In April 2019, the Prudential Regulation Authority (PRA) sent a letter to CEOs highlighting its expectations for Boards of PRA regulated firms to understand and manage climate-related risks. The statement expects firms to allocate responsibility and appoint a Senior Management Function ("SMF") responsible for identifying and managing climate-related risks.
According to the document published in 2019, the Prudential Regulation Authority (PRA) wants firms to use a number of tests and scenario analysis to inform risk identification and understand all financial risks that climate change presents to the firm now and in the future.
You can find the publication "Enhancing banks' and insurers' approaches to managing the financial risks from climate change" here.
Climate Change in Financial Services
Climate change started to get more coverage after the 2015 United Nations Climate Change Conference in Paris. The Paris Agreement was adopted by 196 Parties on 12 December 2015 and entered into force on 4 November 2016. The agreement's goal is to limit global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels.
Since 2015, there's been an increasing global recognition by regulators, central banks and financial services on the potential impacts of climate change on financial services markets. The critical role of the industry is helping to combat climate change.
During a recent webinar with Gowling WLG, Sushil Kuner Principal Associate, UK Financial Services Regulation answered a few questions regarding climate change and the drive towards personal accountability at the board level. Click here to watch the webinar in full.
Financial Risks from Climate Change
Authorities and regulators consider that the financial risks from climate change have distinctive characteristics that combined can present real challenges for firms, and the only way to tackle these challenges is by applying a strategic approach. According to Sushil Kuner, "financial risks arise from two primary channels, physical risks and transitional risks".
Physical risks arise from climate and weather-related events, such as heatwaves, droughts, floods, storms, and sea-level rise.
On the other hand, transitional risks arise from adjustment towards a low carbon economy, such as changes in policy, technology and market sentiment. These risks possibly drive changes in the value of assets and liabilities for banks and insurers.
What Should Firms Be Doing?
The PRA requires firms to consider financial risks from climate change in their governance arrangements. Firms need to identify, measure, and manage these risks with a strategic approach to protect themselves against climate change threats and support an orderly transition to a low carbon economy.
The PRA statement says that "a 'too little, too late' scenario, where significant action is taken, but too late to achieve climate goals, could result in the most severe financial risks crystallizing in the banking and insurance sectors. Financial risks from climate change will be minimized if there is an orderly market transition to a low-carbon world, but the window for an orderly transition is finite and closing."
The topic is growing, and there is an increasing awareness and understanding of the impacts of climate change amongst consumers and investors. According to the 13th edition of the US Sustainable Impact and Investing Trends Report, the demand for green products in the financial industry grew by 42% in the US alone from the start of 2019 to the beginning of 2020, bringing the total to $17 trillion overall. It represents 33% of all assets under management in the US.
In Europe, assets of funds with an environmental, social and governance (ESG) mandate grew 20% in 2020 and 170% since 2015, when the United Nations Climate Change Conference took place.
Firms need to ensure that managers have the proper knowledge and tools to discharge their role in relation to climate change and are supported by an appropriate governance structure.
This is not only a PRA effort. It's a global regulatory effort.
As the Supervisory Statement SS3/19 states: "…The PRA expects firms to have clear roles and responsibilities for the board and its relevant sub-committees in managing the financial risks from climate change. In particular, the board and the highest level of executives should identify and allocate responsibility for identifying and managing financial risks from climate change to the relevant existing Senior Management Function(s) (SMF(s))..."
In Asia, regulators are also increasingly turning their focus to climate change and related risks. Regulators in Asia have started initiatives to build climate resilience within the financial industry and increase awareness of financial risks from climate change and ESG risks.
The Hong Kong Monetary Authority has stabilized a three-phased approach to promote green and sustainable banking. And last year, the Monetary Authority of Singapore proposed guidelines on Environmental Risk Management for a more sustainable economy.
In North America, US regulators have developed much fewer recommendations regarding the topic for the financial industry. Nevertheless, the SEC recently issued a Risk Alert "The Division of Examinations' Review of ESG Investing" with observations of deficiencies and internal control weaknesses from examinations of investment advisers and funds regarding ESG investing.
The Financial Conduct Authority (FCA) in the UK recognizes the growing demand for green services and products and focuses on improving transparency and challenging greenwashing. In the FCA view, climate change is one of a number of environmental factors that firms should consider when managing financial and operational risks. The FCA states that firms should allocate responsibility for managing financial risks from climate change to a suitable individual in line with their approach to the Senior Managers and Certification Regime (SMCR). In a recent SMCR consultation paper, the FCA stated their expectation for firms to pay due regard to climate change risks and mitigate them within their existing risk management strategy.
How Should Firms Respond?
Firms should step up their understanding of the SMCR and similar regimes. Moreover, firms must understand climate change, its impact on their business model, and enhance governance structures. In general, it is up to each organization to decide which senior manager must assume the responsibility. Still, the designated manager needs to have the expertise to achieve the desired objective.
- Do you have a senior manager responsible for climate change and climate risk?
- Are your controls up to standard?
During our webinar with Gowling WLG we discuss this topic and much more. It's worth watching the entire webinar for insights from the team of FCA experts.
On-demand Webinar: The UK SMCR & Enforcement Investigations
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