Why financial institutions are still lagging on climate risk management

February 17, 2022

A recent study suggests that resource constraints, concerns over regulation, and the allure of climate opportunities may all be slowing firms’ work on risk management

European banks received an unwelcome Valentine’s Day gift earlier this week courtesy of UK nonprofit ShareAction, which published a damning breakdown of their ongoing financing of the fossil fuel industry. This revealed that the 25 largest lenders in the region have pumped $400 billion since 2016 into firms that are expanding oil and gas production, with HSBC leading the pack, followed by Barclays, BNP Paribas, Crédit Agricole, and Societe Generale.

ShareAction said this represents “a huge risk” to banks and their investors as each new oil and gas field financed has the potential to become a ‘stranded asset’, which could collapse in value as the energy transition takes hold. Beyond the financial danger, the continued financing of fossil fuels poses reputational risks to banks — especially to those that have signed on to climate-focused coalitions like the Net-Zero Banking Alliance. The fact that these banks continue to take such risks suggests they do not have sophisticated climate risk management frameworks in place — or simply don’t believe the risks are material. 

A recent benchmarking study by consultants Sia Partners and law firm Cadwalader, Wickersham & Taft helps shed some light on the current state of institutions’ climate risk management efforts. The study is based on a survey of over 70 financial institutions from around the world, as well as dozens of qualitative interviews. The headline finding was that about 90% of respondents “have at least started the development of a climate-risk framework.” 

However, other statistics in an executive summary of the study seen by Climate Risk Review show that this isn’t the full story. In particular, they show that many firms’ climate risk frameworks do not cover the kinds of activities that a group like ShareAction would think prudent — like cracking down on fossil fuel lending.

In particular, the study found that 33% of firms “have no specific considerations for climate risk within their lending and underwriting policy documents.” This means no exclusion policies or enhanced due diligence protocols when it comes to climate-harming activities. What’s significant — if not all that surprising — is the regional variation. While 80% of European bank respondents said they do not cater to certain industries on climate grounds, just 11% of US regional banks said the same. Though the executive summary did not delve into the ‘why’, this difference is likely a reflection of the contrasting public policy contexts on either side of the Atlantic.

Furthermore, just 20% of respondents said they had “fully engaged business lines to perform risk assessments.” This implies that most firms have not got to the point where climate policies and standards are being operationalized where it matters: in dealmaking with clients. For some, this may be because they are still thinking over what shape these policies should take. For others, different barriers may be at play. Here’s what Brendan Moriarty, senior manager at Sia Partners, had to say:

“Mobilizing a program for climate risk — hiring, capability building, maybe hiring consultants to help with strategy — is one thing, but when you go out to your business lines, there’s still a bit of education to be done and also a bit of convincing culturally. And for big diversified financial services firms, going out and doing risk assessments is a heavy lift. You don’t do it in one meeting”

Educating employees and changing company culture, though, requires investment — and there’s evidence that many financial institutions are no putting their money to work this way. The study shows that 25% of all participants “have no plans to allocate budget towards climate-risk transformation projects and activities.” It may be that, for some respondents, they simply don’t have the budget to invest in a climate risk program at present.

Another possibility is that laggards are holding off from funding such projects until they have a clearer sense of what supervisory authorities expect of them. This argument makes most sense in the North American context, where until very recentlyregulators addressed the topic side-on, with informal guidance delivered through the odd public speech or statement. In Europe — where the European Central Bank and Bank of England, among others, have already laid out their expectations — firms have less of an excuse for not investing in their climate risk frameworks. 

Still, the benchmark study finds that virtually all institutions — 95% of respondents — believe international frameworks are a “priority for consideration in the development of their frameworks.” This implies that many firms don’t want to ‘front run’ potential regulations by putting in place climate risk frameworks which may not fulfill future supervisory expectations.

On the one hand, regulatory clarity should jolt laggard institutions into getting their climate risk management programs in order. On the other, it could lead to a swathe of new requirements that hamper the flow of their day-to-day businesses and suck up scarce resources. The benchmark study suggests concerns about these potential burdens are very much top of mind. Bradley Ziff, operating partner at Sia Partners, said:

“Banks are communicating forcibly to the official sector that producing a lot of guidelines and requirements on climate without a reality check on their impact to those banks, could result in a number of people left in tears”

Regulatory fragmentation, caused by different jurisdictions developing their own climate standards that don’t gel with one another, is a particular concern. For a start, 92% of respondents to the study said authorities should adopt more standardized or detailed climate disclosure rules. At first glance, it looks as though regulators are moving in lockstep on climate-related disclosures. After all, the G7 and G20 countries have made statements in support of mandatory climate reporting based on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). 

However, dig a little deeper and it’s clear why financial institutions have concerns. A task force working on European Union climate disclosure standards authorized under the bloc’s Corporate Sustainability Reporting Directive, for instance, has laid out 10 disclosure areas, some of which go beyond the TCFD recommendations. Elsewhere, anincoming climate disclosure mandate in Switzerland would compel firms to report both the climate-related financial risks they face and the impacts their activities have on the climate and environment. This “double materiality” approach to disclosure is unlikely to be adopted by other jurisdictions, least of all the US, where regulators are sweating over just how much they can make firms disclose on their climate risks without falling afoul of the courts.

These examples show that authorities are not all taking the TCFD recommendations as gospel, meaning the potential for there to be regulatory fragmentation on disclosure rules is very high. The same is true of prudential regulations — those that could affect institutions’ capital requirements, among other things. While the Basel Committee on Banking Supervision, the global banking standard-setter, has started work on a set of climate risk principles that could be adopted by all its member jurisdictions, the truth is some regions are already racing ahead and implementing their own rules regardless.

Moriarty at Sia Partners touches on another gripe financial institutions have with the drive towards climate risk regulation. This concerns the ways in which regulators are assessing firms’ climate readiness and planning prudential responses — specifically, methods based on climate stress tests:

“There’s concern about capital penalties following these tests. Some of these market participants believe they may have to hold capital because of their stress testing results, and there’s just not enough confidence in the data that they are inputting into the models, so I think that the operational side of stress testing is a big concern for people”

It’s not the first time the financial industry has cautioned its overseers on climate stress testing. The Institute of International Finance (IIF) produced a lengthy paperlast year on the use of stress tests and scenario analysis by supervisors, which argued that the current crop of exercises are not robust enough to inform capital requirements.

Within the industry itself, it’s clear that climate scenario analysis is still a work in progress. The benchmark study shows that just 8% of respondents “conduct scenario analysis to assess the impact of climate risks and broader environmental risks.” Data scarcity and modeling issues are well-known factors impeding faster take-up of scenario analysis, with authorities like the Bank of England admitting that modeling climate risks is in its infancy.

Moriarty adds that the ‘newness’ of climate risk modeling, and how different it is from traditional financial risk modeling, goes a long way towards explaining the slow take-up of scenario analysis and stress testing by institutions:

“In discussions with interviewees around stress testing, there is a lot of concern about model risk. The CCAR [US Comprehensive Capital Adequacy and Review] models are built for nine quarters, so when you talk about 2050 or 2080, it’s not a typical model they’re used to building. Model risk, model validation comes into play and that’s a lot of work”

Is it the alien nature of climate risk management, then, which explains why so few of the banks identified by ShareAction and other climate groups in the past have effective transition risk policies in place? It’s one factor, no doubt — but like any issue at the intersection of financial capitalism, climatology, and politics there are plenty of other dynamics at play. The ongoing financial incentives banks have to fund the fossil fuel industry is a big one, of course. But the benchmark study offers one more: that institutions are more focused on climate change as an opportunity than as a risk.

Here’s Moriarty again:

“Some of our participants were very much looking at this as an opportunity rather than as a risk mitigation issue first — as a profitability play. It was a little surprising considering there’s a lot of concern around mitigating balance sheets and things like that as we transition to carbon neutral”

In fact, 51% of study participants said they are doing internal research to develop new climate-related products for their clients — more than double the percentage of institutions that said they have established climate risk assessments at the business line level. Furthermore, the executive summary stated there was “a pronounced sentiment from participants that some were approaching climate risk strictly as a revenue generating proposition.”

Could it be, then, that institutions’ focus on climate opportunities is taking time, investment, and energy away from their climate risk management programs? Sure, large financial institutions have vast resources and the ability to juggle thousands of tasks at once. However, it’s also true that their internal cultures (not to mention incentive structures) favor revenue-raising over revenue-restriction. 

The banks featured in ShareAction’s list of fossil fuel financiers, then, may not simply be naïve about climate risks, or waiting on regulatory guidance before establishing a climate risk management framework. They may also be too wrapped up in making money from climate change to be giving the risk side of the equation much thought.