On the Biden Administration’s first day in office, the U.S. rejoined the Paris Climate Agreement, a pact among over 190 countries committing to mitigate the effects of climate change. By 2030, the president has targeted a 50% reduction in the U.S. economy’s greenhouse gas emissions from 2005 levels. By 2050, our economy is slated to operate with net-zero emissions. And the administration has made it clear that it will rely on the financial services industry and its regulators to succeed on two fronts: to help achieve these climate goals while protecting the U.S. financial system against climate risk.
To fight climate change, for example, the Commodity Futures Trading Commission (CFTC) called in September 2020 for “financial innovations, in the form of new financial products, services, and technologies, [that] can help the U.S. economy better manage climate risk and help channel more capital into technologies essential for the transition.” Federal lending programs and retirement plans are among the vehicles the administration is exploring to incorporate climate-related factors into financial services. To this end, the Federal Home Loan Bank of New York has provided training on environmental, social, and governance (ESG) risks to financial institutions. Meanwhile, the Securities and Exchange Commission (SEC) issued a Risk Alert on ESG investing to highlight observations from recent exams of investment advisers, registered investment companies, and private funds offering ESG products and services.
To ensure financial stability, the Biden Administration’s May 20 Executive Order on Climate-Related Financial Risk mandates that federal agencies take broad action regarding a range of risks such as climate-related disruption to the proper functioning of financial markets. “New or revised regulatory standards” would be included.
Regulators Take Up the Climate Challenge
However, not all avenues that regulatory bodies could pursue are necessarily new. The CFTC report detailed that “existing legislation already provides U.S. financial regulators with wide-ranging and flexible authorities that could be used to start addressing financial climate-related risk now.” The report went on to state that “this is true across four areas—oversight of systemic financial risk, risk management of particular markets and financial institutions, disclosure and investor protection, and the safeguarding of financial sector utilities.”
In fact, several federal and state agencies have already taken up the climate challenge, including:
- The SEC has begun reviewing public companies’ climate disclosures and published a sample letter to companies to revise their disclosures. It has also created a new position of Senior Policy Advisor on Climate and Environmental, Social, and Governance.
- The National Credit Union Administration (NCUA) has testified that “financial regulators, like the NCUA, have a responsibility to foster resiliency to all material risks to financial institutions, including those related to climate change. By measuring, monitoring, and mitigating such risks, the NCUA can fulfill its core obligations of maintaining the safety and soundness of credit unions, protecting consumers, and safeguarding the Share Insurance Fund.”
- The Federal Reserve, in addition to creating two new panels (Financial Stability Climate Committee and a Supervision Climate Committee), has begun requesting information from lenders about how they are mitigating climate change-related risks to their balance sheets and exploring climate stress-testing scenarios.
- The Office of the Comptroller of the Currency (OCC), Federal Reserve, and Department of Financial Services of the State of New York have joined the Network for Greening the Financial System (NGFS), an international consortium of “central banks and supervisors, willing, on a voluntary basis, to share best practices and contribute to the development of environment and climate risk management in the financial sector and mobilize mainstream finance to support the transition toward a sustainable economy.”
When taken together, these developments signal not only that there is a willingness to develop future climate-related legislation or regulation, but also that financial regulators already feel they have the authority to address climate-related risk in our financial system under existing laws and regulations. An organization that wishes to embody best practices should already be developing and implementing strategies to mitigate both its effect on the environment and the risks a changing environment poses to the organization itself. Doing so will allow that organization to set the tone with regulators rather than just react to inevitable climate change-related policy developments later on.
The Three-Step Preparation
Prudent organizations should prepare for increased regulatory scrutiny pertaining to climate change in three steps:
- Develop your climate risk goals and appetite.
- Assess your current performance.
- Create consistent reporting strategies and routines.
Step 1: Develop Climate Risk Goals and Appetite
The first step in prepping for increased climate change-related supervision in the financial sector is to set expectations of where you want your organization to stand. To ensure your organization is adapting to become more resilient in the face of climate risk, it’s key to anticipate what regulatory expectations you might be required to meet, what your stakeholders will expect, and how your goals will impact your strategic planning, board reporting, risk appetite, and risk management. You should incorporate these expectations into developing a risk appetite for climate, similar to the risk appetites set for other risk types.
Questions to consider include:
- Strategic Planning: How does your organization prepare to handle climate-related and environmental risks? Is this included in your long-term strategic planning?
- Risk Management: Are policies and procedures in place to identify, assess, monitor, report, and manage all quantifiable risks? Are climate-related risks incorporated into credit, liquidity, operational, and insurance processes, and do metrics exist for external reporting and internal monitoring?
- Stress Testing: How do you plan to develop methodologies and tools to capture the size and scale of climate-related risks?
- Green Taxonomies: Are you prepared to align investment choices with green taxonomies requiring classification with respect to mitigating or adapting to the impacts of climate change?
- Disclosures: Are metrics and information on exposure to climate-related risks disclosed accurately and appropriately?
ESG and climate risk are likely to remain a focus on the regulatory agenda for the foreseeable future, and addressing climate-related risks requires adequate resources. Commitment from the executives of your organization is needed to push the agenda forward. Setting goals for where you want your organization to be will allow you to conduct an appropriate gap assessment.
Step 2: Assess Your Current Performance
The second step in prepping for increased climate change-related supervision in the financial sector is to fully contemplate where your organization stands in relation to your climate regulatory compliance and social responsibility goals. In other words, perform a holistic gap assessment in which your organization identifies current progress toward its climate-related goals and evaluates how to complete each goal.
This holistic gap assessment begins as any other would: by gathering the information you need to analyze your company’s progress toward each goal. Many organizations are surprised to learn that existing data can be leveraged in a climate risk analysis. For example, utility bills previously collected for overhead calculations can be capitalized in the extraction of organizational energy usage and subsequent carbon footprint calculations. It is important to think outside of the box in sourcing potential climate data, since consumption (and therefore the potential for environmental degradation) is implicit in all aspects of work and life. For example, at least one major cloud computing platform is now offering businesses a look at how their cloud usage is affecting their carbon footprint1.
By collecting these and other types of macro and micro data, your organization will then be able to understand potential roadblocks to its compliance and social responsibility goals—ranging from excessive brown assets in your portfolio to wasteful operations. From there, your organization can flesh out specific strategies to address climate-related shortcomings and move the needle toward achieving its goals.
Step 3: Develop Reporting Strategies and Routines
Implicit in the data gathering phase is the identification of potential data gaps. It is essential to develop a go-forward data collection strategy that will meet your organization’s monitoring, measuring, and reporting needs to maintain progress in pursuing climate-related goals.
Reporting standards are vital in providing the detailed requirements needed to aid companies in determining what information should be disclosed. The industry has moved toward adopting the Sustainability Accounting Standards Board (SASB) framework along with the Task Force on Climate-related Financial Disclosures (TFCD) recommendations.
The framework provides principle-based guidance to aid in the identification of climate risk topics that should be covered and determine the specific metrics and structure needed to prepare the climate information disclosed. Some companies, however, may prefer to diverge from the framework in favor of company-developed, custom metrics. Either way, it is imperative to understand the company’s objectives.
Putting Plans in Action
Preparing for climate risk supervision will be no easy task. A myriad of factors, such as a lack of reporting standards, data gaps, and increased regulatory activity are converging to create a “perfect storm” for financial institutions.
In addition, the complexity and intersectionality of the impacts of climate risk on financial institution performance can be difficult to comprehend, particularly if climate risk is assessed as part of a broader ESG strategy. For example, a commitment to sustainable investing may impact community reinvestment activities and compliance. On one hand, reducing investments in industries with significant adverse environmental impact may help meet climate goals. On the other hand, such reductions may contribute to loss of employment for historically marginalized communities, which would hinder meeting equity and inclusion goals. Robust materiality assessment can help ensure competing priorities are considered before taking action.
After determining your climate risk appetite and completing your materiality assessment, results should be incorporated into your institution’s strategic plan. This may involve any number of initiatives, including:
- seeking operational efficiencies to reduce your carbon footprint;
- incorporating green principles in supply chain management;
- changing risk management and risk assessment practices;
- reconsidering lending and investment strategies;
- training staff on climate risk;
- stress testing portfolios;
- collecting more data;
- benchmarking against peers; and
- reporting climate commitments and progress to stakeholders.
Some institutions may develop new products, such as green bonds, social bonds, or sustainability-linked loans. Others may apply the International Finance Corporation’s ESG Performance Standards or the Equator Principles to commercial clients and investment prospects. Regardless of the approach taken, a robust corporate governance methodology will be required to successfully incorporate climate risk into financial businesses while complying with regulatory expectations and creating shareholder and stakeholder value.