Banks fail to take strategic view of climate change

Only 10 per cent of banks are taking a strategic view of climate change – with an average planning horizon of just four years, according to Transition in thinking: The impact of climate change on the UK banking sector, a report by the Bank of England’s regulatory arm, the Prudential Regulation Authority (PRA).

The PRA plans to consult on new expectations for how banks and insurers incorporate the financial risks from climate change into their governance, strategy and risk management frameworks, including taking a long-term view of the risks and a strategic, board-level approach. The Bank of England is also aiming to enhance the resilience of the UK financial system by supporting an orderly market transition to a low-carbon economy.

The response so far

While there are signs that banks are now considering the most immediate physical risks to their business models, for example the exposure of mortgage books to flood risk, or the impact of extreme weather events on sovereign risk, many have some way to go in identifying and measuring the financial risks from climate change. These include transition risk as governments’ more stringent climate policies start to take effect, the impact of which will be felt through their exposure to carbon-intensive sectors, consumer loans secured on diesel vehicles, and buy-to-let lending given new energy efficiency requirements.

The PRA has identified three broad approaches being taken by banks to date:

  • ‘Responsible’ – around 30 per cent are taking an approach primarily driven from a corporate social responsibility perspective, focusing on reputational risks.
  • ‘Responsive’ – around 60 per cent view climate change as a financial risk, but look at it from a relatively narrow, short-term perspective.
  • ‘Strategic’ – only ten per cent are taking a more comprehensive, long-term view. This includes engaging at board level, considering both current and future risks, and taking action in the long-term financial interest of the firm.

The majority of banks have had corporate social responsibility (CSR) policies that cover environmental and sustainability issues in place for some time, and those that look at climate factors through a CSR lens tend to focus on reducing credit risk exposure and high risk economic sectors such as the coal industry, usually driven more by concerns around reputational risk. They will often focus their analysis of risk on the impact that a specific company or project may have on the environment, and therefore on the bank’s reputation.

The more responsive firms tend to consider climate change as a significant financial risk beyond business continuity or reputational risks. These banks have progressed further in the process of identifying and measuring specific financial risks from climate change, although they are still working within their current business planning horizons of three to five years.

The banks taking a strategic view of the financial risks from climate change are doing so with board level engagement. Their more comprehensive approach involves taking a long-term perspective grounded in the long-term financial interests of the business. Firms in this category are beginning to enhance their governance and risk management, to minimise financial risks and support an orderly transition to a low-carbon economy.

In the banks with the most advanced strategic plans, boards have also recognised the banking sector’s role in mitigating the financial risks and are aiming to incorporate a forward-looking view of the financial risks outside current business planning horizons. In these organisations, climate change risk is becoming central to their mission and strategy.

Developing a strategic approach

According to the report, firms which have recognised some of the challenges in responding to climate change, such as the tendency to focus on the short term, are developing solutions such as tapping into the expertise of climate financial risk specialists either within their risk function or from universities, research institutes or consultants.

Other actions taken to develop a strategic approach include improving understanding of the financial risks from climate change, looking at longer term risks, considering how to classify and identify assets to enable climate-related risk analysis, and using scenario analysis and forward-looking data to assess the longer-term financial risks.

There’s also a drive towards strategic responses with agreed board-level responsibilities to manage the financial risks from climate change and to consider whether the current and future financial impacts from climate change have been factored into the firm’s risk appetite.

Additionally, firms are beginning to consider how decisions they make today affect future financial risks, by integrating climate-related risk factors into forward-looking assessments and developing a firm-wide framework for climate-related risk management.

While the PRA report focuses on the banking and insurance sectors, the lesson of taking a long-term view is relevant to all UK businesses as we prepare for the future impact of climate change. All companies should be working to reduce the risks and take advantage of the opportunities brought by areas such as new green technologies – after all, climate change will affect us all whether we like it or not, so it pays to be prepared.

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