How are financial institutions reflecting C&E considerations in risk appetite statements?

Thu 25 Jan 2024

There is growing pressure for banks and insurers to incorporate C&E factors in their risk management frameworks (RMF). As a practice, it gives the ability to set clear thresholds for the climate impacts banks and insurers are willing and able to absorb. By establishing these thresholds, firms can effectively monitor their exposure to C&E risks, led by defined guidelines and exposure limits. By using the results of macro-financial and climate stress testing to gain insights into risk exposure, financial banks and insurers can make informed decisions that promote the long-term economic well-being of the firm.

However, incorporating climate considerations into risk appetite statements presents significant challenges, according to the latest Mazars’ survey Sustainability practices stocktake: How banks and insurers have progressed. A significant challenge relates to the short-, medium- and long-term time horizons over which climate considerations will materialise. Notably, the most substantial physical impacts of climate change are expected to manifest beyond the typical timeframes covered by traditional business planning. 

Yet, while the full extent of their impact may not become evident for many years, it’s imperative to take immediate action to assess, measure and mitigate such long-term risks. This creates a complex dynamic in which the urgency of action is mismatched with the longer-term nature of the climate risks involved. 

The use of metrics to define C&E risks within risk appetite statements

Financial institutions should assess their overall business strategies, existing portfolios, and the nature of their climate risk exposure to determine their tolerance for climate risks. They should also define relevant metrics, associated thresholds, and limits, which can encompass results from scenario analysis and be applied across the institution. 

For transition risks, institutions can consider implementing transition risk scores for customers in high transition risk sectors, setting a percentage limit on exposures or investments in high transition risk industries, and developing specific credit, concentration and sectorial policies to monitor and manage transition risks. 

Metrics for physical risks may include assessing the percentage of the portfolio exposed to high-risk locations under different scenarios or determining the probability of impact from physical hazards. These metrics can be integrated into the risk appetite framework. 

While there are variations relating to the financial institution’s size, sector and jurisdiction, over half of the respondents have incorporated C&E risks into their risk appetite framework. Quantitative risk indicators are commonly used by financial institutions to assess their exposure to transition risks, with approximately half of institutions relying on these indicators, according to the study. 

However, a smaller percentage of institutions use quantitative indicators when it comes to physical risks. Specifically, 42% of banks and 30% of insurers employ quantitative indicators to evaluate their exposure to physical risks. 

Managing climate risk exposure

Banks and insurers should conduct measurements at various levels within their organisations to manage climate exposures effectively. By taking a more comprehensive approach, organisations can create heat maps and detailed reports specific to different business activities or units. 

Such actions give financial institutions a more granular understanding of their exposure to climate-related risks and opportunities. With this information, banks and insurers can make informed decisions about allocating specific risk limits to effectively manage and mitigate these exposures.

Additional factors to consider include the percentage of the portfolio aligned with green taxonomies, alignment with net-zero targets, and results of stress and scenario testing for various time horizons that can help institutions monitor climate risks effectively. Different regulatory requirements for climate risk appetite statements should also be considered depending on the jurisdiction.

Going beyond conventional business practices

Financial institutions must thoroughly understand the unique aspects of financial risks stemming from climate change that go beyond conventional business practices. Their risk appetite statements should reflect this by accounting for climate-related risks that may arise in the long term. 

Identifying and assessing physical and transition risks in financial institutions is intricate and continually evolving. It necessitates the utilisation of data, models and tools to evaluate the potential impacts of climate change on the financial system. 

This complex undertaking involves multifaceted analyses and a comprehensive understanding of how climate-related factors affect various aspects of an institution’s operations and portfolio. It’s a critical area of focus as financial institutions aim to proactively manage climate-related risks and align their strategies with sustainability goals.

Ensuring risk identification processes are revised to ensure C&E risk drivers are reflected in risk appetite statements is now a priority.