Weekly round-up: October 18-22

The top five climate risk stories this week

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1) FSOC backs review of financial regulations to tackle climate risks

The US government’s top financial regulatory forum has told federal agencies to consider updating rules for banks, trading firms, and other institutions to protect the financial system from climate risks.

The Financial Stability Oversight Council (FSOC), a committee of high-level regulatory officials chaired by Janet Yellen, the US Treasury Secretary, on Thursday published a report on climate-related financial risk that had been ordered by President Biden earlier this year. It contains over 30 recommendations on how the FSOC’s constituent agencies — which include the Federal Reserve, Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) — can target and tackle the climate-related physical and transition risks facing the US financial system. 

Among the recommendations is a call for FSOC agencies to “review existing regulations, guidance, and regulatory reporting relevant to climate-related risks” in order to “to assess whether updates are necessary” and to check whether “additional regulations or guidance specific to climate-related risks is necessary to clarify expectations” for financial institutions. This includes rules covering credit, market, and counterparty risks, among others, the report says.

“[R]egulators need to consider whether existing guidance should be adjusted — or new guidance or regulations considered — to ensure proper management of climate-related financial risks. We cannot wait for perfect assessments or data to take action,” said Secretary Yellen in remarks at a meeting of the FSOC on Thursday. 

However, the report does not lay out any deadlines by which FSOC agencies should complete this proposed stocktaking exercise. Steven Rothstein, Managing Director of the Ceres Accelerator for Sustainable Capital Markets at the sustainability nonprofit Ceres, said in a statement that each FSOC agency “must now provide specific timelines when they plan to put in place measures to protect the safety and soundness of our financial system, our institutions, our savings and our communities”.

“There are agencies, including the Securities and Exchange Commission and the Department of Labor, that are acting quickly. Others need to match that level of leadership more rapidly,” he added.

The report also said the FSOC would form two internal panels to promote efforts to combat climate-related financial risks. A Climate-related Financial Risk Committee will serve as an information clearing house and foster “common approaches and standards” across FSOC member agencies, reporting to the FSOC twice a year “on the status of the Council’s and its member’s efforts to identify and address climate-related financial risks”. A Climate-related Financial Risk Advisory Committee will gather data and research on climate-related financial risks from climate scientists, think tanks, investors, and other stakeholders.

Climate-related financial disclosures were covered in the report, too. While acknowledging the contribution of voluntary disclosure efforts, the FSOC said that right now climate risk reports “lack the consistency, comparability, and decision-usefulness that investors have expressed a need for”. To enhance the quality of climate risk reporting, the FSOC recommends agencies build on the four core elements of the Task Force on Climate-related Financial Disclosures’ (TCFD’s) framework, covering climate-related governance, strategy, risk management, and metrics and targets. It also encourages agencies to issue reporting requirements that mandate the disclosure of companies’ GHG emissions.

In addition, the FSOC report came out in favour of the use of climate scenario analysis “as a tool for assessing climate-related financial risks”, and recommends agencies explore “common scenarios” based on the work undertaken by the Network for Greening the Financial System (NGFS), the club of climate-focused central banks and regulators, and the Financial Stability Board.

Other sections of the report contained ideas on plugging climate data gaps and on working with international regulators and bodies to enhance federal agencies’ climate risk management programs.

The FSOC members all voted to recommend the report on Thursday except for Jelena McWilliams, Chair of the Federal Deposit Insurance Corporation, who abstained. McWilliams is one of two agency heads held over from the Trump administration and the only Republican on the FDIC board.

2) ECB climate stress test to cover carbon price shock, extreme weather

Lenders will have to assess the impact of a “sharp and unexpected increase” in carbon prices over the next three years on their businesses as part of the European Central Bank’s (ECB) first supervisory climate stress test.

Banks will also have to gauge their resilience to extreme weather events over the next year, and how their businesses would evolve through low-carbon transition scenarios over a 30-year time horizon.

In a letter to the over 100 “significant institutions” directly supervised by the ECB, Stefan Walter, a director at the agency, laid out the parameters of the upcoming climate stress test. The exercise is made up of three parts: in “Module 1”, banks face a questionnaire on how they are building their own stress test capabilities to manage climate risks; in “Module 2”, a peer benchmark analysis comparing lenders on their financed emissions and exposure to carbon intensive industries; and in “Module 3”, a bottom-up stress test of their vulnerability to climate-related physical and transition risks.

While Walter wrote that the ECB considers the stress test to be “a learning exercise”, he explained that the outputs will help inform the central bank’s Supervisory Review and Evaluation Process (SREP) — its annual health check of EU lenders — the results of which are used to set Pillar 2 capital add-ons for covered institutions.

The stress test will run from March to July next year. For the assessment of participants’ vulnerability to physical and transition risks, the ECB will deploy scenarios based on those used in its first economy-wide climate stress test held this year. Firms will have to consider the impacts of the various scenarios on both their lending and trading books. 

For the short-term scenarios, participants will assume static balance sheets, meaning the composition of their portfolios are considered to be frozen in time. For the long-term scenario, they will assume dynamic balance sheets instead.

3) Tie banks to their climate transition plans by law — ECB official

Banks’ Paris Agreement-aligned transition plans should be made legally binding, a top official at the European Central Bank (ECB) has said.

“A legal obligation for banks to have a clear, detailed and prudent transition plan in place would increase the consistency of the regulatory and supervisory framework and contribute to maintaining a level playing field,” said Frank Elderson, Vice-Chair of the Supervisory Board of the ECB, in a speech at the Financial Market Authority’s Supervisory Conference on Wednesday.

He explained that bank transition plans should identify “at any given point in time” their alignment with the policy objectives of the European Union to implement the Paris Agreement, and contain “concrete intermediate milestones” from now until 2050. “If banks fail to meet these milestones, competent authorities — including prudential supervisors — will have to take appropriate measures to ensure that this failure does not result in financial risks,” said Elderson.

To support banks’ efforts, Elderson said “science-based European transition scenarios” are needed. In line with the European Commission’s sustainable finance strategy, Elderson said the climate scenarios developed by the Network for Greening the Financial System (NGFS) should act as the foundation for “Europe-specific transition plans, as well as guiding banks in setting their own targets”. These could also be used to benchmark transition plans across financial institutions and foster “self-discipline among market participants”.

He also said that EU authorities should be “more ambitious” when it comes to disclosure requirements. Current reporting templates proposed by regulators could be enhanced “with tools that give us information on banks’ forward-looking alignment – or a lack thereof – vis-à-vis the European intermediate targets for carbon emissions,” Elderson explained.

4) Financial authorities air challenges using climate scenarios

Central banks and supervisors have struggled to align their own macroeconomic models with the climate change scenarios cooked up by the Network for Greening the Financial System (NGFS), a new survey shows.

In a 33-page progress report on financial authorities’ experiences using climate scenarios, the NGFS included the results of a canvass of 30 members which showed that most have experienced difficulty aligning their domestic models to its suite of climate pathways.

Macroeconomic models are used in the context of climate scenario analysis to define how climate risks are transmitted through the economy. The NGFS scenarios use NiGEM, a multi-region model based on real economic data, for estimating macroeconomic variables.

Half the respondents to the survey said they are using the variables produced by NiGEM when running their climate exercises with the NGFS scenarios. However, some said they used additional modelling alongside NiGEM to generate variables that meet the specific demands of their exercises. Of those respondents not using NiGEM variables, some used the data from the NGFS scenarios’ climate pathways or damage functions as inputs to other models. Matching up the NGFS scenarios’ outputs with the inputs of these domestic models has been challenging, the survey shows.

“Climate models typically don’t model the economy in much detail, and macro models don’t capture climate risks well, so we need to do more work on integrating models across the different disciplines if we are to do a better job of understanding what might happen,” said Sarah Breeden, an executive director at the Bank of England, in a speech on Thursday regarding the NGFS report.

The survey also found that breaking down the impacts of climate risks to the sector level using the NGFS scenarios is tough. Increasing the granularity of climate scenarios is seen as important for analysing transition risks in particular, since different sectors rely on fossil fuels and carbon-intensive processes to varying degrees.

The report further noted that no NGFS members as yet plan to alter their prudential policies, including capital requirements, on the basis of their climate scenario exercises — although some “did express interest in this topic”.

5) Climate risk guides published by UK forum

A UK panel of financial institutions and regulators released a 10-part series of guides on tackling climate-related financial risks to help firms “overcome the significant challenges” they face incorporating these into their organisations.  

Topics covered by the guides include writing climate risk appetite statements, climate risk training, managing climate-related legal risks, and climate data and metrics. The series also includes a database of climate risk data providers, tools, and products, a guide on implementing scenario analysis, and climate-related disclosure case studies. The outputs were published by the Climate Financial Risk Forum (CFRF), a group of financial institutions and regulators jointly chaired by the UK’s Prudential Regulation Authority and Financial Conduct Authority.

On the subject of managing legal risks, the CFRF referred specifically to financial institutions’ concerns that the accuracy and reliability of data used to populate their climate risk reports may not “meet the expectations and legal consequences of mandatory disclosure”. To reduce their risk of liability, the CFRF guide recommends firms clearly explain the limitations of the data they use in their disclosures, describe data gaps and their use of proxy data, and come clean on any issues with the methodologies underpinning the metrics employed. The CFRF also wrote that they expect “the regulatory and accounting environment will have to adapt somewhat further to the particular properties of climate data as reporting practice develops, and as the complexities and sensitivities of climate data become clearer”.

The forum also said it is working on an “online climate scenario analysis tool” to help smaller firms identify their climate risks and opportunities. The tool is scheduled to launch in the first quarter of 2022.

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