Climate-related and environmental risks and the corresponding challenges will have important consequences to various aspects of our lives. Banks are expected to play a major role in for instance financing the transition to a sustainable economy and society.
The European Central Bank (ECB) as well as an increasing number of national regulators and supervisors expect banks to have climate risk considerations integrated in their risk measurement toolkits, stress testing frameworks and practices.
Risk measurement is an important building block of profound risk management systems, and the unique nature of climate risks requires the use of various novel methodologies.
Gap analysis and implementation plans
Assessing your current practices, formulating and implementing action plans to remediate any shortcomings identified in the ECB Climate Stress Test.
Climate stress testing and scenario analysis
Designing relevant climate scenarios and performing regulatory and internal stress tests (e.g. ICAAP) to assess the impact of climate risk drivers.
Dynamic portfolio rebalancing
Implementing a dynamic balance sheet approach to rebalance your portfolio composition based on scenario narratives, your strategy and business insight.
Physical and transition risk measurement
Assessing your portfolio’s vulnerability to physical and transition risks, and integrating climate risk factors into your toolkit such as (shadow) PD / LGD models.
Risk identification and monitoring
Developing climate risk warning indicators and other Key Risk Indicators (KRIs) for risk identification (screening criteria) and/or portfolio monitoring purposes.
Portfolio alignment and target setting
Measuring your portfolio alignment with respect to various climate transition pathways, and assisting you in your climate target setting process.
The ECB’s Guide on climate-related and environmental risks, published in November 2020, provides an overview of 13 recommendations related to Strategy, Governance, Risk management and Disclosures, and banks are expected to fully comply with them. Moreover, with the effects of climate change and environmental risks being more visible than ever in our daily lives and the way business is conducted, financial institutions are more inclined to incorporate corresponding objectives and targets into their practices. However, the effective management and measurement of climate-related and environmental risks remain challenging.
Financial institutions can use their well-established risk management practices and frameworks as a starting point, but they need to enhance them to address the climate-related and environmental risks’ unique features such as the combination of short and medium to long-term impacts, nonlinearities, potential tipping points and interconnectedness among various risk sub-types.
Past experiences in scenario analysis and stress testing also provide the financial industry with the opportunity to get a quantitative view on their exposures to the transition to a more sustainable (Paris Agreement aligned or Net Zero) economy and society, as well as on their exposures to physical risks corresponding to climate-related and environmental issues. Moreover, the ECB and an increasing number of national regulators and supervisors request banks to conduct materiality assessments, various risk identification and monitoring exercises, as well as climate risk stress tests on their portfolios while taking into account various transition scenario pathways.
As climate-related and environmental risk measurements (most importantly stress testing and portfolio alignment calculations) entail a significantly longer time horizon and different methodologies compared to traditional practices, many financial institutions will have to redesign – or enhance at least – their existing toolkits in many aspects of their risk management and risk measurement.
Since the publication of the ECB’s Guide on climate-related and environmental risks in November 2020, the ECB has carried out various assessments and inspections on the banks’ preparedness and practices:
which led to the overarching conclusions that banks still have a lot to do to ensure full compliance with the ECB’s recommendations.
How can Finalyse help you with climate change risk measurement?
Together with its ‘Climate-related and environmental risk management’ services, Finalyse offers a broad range of solutions in the climate-related and environmental risks’ context:
Zsuzsanna Tajti is a Principal Consultant with 15 years of risk management experience, Chartered Financial Analyst (CFA), Financial Risk Manager (FRM, PRM) and holder of the GARP’s Sustainability and Climate Risk (SCR) certificate. Zsuzsanna has had exposure to a wide range of sustainable finance projects, including the ECB Climate Stress Test, Thematic review, Pillar 3 ESG reporting and forward-looking assessments of transition and physical risk impacts.
Christophe Caers is a Senior Consultant based in Finalyse Brussels with experience in climate risk management. He has been involved in the validation of the 2022 ECB climate stress test methodology at a large Belgian bank and the assessment of ESG scorecards. Christophe is a certified Financial Risk Manager (FRM) and holder of the GARP’s Sustainability and Climate Risk (SCR) certificate.
Milenko Petkovic is a Senior Consultant with more than 9 years of experience in risk management. Milenko’s area of expertise lies within the development and validation of credit risk models, ESG scorecards and climate risk stress testing, including transition and physical risks. Milenko is an active member of Finalyse Climate Risk Centre of Excellence and GARP’s Sustainability and Climate Risk (SCR) candidate.
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