are instead concerned with the direct environmental impact and fallout of a business. In essence, such policies are not creating new costs or damages – they are instead accounting for costs that are currently not being reflected in financial and risk models.

While those plans are still being hashed out, there is another source that shows the approach the current government intends to take to manage climate and environment related risks – the executive orders that have already been given by the President. A press release by the White House lists many of the actions the government intends to take, many of which will directly affect businesses across the country. They will result in new risks that need to be managed and new regulations that need to be complied with.

Here are some excerpts from the White House press release:

• Consistent with the goals of the President’s Build Back Better jobs and economic recovery plan, of which his clean energy jobs plan is a central pillar, the order directs the federal agencies to procure carbon pollution-free electricity and clean, zero-emission vehicles to create good-paying, union jobs and stimulate clean energy industries.
• In addition, the order requires those purchases be Made in America, following President Biden’s Buy American executive order. The order also directs agencies to apply and strictly enforce the prevailing wage and benefit guidelines of the Davis Bacon and other acts and encourage Project Labor Agreements. These actions reaffirm that agencies should work to ensure that any jobs created with funds to address the climate crisis are good jobs with a choice to join a union.

While these executive orders show the actions, the government is already taking, a lot more can be expected in the coming year. It is important to understand that the administration is currently focusing on building the foundation upon which their regulatory framework will be built. The creation of a Climate Czar role in the treasury, the creation of the Supervision Climate Committee at the Federal Reserve, and the creation of a Senior Policy Advisor for Climate and ESG position in the SEC are all moves that will help the government create a new regulatory framework that focuses on climate and environment related initiatives.

Creating a New Regulatory Framework

Major regulations are created after a long consideration and research period. Since climate and environment related regulations and policies are still only being discussed, there is enough time for businesses to be ready for the coming changes. While other businesses will be more concerned with how such regulations will impact their bottom line, the financial sector must look at how it needs to reimagine financial risk models and compliance frameworks to account for environmental impacts and assessments.

Risk and compliance technology will play an essential role in helping businesses quickly evaluate the impact of such regulations and how it will affect their policies, processes, disclosures and much more. Interested in seeing how your organization can automate the detection of emerging risks and create a proactive compliance framework? Get in touch with out experts for a demonstration of Predict360, the American Bankers Association endorsed solution for risk and compliance management.