Managing Climate Risk impacts on financial services/ banks is not an easy piece of work however the ground work has already been done and here are the best practices for setting up your house in order. Eventually firms should have a larger landscape of ESG ready to facilitate and absorb all larger and smaller nuances of impacts of Climate risks, its identification assessment, mitigation and adaptation plans. How are you going about it in your firm? please do share
ESG risk management has become a crucial aspect of modern banking, as financial institutions increasingly recognize the importance of sustainability, ethical practices, and responsible governance. In view of Climate Risk, ESG risk management is essentially getting a strong backbone, ready for the firm's new challenges. Here are some key points and best practices to consider:
1. Integration of ESG Factors:
 ESG Integration: Incorporate ESG factors into your bank's risk management framework. Develop processes to identify, assess, and manage ESG risks and opportunities across all business lines. Special regard to the supply chain must be done for emerging risks.
 Materiality Assessment: Conduct a materiality assessment to determine which ESG factors are most relevant to your bank's operations and stakeholders. Focus on issues that can have a significant impact on financial performance and reputation.
 e.g. We are no more focussed on just changing light bulbs or not using straws, that was 10 years ago, we ae now living through a very pertinent time in history where our actions to end GHG emissions will have a long lasting impact. So putting an end to any financial activity that if not improves but should also not degrade current environmental thresholds. Materiality is a key driver to guide operational business activities.
2. Data Collection and Reporting:
 Data Quality and Consistency: Establish robust data collection mechanisms to ensure the accuracy and consistency of ESG data. Utilize industry standards, such as the Global Reporting Initiative (GRI) or Sustainability Accounting Standards Board (SASB) guidelines. Banks can refer to the OECD Guidelines to carry out ESG due diligence systematically to ensure responsible corporate lending.Â
 Regular Reporting: Publish regular ESG reports that provide transparent and accurate information about your bank's ESG performance. Benchmark your bank's ESG performance against industry peers to identify areas for improvement.
3. Risk Assessment and Scenario Analysis:
A. Stress Testing: Incorporate ESG factors into your bank's stress testing and scenario analysis. Assess how different ESG-related shocks could impact your bank's capital adequacy, liquidity, and profitability. Climate risk will induce stress testing scenarios that have not been thought of previously.
Lets take Japan housing/property market scenario, Japan is experiencing empty houses in its urban areas and one of the contributing factors amongst others is that Japan upgrades it building safety codes every 8-10 years hence a property bought in a certain year reduces in value after few years of occupation if its owner does not keep upgrading the house as per newly introduced codes. And mostly don’t because its expensive and there is a state push to build more and more houses to keep up for growth and economic activity reasons. So in contrast to other markets a house is not really a lifelong asset in Japan. However, a change in Japanese government policy triggered by environmental concerns - of not constructing new housing but letting the market use existing houses (to find more sustainable circular ways of consumption) can change housing/property market, in Japan forever.
B. Climate Risk Assessment: Conduct comprehensive climate risk assessments to identify the potential physical and transition risks associated with climate change. Consider factors such as exposure to carbon-intensive industries and regulatory changes. Above example is a positive one for transition risk where houses are no more a stranded assets. However, look at the below image to understand how Physical risks drives impacts on other financial risks:
4. ESG Governance and Strategy:
Time is of huge essence, the better prepared firms are the ones where focus and attention starts from the very top of the organisation and not the back office alone
A. Board Oversight: Ensure that your bank's board of directors has a clear understanding of ESG risks and opportunities. Establish board-level committees or designated individuals responsible for ESG oversight.
B. ESG Strategy Alignment: Align your bank's ESG strategy with its overall business strategy. Integrate ESG considerations into long-term planning and decision-making processes. Develop ESG governance and target operating model transition frameworks to meet public net zero commitments and incorporate ESG considerations into the bank’s products and services
5. Collaboration and Engagement:
A. Stakeholder Engagement: Engage with a wide range of stakeholders, including investors, regulators, customers, and community organizations, to understand their ESG expectations and concerns.
B. Industry Collaborations: Participate in industry initiatives and collaborations related to ESG risk management. Share best practices and learn from peers to enhance your bank's approach (such as this write up)
6. Talent Management and Culture:
A. Employee Training: Provide training and education to employees about ESG risks and the bank's commitment to responsible banking practices. Foster a culture that values sustainability and ethical conduct. Address short-terminism in a world where we are dealing with anthropogenic reasons of climate change.
B. Incentives and Performance Metrics: Link employee incentives and performance metrics to ESG goals to promote responsible behavior and align employee actions with the bank's sustainability objectives. Aligning performance in context of empathy is hugely important, managing climate risk impacts through adaptation and mitigation demands a lot of empathy in dealing with actual disruptive scenarios. The staff should be guided through 101 scenarios of how to address change that was not perceived or planned for by BAU scenarios. Alternative thinking must be inculcated, neural diversity should be promoted – in order to find better ways to deliver on ESG related outcomes, traditional training and education has a huge imprint of capitalism and the pace at which business strategies need to change will only come from varied experiences and expertise and not the same school of thought/taught!
7. Innovation and Technology:
A. Fintech Partnerships: Explore partnerships with fintech companies that offer innovative solutions for ESG risk assessment, data analysis, and reporting.
B. Digital Tools: Utilize digital tools, such as artificial intelligence and data analytics, to enhance ESG risk identification and measurement capabilities. The reliability of tools is a huge discussion point. Let’s talk about climate Risk. The industry does not have data to predict the future when it comes to Climate risk impact, hence the use of models and their limitations has to be understood and well supported by what-if scenario analysis using the right tools, time horizon and capability to quickly draw a scenario when inputs are changing on a daily basis during a running event. Banks do have had a dry run in the form of Covid-19 so firms should be ready with right tools to come up with faster and timely calculations.
8. Regulatory Compliance
A. Stay Informed: Stay updated on evolving regulatory requirements related to ESG risk management. Ensure your bank's ESG practices align with current and upcoming regulations.
B. Engage with Regulators and keep a pulse on government’s decisions: Engage in regular dialogue with regulators to discuss your bank's ESG risk management approach and seek guidance on regulatory expectations.Â
e.g. engaging and following up on how the policies and government’s view is changing sharply to mitigate climate risks impact in social aspect. To protect and improve life on the planet, we will see shift in policies towards a more nature-positive economy that may not sit well with financial short-terminism but one must brace for such changes and plan for it. Take example of ULEZ expansion in London, while there is precedence of such policies in place in other bigger cities such as Manchester and Birmingham to create Clean air zones yet its application is seen as disruptive to city’s population and those who come into city for work using their vehicles that may not be complaint. This is an example of transition risk, where we move towards reduction in impact of GHGs on everyday life, clearly setting precedence for a world free from Carbon, hence the move will not always be ‘an orderly move’.
In its 2022 Global Risks report, the World Economic Forum (WEF) ranks biodiversity loss and ecosystem collapse as one of the top five global risks in terms of likelihood and severity. A separate WEF report finds that $44 trillion – over half of global GDP – is moderately or highly dependent on nature and its services. For financial institutions, this adds up to correlated, systemic risks across their portfolios, rising as economic activity continues to degrade nature. Watch this to understand TNFD (https://youtu.be/IVVpcylTt7c), nature-related risks and opportunities to promote early adoption and encouragement to test and develop the framework themselves.
9. Continuous Improvement:
Feedback Mechanisms: Establish feedback mechanisms to gather insights from internal and external stakeholders on your bank's ESG performance and practices. spending resources in order to benchmark your bank's ESG performance against industry peers and leaders will go a long way to future proof your business operations. Identify areas where your bank can improve and learn from others' successes.
Conclusion:
Implementing effective ESG risk management practices requires a holistic approach that integrates ESG factors into every aspect of a bank's operations. By adopting best practices, engaging stakeholders, leveraging technology, and staying informed about regulatory developments, banks can proactively manage ESG risks and seize opportunities for sustainable growth and long-term value creation.