On 6 July 1988, the Piper Alpha oil platform in the North Sea exploded and caused a massive fire that claimed 167 lives, which was the largest number of deaths in an offshore accident. When the fire broke out, workers were faced with two choices: stay on the platform and hope for the best or jump into the ocean and risk a likely death by hypothermia. With hindsight, the latter would turn out to be the life-saving choice. Today, the phrase 'burning platform' refers to that burning platform, suggesting that, when we are stuck, we sometimes have to make radical decisions that could also very well be for the better.
The pursuit of efforts to limit climate change has begun in earnest when policymakers called upon the banks and supervisors to promote reorienting capital flows towards a more sustainable economy. This requires banks to also have a view on climate-related financial risks. In addition, supervisors such as DNB and ECB recognize that climate-related risks increasingly pose a risk for financial institutions' stability – and hence should be managed more explicitly.
Regulation: the burning platform on climate change?
We have seen in earlier financial crises how regulation can act as a burning platform forcing banks to pursuit real change. Last November, the ECB published their final Guide on climate-related and environmental risks for banks. This Guide lays down 13 supervisory expectations banks need to meet and which will be part of the supervisory dialogue from this year onwards for both Dutch Significant Institutions and Less Significant Institutions. In fact, ECB indicated it may impose qualitative or quantitative measures on a case-by-case basis as soon as 2021 if banks are not taking actions. Therefore, banks need to start thinking about and planning for integrating climate-related financial risk considerations in their business strategy, governance, risk appetite, risk management framework and disclosures, to avoid such measures.
The questionnaire: Part A and B
Earlier this year, both ECB and DNB asked banks to provide insight in their compliance with and planning for the expectations described in the ECB Guide. Dutch banks have been requested to conduct a structured self-assessment ('Part A') and deliver an implementation roadmap ('Part B') covering tangible deliverables, milestones, internal action owners, etc. to ensure supervisory expectations will be broadly met. For the Dutch sector the DNB is taking it even a step further as it requested banks to also pay attention to social risks. All of this was to be completed in 2021 Q2.
Banks started considering ESG risks, in particular climate-related risks
A KPMG survey among European and Dutch banks indicated there is a clear focus on climate-related risks. Social risks are considered the least. It is suggested that climate-related and environmental risks are perceived as potentially more significant and a greater risk to overall financial stability in the long run.
Even with this focus on the E of ESG, banks seem to take a risk-based approach. Risk identification exercises are mostly directed at carbon-intensive sectors and implications for banks' credit risk profile. Ultimately credit risk is seen as the main channel through which environmental risks will be felt by banks.
The fast majority of banks only partially meets supervisory expectations. Those banks stating that sustainability is part of their business model on average seem to meet supervisory expectations better. In addition, banks showing relatively high or low exposure to carbon-intensive sectors perform better than the group in between. It is suggested that those with high exposures already acknowledged there are potentially material financial risks and started to integrate these risks in their risk management framework ahead of supervisory expectations. Those banks with low exposures may reason expectations are easier met due to lower financial risks. We see banks are foremost gradually integrating ESG risks within their risk management framework, starting from what are potentially the largest risks to the bank's financial position.
Measurement and data challenges drive time needed to fully meet expectations
The main challenges for climate-related risk relate to developing methodologies to measure risks and acquiring the required data to apply these methodologies. The traditional methods to assess financial risks are not appropriate as climate-related risks are non-linear, involve longer time horizons and historical data is of little use. Much efforts by banks, supervisors, regulators and academics are being taken to fundamentally understand climate-related risks, their transmission channels to financial risk types and methods to quantify those risks. Methods based on scenario analyses and stress testing play a pivotal role. ECB plans a climate stress test for Significant Institutions in 2022, so this is definitely an area for many banks to continue efforts without delay.
The incorporation of climate-related risks into traditional internal models (e.g. PD and LGD models) has only been explored through pilot studies. As banks currently run programs to simplify their complex model landscape and resolve findings from ECB's Targeted Review of Internal Models, this incorporation is only planned to start after 2022.
These challenges currently hamper efforts of many banks to establish quantified risk indicators, incorporate climate-related risks in risk-based pricing and consider such indicators in business strategy and risk appetites.