Climate risk assessment is still in its infancy, but recent pronouncements by federal regulators should have bank directors and executives considering its implications for their own organizations.
Under a new rule proposed by the Securities and Exchange Commission, publicly traded companies would be required to report on certain climate-related risks in regular public filings.
Though the SEC’s proposal only applies to publicly traded companies, some industry observers say it’s only a matter of time before more financial institutions are expected to grapple with climate-related risks. Not long after the SEC issued its proposal, the Federal Deposit Insurance Corp. issued its own draft principles for managing climate risk. While the principles focus on banks with over $100 billion of assets, Acting Chair Martin Gruenberg commented further that “all financial institutions, regardless of size, complexity, or business model, are subject to climate-related financial risks.”
The practice of assessing climate risk has gained momentum in recent years, but many boards aren’t regularly talking about these issues. Just 16% of the directors and officers responding to Bank Director’s 2022 Risk Survey say their board discusses climate change annually.
To understand what this means for their own organizations, boards need to develop the baseline knowledge so directors can ask management smarter questions. They should also establish organizational ownership of the issue and think about the incremental steps they might take in response to those risk assessments.
“Climate risk is like every other risk,” says Ivan Frishberg, chief sustainability officer at $7 billion Amalgamated Financial Corp. in New York. “It needs the same systems for managing it inside a bank that any other kind of risk does. It’s going to require data, it’s going to require risk assessments, it’s going to require strategy. All of those things are very traditional frameworks.”
The SEC’s proposed rule intends to address a major challenge with sizing up climate risk: the lack of uniform disclosures of companies’ greenhouse gas emissions and environmental efforts. The agency also wants to know how banks and other firms are incorporating climate risks into their risk management and overall business strategies. That includes both physical risk, or the risk of financial losses from serious weather events, and transition risk, arising from the shift to a low-carbon economy.
Bank Director’s Risk Survey finds that many boards need to start by getting up to speed on the issue. Though 60% of survey respondents say that their board and senior leadership have a good understanding of physical risks, just 43% say the same about transition risk. Directors should also get a basic grasp of what’s meant by Scope 1, Scope 2 and Scope 3 emissions to better gauge the impact on their own institutions.
Understanding Carbon Emissions
Scope 1: Emissions from sources directly owned or controlled by the bank, such as company vehicles.
Scope 2: Indirect emissions associated with the energy a bank buys, such as electricity for its facilities.
Scope 3: Indirect emissions resulting from purchased goods and services (business travel, for example) and other business activities, such as lending and investments.
The SEC’s proposal would not require scenario analysis. However, directors and executives should understand how their loan portfolios could be affected under a variety of scenarios.
Talking with other banks engaged in similar efforts could help institutions benchmark their progress, says Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets, a nonprofit that works with financial institutions on corporate sustainability. Boards could also look to trade associations and recent comments by federal regulators. In a November 2021 speech, Acting Comptroller of the Currency Michael Hsu outlined five basic questions that bank boards should ask about climate risk. The Risk Management Association recently established a climate risk consortium for regional banks.
Assessing climate risk involves pulling together large amounts of data from across the entire organization. Banks that undertake an assessment of their climate-related risks should appoint somebody to coordinate that project and keep the board apprised.
Banks might also benefit from conducting a peer review, looking at competing institutions as well as banks with similar investor profiles, says Lorene Boudreau, co-leader of the environment, social and governance working group at Ballard Spahr. “What are the other components of your investors’ profile? And what are they doing? Use that information to figure out where there’s a [gap], perhaps, between what they’re doing and what your company is doing,” she says.
Finally, boards should think about the shorter term, incremental goals their bank could set as a result of a climate risk assessment. That could look like smaller, sector-specific goals for reducing financed emissions or finding opportunities to finance projects that address climate-related challenges, such as storm hardening or energy efficiency upgrades.
A number of big banks have made splashy pledges to reduce their greenhouse gas emissions to net zero by 2050, but fewer have gotten specific about their goals for 2030 or 2040, Boudreau says. “It doesn’t have a lot of credibility without those interim steps.”
While many smaller financial institutions will likely escape regulatory requirements for the near term, they can still benefit from adopting some basic best practices so they aren’t caught off guard in a worst-case scenario.
“Climate risk is financial risk,” says Rothstein. “If you’re a bank director thinking about the safety and soundness of a bank, part of your job has to be to look at climate risk. Just as if someone said, ‘Is the bank looking at cyber risk? Or pandemic risk or crypto risk?’ All of those are risks that directors, through their management team, have to be aware of.”