Climate change can have a substantial impact on asset values, the cost and availability of insurance and the creditworthiness of borrowers. Risks may be physical, or they may arise from the transition to a zero carbon emissions economy. However, the extent of, and the timing of the impact of climate change, is difficult to assess.
The PRA has asked the firms it regulates to implement a climate change risk management framework, which has to be embedded by December 2021. For many firms, deciding what methodology to use and getting the data to apply it can be challenging, in particular in integrating meaningful scenario analysis. There are also other issues such as giving it sufficient time with all of the other business priorities, and having the right set of in-house skills. Whilst there are a number of guidelines from different sources, these are often generic in nature and lack specific step-by-step guidance.
Taking some time to reflect on how to approach the risk assessment exercise is key. Careful consideration should be given to the methodology, the future operating model and the approach to scenario analysis in order to facilitate the process. Essential aspects to consider include:
1. Climate Change Risk Assessment Methodology
Quantitative risk assessments utilise numeric values (i.e. percentage of exposures per industry or location), which are allocated to different risk factors, rating controls to assess their effectiveness to then calculate the residual risk. Qualitative risk assessment is more scenario-based, and entails analysing different climate-related financial risk situations to anticipate the future materialisation of risks.
A qualitative risk assessment tends to be more subjective than a quantitative one. On the other hand, calculations in a quantitative risk assessment can be more complex and require preliminary work of collecting and quantifying data on factors such as: product and services offerings; client demographics; and countries of operation. Qualitative risk assessments are inherently simpler and do not typically require as much preliminary work, but the results are often more difficult to utilise.
The most appropriate risk assessment approach for each firm will be proportionate and reflect its exposure to climate change risk, as well as the complexity of its operations. Firms with larger exposures, larger scale and volume of activities, and with timescales of longer-term commitments will therefore need more rigour and granularity. This should push them down the quantitative route.
Another thing to consider within the methodology is the scope i.e. whether it will cover both external exposures arising as a result of the business activities as well as the business’ own Scope 1 and 2 Greenhouse Gases (“GHG”) carbon emissions and related risks.
2. Where In The Business Wide Risk Management Framework Climate Change Risk Fits Better
The PRA has told firms that climate risk should be integrated into the existing business-wide risk management framework.
The Climate Financial Risk Forum (“CFRF”) guide presents three options. The first is as a standalone, principal risk type. The second is as a risk within other existing risk types (i.e. credit or operational). Or the third is to include it both within existing risk types and as a principal risk. Whilst a standalone approach appears the simplest initially, given the types of impact climate risk is likely to have, it may be more difficult to manage. Again, this will be for firms to decide based on their own circumstances. However, it is important to keep in mind that climate risks are interlinked with other established risks (such as credit, operational, or economic crime) and that these links are clearly established and understood.
3. Scenario Analysis
Scenario analysis needs to be integrated into the broader risk assessment process. This requires modelling and deciding the best approach either through bespoke or off-the-shelf models.
The approach can vary from considering a number of scenarios or, as suggested by the CFRF, a scenario consistent with a 2°C pathway with a scenario from the Shared Socioeconomic Pathways (“SSPs”) and the most appropriate Integrated Assessment Model (“IAMs”) . Alternatively, some firms can initially choose from two possible scenarios: one in which rapid decarbonisation achieves a 2°C outcome, and one where emissions remain high and physical climate impacts arise . Mainly, potential climate scenarios need to be aligned with your firm’s own circumstances, and must consider material impacts on, for example, credit, operations, logistics and supply chains.
HOW CAN BDO HELP?
Our ESG and Climate Change team advises on best practice, helps identify organisational specific risks, and develops effective solutions in a number of areas, including:
- Climate change governance and strategy.
- Climate change risk management and mitigation strategies, risk appetite and scenario analysis.
- Scope 1, 2 and 3 GHG emissions and related risks.
- Policies and procedures and due diligence controls for managing climate change risk.
- Management information, data, metrics, thresholds and targets for managing climate related financial risk and opportunities and monitoring capabilities.
- Disclosures and reporting.
If you have any queries on the services that we provide please do not hesitate to contact a member of our team.
Our previous articles on climate change can be found here and here.