Climate Risk Management

Banks across the Asia Pacific are in the process of implementing the latest measures to systematically manage climate-related risks in their business models. They are aligning their practices with expectations on climate and environmental risks, led by regulators from Hong Kong and other jurisdictions including the Chinese Mainland, Singapore and Australia. Adoption progress varies across the region and size of institutions.

Regional regulators have released climate-related guidance, and in some cases, conducted pilot climate risk stress test (CRST) exercises. As part of sector-wide capability-building efforts to enhance climate resilience, regulators have continued to promote the adoption of effective tools such as scenario analysis and stress testing.

Banks in the region are responding to regulatory expectations through implementing climate risk management practices, developing quantitative analytical models and releasing climate risk disclosures. Leading banks are adopting more advanced initiatives to further embed climate risk into their risk management frameworks as well as business processes.

However, there are pockets of resistance throughout the region where climate risk mitigation has been put on the back burner as some economies deal with the post-pandemic recovery by pursuing resource-heavy economic growth. Banks are presented with the challenge of balancing risk appetite frameworks between prioritising growth versus climate resilience.

Gemini Yang

Partner, Financial Risk Management

KPMG China

mail
call

HKMA enhances climate risk stress testing framework

Following the HKMA’s successful climate risk stress test pilot in 2021, banks in Hong Kong are now entering the second round of stress testing, which will run from June 2023 to June 2024. Drawing on the experience gained from the pilot and industry feedback, for the second round the HKMA has enhanced the CRST framework with a view to obtaining a more comprehensive assessment of authorized institutions’ (AIs) exposures to climate risks, as well as strengthening their capabilities in managing them. The major enhancements are:

Scenarios

a new five-year scenario has been introduced to assess the potential impacts on participating AIs arising from simultaneous economic and climate-related shocks. The new scenarios and the long-term scenarios developed by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) can complement each other to provide useful insights on the banking sector’s climate resilience covering both the short term and longer term scenarios.

Assessment requirements

apart from exposures to highly vulnerable to climate-related shocks (e.g. coal, oil and gas, cement, steel and chemicals) exposures that are usually considered less susceptible to climate change will also be covered.

Reporting standards

more detailed reporting standards than in the pilot exercise have been developed for each of the scenarios.

As before, the stress testing includes variables directly related to climate change, like physical risk from rising sea levels and transition risk such as carbon prices. A new addition is that economic changes have been embedded. Banks will now have to merge their traditional macroeconomic variable-driven stress testing with the new climate change-related stress testing. This will not be a simple A+B exercise, and banks will need to build new models to merge these two different stress tests.

This is part of a general trend as central banks around the world are enhancing their scenarios to integrate variables from both the macroeconomic environment and climate change.

Banks should ensure that they understand the HKMA’s framework and consider building -- if they haven’t done so yet -- comprehensive approaches to assess the risk factors and metrics. These reporting standards are very specific, so a superficial assessment will not be sufficient.

The challenge for banks will be ensuring that they have the data systems and modelling capabilities to fulfil these enhanced requirements. Due to regulatory action and support over the past three years, some local banks have conducted a lot of work on climate risk, so are generally well prepared to move forward to the next level.

New physical risk assessment platform and green taxonomy

To help the banking sector to adapt to climate change, the HKMA is currently setting up a physical risk assessment online platform to support all the local AIs that come under the regulator’s remit. All banks in Hong Kong will be able to leverage this platform to analyse their existing physical risk portfolio.

Regulators from non-banking financial sectors may also consider leveraging the HKMA platform to develop their own versions. The various financial regulators in Hong Kong work closely together as part of the same cross-agency working group to promote sustainable finance and collaborate on green initiatives that benefit the whole sector.

The new platform is also a significant development for Hong Kong, as HKMA is the first regulator globally to introduce such an initiative. It sends a positive signal about Hong Kong’s capabilities in climate risk, and shows that the city is a proactive leader in green and sustainable finance.

In the future, banks in Hong Kong will also be able to draw on a green taxonomy. The HKMA, like many other jurisdictions, is working to develop its own set of standards. Once these are established, this will enable banks to classify their portfolios in terms of sustainability, and to identify which potential investments will trigger larger transition risk.

This taxonomy will create considerable financial reporting related impacts, but will also help banks to further demonstrate how they are managing their climate risk and their sustainability credentials.

Climate risk profiling and seizing opportunities

While banks have been carrying out climate risk stress testing and otherwise enhancing their green capabilities in response to regulatory requirements, it is not just a box-ticking exercise. There is also the opportunity for them to use the process to drive value and grow the business.

If banks can demonstrate that they are managing their risks well and that they have developed excellent climate risk management capabilities internally, this will give them greater bargaining power to win more business opportunities. They can also use their expertise to develop new products such as green loans, green bonds, and other green investment products, which are a growing area of interest among investors.

Banks in Hong Kong have generally made excellent progress in the past few years on climate risk. In addition to the climate risk stress testing, they have also had to fulfil other requirements, such as the submissions for the Task Force on Climate-related Financial Disclosures by mid-2023.

Besides keeping up to date with regulatory developments, banks have made considerable efforts to train their staff to understand the topic. Relationship managers and middle-office staff are therefore more able to collect the crucial information from the customers, especially those in high-emission industries. There has also been good progress in areas like KYC and due diligence. This enables staff to mitigate the potential transition risk, and also better assess their customers for credit approval and other services.

Credit approval revamp

Banks have also been embedding climate risk considerations throughout the credit approval process including climate rating, Equator Principles due diligence and pricing. This understanding of how to manage climate risk quantitively means that banks can help to drive change in the real economy. Skilled staff can effectively review their corporate customers’ portfolios, and explain the impact if they do not become more sustainable. For example, high-polluting businesses will find it more difficult to access funding as they will face more stringent credit limits and higher credit interest. Already, greener businesses are able to access loans with more beneficial interest rates.

Some banks are exploring multiple avenues of embedding the financial implications of climate risk into business processes such as due diligence, underwriting, credit approval and annual reviews. These practices are exploratory in nature and expected to be fine-tuned over time. Ultimately, having a fuller understanding of the financial implications should then spur corporates to take action to remedy the situation and improve their sustainability standing.