“Addressing climate-related risks and opportunities… will require a sustained commitment—both from financial institutions and their regulators,” Federal Reserve Board governor Lael Brainard said in her speech at the 2021 IIF U.S. Climate Finance Summit. While it is difficult to predict the magnitude of impact, the fact that climate risk is real remains “unequivocal,” Ms. Brainard said.
She highlighted the potential exposure of financial institutions to “outsized losses” from climate-related risks and the need for a framework to measure, monitor, and manage the damages caused by a warming climate on their assets, as well as risks associated with “a disorderly transition” to a low-carbon economy. Supervisors, she said, have a responsibility to ensure that financial institutions are resilient to all material risks, including climate change, and suggested that scenario analysis, as a complement to traditional regulatory stress testing, could be helpful in assessing the implications of climate risks. Treasury Secretary Janet Yellen separately suggested that such analysis could be revealing to both regulators and firms, adding that Treasury might be able to “facilitate” the Federal Reserve’s climate-related stress testing efforts.
While acknowledging that differences exist between jurisdictions, Ms. Brainard noted the benefit of collaboration across the official sector and acknowledged that many financial institutions are incorporating supervisory expectations around climate-related risks that have been implemented in foreign jurisdictions such as the European Central Bank and the UK Prudential Regulatory Authority.
Financial institutions should anticipate an equally active approach to supervision by U.S. regulators. To date, climate disclosures in the United States have been at the discretion of individual companies, resulting in significant variations from firm to firm in terms of both scope and materiality. While Ms. Brainard acknowledges that individual firms may choose different strategies for mitigating and reporting climate-related risk, they should not delay defining their approach at an enterprise level.
Preparing for a new level of supervision
Ms. Brainard noted that “improved data, disclosures, and modelling techniques will be crucial to reducing uncertainty around the potential magnitude of risks related to climate change.” As financial institutions prepare, they should consider that:
- Existing risk frameworks and operating models of most firms were not developed with climate risk in mind and, as such, there will likely be a heavy lift involved in harmonizing terminology, definitions, materiality and measurement across different lines of business, geographies and products.
- Data (or the absence of data) will be a significant hurdle. New external data may need to be purchased, and both internal data capture and cleanliness may need enhancement.
- Analytics and artificial intelligence may be needed to absorb and assess a significant volume of often unstructured data.
Acting with urgency
Ultimately, financial institutions will need to stand up an enterprise-wide program with representation from risk, finance, and front-line business units to ensure they are effectively managing the physical and transition risks presented by climate change, and to address the significant data, disclosure, modelling, measuring, and reporting issues that climate risk presents.
The magnitude of these tasks means that firms that delay commencing their climate risk initiatives will not only increase their exposure to the operational and financial risk posed by a changing climate, but will also quite possibly be laggards when regulations are introduced, potentially inviting unwanted regulatory attention and even reputational damage. In contrast, getting an early start is the hallmark of an industry leader.