Welcome to our series of blogs on Climate Risk Appetite, a topic receiving a great deal of attention from the office of the Chief Risk Officer (CRO) across a range of financial institutions[1]. In this blog, we introduce the topic along with five key challenges we see institutions grappling with when framing climate risk appetite. A further five blogs will follow in the coming weeks tackling each of the five challenges in turn.

Financial services regulators are increasingly encouraging industry participants to recognise the importance of climate-related risks and to respond with a coherent climate risk plan. This trend has become global, with supervisory authorities from Hong Kong to Canada accelerating the adoption of climate risk management practices, in varying degrees and some making adoption mandatory. Two jurisdictions – the UK and the European Union – serve as notable examples. 

In July 2020, the Prudential Regulation Authority (PRA) wrote directly to CEOs of banks and insurers, providing thematic feedback on their 2019 climate risk plans and setting out the PRA’s future expectations on climate risk. The PRA noted that very few supervised institutions have implemented integrated climate risk policies, defined suitable climate-related thresholds, put in place monitoring capabilities or agreed board-level risk appetite statements. Climate risk mitigation strategies are, it seems, relatively underdeveloped.

In May 2020, the European Central Bank (ECB) also set out its expectations in a public consultation in its guide on climate-related and environmental risks which outlines the need to capture these risks in the risk appetite framework (RAF). To illustrate how deeply the ECB wishes to see this embedded in front-line risk management, loan pricing frameworks are expected to reflect credit risk appetite, appropriately adjusted for climate-related and environmental risks.

While regulation is an important driver, public recognition of a climate emergency is arguably equally significant. The Covid-19 crisis, in particular, has refocused attention on the need for further and more impactful global action to tackle climate change. It has reemphasised the need for urgent measures to accelerate the transition to a cleaner, net zero carbon emission economy. According to the International Energy Agency, annual energy demand could drop by 6% in 2020, owing in large part to the lockdown responses from the vast majority of countries. The reality is that, as the world and global economy eventually recovers, the 7.6% emissions reduction required for the next 10 years to meet the 1.5˚C Paris Agreement target appears increasingly challenging. Further delays will only increase the chances of a disorderly transition to a low-carbon economy, while also increasing the chances of suffering the consequences of extreme climatic events. For financial institutions, this underscores the need for CROs[2]  to articulate, measure, manage and govern climate risks – a compelling business reason to accelerate the inclusion of these risks into the RAF.

Box 1: Risk Appetite Framework
Here we provide a reminder of the core themes that underpin a Risk Appetite Framework (RAF). The RAF supports the articulation of the types and levels of risk an institution is: a) able to assume (“risk capacity”); and b) willing to assume in pursuit of its business objectives (“risk appetite”). The RAF is intrinsically linked to the overall business strategy and comprises a set of qualitative statements and quantitative risk metrics with associated risk limits and triggers. Increasingly, the RAF also reflects the institution’s risk culture and its risk governance. Figure 1 below illustrates these four elements of a RAF.

Figure 1: A typical Risk Appetite Framework

Five challenges for climate risk appetite

Typically, financial institutions have significant experience designing, building, implementing and governing a RAF. This is especially true given the regulatory focus and the recognised benefits a RAF offers as an integral tool for managing the business. Expanding this to include climate risk should, in principle, be a straightforward extension. However, the inclusion of climate risk poses five challenges:

1. The strong link with climate change strategy: The institution needs clarity on its strategic ambitions on climate change to properly capture its risks. What role does it want to adopt on the increasingly high-profile climate change agenda (catalyst, strategist, steward and operator – to be explored in our second blog)? Institutions must articulate the ambition and take meaningful action to manage the risks emanating from climate change that are commensurate with this stated ambition. Any ambiguity, delay or inconsistency between ambition and action, will risk damaging the credibility of the institution’s strategy and its reputation among stakeholders. Arguably, because of the shared public and investor concern around the climate emergency, inaction on climate risk will draw more attention than most other risk categories.

2. Ownership and accountability: Climate risk is a cross-cutting risk and spans across other risk categories such as market, credit and operational risk. It is not easily boxed, posing conundrums about ownership and accountability in the RAF.

3. Telescopic view (multiple time horizons): Climate risk drivers operate at multiple time horizons, spanning the short-term, the medium-term and the very long-term in a way that is distinct from other risk categories[3].

4. Quantification ambitions: When it comes to selecting and developing metrics for the risk appetite dashboard, climate risk relies on data that is heavily forward-looking, new and not necessarily readily available internally. This poses challenges on data collection, data quality and consistency, as well on the development of new methods and metrics.

5. A different perspective on risk-adjusted returns: The typical risk-return analysis common to how other business risks are managed may be too narrow a perspective for capturing the nuances of climate risk. There is an external, public good dimension to managing climate-related risks, where action generates positive societal impact or client satisfaction without necessarily contributing to the institution's bottom line. This requires a wider lens.

What do these challenges mean in practice for incorporating climate risk into the RAF? In our view, they invite the adoption of a set of building blocks. These building blocks can bring together the institution’s climate risk appetite and embed this within its existing RAF. Each block requires in-depth discussion. We propose to explore each of these in a series of five subsequent blogs (see Figure 2), with each blog expanding on one building block at a time, and by doing so, covering each of the five challenges specified above for climate risk appetite development.

Figure 2: Five building blocks for framing Climate Risk Appetite

[1] Financial institutions here is intended to cover banks, insurers and large asset managers.

[2] It is typically the CRO from the Senior Management Function who is accountable for managing climate risks but not always and this is still under consideration in many institutions.

[3] As an example, daily or monthly record temperatures may immediately impact the institution’s own supply chain (or those of its largest client groups) and hence require monitoring in the very short-term. In contrast, the credit attributes of a book of retail mortgages (with say a weighted average maturity of 20 years) may take a decade to change materially, yet still require close ongoing attention. Then, looking even further out, the successful progress (or lack thereof) of the financial industry and the wider economy to hit net-zero emissions targets may require continuous tracking of the lingering climate risk several decades out in the future.

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Our Financial Risk Management and Sustainable Finance teams would be pleased to discuss any aspects of this with you further. Please reach out to the authors for further discussion.