‘Climate adaptation: What steps should financial institutions be taking now?’

Blurring the lines

In many sectors including financial services the line between adaptation and mitigation can sometimes be blurred. The Financial Conduct Authority (FCA) picked this up in its 2021 Climate Change Adaptation Report, noting that adaptation activity often goes hand in hand with mitigation activity. It gave the example of an asset manager including investments in renewable energy in its portfolio so that it may help make the portfolio more resilient against the impacts of climate change (adaptation) but also the investment itself may help reduce global emissions (mitigation).

A more recent example can be drawn with the new FCA sustainability disclosure requirements and the EU Sustainable Finance Disclosure Regulation. Both do not really draw the distinction between mitigation and adaptation techniques. Rather, both regimes appear to refer to climate objectives in open end terms.

Why is adaptation important?

As noted in the BSR’s Adapting to Climate Change: A Guide for the Financial Services Industry,¹ proactive and responsible adaptation should concern the financial services sector for the following reasons:

• The physical risks of climate change, and their consequences, pose immediate and long-term threats to operations.

• Company and client investments require risk screening that includes climate change on a localized level, as it can differ significantly by geography and sector. It should be complemented with opportunity screening, particularly in markets previously classified only as high risk.

• FS companies have a distinct opportunity to not only provide desired solutions to climate change issues, but also incentives and strategic funding for adaptation measures. New areas for insurance coverage such as rainfall insurance in India, where there is a strong fear of drought, and weather derivatives and climate information products are a few among many new opportunities.

The guide provides examples of adaptive practices that firms have used in response to these risks and opportunities, with many companies now pursuing a range of adaptive practices to stay ahead of current and expected climate change disruptions.

In some cases, these practices are intended to protect value of existing assets and systems. In others, practices seek to create value through innovation and meet new needs that stem from the effects of climate change. It also sets out certain key components that financial services companies should consider when establishing change adaptation strategies.

Climate risks

Perhaps one of the most important points to note is that climate-related risks generally manifest themselves in the financial services sector as drivers of existing types of risk. This means that climate risks need to be managed as an integral part of a broader approach to risk management, rather than as a distinct and separate set of risks to address.

The Climate Financial Risk Forum’s June 2020 Risk Management Chapter (CFRF chapter)² highlighted how physical and transition risks can manifest in financial services and provides practical guidance on how to address climate risks within financial institutions.

In terms of how physical and transition risks can manifest themselves, the CFRF chapter covered a number of areas including insurance underwriting risk, credit risk, financial market risk and operational risk. As for financial market risk and operational risk:

• Financial market risk: the impact on the value of bonds, loans, property/real estate, commodities and equities due to the societal, legal and technological response to climate change. There is evidence that climate risks are not yet internalised within asset valuations.

• Operational risk: The potential economic, reputational and compliance impacts of inadequate or failed internal processes and systems, or from external events, including legal risk and the risk of a material misstatement in financial reporting.

Governance

With any type of risk management, the tone from the top will be key and effective governance will need to be in place. In addition to the CFRF chapter providing useful tips, the World Economic Forum’s ‘How to set up Effective Climate Governance on Corporate Board’³ is also instructive, particularly as it sets out a series of guiding principles and questions that boards should be asking themselves.

Many firms in the financial services sector, particularly the bigger organisations, will already have organised their governance arrangements around climate risks given the regulators’ focus on it but it may not be a bad idea to review the comments made in these documents.

For example, Principle 2 covers the board’s command of the climate subject which is then further broken down into board composition and agenda and maintaining and enhancing climate competence. As for climate competence, the board might, as a reminder, like to ask itself:

• What steps is it taking to ensure it remains sufficiently educated about the relevant climate-related risks and opportunities for its business?

• Has the board considered whether it would benefit from the advice of external experts? If so, has the board considered which experts would be most well suited?

• How can the board plan for succession to ensure that climate awareness does not stop if an important individual or a vocal climate champion leaves the organization or the board?

• What kind of skills should be incorporated into the desired profile for a new board director?

Risk management framework

Again, many financial services firms will already be fairly advanced on adapting their risk management framework to climate change. For those not so advanced perhaps the key decision to make early on is whether to treat climate risk as a standalone, principal risk or as a cross cutting risk which embeds in other types of risk. Conducting a materiality assessment of climate risks will help the firm decide on the best approach and factors to consider may include the firm’s exposure to physical and transition risks.

Since risk, including climate risk, is always present and developing those with established risk management frameworks should continuously review them and update where necessary. This will also include conducting regular training sessions to enhance employees’ awareness of risks and their roles in risk management.

Risk appetite

When considering risk appetite the CFRF’s October 2021 Risk Appetite Statements offer practical advice on writing, implementing and maintaining an effective risk appetite statement, factoring in different aspects of climate risk. For example, for asset managers the CFRF notes that the key dimension to consider is balancing climate risk management with fiduciary and agency responsibilities.

Asset managers will need to balance what client mandates allow and what the firms’ desired outcomes are in relation to climate risks. For instance, a passive fund cannot simply divest out of a security because it is a high-carbon emitter if the security is within the benchmark of the fund mandate.

For retail banking, the risk categories most impacted by climate risk include credit risk, conduct risk, and operational risk – especially business continuity risk (BCR) and reputational risk. It is worth noting that banks have, in recent years, invested considerable time and effort into identifying and proactively managing reputational risk, setting up dedicated first line advisory teams looking to manage risks that adversely affect stakeholder, client and regulator relationships. ESG-linked issues are often routed in how banks set expectations against which they will be measured in the future, such as disclosures and pledges to market.

Adaptive policies

Firms often do not label adaptive activities as such, instead placing them under other strategic, risk management or project design headings. In addition, the benefits from investment in adaptation and resilience are typically considered in terms of avoided losses and cost-benefit ratios. This contrasts with mitigation projects that deliver an output.

It may also be worth referring to The World Economic Forum’s November 2022 Critical Business Actions for Climate Change Adaptation. This outlines, amongst other things, the need for higher engagement in climate change adaptation, as it currently ‘lags’ behind the focus on climate change mitigation. Firms are increasingly taking steps to assess climate risks and plan for resilience, while action on adaptation remains challenging. In order to deliver an output, the World Economic Forum details the three pillars required to deliver an effective framework for business action on adaptation:

• Avoiding economic loss - enhancing resilience by assessing the impact of climate risks on business and acting to adapt and build resilience.

• Increase revenue, cost savings and sustainability – capitalising on opportunity by leveraging products, services and business models that help businesses, communities and ecosystems adapt and build resilience to climate risks and ensure the pursuit of adaptation opportunities that contribute to efficiency and sustainability.

• Protect communities and ecosystems - by participating in multistakeholder efforts that promote action on climate change adaptation, it enables firms to deliver transformative projects that will build community and ecosystem resilience.

The final step in this framework is to cement enabling actions into the firm’s practices. A firm must establish a climate strategy that integrates climate change adaptation and net-zero transformation, mainstream resilience considerations into business decision-making and ensure comprehensive and transparent climate disclosures. In adopting such a framework for adaptation, a firm can not only enhance business resilience and capitalise on opportunity, but it can catalyse systemic action – the most important aspect at the forefront of the fight against climate change.

Insurance options

And finally, insurance has a role and needs to be incorporated into a long-term, comprehensive climate adaptation strategy. Existing business as usual insurance policies need to be considered through a climate lens to ensure they respond as necessary in the event of a claim.

Depending on a firm’s exposure to certain risks, new insurance products may need to be considered. For physical climate risks, property insurance would be the most obvious product. For climate liability risk, directors and officers insurance (or D&O) is important particularly as regards shareholder claims and regulatory enforcement investigations/proceedings arising from matters, such as alleged disclosure issues or the way the firm is operated.

However, these products will not deal with any reputational damage that a firm may incur from a claim and therefore a key component of managing reputational damage is risk management processes.

This article was first published in www.compliancemonitor.com and www.i-law.com on 6 September 2024.