By Lara Alvarez
Climate-risk exposure of financial institutions remains high
There is a growing recognition, particularly amongst asset owners, lenders and insurers, that financial institutions own part of the GHG emissions they finance. A broad range of public and private actors have responded to the Paris 2015 goal of aligning finance flows with a low-carbon trajectory as a result. Examples include the Coalition of Finance Ministers for Climate Action, the International Network of Financial Centres for Sustainability and the Net-Zero Asset Owners Alliance.
To drive the decarbonisation of the system at the pace needed, it is critical that absolute rather than relative emission reductions take place. This requires commitments to align financed emissions with net zero to be supported by monitoring mechanisms and clear compliance criteria.
According to the ‘Banking on Climate Change. Fossil Fuel Finance Report 2020’ ,although in the 5 years since the Paris Agreement Globally Systemic Important Banks (GSIBs) have increased their participation in sustainable finance initiatives at a remarkable rate, their fossil fuel finance (when considered as a group) has increased, surpassing the U$S 600 trillion.
The latest Financial Stability Review published by the European Central Bank (ECB) in May 2022 identified evidence of financial stability risks arising from the interdependencies between natural hazards and financial sectors, which through amplification mechanisms (i.e. fire-sale dynamics) driven by exposure concentration, cross-hazard correlation and overlapping portfolios, could lead to hard-to-price climate-related tipping points.
The financial sector is also exposed to transition risks via credit and market risks. The ECB noted that exposures of euro area banks to high-emitting firms (mainly concentrated in the manufacturing, real estate and retail sectors) remain high, whereas the carbon intensity of bank portfolios has seen a small increase.
In addition, owing to the lack of a common regulatory standard for green bonds and the divergent ESG fund classification from commercial data providers, greenwashing risks in capital markets could potentially compromise market integrity and investor confidence, and reduce the pace and scale of capital reallocation needed to achieve tangible progress. In turn, this could pose a risk to financial stability if transition risks are undervalued.
Understanding the climate-related risks, as well as the opportunities faced by financial institutions is, therefore, essential to developing a robust business strategy and increasing the resilience of the financial system as a whole.
The journey towards alignment in reporting and disclosure frameworks
Demand for action and transparency on the way enterprises and financial markets operate is growing amongst stakeholders. Investors, the private sector and policy are following suit, and voluntary and mandatory frameworks are being developed at a pace demanding meaningful disclosures. The resulting fragmentation in frameworks has fostered innovation but has also increased complexity for organisations.
In turn, the proliferation of frameworks has led to a strong demand to streamline and standardise sustainability disclosures. One of the most notable consolidation efforts is the recently created International Sustainability Standards Board (ISSB), operating under the International Financial Reporting Standards (IFRS) Foundation and announced in Glasgow during COP26.
The ISSB’s proposed general sustainability disclosure standards and climate-related disclosure standards, expected to be finalised in 2023, build upon the TCFD recommendations, with the latter covering elements of all 11 recommended TCFD disclosures. Moreover, the draft EU Sustainability Reporting Standards published for comment in April 2022 by the European Financial Reporting Advisory Group also follow the pillars of the TCFD recommendations and ISSB standards.
Using TCFD to de-risk operations and enhance resilience
The Taskforce for Climate-Related Financial Disclosures (TCFD) was founded in 2015 by the Financial Stability Board (FSB) to review and advise the financial sector on climate-related risks.
More than a disclosure framework, the TCFD recommendations constitute an overarching and dynamic management framework under which climate-related risks and opportunities can be evaluated in the context of future operational, commercial and financial viability under a coherent structure, and resilience can be built in through targeted action and innovative solutions. In doing so, the TCFD recommendations promote transparency and the redirection of financial flows towards Paris-aligned activities.
Crucially, the TCFD recommendations can be applied at all organisational levels, from portfolio level alignment with Paris agreement as well as national climate goals to de-risk lending, underwriting and/or investment activities, to enable the successful transition to a climate-resilient and low-carbon economy.
A critical aspect of the application of TCFD recommendations for financial institutions is climate risk stress testing. Scenario analysis enables the identification and assessment of the potential financial loss under different emissions reduction ambition levels. In practice, this requires organisations to assess their exposure to a broad range of risks that go beyond carbon exposure, including shifts in customer behaviour or consumer preferences, increased operational costs or exposure to litigation, amongst other risks.
By embedding TCFD recommendations, financial institutions can enhance their strategies through robust transition and adaptation plans, anchored in quantitative metrics, and supported by effective governance structure, risk identification, assessment and management processes, along with periodic monitoring to assess performance.
Interestingly, the TCFD model is being replicated by the Taskforce for Nature-Related Financial Disclosures, and the pressure for financial institutions is increasing to embed Nature Positive goals into transition strategies alongside Net Zero goals. Why should financial institutions take note? An integrated approach to both, climate and nature, will enable organisations to identify and assess synergies, compounding effects and trade-offs for a more efficient capital allocation and greater gains. With early adopters set to gain a competitive advantage and reap the rewards, the pressure is on for greening the financial system.
About the Author
Lara Alvarez is a Director at Ramboll Management Consulting. Specialising in sustainable finance and in the use of double materiality approaches including natural capital and climate transition frameworks, Lara is an environmental economist with over 20 years of experience in the sector.