Insights

Climate Change – the Asset Imperative

By Phil Noble , Roger Wood , Roman Zaytsev   /

Managing Climate Risk in Banking & Financial Services

Takeaways

  • Climate change is expected to impact Financial Institutions across their operational areas, which could put their asset base and customer relationships at risk.
  • Australia has not been an early adopter of climate risk response measures, however, regulators are increasingly demanding a comprehensive climate risk management approach.
  • The FS Sector can respond using a range of customer-facing and operational innovations. Yet a capability gap is slowing market-wide adoption of these innovations.
  • Financial Institutions can harness the power of data, technology and decision-making frameworks to manage these risks.

Climate change is well recognised as a threat to Financial institutions

Over the last decade, the expected risks of climate change and the threat they pose to investors, citizens and businesses continues to take centre stage, particularly when the risks associated with financial and real assets are taken into consideration.

In a recent survey undertaken by Chief Risk Officers, over 91% recognised climate as the most important emerging risk1.

The likely impacts of climate change as reported by the Inter-governmental Panel on Climate Change are extensive and severe. Extreme temperatures, weather events and sea level rise, are expected to cause impacts including infrastructure damage, a potential deficit in natural resources and energy, and ultimately, a deterioration in health and human lifestyle2. In turn, these changes can impact FSI’s in at least two key ways, as shown below.

3 4

FSI’s will feel the impact in 3 areas

When considering the science and the expected flow-on impact of climate change on FSI’s, we see three areas that cover the bulk of climate change impact:

  1. Customer behaviour change as spending and consumption patterns alter, and activism increases;
  2. An increase in operational costs, disclosure requirements, and reporting demands; and finally
  3. Key risk areas will increase in their importance, including physical risk (direct property damage), transition risks as we adjust, potential liabilities due to regulation and enforcement, and credit risk.


These specific impacts all need a pattern of well organised, and urgent response.

Customer behavior impacts

– Spending & consumption: preference for more sustainable products and services, alongside initiatives to reduce overall physical footprint from financial activities and support financial institutions that are committed to sustainability.

– Investment: increased investment in environmentally-friendly sustainable assets (funds, ETFs) , and decreased investment or divestment from harmful assets.

– Activism and advocacy: increased engagement with eco-literacy programs and support of initiatives to influence financial institutions’ ESG activity.

Operational impacts

– Operating costs: increase in costs associated with environmental footprint (e.g. carbon taxes) and energy consumption as well as broader ESG activities and resilience capabilities.
– Disclosure: pressure from all stakeholder groups (customers, investors, regulators, industry) to measure and disclose the ESG impact across all areas of operations and value chain (including suppliers).
– Investment/Divestment: prioritisation of sustainable financial products and services as investment vehicles and pressure to reduce investment in environmentally harmful businesses and projects.

Risks & Risk Management impacts5

– Physical: direct damage to assets or property from changing climate and extreme weather events.
– Transition: adjustment to new socio-economic conditions from policy changes, technological innovation and social adaptation.
– Liability: litigation and regulatory enforcement due to inaction.
– Credit: potential losses associated with exposure to climate-impacted borrowers and businesses, as well as higher capital adequacy requirements.

Climate impact needs to be understood at an industry level

Banks are facing considerable risk to their balance sheet due to climate change.

When understanding the exact nature of this risk, it is important to consider the impact by industry sector.

The table below lists a number of industry sectors where the change will be keenly felt.

In each case, Banks and other financial institutions need to start to consider the impact on their own line-of-business and then tailor solutions accordingly.

Up to 15% of EU bank balance sheets are at risk due to climate change. Australian banks face similar challenges in the key industries, with potentially higher risks6


Examples of impacts in specific industries
7 8 9 10 11 12 13 14

Regulators are increasing pressure on FSIs to manage and report climate risk exposure

Australia has been lagging, but is catching up…

Australia has been behind offshore approaches to the management of climate risk, although requirements are now in place that all Australian financial institutions must adhere to.

Regulations and disclosure requirements in the field have rapidly evolved since 2017. In the EU, a largely voluntary and recommendation- based approach was replaced by extensive mandatory reporting.

Australian regulators are now catching up with the global trend and will mandate baseline disclosures from around mid 2024. Further tightening and expansion to all FS organisations will most likely occur over the next 2 to 3 years.15

APRA have provided some useful guidance for managing climate-related risk

APRA have identified 5 key capabilities16

Incorporating TCFD standards and best industry practice, APRA have introduced practical guidance for climate risk management:

  • Risk identification & measurement: Identify areas with exposures to climate risks, and develop metrics to measure these risks
  • Risk Monitoring: Ensure climate risk data, metrics and targets are monitored and updated regularly to support decision-making
  • Scenario Analysis: Develop capabilities in climate scenario analysis and stress testing to inform short- and long-term risk identification
  • Risk Response: Implement plans to mitigate climate risks, manage risk exposures, and review effectiveness of mitigation plans
  • Reporting: Establish processes to continuously provide relevant information on material climate risk exposures.

A benchmark against APRA’s guidance is a great place to start

Utilising APRA’s climate risk management framework, SPP has developed a quick assessment tool to support the initial benchmarking of your organisational capabilities in climate risk management.

Unique solutions are rapidly emerging

Customers are asking more of their FIs

In response to growing ESG-sentiment and regulations, banks have expanded their value propositions across major product categories and services to better address customer needs and manage risk. Some of these examples are highlighted below.

CoGo partners with banks (Westpac, CBA) to expand their propositions with environmental features:17
– Carbon footprint calculator (based on customer spend and CoGo data)
– Carbon offset (CoGo purchases carbon credits from the offset providers)
– Behavioural nudges (comparison of customer’s footprint to average levels, recommendations to switch to lower carbon footprint products and services, rewards for taking action to reduce carbon footprint).

Indian ICICI bank is using satellite imaging for lending decisions and credit-worthiness assessment of its customers. It measures an array of parameters related to land, irrigation, and crop patterns.18

Westpac currently provides sustainability-linked loans, with interest rates linked to the borrower’s performance on climate-related metrics, such as biodiversity, greenhouse gas emissions and renewable energy use.19

Better climate risk assessment is supported by modelling & high-quality data

Modelling a solution can be undertaken using a variety of data inputs which are available from external parties, including PEXA and Government organisations. Utilising both external and internal datasets, an institution could model the pre and post-climate risk of financing a given asset. A conceptual model outlining this approach, based on models suggested by a variety of consulting and government groups, is shown below.

Establishing a case for change

One way to start moving with a clear response to the climate issue is to consider building a case for change. A simple framework as shown below, can help organisations understand the risks at hand, how other groups are approaching those risks, and utilise data to identify a prioritised set of actions.

Exhibit – Sample workshop for developing a climate-risk response

Climate change remains one of the most challenging issues facing organisations in financial services today. How ready is your organisation to respond?

References

  1. EY (2021), “EY and IIF risk management survey shows climate change now a top concern for banks”, https://www.ey.com/en_gl/news/2021/06/ey-and-iif-risk-management-survey-shows-climate-change-now-a-top-concern-for-banks ↩︎
  2. NASA (2023), “Climate Change: Vital Signs of the Planet”, https://climate.nasa.gov/effects/ ↩︎
  3. EY (2021), “Climate related risks in financial statements”, https://assets.ey.com/content/dam/ey-sites/ey-com/en_au/topics/ifrs/climate-related-risks-in-financial.pdf ↩︎
  4. Amoodu et al. (2023), “Impact of climate change and heat stress on workers’ health and productivity: A scoping review”, https://www.sciencedirect.com/science/article/pii/S2667278223000494 ↩︎
  5. Bank for International Settlements (2021), “Climate-related risk drivers and their transmission channels”, https://www.bis.org/bcbs/publ/d517.pdf ↩︎
  6. McKinsey & Company (2020), “Banking imperatives for managing climate risk”, https://www.mckinsey.com/capabilities/risk-and-resilience/our-insights/banking-imperatives-for-managing-climate-risk ↩︎
  7. The McKell Institute (2021), “The cost of extreme weather”, https://insurancecouncil.com.au/wp-content/uploads/2022/09/McKell_Cost-of-Natural-Disasters_SINGLES_WEB.pdf ↩︎
  8. Department of Agriculture, Fisheries and Forestry (2023), “Building a world-leading, climate-smart agriculture industry”, https://www.agriculture.gov.au/about/news/national-statement-climate-agriculture ↩︎
  9. Department of Climate Change, Energy, the Environment and Water (2022), “Australian Energy Statistics – Electricity generation by fuel type 2020-21 and 2021”, https://www.energy.gov.au/publications/australian-energy-statistics-table-o-electricity-generation-fuel-type-2020-21-and-2021 ↩︎
  10. Smart Energy Council (2021), “82% Renewables by 2030 – Smart Energy Council Welcomes Labor’s Powering Australia Plan”, https://smartenergy.org.au/articles/media-release-82-renewables-by-2030-smart-energy-council-welcomes-labors-powering-australia-plan/ ↩︎
  11. The Guardian (2022), “AGL will close Victoria’s coal-fired power station Loy Yang A a decade early”, https://www.theguardian.com/business/2022/sep/29/agl-to-unveil-plan-to-close-coal-fired-power-station-loy-yang-a-a-decade-early ↩︎
  12. PGIM Investments (2023), “Commercial real estate: Emerging value amidst storm”, https://www.pgim.com/ucits/article/commercial-real-estate-emerging-value-amidst-storm ↩︎
  13. Department of Climate Change, Energy, the Environment and Water (2023), “Commercial buildings”, https://www.energy.gov.au/government-priorities/buildings/commercial-buildings ↩︎
  14. JLL Australia (2022), “Retrofitting Buildings to be Future-Fit”, https://www.jll.com.au/en/trends-and-insights/research/retrofitting-buildings-to-be-future-fit#:~:text=80%25%20of%20office%20buildings%20which,of%20broader%20asset%20repositioning%20strategies. ↩︎
  15. Australian Treasury (2023), “Climate-related financial disclosure: Consultation paper”, https://treasury.gov.au/sites/default/files/2023-06/c2023-402245.pdf ↩︎
  16. APRA (2021), “Prudential Practice Guide”, https://www.apra.gov.au/sites/default/files/2021-11/Final%20Prudential%20Practice%20Guide%20CPG%20229%20Climate%20Change%20Financial%20Risks.pdf ↩︎
  17. Westpac (2023), “Westpac to offer customers the ability to track carbon footprint), https://www.westpac.com.au/about-westpac/media/media-releases/2023/4-May/ ↩︎
  18. ICICI Bank (2020), “ICICI Bank introduces use of satellite data to power credit assessment of farmers”, https://www.icicibank.com/about-us/article/news-icici-bank-introduces-use-of-satellite-data-to-power-credit-assessment-of-farmers-20202508150716236 ↩︎
  19. Westpac (2022), “Westpac supports sustainability-linked loan targeting biodiversity and natural capital”,  https://www.westpac.com.au/about-westpac/media/media-releases/2022/6-september/ ↩︎

Key Contacts

Phil Noble  /  Founder and Managing Partner

Phil Noble is the Founder and Managing Partner of SPP. He is an experienced General Manager, Consultant and Entrepreneur and has worked in a wide range of industries including financial services, telecommunications, infrastructure and Not for Profit.  Phil has...

Connect on email

Connect on LinkedIn

Roger Wood  /  Principal

Roger Wood is a Principal at SPP with over 20 years’ experience as a senior strategy consultant and executive line manager at major financial services business. Roger has extensive experience in strategic projects and the delivery of transformational change...

Connect on email

Connect on LinkedIn

By Phil Noble , Roger Wood , Roman Zaytsev   /