Most firms have undoubtedly progressed their understanding of Environmental, Social & Governance (ESG) and climate risks, however, less than one in five quantify its impact1. In response to the huge risk that climate change poses to their own and counterparty portfolios, many institutions are developing climate scenario analysis capabilities or plan to do so. Yet it’s unclear how they should calculate and disclose the impacts of climate change or address the broader impact of the customer portfolio’s climate risks and carbon footprint on the bank’s stability, profitability, and reputation.
When it comes to climate data, there is no industry standard methodology or approach. Companies can’t wait for regulators to sort it out. They need to develop methods now to calculate the risks presented by rising temperatures, climate-related policies, and emerging technologies. Sudden weather events have material impact on collateral and asset values. When they occur, companies need the ability to measure the impact (and possibly liquidate assets) quickly and accurately.
Rightfully, institutions want to get their arms around climate risk and methodologies. It would be unwise, however, to focus on a single methodology or data set, in an evolving environment. Taking a longer-term view and investing in technology that addresses bank specificities and meets evolving regulations, yet robust enough to grow and converge all data and reporting, will ensure you have a future proofed ESG and climate risk strategy.
But how and where to start? For financial institutions ready to take the path of measuring climate risk, here are five key considerations.
1. Do you take a top down or bottom-up approach when analyzing your climate data?
At the start of your ESG journey, you need to decide what data to collect and how granular to take it. Is a portfolio level appropriate, or do you need to analyze risk by customer or contract? Is a macroeconomic view sufficient or do you need data at counterparty level? The answers depend on how you plan to use the information and which view is most actionable.
Access to qualitative data is another key driver. Do you have the tools to collect and verify millions of data points and analyze them at distinct levels? The tools for measuring climate risk can be expensive, especially for smaller banks. Most regulators are therefore taking a macroeconomic or portfolio-level approach.
Do you therefore take a top-down or bottom-up approach? A combined approach may meet everyone’s needs. For example, you could perform a top-down analysis of activities and apply a materiality rule (80%–20%) for the bottom-up approach. Banks should therefore invest in capability to track, gather, reconcile, and report emission data over time and validate the range of outcomes with multiple scenarios, data points and data changes.
2. Has your ESG and climate data been curated and benchmarked?
When using climate data from third parties, establish and evidence that it has been curated, reconciled, and benchmarked. While climate risk ratings are available, in many cases they are not comparable as each vendor would have approached it with different parameters. Make sure you understand what each rating means and how it was calculated. Then, see if you can repeat the calculations internally.
Validate the data two ways:
- Try to replicate the result using the same definitions, inputs, and calculation methods.
- Then, confirm the rating is reasonable for your organization. A third-party rating may indicate how the world sees a specific climate risk. But in your portfolio, a particular risk may be higher or lower. Scrutinize and analyze the risk ratings for your business.
3. Do you need to calculate a single rating or a range of outcomes?A single rating is easy to understand but it might oversimplify (or understate) reality. Plus, emphasizing a single rating could skew decisions, when the best outcome results from more-moderate performance across a range of metrics and scenarios, data points and data changes over time.
A scholastic approach might be the most appropriate. Use a combination of calculation methods and metrics to identify possible outcomes and their probabilities. A more well-rounded approach can also smooth out (or at least explain) outliers.
Until standards are set, it’s unwise to rely on a single method, data set or rating system to calculate climate impact.
4. Should you use public or proprietary tools and data?
For the most accurate assessments, use all the data and tools that are available to you. Don’t limit yourself to one data set or methodology. Explore a few approaches to create benchmarks and validate the data. The NGFS Climate Scenarios are a good starting point (and the reference point set by regulators).
Adding proprietary data gives you a better understanding of company-specific risks than public data alone. Ultimately, you need to understand climate risk for your business and portfolios. If you only use public data, you could miss risks that are unique to your business and counterparties.
5. When is the best time to engage counterparties?
Right now! Collect and use the NGFS scenarios and data readily available, to help set the stage and benchmark for future calculations and expectations. From there on, you need to assess your investments and risk associated with your counterparties to avoid future issues in your portfolio and counterparty arrangements. Not having these insights might mean your organization has to absorb the risk of the counterparty by not accounting for the real climate risk they are facing and the counterparty not paying the right price.
Financial institutions should integrate climate considerations into their enterprise financial risk management to effectively measure, manage, and mitigate climate-related risks and drive optimization across banking investments. However, focusing on a single methodology, data set or solution would be unwise. As the market will further converge, standardization will set in, and methodologies and processes will become more prescriptive. Our experts are available to advise and guide you on your climate risk journey. Connect with us now!