The CFRF’s practical Guide encourages UK regulated financial services firms to take active steps to manage climate-related financial risks.
By Paul Davies, Nicola Higgs, Sherryn Buehlmann and Anna Lewis-Martinez
On 29 June 2020, the Climate Financial Risk Forum (CFRF) launched its guide to climate-related financial risk management (Guide) that will be useful for financial services firms to understand the risks and opportunities that arise from climate change. The Guide provides a voluntary framework for how to integrate these climate-related risks and opportunities into firms’ risk, strategy, and decision-making processes.
The CFRF was established by the UK financial services regulators, the Prudential Regulation Authority (PRA), and the Financial Conduct Authority (FCA) in early 2019 to bring together senior representatives from across the financial sector to produce tools and recommendations to help firms respond to climate-related financial risks and capture relevant opportunities. The CFRF is comprised of senior representatives from across the sector (including banks, asset managers and insurers) and trade bodies sit as observers to feed in views of a broader range of firms / industry participants.
The Guide is intended to serve as a practical tool (“written by industry, for industry”) to help firms develop their own approach to managing risks across the following four key areas:
- Risk management
- Scenario analysis
The Guide is designed to complement existing frameworks and initiatives, e.g. the UN-supported Principles for Responsible Investment, Banking and Insurance, as well as the Taskforce on Climate-related Financial Disclosures (TCFD). The Guide also aims to help firms regardless of the stage of environmental, social, and governance (ESG) planning that they may be in.
As the substantive provisions of the Sustainable Finance Disclosure Regulation (SFDR) come into force on 10 March 2021, industry participants are increasingly focusing on ESG-related disclosures. The Guide reminds firms to focus on internal risk management as well as business and strategy development, as only then will any disclosures be meaningful. Nonetheless, the CFRF acknowledges that the task is not easy (e.g. because access to suitable data may be limited, as will firms’ ability to conduct accurate scenario testing). So the Guide stresses the need for progress to be iterative and for firms to continually review developments.
Notably, although the FCA and PRA have stressed that the Guide does not represent their views and does not constitute regulatory guidance, the Guide will likely assist firms navigating what can be a vast and overwhelming area and help firms benchmark their methods against their peers.
The risk management section of the Guide stresses the need for firms to embed climate-related financial risk considerations into their governance and risk management processes in order to make informed business decisions and improve their resilience. The Guide provides examples of good practice and case studies, e.g. by providing a step-by-step plan for setting up board governance and example models for performing risk assessments.
Although the CFRF acknowledges that firms should take a proportionate approach, depending on their size, interests, and activities, the following key points will be relevant to all firms:
- Links to other risk factors: Firms should consider whether climate-related financial risks should be treated as a principal/stand-alone risk or a cross-cutting risk (i.e. as part of established risks, such as credit, market, or operational risks). Although the CFRF favours the latter, regardless of approach taken, the CFRF stresses the need for links to be made to existing risk factors.
- Risk horizon: In addition to the standard planning cycle (typically 3-5 years), the nature of climate change impacts requires firms to perform risk assessments over longer periods, e.g. 30 years with interim assessments.
- Senior management function: In line with the UK’s Senior Management and Certification Regime (SMCR), the CFRF recommends that firms assign responsibility for climate-related risks to one or more existing Senior Management Functions (SMFs), but that the responsibility should not be shared between too many individuals (as a guiding principle, the Guide recommends two people). However, that alone is not sufficient, and responsibility should also be allocated across all three lines of defence, as set out in the Guide.
- Risk assessment: Climate-related financial risks should be measured, monitored, and mitigated within a firm’s risk appetite. The CFRF considers four risk categories to be the most material and applicable across the financial sector: insurance underwriting risk, credit risk, financial market risk, and operational risk. A firm’s risk appetite should be set and translated into definable and measurable risk limits that key stakeholders across a firm can understand. Appropriate communications and training should be deployed to ensure the risk limits are understood.
Scenario analysis (also a focus of PRA Supervisory Statement 3/19) is necessary for firms to better understand and manage future risks and may also inform firms’ strategies and business decisions.
Acknowledging that scenario analysis may be daunting, the CFRF advocates (and elaborates on) a three-step approach for firms conducting an analysis for the first time. This approach is loosely based on asking a series of simple “what if” questions and tracking those through to implementation.
For firms that have already been undertaking climate-related scenario analyses, the Guide offers further direction on how those firms can identify and develop suitable climate-related scenarios, make quantifiable risk assessments, and determine the financial impacts on the business.
The CFRF anticipates that such scenarios are the start of an iterative process that will become more sophisticated with time. The results from identifying potential exposures will likely inform the scenario development process, which, in turn, should determine the key assumptions used in assessing the financial impact of a scenario. Insights gained from that financial impact analysis should, in turn, feed back into the refinement and identification of new risks and potential exposures and inform the ongoing development of existing scenarios. Those insights should also help identify potential new scenarios to be analysed.
End-to-end climate scenario analysis process
Source: Climate Financial Risk Forum Guide 2020
As mentioned above, the imminence of the SFDR means that many firms are currently contemplating how to make effective climate-related financial disclosures. The disclosures covered in the Guide, however, go beyond those envisaged by the SFDR (i.e. the disclosures are not limited to a subset of firms and/or products) but relate to firms’ activities generally and cover governance, strategy, and risk management as well. The Guide also provides suggested metrics for reporting and draws distinctions based on whether a firm is a bank, asset manager, or insurer.
The CFRF’s recommendations are based on the principles set out in the TCFD framework and seek to provide a financial services overlay for that framework. The CFRF also acknowledges that, despite such global initiatives, the “disclosure ecosystem” is not perfect. In particular, disclosures are based on a complex network of relationships that are not always reliable — e.g. firms depend on information disclosed to them by third parties. These disclosures then inform firms’ identification, assessment, and management of their own climate-related risks and/or the climate-related risks of the financial products that they manage on behalf of clients. In turn, firms must then decide what information they disclose to their own stakeholders. Notwithstanding these challenges, firms should plan to make some level of disclosure, acknowledging the assumptions made and challenges faced.
Although a firm’s approach regarding disclosures will differ depending on firm type and its activities, the Guide notes that a key challenge for all firms is balancing what a firm wants to say against what its client base and stakeholders want to hear. For example, firms may be reluctant to disclose scenario analysis assumptions due to the inclusion of confidential business information, but users will want to understand the firm’s assumptions and their impact on the analysis and the organisation.
The CFRF anticipates that the following factors are those of most interest to their audiences:
- The potential for absolute financial loss (due to climate-related financial risk that those audiences may face due to exposure to the firm and/or its financial products)
- The potential of relative financial loss (through an audience’s exposure to the firm and/or the financial products compared to peers)
- The potential for firms to mitigate these risks through effective strategy
- The potential for firms to adapt to future developments in these areas through effective governance and strategy changes
The Guide suggests a two-stage phased implementation. The first (to be completed mid-2021) focuses on high-level, mainly qualitative, disclosures covering governance, firm-level strategy, and risk management processes. The second (to run from mid-2021 to the end of 2022) focuses on adding quantitative disclosures and ultimately ensuring full disclosure, including disclosure of targets and commitments that the firm is deploying to actively contribute to achieving a net-zero carbon economy.
When launching the Guide, the FCA/PRA acknowledged the need for, and encouraged the development of, novel products, services, policies, and approaches to respond to the potential impacts of climate change and to meet climate goals. To achieve these goals, rapid transition from investments in “brown” to “green” assets is required, but in such a way that maintains financial stability and investment in new markets.
The Guide outlines a number of recommendations that firms may act upon, including:
- Developing new investment vehicles and products (e.g. transition bonds and emerging market green infrastructure funds)
- Building local partnerships between financial institutions, local authorities, and other public sector bodies to support the development of investable, net-zero carbon projects
- Improving the quality and consistency of climate-related data to enable markets to better quantify risks and opportunities and then act on them
The CFRF also encourages regulatory flexibility to permit these activities to be acted on.
Following the publication of the Guide, the CFRF is establishing its work plan for the upcoming year. In the short term, both the FCA and PRA have suggested that firms can expect further (official) regulatory guidance. In particular, firms should expect to hear from the PRA in the summer of 2020 as it plans to build on the policies that it set out in Supervisory Statement 3/19 around approaches to managing the financial risks from climate changes.
Latham & Watkins will continue to monitor developments in this area.
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