Climate risk and the climate-nature nexus
Making managing environmental risk business as usual
Financial Markets Regulatory Outlook 2023
In focus
- 2022 demonstrated the disruptive effects of both physical and transition risks, putting it beyond doubt that climate risks demand immediate and proactive risk management. Supervisory reviews conducted in 2022 highlighted that firms will need to make faster progress in integrating climate risks into their strategies and risk management frameworks.
- In 2023 nature risk will rise in prominence as a concern for regulators. Fully incorporating nature risk into risk management assessments will be challenging – an important and more tractable starting point is to focus on the climate-nature nexus. Nature risk is already “baked in” to extant rules and guidelines from the European Central Bank (ECB) and European Banking Authority (EBA), and we expect supervisory scrutiny to intensify during 2023.
- Use of Pillar 2 framework (for banks) is now established and will likely become more widespread in 2023.
- Supervisors expect banks and insurers to be able to demonstrate that climate risk management is having a consequential impact on business decisions.
The economic disruption and losses due to climate change and degraded natural environments were all too clear across EMEA – and globally – in 2022, as heatwaves, drought and wildfires wreaked havoc. Energy price rises and volatility – although not in 2022 triggered by environmental factors – also provided a stark illustration of how transition risks associated with climate and nature might rapidly feed through to the real economy. And while last year’s climate stress tests in the UK and EU may not have demonstrated any near-term financial doomsday scenarios for banks or insurers, this was arguably due at least in part to limitations in the scope of the scenarios used. The environmental, political and economic turbulence of the past year should concentrate minds that management of climate and nature risks is a here and now problem.
Climate risk management
Firms have undoubtedly made progress in the foundational aspects of how they understand climate risks, and how they integrate that understanding into decision-making. The use of scenario analysis is becoming more widespread, models are beginning to incorporate more variables, transmission channels and risk types, and data is slowly improving. But, as emphasised by both the ECB and Prudential Regulation Authority (PRA) in 2022, significant work remains.
The supervisory deep dives, stress tests and on-site expectations we saw in 2022 will continue. In particular, we expect banking and insurance supervisors in the EU and the UK to run scenario exercises in 2023, including to cover trading book risks for the first time. Supervisors will also emphasise firms making greater use of short-term stress tests to quantify exposures. Supervisors will expect all firms’ practices to mature at a faster pace in 2023, and less advanced firms will be given progressively less leeway.
Improvements should not be confined to analytical processes, such as scenario analysis or credit risk modelling. Supervisors will expect the results of these processes to be integrated into a wide range of business as usual activities and ultimately enabling management to steer their firm’s balance sheet. Risks need to be incorporated in risk appetite frameworks (including quantitative and consequential risk limits, early warning indicators and escalation procedures) and cascaded through to relevant business units and portfolios. Scenario analysis outputs need to be factored into first-line processes (such as client selection and lifecycle management, pricing, underwriting and product development), second-line processes (such as capital and liquidity adequacy assessments, macroeconomic forecasting, and impairment calculations) and strategy. In short, climate risks need to be calculated and then used to make or inform decisions, with scenarios designed to deliver decision-useful outputs akin to the “use test” that banks and insurers must satisfy when seeking approval to use their internal models for capital calculations.
A similar point can be made for models – it will take time for all firms to develop the right in-house modelling capabilities, but supervisors will expect banks and insurers to become less reliant on third parties (TPs) over time or, at the very least, to develop internal capabilities to customise, scrutinise and challenge model outputs from such sources (as covered in the model risk management chapter).For non-life insurers in particular there is work to be done around developing data extraction and modelling techniques to examine climate litigation exposure (both direct and through policyholders) to identify data and modelling gaps; and whether coverage intent is aligned with contract wording, to identify areas of contract uncertainty. This will prove an important exercise ahead of the PRA’s next insurance stress test, which will explore the implications of contract uncertainty.
Nature risk
This year climate risk will remain the area of focus for regulators, supervisors, and firms, but nature risk is rising in prominence. The ten-year strategy agreed at the biodiversity COP15 contributed to this, and the finalisation of the Taskforce for Nature-related Financial Disclosures framework in September 2023 will further consolidate the place of broader nature-related considerations within the environmental agenda. However, firms should not wait for this work to be completed before taking action. Nature loss and degradation are clear and present sources of financial risk, and it is imperative that firms begin to understand their exposure. There are various ways that nature risk is already “baked in” to extant rules and guidelines from the ECB and EBA, as well as from the Bank of England. Supervisors in the EU and UK have already voiced concerns about nature risk and (in the EU) have started to ask firms about their action plans for managing broader environmental risks.
Nevertheless, full incorporation of nature-related risks will be every bit as – if not more – challenging a journey than the one already underway on climate. An important and more tractable starting point is to focus on the climate-nature nexus – where nature interacts with climate and has the potential to compound or ameliorate climate risks. That is, identifying those aspects of the broader nature-related risk landscape that intersect with climate risks already under assessment. This analysis could include a qualitative assessment of the firm’s exposure, potentially including a “heatmap” approach informed by expert judgement (similar to many firms’ early climate risk materiality assessments).
Prudential requirements
How climate risks will feed through to prudential requirements remains an open question. Banks and insurers’ approaches to capturing material climate risks in their internal capital assessments (Internal Capital Adequacy Assessment Process and Own Risk and Solvency Assessment, respectively) should be maturing from descriptive to quantitative in 2023 and, in time, should begin to reflect broader environmental risks as well.
In 2022 the Basel Committee on Banking Supervision published FAQs clarifying that it expects climate risks to be integrated into certain parts of the Pillar 1 framework, but it is not yet clear whether and how the EU and UK will take forward those clarifications in 2023. What is more certain is that the use of Pillar 2 will become more prevalent this year. For the first time, in 2022 the ECB imposed Pillar 2 add-ons upon some banks to incentivise faster progress on climate risk management. We expect this practice will be more widespread this year, and the PRA may adopt a similar approach for UK firms.
We also expect that climate risks will be progressively integrated into solvency stress testing by EU and UK supervisors, creating an additional channel through which climate risks influence Pillar 2 capital. We expect bank supervisors in the EU and the UK to consult on methodologies in 2023, although exercises may not be launched until 2024.
Actions for firms
Strengthening climate risk management
- Ensure that the firm’s climate risk management is:
- comprehensive, with the risk identification process covering a wider array of risk drivers and increasing in granularity;
- cascaded, with the overall strategy and risk appetite understood and implemented across the business; and
- consequential, with the policies and procedures put in place having a tangible impact on business decisions.
- Analytical processes such as scenario analysis should be designed in a way that delivers decision-useful, forward-looking information to management.
- Expand risk assessments to include broader environmental risks, at a minimum starting with the climate-nature nexus, and considering at least qualitatively how they could drive prudential risks and interact with climate risks.
Climate scenario analysis
- Develop more sophisticated climate scenario analysis capabilities, with internal capacity to design and interpret climate scenarios tailored to the nature of the firm’s activities.
- For non-life insurers, focus on modelling and data capabilities in relation to climate litigation to enable scenario testing that helps to measure exposure to this risk and identifies contract uncertainty issues where coverage intent is unclear.
Counterparty engagement
- Proactively engage with counterparties, gathering risk-relevant data and a gaining a deeper understanding of clients’ short-, medium- and long-term strategies for reducing their transition risk exposure or adapting to physical risks.
- Counterparty engagement should also play a role in firms’ active management of climate risks, for example through setting client-specific transition targets and defining consequences for failure to meet targets.
