By Francesca Sacchi, Senior Analyst, Financial Institutions, S&P Global Ratings
Regulatory bodies globally are working on various initiatives to address climate-related risks for banks, including through stress tests. Although they support the industry’s awareness and preparedness, these regulatory exercises are being done at different paces and levels of detail. In some jurisdictions, in Europe and Asia-Pacific (APAC) for example, the analysis of climate-related risks is more advanced than in others.
Regulators’ current focus is to assess banks’ stages of development in climate stress testing and scenario analysis, aiming to uncover potential systemic risks. We found several common characteristics among Climate Stress Tests (CSTs), including their exploratory nature and the disclosure of only aggregated results and not at the individual bank level. To date, the main objective has been to assess the preparedness of management teams in understanding, managing, and mitigating climate risks.
Only some of these regulatory exercises, namely the CSTs in Europe and in some APAC countries, have disclosed the quantitative impact of climate-related risks on their banking sectors’ creditworthiness. The ECB’s CST, which we consider the most comprehensive and detailed one we have observed so far, the estimated banks’ credit and market losses stood at about €70 billion in the three-year disorderly transition and in the two one-year physical risk scenarios (flood, drought, and heat). Based on these estimates, we think the banks could cover such losses via earnings—representing around 18% of 2021 pre-tax profits—without capitalization levels being threatened. This is consistent with the results the Bank of England (BoE) reported in May 2022 in its Climate Biennial Exploratory Scenario. The BoE estimated losses of 10%-15% of U.K. bank earnings, not enough to materially reduce capital levels. That said, we view these estimates as likely understating the climate stress losses banks might face in practice. This is because of data limitations, but also the macro assumptions (based on the Network for Greening the Financial System scenarios) being relatively benign and the exercise covering only about one-third of total exposures of the 41 banks in the ECB’s CST scope.
In the U.S., the regulatory oversight of banks’ measurement and management of climate-related risks is accelerating. On Sept. 29, 2022, the Fed announced a pilot climate scenario analysis with participation by six of the U.S.’s largest banks. The Fed expects to release findings of this pilot by year-end 2023. These learnings are likely to help in the development of future supervisory stress-testing regimes for climate change.
Most of the CSTs also revealed that banks face methodological challenges and data availability issues that continue to hinder progress in assessing their vulnerability to climate-related risks. We also noted that supervisors have so far focused on assessing the drivers of climate risks through the lens of credit risk analysis, and to a much lesser extent through other types of risk (such as reputational risk, business modeling, legal risk, and strategic positioning). We anticipate that supervisors will fine-tune their stress tests over time, providing more detailed quantitative measures of the climate-related risks at system and individual bank levels.
Banks Struggle to Navigate the Plethora of Recommendations and Disclosure Standards
Another hurdle for banks is navigating the numerous recommendations and standards to disclose climate risks, with different approaches to identifying issues to report on, and some still under development. Europe appears furthest along to date in terms of setting up climate-related disclosure standards.
In June 2017, the TCFD released its recommendations for a global framework for companies to develop more effective climate-related financial disclosures through their existing reporting processes. Since then, companies, including banks, have increasingly supported alignment with the TCFD recommendations (charts 1), and multiple initiatives have been launched to encourage better disclosure of climate-related information.
The European Commission released its proposed Corporate Sustainability Reporting Directive (CSRD) in April 2021. This was part of a broader sustainable finance policy package that was open for consultation until early August 2022. The CSRD requires all large and listed EU companies to report in line with mandatory EU sustainability reporting standards for fiscal years beginning on or after Jan. 1, 2023. The EU directive aims to improve the consistency and comparability of companies’ sustainability reporting by requiring them to publicly disclose information about sustainability issues in compliance with EU regulations, including the EU Taxonomy, and according to the concept of “double materiality.”
The U.S. Securities and Exchange Commission published in March 2022 a proposal to standardize climate change reporting in companies’ annual reports and other public documents. The SEC’s proposal applies to publicly traded companies in the U.S. and, if implemented, would require these companies to, among other things, report on their climate-related governance practices and transition plans to achieve decarbonization targets. The SEC’s proposal is mainly focused on financial materiality; it would require companies to disclose how climate change is affecting their business and financial results. Required climate-related information would include disclosing greenhouse gas (GHG) emissions, a common metric for assessing a company’s exposure to climate-related risks. All publicly traded companies would be asked to disclose their scope 1 and 2 GHG emissions, while scope 3 disclosure would be required only for companies that have either set a decarbonization target that includes scope 3 emissions or have found scope 3 emissions to be material to their operations and financial performance. Companies would also be required to explain how they have identified climate-related risks and their potential impact.
The International Financial Reporting Standards (IFRS) Foundation set up the International Sustainability Standards Board (ISSB) in November 2021 to establish IFRS Sustainability Disclosure Standards. In March 2022, the ISSB released two drafts for consultation. The first, which covers general requirements for disclosing sustainability-related financial information (IFRS S1), requires companies to disclose, as part of their financial reporting, information about their significant sustainability-related risks and opportunities and how sustainability-related financial information is related to information in their financial statements. The second, which relates to climate-related disclosures (IFRS S2), requires companies to disclose information about how they expect climate change to affect their business model, strategy, and financial performance, as well as the governance processes, controls, and risk management practices they are using to monitor and manage climate-related risks and opportunities. The proposed disclosure requirements include not only scope 1, 2, and 3 emissions, but also companies’ transition plans and business-strategy resilience in multiple climate-change scenarios. Having closed the consultation period at end-July 2022, the ISSB is now expected to issue its new standards by the end of the year.
These initiatives highlight an already heightened awareness as to how relevant the climate-related disclosure is for policymakers to address climate risks. They also represent important progress toward a standardized and reliable set of climate-related information. We believe the creation of harmonized climate-related disclosure will help reduce information asymmetries, enhance transparency, and improve comparative analysis of environmental data. But the real step-change would be globally agreed disclosure standards. These would enable banks, regulators, and investors to assess climate-related risks more accurately. However, reaching global agreement is challenging and will take time; we can see this clearly in the ongoing efforts to converge US GAAP and IFRS.
The Prudential Treatment of Environmental Risks is a Complex Issue
Although several options to integrate climate-related risks into prudential measures are being considered, the data availability in climate-related information disclosures as well as the analytical challenges of measuring the financial impact of climate change on banks’ business and financial performance make it difficult for financial regulatory authorities to incorporate climate-related risks into their prudential frameworks. While the EBA explored some potential amendments within the Pillar 1 capital framework that could enhance the incorporation of environmental risks into existing risk factors (especially credit risk), we view as unlikely any large near-term increase in capital requirements related to these risks. Conversely, we anticipate that evidence of differences in the vulnerability of banks because of climate change might lead to some Pillar 2 add-ons (as has already happened to reflect deficiencies in risk management, high litigation risks, or other aspects of governance), which could ultimately influence banks’ strategies over time.
Beyond Climate Change, Nature-Related Risk Analysis is Gaining Traction
Climate-related risks are in the spotlight, but the notion that nature-related financial risks, including biodiversity loss and water stress, could have material implications for financial stability is only now gaining traction. A few jurisdictions’ initiatives highlight some financial authorities’ efforts to address these risks. Difficulties in measuring biodiversity loss and other nature-related risks make the assessment of their impacts even more challenging than climate change. We expect that the assessment of nature-related risks will gradually be incorporated into forward-looking scenario analysis, similarly to climate change. Progress on this front would require increased biodiversity-related data and disclosure, which is currently even less advanced than climate-related disclosure.
Better Disclosure of Banks’ Climate-Related Risks Will Inform our Credit Rating Analysis
Despite environmental factors being generally a neutral consideration in our credit rating analysis on most rated banks, we think that such factors will likely become more negative considerations over time. Public policy changes to support the transition to a low-carbon economy and more frequent severe climate events will increase the materiality of these risks, as well as amplify the effects they might have on financial systems. As such, a bank’s ability to measure and mitigate climate-related risks will likely become a more material factor that could affect its creditworthiness. More harmonized and comparable disclosures of banks’ exposures and vulnerabilities to climate and environmental risks would better inform our credit rating analysis and help us further differentiate among banks. As supervisors and banks provide greater transparency on the financial sector’s vulnerability to these risks, this will likely increase the quality and the quantity of data we can leverage in our analysis.