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 By Manoj Reddy, Head of BFS Risk & Compliance & LIBOR Transition Practice for TCS (TATA CONSULTANCY SERVICES) in North America

Global Impacts of Climate change are becoming increasingly observable in the last few years and is expected to proliferate in the coming years. The economic and financial losses that can be attributable to the changes in environment is broadly referred to as Climate Risk.  It is applicable to virtually any organization across Industries but there is growing realization of its impact now on the Banking and Financial services Industry and the pressing need to identify and manage it. At a very broad level banks could be exposed to climate risk by way of (i) their lending to, and investments in entities whose sustainability and revenue earning potential is compromised by climate change, and (ii) potential losses to its own operations and sustainability owing to climatic changes.

Also, Climate Risk on account of impact to the obligor and investee entity can be attributable to two channels or sources, Physical and Transitional.  Physical risks are potential losses on account of climatic change events or environmental changes and Transition risk are potential losses on account of an organization transitioning to a low carbon footprint policy or technology and transforming into a more climate resilient entity.   Very few banks at this point of time may have climate risk identified as a material risk type in their Enterprise Risk Management framework.  Infact, it should not come as a surprise if they are not a significant part of any scenario analysis or stress testing frameworks being used by Banks today.  The biggest challenge for Banks has been the availability of reliable data to be able to construct a robust framework for climate risk.   Those Banks that have identified Climate risk as a material risk type are working towards strengthening their framework across key dimensions such as Governance, Risk Management & Disclosures.

Key dimensions for a Holistic Climate Risk Framework

Cross Impacts of Climate Risk across Primary & Secondary Risk Types

Though climate risk needs to be recognized and managed as a separate risk type by itself, with its own independent risk management framework, we still need to understand and calibrate its cross impact on the other primary and secondary risk types which are a part of the overall enterprise risk management framework.  Below are some of the high-level cross impacts on other risk types and recommended practices to be incorporated to manage climate risk.

Credit Risk –   For Banks, Credit Risk is one of the biggest risk category which has a huge cross impact from climate risk since climate risk primarily impacts obligor’s business performance, eventually having an unavoidable bearing on their credit worthiness and their ability to service or repay their loans extended by the Bank.   The key areas of impact within Credit risk are-

• Credit Rating – Some of the climate risk metrics intended to be captured from obligors need to be factored into the credit rating process. These metrics could be assigned a certain weightage in the rating model for them to be appropriately factored into the credit risk assessment process.  Even a customer declaration of intent to transition to more sustainable forms of energy and sustainable sources could be qualitatively factored into the Rating process.   Also, in addition to obligor’s Probability of default (PD) ratings the facility Loss given default (LGD) rating needs to be calibrated for potential impact of climate risk events on the value of collaterals extended to secure the underlying loans.
• Credit Polices – Credit Policies largely determine the composition and quality of portfolios for banks, hence these policies can be reviewed and updated to limit further exposure to sectors and geographies which have an elevated climate risk profile. Also, credit policies need to be updated to promote…