FINANCIAL INSTITUTIONS FACE THE HEAT OF CLIMATE CHANGE
Climate change poses a threat to sustained, global and local economic growth. However, financial institutions are taking voluntary steps towards integrating climate risk in decision-making.
Climate Change impacts poverty reduction goals; quality of life across the board and contributes to political instability in the world. To financial organisations, climate-related risks include physical, transition and liability risks that can be transmitted through the financial system, across borders and sectors. According to the Intergovernmental Panel on Climate Change (IPCC), a body of the UN responsible for advancing knowledge on human-induced climate change, there have already been widespread adverse impacts and related losses and damages to nature and people, beyond natural climate variability.
Organisations such as the International Monetary Fund (IMF), are working closely with member countries to develop the tools that can be used to identify, assess, and respond to the climate-related risks. While there’s a lot of research being carried out, to date authorities are still facing challenges in making tangible progress. As they continue to evaluate their information needs and move towards regular standardised regulatory reporting requirements there are key policy considerations to be made. These include, the expansion of regulatory returns to gather more granular and specific climate-related data on a regular basis; capacity building including upskilling staff and developing analytical tools; information system capabilities; and proportionality, considering the nature, size, and risk profile of a financial institution.
Supervisory and regulatory assessments and policies on climate risk need to better incorporate a system-wide approach and steps taken so far by authorities have focused on establishing supervisory expectations on financial institutions’ risk management practices. South Africa (S.A.) currently has no active regulation relating to climate risk but there is an initiative being taken by the Prudential Authority to enforce a set of regulations into practise.
However, financial institutions are taking voluntary steps towards integrating climate risk in decision-making. They may follow the guidelines set by the European Central Bank and the Bank for International Settlements to have climate risk as part of their stress testing process. Some of the larger banks have already adopted the Task Force on Climate-related Financial Disclosures framework for their climate-related risk reporting. The financial institutions are encouraged to use climate scenario analysis and stress testing tools in a system-wide view to incorporate both physical and transition risks. A top-down approach could be used to capture system-wide climate-related risks and balance sheet assumptions that could help determine the adverse impacts on the broader economy.
This approach acknowledges that climate change impacts are not isolated events but have interconnected effects across various sectors. It entails assessing the intricate interactions between climate change, the economy, and the financial system. By considering the interdependencies and feedback loops, this approach offers a comprehensive understanding of how climate-related risks propagate throughout the system, facilitating the development of more effective risk management strategies.
Climate change is a long-term phenomenon where the largest consequences of physical risk and the benefits of policy actions are typically judged to emerge over a 30-to-80-year horizon, well beyond the conventional 3-to-5-year horizon typically considered for risk analysis in stress testing exercises. The modelling outcomes of both physical and transition risks from a macroeconomic perspective are very complex and highly susceptible to model uncertainty. The availability of granular data is another setback for climate risk analysis, not to mention the scientific expertise in the assessment of projections of physical risk models and their calibration. This has further led to the separation of physical and transition risk analysis which in principle should be jointly analysed since the risks are interconnected.
The climate work that has been done by banks in South Africa is still at an early stage but shows signs of developing rapidly in the long term following a prudential policy communication that South African Reserve Bank will begin monitoring how supervised financial institutions have approached the integration of climate risk into their governance, risk management and reporting processes. There are many aspects to consider for S.A to move towards creating a robust and sustainable approach to managing climate related risk. This is not just in the financial services only, but in other different sectors as well such as energy generation where there’s still heavily reliance on coal which decelerates Paris Agreement commitment to reduce greenhouse gas emissions by at least 40% towards year 2030.
Currently, with the recent state of loadshedding, it might seem that S.A. is currently meeting their greenhouse gas emission goals in line with the Paris Agreement, but this is because power production has been lower rather than the energy sector making efforts to reduce their emissions. As energy generation improves in the long-run, players in the energy sector will have to make efforts to mitigate emissions and be more innovative in considering clean energy alternatives.
Co-authors: Nkosikhona Moyo and Dylan Durieux