The financial system has now recognised that global warming is a financial stability risk

According to the World Meteorological Organization, record greenhouse gas levels are driving temperatures to "increasingly dangerous levels". The implications of this on people, business and society are far reaching, and financial services institutions face some specific challenges in the years ahead. This includes accounting for climate change in their risk management processes.

Now, regulators are increasingly expecting banks and insurers to account for climate change in their risk management processes as the climate crisis is continuing to grow.

So, what are the financial risks?

The Network for Greening the Financial System (NGFS), a collective group of 34 central banks and supervisors, representing five continents, has grouped climate-related risks into three areas: 

• Physical: These are the immediate problems caused by increasingly frequent climate and weather-related events - such as severe droughts or cyclones that affect crops. Businesses operations can be stalled or entirely put to a stop.

• Transition: For example, when a business moves away from carbon-intensive industries and technologies in a "sudden or disorderly" way, their business models and asset valuations can end up taking a hit.

• Liability: When people or businesses claim compensation for losses suffered from either the physical or transition risks, which can have a huge impact on insurers.

Clearly, as temperatures and sea levels rise, financial institutions are being put under greater pressure. Exposed to more significant - and unexpected - pay-outs.

Climate compliance

Until four years ago, central bankers almost never talked about climate change. The Financial Conduct Authority (FCA) is proposing measures around the disclosure of climate risk management, as well as requirements for personal pension schemes to consider climate change in investment decisions. However, the Prudential Regulation Authority (PRA) has identified that 90% of banks do not yet take a sufficiently forward-looking view on climate change and its long-term financial impact.

Banks need to be prepared to step up the monitoring of climate-related risk and analyse an influx of regulatory notices. And, with climate change initiatives frequently led by different internal stakeholders, it is particularly important that there are clear processes in place to understand which notices are relevant. Also, which information should go to which internal team.

Getting to the root cause of the problem

Manging the risks of climate change is one thing, but banks must also take action to reduce its impact in the first place. The Governor of the Bank of England, Mark Carney, recently issued a stark warning that banks cannot ignore the “catastrophic” effects of climate change and must be at the heart of tackling the problem. Along with other central bankers from around the world, he called on governments and financial institutions to play a pivotal role in keeping temperature rises “well below 2C” - as pledged under the Paris climate agreement. There is a mass of support behind this movement.

There are many practical steps banks and financial institutions can take. This include making sure their own balance sheets are environmentally sustainable, making public any data they have on climate-related risks, cutting short partnerships with organisations which do not support certain standards on the environment, and supporting industry collaboration to develop innovation solutions to climate change. 

Regulatory responses

With the issue of climate change is accelerating, and rapidly rising in the public conscious, we can expect to see an increase in regulatory intervention. Banks need to act now to curb climate-related risk and get prepared for financial regulations coming into force.