On Wednesday, 16 banks, the UN Environment Finance Initiative (UNEP FI) and climate risk advisory firm Acclimatise published new methodologies that will help banks understand how the physical risks and opportunities of a changing climate might affect their loan portfolios. The methodologies are designed to enable banks to be more transparent about their exposure to climate-related risks and opportunities, in line with the recommendations of the Financial Stability Board's (FSB) Task Force on Climate-related Financial Disclosures (TCFD).
The banks leading this work and currently piloting the methodologies are ANZ, Barclays, BBVA, BNP Paribas, Bradesco, Citi, DNB, Itaú Unibanco, National Australia Bank, Rabobank, Royal Bank of Canada, Santander, Société Générale, Standard Chartered, TD Bank Group and UBS. With these methodologies, banks can begin to assess physical climate risks in their loan portfolios, evaluating the impacts on key credit risk metrics — Probability of Default (PD) and Loan-to-Value (LTV) ratios. The forward-looking assessments offer longer-term insights that go beyond the usual stress-testing horizon of 2-3 years.
The methodologies, published in the report ***Navigating a new climate***, were piloted across three climate-sensitive industry sectors: agriculture, energy and real estate. First piloting results demonstrate the need for a balanced approach to assessing the risks to banks' clients and loan books from both incremental climate change (such as rising temperatures and changing precipitation patterns) and increasingly frequent and extreme weather events.
Extreme events often attract more attention as their impacts are more apparent, but incremental changes have the potential to gradually erode the financial performance of entire borrower segments. Understanding these phenomena and how they translate into financial risk and opportunity is fundamental to banks' strategies to increase their resilience to a changing climate. Case studies from leading banks that piloted the methodologies are provided in the report.
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"This report provides a practical way to assess the physical risks of climate change, which we have piloted on our real estate mortgage portfolio to consider how flood risks could impact Barclays' customers now and in the future,” said Jon Whitehouse, Head of Government Relations & Citizenship at Barclays. “This type of assessment helps us to manage climate change risk and opportunity, both at a transactional and portfolio level."
"For financial institutions and other market actors, effectively managing and responding to climate change always means two things: understanding and responding to the intensifying physical impacts of unavoidable climate change; and also mitigating the risks and seizing the opportunities from the decarbonization of the economy,” said Eric Usher, Head of UNEP FI. “We are proud of our collaboration with these 16 leading banks and Acclimatise in the development of methods and tools that will help the global financial industry respond to climate change in a holistic manner, spanning both the physical and transition dimensions of the challenge."
The methodologies demonstrate that physical risks will worsen if the global economy continues on its current GHG emissions pathway. Future negative impacts could be reduced somewhat, but not avoided completely, if strenuous and rapid efforts are made globally to cut emissions.
The guidance also aims to inform banks' strategies to support clients in adapting to changing conditions. Clients who face physical risks may need to make investments to become more climate-resilient. What's more, global markets are developing for providers of climate-related products and services, as companies such as engineering and technology providers are identifying opportunities to capitalize on shifting market trends. Banks may have opportunities to support these investments.
"While we are still in the early stages of testing this approach, we expect it will be a useful framework to inform our ongoing discussions with customers regarding their climate-related risks and opportunities,” said Kevin Corbally, Chief Risk Officer at ANZ. “Our participation in this working group along with our peer banks aligns with our purpose of shaping a world where people and communities thrive."