Climate risk has two components: the potential financial and reputational losses arising from
Physical Risk: increased frequency and severity of extreme weather events and
Transition Risk: inability to adapt to meet legislative, regulatory, or market expectations for low greenhouse gas (GHG) emission requirements.
Physical Risk can have huge impacts on local economies that are located in geographies that are highly vulnerable to the impact of extreme weather, which in turn can cause huge credit losses in residential and commercial real estate portfolios of banks. Many banks have property and casualty insurers as counterparties. How many of these issues will remain creditworthy or become insolvent? Physical Risk is not just about the losses suffered by damage to the bank's own physical assets but it affects the bank's loan and derivative portfolios
Transition Rrisk in some cases may to too large to surmount. For example, if the global economy makes a full transition from oil to electricity, what can oil refineries realistically transition to? The current situation is similar to the early 1900s when the transportation industry transitioned from horse and carriage to cars and trucks. Most of the horse and carriage companies and related companies such as blacksmiths and whip makers did not survive. There was nothing for the horse and related companies to transition to. They were replaced by new companies such as Ford and General motors.
OSFI has issued a draft Climate Risk Management Guidance. it is in the consultation stage, which means OSFI is soliciting industry feedback on the proposed regulation and will issue its final Guidance in near future. Read more
The Guidance has three expected outcomes:
business model and strategy impact and mitigation
governance and risk management practices to manage climate risk ( apply ECRG to climate risk)
financial and operational resilient ( apply ECRG to climate risk)
The first is about the expectation that the impact of climate risk on the business model and business strategy is understood and mitigated. An example could be that the Finacial Institution shifts its target market from brown to green industries. Another could be building a fee-based client advisory business on helping clients improve their BCM practices.
We will focus on the second and third requirements where the CRO plays a leadership role.
Resources (courtesy of Hasan Matin, Consultant, Advisory Services Financial Risk Management KPMG LLP)
In applying ECRG to climate risks, what are the key factors that CROs should consider to ensure both financial and operational resilience in the face of these risks?
Can you elaborate more on how physical risks affects the bank's loan and derivative portfolios?
The case highlights how many companies did not survive during major industry transitions. Given that transition risks are deemed 'in some cases too large to surmount,' what role does effective transition risk management play? Could enhanced risk management strategies enable businesses, such as horse and carriage companies, to overcome the dilemma under such drastic changes?
BIS: Climate-related risk drivers and their transmission channels In this link, it said that there "There is little public research on the operational risks faced by banks and arising from physical risk drivers" Also it mentioned Macroeconomic Impacts from liquidity and operational risks also has limited research. Most of those risks falls under other risk types. Can you give some examples of specific operational risks that occurs during certain climate events?
How does shifting from brown to green industries align with the business model and strategy impact that OSFI expects from financial institutions concerning climate risk? Can you provide examples of how financial institutions might leverage their expertise to build fee-based advisory services aiding clients in improving their BCM practices?