In total 104 banks participated in the stress test that was intended as a learning exercise, for the ECB and the participating banks alike. In this article we provide a brief overview of the main results.

The ECB’s goal with the climate risk stress test was to assess the progress banks have made in developing climate risk stress-testing frameworks and the corresponding projections, as well as understanding the exposures of banks with respect to both transition and physical climate change risks. The stress test therefore consisted of three modules: 1) a qualitative questionnaire to assess the bank’s climate risk stress testing capabilities, 2) two climate risk metrics showing the sensitivity of the banks’ income to transition risk and their exposure to carbon emission-intensive industries, and 3) constrained bottom-up stress test projections for four scenarios specified by the ECB¹. The third module only had to be completed by 41 directly supervised banks to limit the burden for some of the smaller banks included in the climate risk stress test.

An understatement of the true risk

The constrained bottom-up stress test projections show that the combined market and credit risk losses for the 41 banks in the sample amount to approximately EUR 70 billion in the short-term disorderly transition scenario. The ECB emphasizes that this probably is an understatement of the true risk, because it does not consider the scenarios underlying the stress test to be ‘adverse’. Second round economic effects from climate risk changes have, for example, not been factored in. Furthermore, only a third of the total exposures of the 41 banks were in scope and, on top of that, the ECB considers the banks’ modeling capabilities to be ‘rudimentary’ in this stage: they report that around 60% of the banks do not yet have a well-integrated climate risk stress testing framework in place, and they expect that it will take several years before banks achieve this. Even though banks are not meeting the ECB’s expectations yet, the ECB does conclude that banks have made considerable progress with respect to their climate stress testing capabilities.

Be aware of clients’ transition plans

A further analysis of the results shows that the share of interest income related to the 22 most carbon-intensive industries amounts to more than 60% of the total non-financial corporate interest income (on average for the banks in the sample). Interestingly, this is higher than the share of these sectors (around 54%) in the EU economy in terms of gross added value. The ECB argues that banks should be very much aware of the transition plans of their clients to manage potential future transition risks in their portfolio. The exposure to physical risks is much more varied across the sample of banks. It primarily depends on the geographical location of their lending portfolios’ assets.

The ECB points out that only a few banks account for climate risk in their credit risk models. In many cases, the credit risk parameters are fairly insensitive to the climate change scenarios used in the stress test. They also report that only one in five banks factor climate risk into their loan origination processes. A final point of attention is data availability. In many cases, proxies instead of actual counterparty data have been used to measure (for example) greenhouse gas emissions, especially for Scope 3. Consequently, the ECB is also promoting a higher level of customer engagement to improve in this area.

Many deficiencies, data gaps and inconsistencies

The outcome of the climate risk stress test will not have direct implications for a bank’s capital requirements, but it will be considered from a qualitative point of view as part of the Supervisory Review and Evaluation Process (SREP). This will be complemented by the results from the ongoing thematic review that is focused on the way banks consider climate-related and environmental risks into their risk management frameworks. The combination will indicate to the ECB how well a bank is meeting the expectations laid down in the ‘Guide on climate-related and environmental risks’ that was published by the ECB in November 2020.

The ECB notes that the exercise revealed many deficiencies, data gaps and inconsistencies across institutions and expects banks to make substantial further progress in the coming years. Furthermore, the ECB concludes that banks need to increase customer engagement to obtain relevant company-level information on greenhouse gas emissions, as well as to invest further in the methodological assumptions that are used to arrive at proxies.

If you are looking for support with the integration of Environmental, Social, and Governance risk factors into your existing risk frameworks, please reach out to us.

Notes
1) See our earlier article on the ECB’s climate stress test methodology for more details.

The last three to four years have seen a rapid increase in the number of publications and guidance from regulators and industry bodies. Environmental risk is currently receiving the most attention, triggered by the alarming reports from the Intergovernmental Panel on Climate Change (IPCC). These reports show that it is a formidable, global challenge to shift to a sustainable economy in order to reduce environmental impact.

The Working Group II contribution to the IPCC’s Sixth Assessment Report states that “climate change is a grave and mounting threat to our wellbeing and a healthy planet”. It is a formidable, global challenge to transition to a sustainable economy before time is running out. Banks have an important role to play in this transition. By stepping up to this role now, banks will be better prepared for the future, and reap the benefits along the way.

In the Paris Agreement (or COP21), adopted in December 2015, 196 parties agreed to limit global warming to well below 2.0°C, and preferably to no more than 1.5°C. To prevent irreversible impacts to our climate, the IPCC stresses that the increase in global temperature (relative to the pre-industrial era) needs to remain below 1.5°C. To achieve this target, a rapid and unprecedented decrease in the emission of greenhouse gasses (GHG) is required. With CO2 emissions still on the rise, as depicted in Figure 1, the challenge at hand has increased considerably in the past decade.

Figure 1 – Annual CO2 emissions from fossil fuels.

To further illustrate this, Figure 2 depicts for several starting years a possible pathway in CO2 reductions to ensure global warming does not exceed 2.0°C. Even under the assumption that CO2 emissions have already peaked, it becomes clear that the required speed of CO2 reductions is rapidly increasing with every year of inaction. We are a long way from limiting global warming to 2.0°C. This even holds under the assumption that all countries’ pledges to reduce GHG emissions will be achieved, as can be observed in Figure 3.

To quote the IPCC Working Group II co-chair Hans-Otto Pörtner: “Any further delay in concerted anticipatory global action on adaptation and mitigation will miss a brief and rapidly closing window of opportunity to secure a livable and sustainable future for all.”

Figure 2 – CO2 reduction need to limit global warming.

Figure 3 – Global GHG emissions and warming scenario’s.

The role of banks in the transition – and the opportunities it offers

Historically, banks have been instrumental to the proper functioning of the economy. In their role as financial intermediaries, they bring together savers and borrowers, support investment, and play an important role in facilitating payments and transactions. Now, banks have the opportunity to become instrumental to the proper functioning of the planet. By allocating their available capital to ‘green’ loans and investments at the expense of their ‘brown’ counterparts, banks can play a pivotal role in the transition to a sustainable economy. Banks are in the extraordinary position to make a fundamentally positive contribution to society. And even better, it comes with new opportunities.

The transition to a sustainable economy requires huge investments. It ranges from investments in climate change adaption to investments in GHG emission reductions: this covers for example investments in flood risk warning systems and financing a radical change in our energy mix from fossil-fuel based sources (like coal and natural gas) to clean energy sources (like solar and wind power). According to the Net Zero by 2050 Report from the International Energy Agency (IEA)², the annual investments in the energy sector alone will increase from the current USD 2.3 trillion to USD 5.0 trillion by 2030. Hence, across sectors, the increase in annual investments could easily be USD 3.0 to 4.0 trillion. As much as 70% of this investment may need to be financed by the private sector (including banks and other financial institutions)³. To put this in perspective, the total outstanding credit to non-financial corporates currently stands at USD 86.3 trillion⁴. Assuming an average loan maturity of 5 years, this would translate to a 12-16% increase in loans and investments by banks on a global level. Hence, the transition to a sustainable economy will open up a large market for banks through direct investments and financing provided to corporates and households.

The transition to a sustainable economy is also triggering product development. The Climate Bonds Initiative (CBI) for example reports that the combined issuance of Environmental, Social, and Governance (ESG) bonds, sustainability-linked bonds and transition debt reached almost USD 500 billion in 2021H1, representing a 59% year-on-year growth rate. Other initiatives include the introduction of ‘green’ exchange-traded funds (ETFs) and sustainability-linked derivatives. The latter first appeared in 2019 and they provide an incentive for companies to achieve sustainable performance targets. If targets are met, a company is for example eligible for a more attractive interest coupon. Again, this is creating an interesting market for banks.

By embracing the transition, with all the opportunities that it offers, banks are also bracing themselves for the future. Banks that adopt climate change-resilient business models and integrate climate risk management into their risk frameworks will be much better positioned than banks that do not. They will be less exposed to climate-related risks, ranging from physical and transition risks to risks stemming from a reputational perspective or litigation, also justifying lower capital requirements. The early adaptors of today will be the leaders of tomorrow.

A roadmap supporting the transition

How should a bank approach this transition? As depicted in Figure 4, we identify four important steps: target setting, measurement and reporting, strategy and risk framework, and engaging with clients.

Figure 4 – The roadmap supporting the transition to a sustainable economy.

Target setting

The starting point for each transition is to set GHG emission targets in alignment with emission pathways that have been established by climate science. One important initiative that can support banks in setting these targets is the Science Based Targets initiative (SBTi). This organization supports companies to set targets in line with the goals of the Paris Agreement. Unlike many other companies, the majority of a bank’s GHG emissions are outside their direct control. They can influence, however, their so-called financed emissions, which are the GHG emissions coming from their lending and investment portfolios. The SBTi has developed a framework for banks that reflects this. It encourages banks to use the Absolute Contraction approach that requires a 2.5% (for a well-below 2.0°C target) or 4.2% (for a 1.5°C target) annual reduction in GHG emissions. A clear emission pathway guides banks in the subsequent steps of the transition process.

Measurement and reporting

With targets in place, the next important step for a bank is to determine their level of GHG emissions: both for scope 1 and 2 (the GHG emissions they control) and for scope 3 (the financed emissions). Important initiatives for the quantification of the financed emissions are the Paris Agreement Capital Transition Assessment (PACTA) and the Platform Carbon Accounting Financials (PCAF). PCAF is a Dutch initiative to deliver a global, standardized GHG accounting and reporting approach for financial institutions (building on the GHG Protocol). PACTA enables banks to measure the alignment of financial portfolios with climate scenarios.

By keeping track of the level of GHG emissions on an annual basis, banks can assess whether they are following their selected emission pathway. Reporting, in line with the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), will contribute to a greater understanding of climate risks with their investors and other stakeholders.

Strategy and risk framework

Setting targets and measuring the current level of GHG emissions are necessary but not sufficient conditions to achieve a successful transition. Climate change risk needs to be fully integrated into a bank’s strategy and its risk framework. To assess the climate change-resilience of a bank’s strategy, a logical first step is to understand which climate change risks are material to the organization (e.g., by composing a materiality matrix). Subsequently, studying the transmission channels of these risks using scenario analysis and/or stress testing creates an understanding of what parts of the business model and lending portfolio are most exposed. This could lead to general changes in a bank’s positioning, but these risks should also be factored into the bank’s existing risk framework. Examples are the loan origination process, capital calculations, and risk reporting.

Engaging with clients

A fourth step in the game plan to successfully support the transition is for a bank to actively engage with its clients. A dialogue is required to align the bank’s GHG emission targets with those of its clients. This extends to discussing changes in the operations and/or business model of a client to align with a sustainable economy. This also may include timely announcing that certain economic activities will no longer be financed, and by financing client’s initiatives to mitigate or adapt to climate change: e.g., financing wind turbines for clients with energy- or carbon-intensive production processes (like cement or aluminium) or financing the move of production locations to less flood-prone areas.

Conclusion

Banks are uniquely positioned to play a pivotal role in the transition to a sustainable economy. The transition is already providing a wide range of opportunities for banks, from large financing needs to the introduction of green bonds and sustainability-linked derivatives. At the same time, it is of paramount importance for banks to adopt a climate change-resilient strategy and to integrate climate change risk into their risk frameworks. With our extensive track record in financial and non-financial risk management at financial institutions, Zanders stands ready to support you with this ambitious, yet rewarding challenge.

ESG risk management and Zanders

Zanders is currently supporting several clients with the identification, measurement, and management of ESG risks. For a start, we are supporting a large Dutch bank with the identification of ESG risk factors that have a material impact on the credit risk profile of its portfolio of corporate loans. The material risk factors are then integrated in the bank’s existing credit risk framework to ensure a proper management of this new risk type.

We are supporting other banking clients with the quantification of climate change risk. In one case, we are determining climate change risk-adjusted Probabilities of Default (PDs). Using expected future emissions and carbon prices based on the climate change scenarios of the Network for Greening the Financial System (NGFS), company specific shocks based on carbon prices and country specific shocks on GDP level are determined. These shocked levels are then used to determine the impact on the forecasted PDs. In another case, we are investigating the potential impact of floods and droughts on the collateral value of a portfolio of residential mortgage loans.

We also gained experience with the data challenges involved in the typical ESG project: e.g., we are supporting an asset manager with integrating and harmonizing ESG data from a range of vendors, which is underlying their internally developed ESG scores. We also support them with embedding these scores in the investment process.

With our extensive track record in financial and non-financial risk management at financial institutions in general, and our more recent ESG experience, Zanders stands ready to support you with the ambitious, yet rewarding challenge to adopt a climate change-resilient strategy and to integrate climate change risk in your existing risk frameworks.

Foot notes:

1 The IPCC Working Group II contribution: Climate Change 2022: Impacts, Adaptation and Vulnerability.
2 The IEA report, Net Zero by 2050.
3 See the Net Zero Financing roadmaps from the UN, ‘Race to Zero’ and the ‘Glasgow Financial Alliance for Net Zero’ (GFANZ).
4 Based on the statistics of the Bank for International Settlements (BIS) per 2021-Q3.
5 The Climate Bonds Initiative’s Sustainable Debt Highlights H1 2021.

This publication fits nicely into the ‘horizon priority’ of the EBA¹ to provide tools to banks to measure and manage ESG-related risks. In this article we present a brief overview of the way the ITS have been developed, what qualitative and quantitative disclosures are required, what timelines and transitional measures apply – and where the largest challenges arise. By requiring banks to disclose information on their exposure to ESG-related risks and the actions they take to mitigate those risks – for example by supporting their clients and counterparties in the adaptation process – the EBA wants to contribute to a transition to a more sustainable economy. The Pillar 3 disclosure requirements apply to large institutions with securities traded on a regulated market of an EU member state.

The current version of the IRRBB Guidelines, published in 2018, came into force on 30 June 2019. At that time, the IRRBB Guidelines were aligned with the Standards on interest rate risk in the banking book, published by the Basel Committee on Banking Supervision (in short, the BCBS Standards) in April 2016.

In this article, we focus on one of these consultation papers, which concerns updates to the supervisory outlier test (SOT) for the Economic Value of Equity (EVE) and the introduction of an SOT for Net Interest Income (NII).

As the financial sector is key for the transition towards a low-carbon and more circular economy, financial institutions have to deal with climate-related and environmental financial risks (C&E risks). At the same time, the increased importance of these C&E risks also presents new business opportunities for the financial sector. Therefore, to support banks in their self-assessment and action plans, Zanders developed a Scan & Plan Solution on C&E risks.

According to the 2021 World Economic Forum Global Risk Report¹, extreme weather, climate action failure, human environmental damage and biodiversity loss are ranked as four of the top five global risks by highest likelihood and four of the six global risks with the largest impact. It is not surprising that over the past years, numerous articles on C&E risks have been published and many initiatives have been taken to identify, measure and manage these risks. The Paris Agreement², the United Nations 2030 Agenda for Sustainable Development³ and more recently the European Green Deal⁴ are the main examples of international governmental responses to address C&E risks.

The financial sector is considered key for the transition towards a low-carbon and more circular economy. This is illustrated by the fact that the European Central Bank (ECB) has identified climate-related risks as a key risk driver for the euro area banking system in their Single Supervisory Mechanism Risk Map⁵. At the same time, the increased importance of C&E risks also presents new business opportunities for the financial sector, such as providing sustainable financing solutions and offering new financial instruments that facilitate C&E risk management. To illustrate, the UN’s Intergovernmental Panel on Climate Change⁶ (IPCC) estimates that the required investment for alignment with the Paris Agreement would be at least $3.5tn per year until 2050 for the energy sector alone.

To address C&E risks, the ECB published a Guide on climate-related and environmental risks⁷ for banks that describes the ECB’s supervisory expectations related to risk management and disclosure. Banks are required by the ECB to perform a self-assessment with respect to the supervisory expectations and to draft an action plan in 2021. The self-assessments and plans will subsequently be reviewed and challenged by the ECB as part of the supervisory dialogue. In 2022, the ECB will conduct a full supervisory review of bank’s practices related to C&E risks.

The Zanders Scan & Plan Solution provides clear insights into gaps with the ECB expectations and proposes practical actions that are tailored to a bank’s nature, scale and complexity. This article provides a brief explanation of C&E risks, outlines a few specific ECB supervisory expectations and elaborates on the Solution.

Definition of C&E risk

Financial risks from climate and environmental change arise from two primary risk categories:

• Physical risks. The first risk category concerns physical risks caused by acute (direct events) or chronic (longer-term events which cause gradual deterioration) C&E events. Examples of acute events are floods, wildfires and heatwaves, whereas chronic events relate to the likes of rising sea levels, acidity and biodiversity losses, for example.
• Transition risks. The second risk category comprises transition risks resulting from the process of moving towards a low-carbon economy. Changes in policy, regulation, technology, market sentiment and consumer sentiment could destabilize markets, tighten financial conditions and lead to procyclicality of losses.

These two risk categories are distinct from other risk categories in the following aspects: 1) they have a correlated and non-linear impact on all business lines, sectors and geographies, 2) they have a long-term nature and 3) the future impact is largely dependent on short-term actions. The risk categories are, among others, drivers of credit, market and operational risk, as shown in Figure 1.

Figure 1: Examples of the impact of physical risks and transition risks on traditional risk types from the ECB Guide on climate-related and environmental risks.

ECB Supervisory Expectations

In the Guide on climate-related and environmental risks⁷, published in November 2020, the ECB explains that banks are expected to reflect C&E risks as drivers of existing risk categories (e.g., credit risk, market risk, operational risk) rather than as a separate risk type. This indicates that not only efforts should be made by banks to develop risk management practices related to C&E risks but that these practices should also be integrated in existing risk management frameworks, models and policies.

The ECB Guide covers four main areas. First, in relation to ‘business models and strategy’, the ECB expects banks to understand the impact of C&E risks on their business environment and integrate C&E risks in their business strategy. Secondly, the guide addresses ‘governance and risk appetite’. The ECB expects a bank’s management to include C&E risks in the risk appetite framework, assign responsibilities related to C&E risks to the three lines of defense and establish internal reporting. Thirdly, in relation to ‘risk management’, the ECB expects that banks integrate C&E risks into their existing risk management framework. Finally, regarding ‘disclosures’, the ECB expects banks to disclose meaningful information and metrics on C&E risks. The four above-mentioned areas are covered in 13 expectations, which are in turn further divided in 46 sub-expectations. Banks are required by the ECB to perform a self-assessment with respect to the supervisory expectations and to draft an action plan in 2021. The self-assessments and plans will subsequently be reviewed and challenged by the ECB as part of the supervisory dialogue. The ECB recommends National Competent Authorities, in their supervision of less significant institutions, to apply these expectations proportionate to the nature, scale and complexity of the bank’s activities.

Zanders has thoroughly analyzed all (sub)-expectations and has highlighted a few specific expectations including possible actions below.

Expectation 4.2: Institutions are expected to develop appropriate key risk indicators (KRI) and set appropriate limits for effectively managing climate-related and environmental risks in line with their regular monitoring and escalation arrangements.

Here, the ECB expects institutions to monitor and report their exposures to C&E risks based on current data and forward-looking estimations. In addition, institutions are expected to assign quantitative metrics to C&E risks. It is however acknowledged that, since definitions, taxonomies and methodologies are still under development, qualitative metric or proxy data can be used as long as specific quantitative metrics are not yet available. The ECB deems that the metrics should reflect the long-term nature of climate change, and explicitly consider different paths for temperature and greenhouse gas emissions. Finally, the ECB expects institutions to define limits on the metrics based on the risk appetite regarding C&E risks.

This expectation has various elements to it, and Zanders has defined as the most important and first step to identify the internal and external data availability related to C&E risks. If the data availability allows it, an institution should set up quantitative metrics and limits on these metrics that reflect C&E risks. A first step to achieve this would be to define several firmwide KRIs, for example by limiting the carbon emission of the whole portfolio in line with the Paris Agreement² or other (inter)national climate agreements. These KRIs can then be cascaded down to business lines and/or portfolios, such as limiting the exposure to specific sectors with large carbon footprints or substantial use of water. If the current data availability does not allow for quantitative metrics, the bank should identify which data is still lacking and assess ways to collect this data from internal data sources or external data providers in the course of time. In the meantime, qualitative metrics or proxies could be developed such as a qualitative score for the sophistication of the climate strategy of large corporates in the portfolio.

Should a bank already have some metrics in place, Zanders advises to evaluate if these metrics sufficiently cover all material physical and transition C&E risks that the bank is expected to face and if there are ways to increase the sophistication of these metrics, for example by including forward-looking estimations. Finally, Zanders advises banks to create a monitoring procedure to ensure that these metrics and their limits are evaluated regularly.

Expectation 8.1: Climate-related and environmental risks are expected to be included in all relevant stages of the credit-granting process and credit processing.

In this expectation, the ECB underlines that banks should identify and assess material factors that affect the default risk of loan exposures. The quality of the client’s own management of C&E risks may be taken into account in this case. In addition, banks are expected to consider changes in the credit risk profiles based on sectors and geographical areas.

The way to address this expectation is highly dependent on the nature of the bank, on the existing credit granting process and on the availability of data. Some examples of including C&E risk in the credit granting process in a qualitative way, which Zanders has observed in the market, are the development of shadow PD models that trigger mitigating actions in case of large discrepancies with the regular PDs, or the introduction of a scorecard based on quantitative as well as qualitative aspects.

It should be noted that these and other solutions are not mutually exclusive and that multiple approaches can be adopted for different parts of the portfolio. Also, the efforts for several individual expectations can be combined. For example, taking C&E risks into account in the credit granting process could also be linked to the qualitative and quantitative metrics set as part of expectation 4.2 (see above). The quality of the client’s own management of C&E risks can for instance be measured based on the qualitative score for the climate strategy sophistication of large corporates mentioned above.

Expectation 11: Institutions with material climate-related and environmental risks are expected to evaluate the appropriateness of their stress testing, with a view to incorporating them into their baseline and adverse scenarios.

This expectation indicates that banks should evaluate the appropriateness of their stress testing in relation to C&E risks. In this evaluation, the bank should take into account the following considerations: i) how will the bank be affected by physical and transition risks, ii) how will C&E risks evolve under various scenarios (thereby taking into account that these risks may not fully be reflected in historical data), and iii) how may C&E risks materialize in the short-, medium- and long-term. Based on these considerations and on scientific climate change pathways as well as on assumptions that fit with their risk profile and individual specification, banks should incorporate C&E risks in their baseline and adverse scenarios.

To address this recommendation, Zanders advises banks to first identify C&E risks scenarios with different severities based on the materiality of C&E risks for the bank. Examples of this include early or late transition to a low-carbon economy (transition risk), introduction of a carbon tax (transition risk) or staying below or above a 2°C temperature increase (physical risk). These scenarios could be based on scientific scenarios from the IPCC⁸ or the International Energy Agency⁹. The next step is to translate these scenarios into macro-economic variables, such as GDP, inflation and loan valuations, over a range of relevant sectors and geographies. Since there is not yet a single methodology to do this, banks need to be creative and combine new qualitative and quantitative approaches with existing modeling methodologies.

Zanders Scan & Plan Solution

To manage C&E risks, to seize new business opportunities and to meet the regulatory expectations related to C&E risks, it is crucial for banks to have transparency about their exposure to these risks. To support banks with this, the Zanders Scan & Plan Solution is available. The Scan assesses the gaps between the bank’s current practices and each of the expectations in the ECB guide. These gaps are scored based on a pre-defined scoring system and are shown in a heatmap that is easy to interpret. Subsequently, the Plan proposes possible actions to close the identified gaps. These possible actions will be tailored to the nature, scale, and complexity of the bank and to the level of sophistication of the bank in the field of C&E risks. The Scan & Plan will be provided in the form of a detailed report.

Zanders has previously supported clients on topics related to climate change, published market insights and supported research. In addition, Zanders has broad experience in supporting clients in each of the areas of the ECB guide: business models and strategy, governance and risk appetite, risk management and disclosure. Hence, Zanders is in an excellent position to also support banks with the implementation of the proposed actions from the Scan & Plan or with shaping new business activities related to C&E risks.

To learn more about the Zanders Scan & Plan solution and how Zanders can support your institution with managing C&E risks, please contact Petra van Meel, Marije Wiersma or Pieter Klaassen.

References
1) http://www3.weforum.org/docs/WEF_The_Global_Risks_Report_2021.pdf
2) https://unfccc.int/sites/default/files/english_paris_agreement.pdf
3) https://sdgs.un.org/2030agenda
4) https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_en
5) https://www.bankingsupervision.europa.eu/ecb/pub/ra/html/ssm.ra2021~edbbea1f8f.en.html#toc1
6) https://www.ipcc.ch/site/assets/uploads/sites/2/2019/02/SR15_Chapter4_Low_Res.pdf
7) https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.202011finalguideonclimate-relatedandenvironmentalrisks~58213f6564.en.pdf
8) https://www.ipcc.ch/report/emissions-scenarios/
9) https://www.iea.org/reports/world-energy-model/sustainable-development-scenario

One of the key subjects in this re-assessment is the implementation of tangible and transparent Environment, Social, and Governance (ESG) factors into the business.

Treasury can drive sustainability throughout the company from two perspectives, namely through initiatives within the Treasury function and initiatives promoted by external stakeholders, such as banks, investors, or its clients. When considering sustainability, many treasurers first port of call is to investigate realizing sustainable financing framework. This is driven by the high supply of money earmarked for sustainable goals. However, besides this external focus, Treasury can strive to make its own operations more sustainable and, as a result, actively contribute to company-wide ESG objectives.

Figure 1: ESG initiatives in scope for Treasury

Treasury holds a unique position within the company because of the cooperation it has with business areas and the interaction with external stakeholders. Treasury can leverage this position to drive ESG developments throughout the company, stay informed of latest updates and adhere to regulatory standards. This article shows how Treasury can become a sustainable support function in its own right, highlights various initiatives within and outside the Treasury department and marks the benefits for Treasury – on top of realising ESG targets.

Internal initiatives

Automation and digitalization drive certain environmental initiatives within the Treasury department. Full digitalized records and bank statement management and the digitalization of form processes reduce the adverse environmental impact of the Treasury department. Besides reducing Treasury’s environmental footprint, digitalization improves efficiency of the Treasury team. By reducing the number of manual, cumbersome operational activities, time can be spent on value-adding activities rather than operational tasks.

Another great example of how Treasury can contribute to the ESG goals of the company, is to incorporate ESG elements in the capital allocation process. This can be done by adding ESG related risk factors to the weighted average cost of capital (WACC) or hurdle investment rates. By having an ESG linked WACC, one can evaluate projects by measuring the real impact of ESG on the required return on equity (ROE). By adjusting the WACC to, for example, the level of CO2 that is emitted by a project, the capital allocation process favours projects with low CO2 emissions.

An additional internal initiative is the design of a mobility policy with the objective to lower CO2 emissions. On one hand, this relates to decreasing the amount of business trips made by the Treasury department itself. On the other hand, it relates to the reduction of business travel by stakeholders of treasury such as bankers, advisors and system vendors. A framework that offsets the added value of a real-life meeting against the CO2 emission is an example of a measure that supports CO2 reduction on both sides. Such a framework supports determination whether the meeting takes place online or in person.

Furthermore, embedding ESG requirements into bank selection, system selection and maintenance processes is a valuable way of encouraging new and existing partners to undertake ESG related measures.

When it comes to social contributions, the focus could be on the diversity and inclusion of the Treasury department, which includes well-being, gender equality and inclusivity of the employees. Pursuing these policies can increase the attractiveness of the organization when hiring talent and make it easier to retain talent within the company, which is also beneficial to the Treasury function.

The development of a structured model that defines the building blocks for Treasury to support the achievement of companywide ESG objectives is a governance initiative that Treasury could undertake. An example of such a model is the Zanders Treasury and Risk Maturity Model, which can be integrated in any organization. This framework supports Treasury in keeping track of its ESG footprint and its contribution to company-wide sustainable objectives. In addition, the Zanders sustainability dashboard provides information on metrics and benchmarks that can be applied to track the progress of several ESG related goals for Treasury. Some examples of these are provided in our ‘Integration of ESG in treasury’ article.

External initiatives

Besides actions taken within the Treasury department, Treasury can boost company-wide ESG performance by leveraging their collaboration with external stakeholders. One of these external initiatives is sustainability linked financing, which is a great tool to encourage the setting of ambitious, company-wide ESG targets and link these to financing arrangements. Examples of sustainability linked financing products include green loans and bonds, sustainability-linked loans, and social bonds. To structure sustainability-linked financing products, corporates often benefit from the guidance of external parties when setting KPIs and ambitious targets and linking these to the existing sustainability strategy. Besides Treasury’s strong relationships with banks, retaining good relationships with (ESG) rating agencies and financial institutions is critical to stay abreast of the latest updates and adhere to regulatory standards. Additionally, investing excess cash in a sustainable manner, using green money market funds or assessing the ESG rating of counterparties, is an effective way of supporting sustainability.

Apart from financing instruments, Treasury can drive the ESG strategy throughout the organization in other ways. Treasury can seek collaborations with business partners to comply with ESG targets, which is another effective manner to achieve ESG related goals throughout the supply chain. An increasing number of corporates is looking to reduce the carbon footprint of their supply chain, for which collaboration is essential. Treasury can support this initiative by linking supplier onboarding on its supply chain finance program to the sustainability performance of suppliers.

To conclude

As developments in ESG are rapidly unfold9ing, Zanders has started an initiative to continuously update our clients to stay ahead of the latest trends. Through the knowledge and network that we have built over the years, we will regularly inform our clients on ESG trends via articles on the news page on our website. The first article will be devoted to the revision of the Sustainability Linked Loan Principles (SLLP) by the Loan Market Association (LMA) and its American and Asian equivalents.

We are keen to hear which topics you would like to see covered. Feel free to reach out to Joris van den Beld or Sander van Tol if you have any questions or want to address ESG topics that are on your agenda.

The Bank of England is even of the opinion that climate change represents the tragedy of the horizon: “by the time it is clear that climate change is creating risks that we want to reduce, it may already be too late to act” [1]. This article provides a summary of the type of financial risks resulting from climate change, various initiatives within the financial industry relating to the shift towards a low-carbon economy, and an outlook for the assessment of climate change risks in the future.

At the December 2015 Paris Agreement conference, strict measures to limit the rise in global temperatures were agreed upon. By signing the Paris Agreement, governments from all over the world committed themselves to paving a more sustainable path for the planet and the economy. If no action is taken and the emission of greenhouse gasses is not reduced, research finds that per 2100, the temperature will have increased by 3°C to 5°C².. Climate change affects the availability of resources, the supply and demand for products and services and the performance of physical assets. Worldwide economic costs from natural disasters already exceeded the 30-year average of USD 140 billion per annum in seven out of the last ten years. Extreme weather circumstances influence health and damage infrastructure and private properties, thereby reducing wealth and limiting productivity. According to Frank Elderson, Executive Director at the DNB, this can disrupt economic activity and trade, lead to resource shortages and shift capital from more productive uses to reconstruction and replacement³.

According to the Bank of England, financial risks from climate change come down to two primary risk factors⁴:

Increasing concerns about climate change has led to a shift in the perception of climate risk among companies and investors. Where in the past analysis of climate-related issues was limited to sectors directly linked to fossil fuels and carbon emissions, it is currently being recognized that climate-related risk exposures concern all sectors, including financials. Banks are particularly vulnerable to climate-related risks as they are tied to every market sector through their lending practices.

Financial risks

• Physical risks. The first risk factor concerns physical risks caused by climate and weather-related events such as droughts and a sea level rise. Potential consequences are large financial losses due to damage to property, land and infrastructure. This could lead to impairment of asset values and borrowers’ creditworthiness. For example, as of January 2019, Dutch financial institutions have EUR 97 billion invested in companies active in areas with water scarcity⁵. These institutions can face distress if the water scarcity turns into water shortages. Another consequence of extreme climate and weather-related events is the increase in insurance claims: in the US alone, the insurance industry paid out USD 135 billion from natural catastrophes in 2017, almost three times higher than the annual average of USD 49 billion.
• Transition risks. The second risk factor comprises transition risks resulting from the process of moving towards a low-carbon economy. Revaluation of assets because of changes in policy, technology and sentiment could destabilize markets, tighten financial conditions and lead to procyclicality of losses. The impact of the transition is not limited to energy companies: transportation, agriculture, real estate and infrastructure companies are also affected. An example of transition risk is a decrease in financial return from stocks of energy companies if the energy transition undermines the value of oil stocks. Another example is a decrease in the value of real estate due to higher sustainability requirements.

These two climate-related risk factors increase credit risk, market risk and operational risk and have distinctive elements from other risk factors that lead to a number of unique challenges. Firstly, financial risks from physical and transition risk factors may be more far-reaching in breadth and magnitude than other types of risks as they are relevant to virtually all business lines, sectors and geographies, and little diversification is present. Secondly, there is uncertainty in timing of when financial risks may be realized. The possibility exists that the risk impact falls outside of current business planning horizons. Thirdly, despite the uncertainty surrounding the exact impact of climate change risks, combinations of physical and transition risk factors do lead to financial risk. Finally, the magnitude of the future impact is largely dependent on short-term actions.

Initiatives

Many parties in the financial sector acknowledge that although the main responsibility for ensuring the success of the Paris Agreement and limiting climate change lies with governments, central banks and supervisors also have responsibilities. Consequently, climate change and the inherent financial risks are increasingly receiving attention, which is evidenced by the various recent initiatives related to this topic.

Banks and regulators

The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) is an international cooperation between central banks and regulators⁶. NGFS aims to increase the financial sector’s efforts to achieve the Paris climate goals, for example by raising capital for green and low-carbon investments. NGFS additionally maps out what is needed for climate risk management. DNB and central banks and regulators of China, Germany, France, Mexico, Singapore, UK and Sweden were involved from the start of NGFS in 2017. The ECB, EBA, EIB and EIOPA are currently also part of the network. In the first progress report of October 2018, NGFS acknowledged that regulators and central banks increased their efforts to understand and estimate the extent of climate and environmental risks. They also noted, however, that there is still a long way to go.

In their first comprehensive report of April 2019, NGFS drafted the following six recommendations for central banks, supervisors, policymakers and financial institutions, which reflect best practices to support the Paris Agreement⁷:

1. Integrating climate-related risks into financial stability monitoring and micro-supervision;
2. Integrating sustainability factors into own-portfolio management;
3. Bridging the data gaps by public authorities by making relevant data to Climate Risk Assessment (CRA) publicly available in a data repository;
4. Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing;
5. Achieving robust and internationally consistent climate and environment-related disclosure;
6. Supporting the development of a taxonomy of economic activities.

All these recommendations require the joint action of central banks and supervisors. They aim to integrate and implement earlier identified needs and best practices to ensure a smooth transition towards a greener financial system and a low-carbon economy. Recommendations 1 and 5, which are two of the main recommendations, require further substantiation.

• The first recommendation consists of two parts. Firstly, it entails investigating climate-related financial risks in the financial system. This can be achieved by (i) mapping physical and transition risk channels to key risk indicators, (ii) performing scenario analysis of multiple plausible future scenarios to quantify the risks across the financial system and provide insight in the extent of disruption to current business models in multiple sectors and (iii) assessing how to include the consequences of climate change in macroeconomic forecasting and stability monitoring. Secondly, it underlines the need to integrate climate-related risks into prudential supervision, including engaging with financial firms and setting supervisory expectations to guide financial firms.
• The fifth recommendation stresses the importance of a robust and internationally consistent climate and environmental disclosure framework. NGFS supports the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD⁸) and urges financial institutions and companies that issue public debt or equity to align their disclosures with these recommendations. To encourage this, NGFS emphasizes the need for policymakers and supervisors to take actions in order to achieve a broader application of the TCFD recommendations and the growth of an internationally consistent environmental disclosure framework.

Future deliverables of NGFS consist of drafting a handbook on climate and environmental risk management, voluntary guidelines on scenario-based climate change risk analysis and best practices for including sustainability criteria into central banks’ portfolio management.

Asset managers

To achieve the climate goals of the Paris Agreement, €180 billion is required on an annual basis⁵. It is not possible to acquire such a large amount from the public sector alone and currently only a fraction of investor capital is being invested sustainably. Research from Morningstar shows that 11.6% of investor capital in the stock market and 5.6% in the bond market is invested sustainably⁹. Figure 1 shows that even though the percentage of capital invested in sustainable investment funds (stocks and bonds) is growing in recent years, it is still worryingly low.

Figure 1: Percentage of invested capital in Europe in traditional and sustainable investment funds (shares and bonds). Source: Morningstar [9].

The current levels of investment are not enough to support an environmentally and socially sustainable economic system. As a result, the European Commission (EC) has raised four initiatives through the Technical Expert Group on sustainable finance (TEG) that are designed to increase sustainable financing¹⁰. The first initiative is the issuance of two kinds of green (low-carbon) benchmarks. Offering funds or trackers on these indices would lead to an increase in cash flows towards sustainable companies. Secondly, an EU taxonomy for climate change mitigation and climate change adaptation has been developed. Thirdly, to enable investors to determine to what extent each investment is aligned with the climate goals, a list of economic activities that contribute to the execution of the Paris Agreement has been drafted. Finally, new disclosure requirements should enhance visibility of how investment firms integrated sustainability into their investment policy and create awareness of the climate risks the investors are exposed to.

Insurance firms

Within the insurance sector, the Prudential Regulation Authority (PRA) requires insurers to follow a strategic approach to manage the financial risks from climate change. To support this, in July 2018, the Bank of England (BoE) formed a joint working group focusing on providing practical assistance on the assessment of financial risks resulting from climate changes. In May 2019, the working group issued a six-stage framework that helps insurers in assessing, managing and reporting physical climate risk exposure due to extreme weather events¹¹. Practical guidance is provided in the form of several case studies, illustrating how considering the financial impacts can better inform risk management decisions.

Authorities

Another initiative is the Climate Financial Risk Forum (CFRF), a joint initiative of the PRA and the Financial Conduct Authority (FCA)¹². The forum consists of senior representatives of the UK financial sector from banks, insurers and asset managers. CFRF aims to build capacity and share best practices across financial regulators and the industry to enhance responses to the financial climate change risks. The forum set up four working groups focusing on risk management, scenario analysis, disclosure and innovation. The purpose of these working groups, which consist of CFRF members as well as other experts such as academia, is to provide practical guidance on each of the four focus areas.

Current status and outlook

On 5 June 2019, the TCFD published a Status Report assessing a disclosure review on the extent to which 1,100 companies included information aligned with these TCFD recommendations in their 2018 reports. The report also assessed a survey on companies’ efforts to live up to TCFD recommendations and users’ opinion on the usefulness of climate-related disclosures for decision-making¹³. Based on the disclosure review and the survey, TCFD concluded that, while some of the results were encouraging, not enough companies are disclosing climate change-linked financial information that is useful for decision-making. More specifically, it was found that:

• “Disclosure of climate-related financial information has increased, but is still insufficient for investors;
• More clarity is needed on the potential financial impact of climate-related issues on companies;
• Of companies using scenarios, the majority do not disclose information on the resilience of their strategies;
• Mainstreaming climate-related issues requires the involvement of multiple functions.”

Further, the BoE finds that despite the progress, there is still a long way to go: while many banks are incorporating the most immediate physical risks to their business models and assess exposures to transition risks, many of them are not there yet in their identification and measurement of the financial risks. They stress that governments, financial firms, central banks and supervisors should work together internationally and domestically, private sector and public sector, to achieve a smooth transition to a low-carbon economy. Mark Carney, Governor of the BoE, is optimistic and argues that, conditional on the amount of effort, it should possible to manage the financial climate risks in an orderly, effective and productive manner⁴.

With respect to the future, Frank Elderson made the following claim: “Now that European banking supervision has entered a more mature phase, we need to retain a forward-looking strategy and develop a long-term vision. Focusing on greening the financial system must be a part of this.”³.

References

¹ https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/avoiding-the-storm-climate-change-and-the-financial-system-speech-by-sarah-breeden.pdf
² https://public.wmo.int/en/media/press-release/wmo-climate-statement-past-4-years-warmest-record
³ https://www.bankingsupervision.europa.eu/press/interviews/date/2019/html/ssm.in190515~d1ab906d59.en.html
⁴ https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/report/transition-in-thinking-the-impact-of-climate-change-on-the-uk-banking-sector.pdf
⁵ https://fd.nl/achtergrond/1294617/beleggers-moeten-met-de-billen-bloot-over-klimaatrisico-s
⁶ https://www.dnb.nl/over-dnb/samenwerking/network-greening-financial-system/index.jsp
⁷ https://www.banque-france.fr/sites/default/files/media/2019/04/17/ngfs_first_comprehensive_report_-_17042019_0.pdf
⁸ https://www.fsb-tcfd.org/publications/final-recommendations-report/
⁹ http://www.morningstar.nl/nl/
¹⁰ https://ec.europa.eu/info/publications/sustainable-finance-technical-expert-group_en
¹¹ https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/publication/2019/a-framework-for-assessing-financial-impacts-of-physical-climate-change.pdf
¹² https://www.bankofengland.co.uk/news/2019/march/first-meeting-of-the-pra-and-fca-joint-climate-financial-risk-forum
¹³ https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-2017-TCFD-Report-11052018.pdf

The current trend to operate a ‘data-driven business’ and the fact that regulators are increasingly focused on data quality and data availability, could give an extra impulse to the use of ML models.