- This is the first in a series of articles looking at the regulatory and compliance implications of climate risk for financial institutions. This is an introductory article to help Compliance Officers less familiar with the UK Government and UK Regulatory policy objectives, to get a Compliance Officer’s view on what is a wide ranging, complex and evolving subject. This is a core strategic issue for the financial services industry globally and will become a mainstream risk management discipline over the next 5 years.
- Subsequent articles will look at the regulatory timetable for the implementation of new regulatory requirements in 2021/22 related to climate risk management and review the key international organisations and climate risk management initiatives underway globally.
- We are keen to work with Compliance Officers interested in this subject and to deepen both understanding and awareness of how firms are responding to the new regulatory requirements.
- Managing climate change and the degradation of the world’s natural capital assets is a defining issue of our time. Over the next decade, decisions taken today will shape the future of our planet for decades to come.
- The UK financial services regulators (PRA and FCA) are focused on proactively managing the financial and systemic risks from climate change. They are ensuring that climate and environmental factors are fully integrated into mainstream financial decision making across all sectors and asset classes. Firms will need to make financial decisions which take the risks and opportunities from climate change into account and which are at the core of the regulatory agenda alongside assessing the resilience of firms’ strategies to transition risks.
- The UK is a global leader in climate change risk management. It is a key participant in the major EU and international governmental and regulatory driven climate change programmes. The number of regulatory initiatives that require financial institutions to manage climate risk is gathering pace and requires firms to take a strategic and proportionate approach according to the nature, scale and complexity of its business.
UK Government Policy objectives
- The UK government has undertaken a legally binding commitment to reach net zero greenhouse gas emissions by 2050. The government’s Green Finance Strategy (Transforming Finance for a Greener Future) was published in 2019 and contributes to this policy commitment. It has two objectives: to align private sector financial flows with clean environmentally sustainable and resilient growth and to strengthen the competitiveness of the UK financial sector. The government plans to use three strategic pillars to achieve these objectives:
(i) greening finance: mainstreaming climate and environmental factors as a financial and strategic imperative
(ii) financing green: mobilising private finance for clean and resilient growth
(iii) capturing the opportunity: cementing UK leadership in green finance
- Systemic changes are required across the economy, but the financial services sectors has a bigger role to play than other sectors, which includes delivering a financial system that supports and enables these policy outcomes.
UK regulatory climate change objectives
Climate change and the transition to a low carbon economy, creates financial risks for financial institutions through two primary risk channels:
Physical risks include:
- Acute weather events like floods, wildfire, typhoons, heatwaves and landslide.
- Longer-term shifts in climate patterns (eg sea level rising and rising mean temperatures) which will cause damage to livability and workability (eg through heat waves and floods).
- The negative impacts on food systems, physical assets, infrastructure and natural habitats.
Transition risks (from the process of adjustment to a net-zero carbon economy) include:
- Climate related developments in policy and regulation (eg tightening of energy efficiency standards for domestic and commercial buildings, will impact the risk in lending portfolio’s).
- The emergence of disruptive technology or business models (eg renewable energy technology or rapid development of electric vehicles which will affect the value of financial assets in the energy and automotive sectors).
- Decreases in the value of investments that result from policy changes leading to the creation of ‘stranded assets’ on balance sheets (ie worthless assets).
- Shifting societal preferences affecting demand for different products and services, such as demand for genuinely ‘green’ financial products and services or investors who are demanding environmentally and socially responsible investing.
- Companies failing to mitigate, adapt or disclose their financial risks from climate change run the risk of litigation and a deterioration in their market value.
These financial risks to financial institutions, pose material risks to the safety and the soundness of the financial system. The climate change regulatory objectives for the Bank of England (and the PRA) and the FCA are as follows:
- The Bank of England response to climate change is motivated by its statutory objectives. Firstly, promoting safety and soundness of the financial system by enhancing the PRA’s approach to supervising the financial risks from climate change. Secondly, enhancing the resilience of the UK financial system by supporting an orderly market transition to a low-carbon economy.
- Likewise, to meet the FCA’s strategic and operational objectives in respect of climate change and green finance, the FCA is focusing on three outcomes:
- Issuers provide markets with readily available, reliable and consistent information on their exposure to material climate change risks and opportunities.
- Regulated financial services firms integrate consideration of material climate change risks and opportunities into their business, risk and investment decisions.
- Consumers have access to green finance products and services, which meet their needs and preferences, and receive appropriate information and advice to support their investment decisions.
Regulatory requirements for financial institution’s
The PRA set out its supervisory expectations of firms’ approach to the managing of climate change in its April 2019 Supervisory Statement 3/19 covering: (i) governance and organisational arrangements, (ii) risk management processes, metrics and quantification, (iii) scenario analysis capabilities, data and tools and (iv) disclosure requirements. This was followed by the recently published ‘Dear CEO letter: Managing climate-related financial risk’ which provided feedback to firms on examples of good practice and highlighted where the PRA had seen gaps between firms’ intentions and its expectations. It also provided further guidance and new requirements for firms to have their approaches to managing climate-related financial risk fully embedded by the end of 2021.
This article does not seek to replay the PRA’s findings, but draws out key points of direct relevance for Compliance Officers.
Compliance and conduct considerations
Whilst the primary focus of climate risk management is on identifying the financial impacts from the physical and transition risks, there are a range of organisational, compliance and conduct considerations which must be addressed. We suspect, most compliance functions are not actively involved in climate risk management activities and levels of knowledge on the regulatory environment and evolving requirements is fairly low but increasing at this moment in time. We believe Compliance Officers have a key role to play in the active management of the non-financial risks associated with climate change working alongside dedicated ESG or Sustainability teams.
With the increasing focus on climate risk management, green finance, green investment products etc, there is plenty of scope for deliberate or inadvertent misconduct by bad actors. For example:
- Conveying a false impression or providing misleading information about a firm’s green financing credentials and capabilities (‘greenwashing’) which misleads clients and investors.
- Exposure to fraudulent activities (eg investments in green financing projects which are set up with criminal intent or in green investment products and services that do not meet industry standards for green investments).
- Inadequate or inaccurate climate risk disclosures in product documentation.
Organisational considerations for Compliance Officers (starter questions for compliance managers):
- Are you aware of the Board level discussion and strategy for your firms’ approach to climate risk management?
- Which function is responsible for developing the enterprise wide risk management framework for managing climate risk? Do you have a stand-alone Sustainability Team or ESG function at the Group or Divisional level? What are the roles and responsibilities of different functions across the 3 lines of defence? What is the role of the compliance function within this risk management framework?
- Who is the senior manager responsible for climate risk management and what are their responsibilities?
- Does the Compliance function participate in governance bodies which manage climate related risks?
Compliance and conduct considerations for sell-side and buy-side firms
1) Is your team trained on the firm’s climate risk management framework and the evolving regulatory environment?
- Has your Compliance team being trained on the firm’s approach to climate change risk management, the risk appetite and policy requirements? What is the level of interaction between your compliance team and ESG and Sustainability colleagues?
- Does your team have an awareness of FCA and PRA regulatory requirements and the new UK and EU regulatory requirements which are in the pipeline for 2021/22?
2) What are the potential conduct risk issues which may crystalise in green finance?
- Are employees incentivised to push green financing and investor products to clients?
- Collusion with third parties to develop fraudulent financing schemes?
- Misrepresenting the firms green financing capabilities to generate financing mandates?
3) Does your team have the skills required to effectively review and approve client and marketing documentation which contains climate risk content?
- For example, does your investment research department comment on climate risk matters? Do you produce marketing materials on the firm’s green credentials and green finance capabilities? Do you provide marketing materials to clients on green financing or investment opportunities? Are you marketing green products to your investor clients?
- Does your team have the skill set to challenge the accuracy and appropriateness of the content?
4) How are you planning to modify new product approval and product governance frameworks to capture climate risk (and ESG) factors?
- For example, what are the relevant sustainability risk factors which need to be embedded in your new product governance processes?
- For manufacturers of structured retail products, how are you proposing to build climate risk disclosure into your product offerings and align that to target markets?
- Are you marketing genuinely ‘green finance and investor’ products and how are you satisfying yourselves that the representations are accurate?
5) How are you identifying potential conflicts of interest that may arise as business models and service offerings evolve in response to climate risk appetite changes?
- This is a new area, have you started considering potential conflict scenarios and building them into your conflict clearance processes?
6) Do you need to make changes to your KYC and AML processes to identify clients in industries which are potentially high risk from a climate risk management perspective?
- Do you need make changes to your client due diligence framework for additional screening for client types in higher risk industries and link that to your risk appetite framework and reputational risk processes?
- Does it make sense to add ESG type alerts into your AML adverse news screening to identify potential incidents which would impact a client’s reputation or financial well-being?
How can Eiger Regulatory Partners (ERP) help you?
- ERP has access to a pool of experienced compliance officers who want to help firms develop their climate risk management frameworks providing technical support to compliance teams working alongside ESG and Sustainability Teams.
- ERP is also keen to connect with Compliance professionals versed in ESG and sustainability issues, to further develop a knowledge base of evolving best practices in advance of the new UK and EU rules and regulations on climate risk management in 2021/22 (including the EU Taxonomy Regulation, the Sustainable Finance Disclosure Regulation, the Climate Benchmarks Regulation and the Bank of England 2021 biennial exploratory scenario on the financial risks from climate change).
Please contact Malcolm Hill if you would like to further discuss this article and how we may help your firm or to join our network.