The Basel Committee has just issued a consultative document on best practices for managing climate issues[1]. The topic is topical and, in the continuity of the reports on this subject[2]. The Basel Committee is thus seeking to provide a framework for the governance system on this subject.

The following is a summary of the main elements of this document, structured around 18 principles, and translates them into recommendations.

1.   Concerning the governance and organization of the system

Institutions need to consider the potential impacts of climate-related risk factors on their individual business models and assess the financial materiality of these risks.

Banks should manage climate-related financial risks in a manner commensurate with the nature, scale and complexity of their business and in line with their risk appetite.

Climate-related risks can have very diverse impacts in terms of the sectors and geographical areas concerned.

In addition, climate issues can affect risks over periods longer than 2-3 years, which is generally linked to capital planning.

The bank must therefore have a system that allows it to establish itself over the long term while being flexible and responsive to future uncertainties.

2.   Governance principles: accountability and competence

Principle 1: Banks should develop and implement a structured process for understanding and assessing the potential impact of climate-related risk factors on their business and the environments in which they operate.

Principle 2: The board and senior management should clearly assign climate-related responsibilities to members and committees and exercise effective oversight of climate-related financial risks.

Recommendations

  • Ensure that the board and senior management have an adequate understanding of climate-related financial risks and that senior management has the right skills and experience to manage these risks. Where necessary, banks should enhance the level of expertise of the board and senior management.

Principle 3: Banks should adopt appropriate policies, procedures and controls, to be implemented throughout the organisation, to ensure effective management of climate-related financial risks.

3.   INTERNAL CONTROL FRAMEWORK: role of the control lines

Principle 4: Banks should integrate climate-related financial risks into their internal control frameworks across the three lines of defence to ensure robust, comprehensive and effective identification, measurement and mitigation of climate-related financial risks.

Recommendations

Include a clear definition and assignment of climate-related responsibilities and reporting lines throughout the organization as part of the internal control framework.

  • Specify the role of the control lines :
    • The front line: climate risk assessments at client intake, credit application and credit. Staff must have sufficient awareness and understanding to identify potential climate-related financial risks.
    • The second line of defence: the risk function should be responsible for independent assessment and monitoring of climate-related risks, including challenging the initial assessment by front-line staff.
    • The compliance function is responsible for ensuring compliance with applicable rules and regulations.
    • The third line of defence, the internal audit function, should conduct regular reviews of the overall internal control framework and systems in light of changes in methodology, activities and risks, and the quality of data used.

4.   Acapital and liquidity issue

Principle 5: Banks should identify and quantify climate-related financial risks and incorporate those deemed material over relevant time horizons into their internal assessment of capital adequacy and liquidity.

Recommendations

  • Develop processes to assess the impact on solvency of climate-related financial risks that may arise over their capital planning horizons (ICAAP).
  • Assess whether climate-related financial risks are likely to result in net cash outflows or depletion of cash reserves under business-as-usual and stress conditions.
  • Build scenarios with relevant time horizons to assess the potential impact on liquidity adequacy (ILAAP).

5.   risk management: a potential entrant to the RAF [3]

Principle 6: Banks should identify, monitor and manage all climate-related financial risks that could adversely affect their financial condition, including capital and liquidity resources.

Recommendations

  • Integrate these issues into the Risk Appetite Framework (RAF) and monitor this appetite.
  • Ensure, as a governance body, that these issues are taken into account, depending on their significance.
  • Regularly assess climate-related financial risks and provide clear definitions and thresholds (limits) for these risks.
  • Integrate concentration issues, particularly those related to industry, economic sectors and geographic regions.
  • Develop appropriate key risk indicators for effective management of significant climate-related risks, which are part of the information and communication loop (escalation mechanism).

6.   PILOTING AND COMMUNICATION: information and data quality issues

Principle 7: Risk aggregation capabilities and internal risk reporting practices should take into account climate-related financial risks. Banks should ensure that their internal reporting systems are capable of tracking significant climate-related financial risks and producing timely information for effective board and senior management decision-making.

Recommendations

  • Have risk data aggregation capabilities to facilitate the identification and reporting of risk exposures, concentrations and emerging risks.
  • Have systems in place to collect and aggregate climate-related financial risk data across the banking group as part of overall data governance.
  • Find an intermediate situation when reliable or comparable climate data are not available; possibility of using reasonable approximations and assumptions as alternatives in internal reporting to improve data quality.
  • Actively engage clients and counterparties and collect additional data to better understand climate-related financial risks.
  • Set up adapted and periodic reports

7.   INFLUENCE OF CLIMATE ISSUES ON CREDIT RISK MANAGEMENT

Principle 8: Banks should consider the impact of climate-related risk factors on their credit risk profiles and ensure that credit risk management systems and processes take into account significant climate-related financial risks.

Recommendations

  • Have clearly defined credit policies and processes to incorporate these risk factors into the credit risk management process (including counterparty risk).
  • Consider significant financial climate risks throughout the credit lifecycle, including in the process of integrating and continuously monitoring client risk profiles.
  • Monitor concentration risk related to climate issues: identify, measure, assess, monitor, report and manage these concentrations (concentration in certain geographical areas or sectors related to climate factors)

8.   Global management of market, liquidity, operational and other risks

Principle 9: Banks should understand the impact of climate-related risk factors on outstanding market risk exposures and ensure that market risk management systems and processes take into account material financial climate-related risks.

Recommendations

  • Identify climate-related risk factors that could affect the value of financial instruments in the portfolios; assess the potential risk of losses and increased volatility in the portfolios, and establish effective processes to control these risks.
  • Possible elaboration of stress scenarios in the context of the trading portfolio (in particular the stakes in terms of liquidity of instruments).
  • Evaluation of the influence of climate issues on the valuation and liquidity of hedging instruments.

 Principle 10: Banks should consider the impact of climate-related risk factors on their liquidity risk profile and ensure that the liquidity risk management process properly incorporates them.

Recommendations

  • Assess the impact of climate-related financial risks on net cash outflows (e.g., increased credit line drawdowns, accelerated deposit withdrawals) or the value of assets constituting their liquidity reserves.
  • Take into account these impacts, where appropriate, in the calculation of liquidity cushions and in their liquidity risk management framework.

Principle 11: Banks should understand the impact of climate-related risk factors on their operational risk and ensure that risk management systems and processes address significant climate-related risks.

More broadly, all risks must be taken into account, such as strategic and reputational risk as well as compliance risk.

Recommendations

  • Assess the impact of climate-related risk factors on overall operations and on the ability to continue to provide essential services.
  • Consider the influence of climate-related risks on business continuity and assess the relevance of current continuity plans.
  • Anticipate strategic, reputational, litigation and/or liability issues that may arise from changes in the regulatory environment and stakeholder expectations.
  • Integrate these issues upstream of the strategy.

9.   The role of scenarios

Principle 12: Where appropriate, banks should use scenario analysis and stress testing to assess the resilience of their business models and strategies in the face of uncertainty about the impact of these issues.

These analyses should consider physical and transitional risks as factors in credit, market, operational and liquidity risk over a range of relevant time horizons.

Recommendations

  • The objective(s) of climate scenario analysis, including stress testing, should be linked to the bank’s overall climate risk management objectives as defined by the governance bodies (role of the Board and senior management).
  • Example of objectives (linked to what was presented earlier):
  • Analyze the impact of climate change and the transition to a low-carbon economy on the bank’s strategy and the resilience of its business model;
  • Identify climate-related risk factors ;
  • Measure the bank’s vulnerability to climate issues and estimate potential exposures and losses;
  • Assessing the limitations of climate risk management data and methods ;
  • Set up an information and communication circuit to facilitate management control of the situation. Provide periodic visibility on the control of these issues.
  • Define scenarios adapted to the bank’s business model, its risk profile and its commercial strategy.
  • Have sufficient capacity and expertise to carry out the analysis of climate scenarios, which must be proportionate to the size, business model and complexity of the operations.
  • Use of a range of time horizons, from short to long term, to target different risk management objectives. Longer time frames (higher levels of uncertainty), can be used to assess the resilience of existing strategies and business models to structural changes in the economy, financial system or risk allocation.

10.  Supervision issues

Finally, principles are established concerning the role and tasks of the supervisor in relation to these issues. We present them below, without these principles calling for any particular remarks.

Principle 13: Supervisors should assess whether banks’ integration of material climate-related financial risks into their business strategies, corporate governance and internal control frameworks is robust and comprehensive.

In particular, it is a matter of ensuring that the executive and deliberative bodies take proper account of these issues.

Recommendations

  • Evaluate the effectiveness of the Board’s and senior management’s oversight of climate-related financial risks and ensure that the Board and senior management receive accurate and appropriate internal reporting of significant climate-related financial risks in order to exercise this oversight.

Principle 14: Supervisors should consider whether banks are able to adequately identify, monitor and manage all significant climate-related financial risks as part of their risk appetite assessment and risk management frameworks.

Principle 15: Supervisors should ensure that banks comprehensively identify and assess the impact of climate-related risk factors on their risk profile and ensure that significant financial climate-related risks are appropriately considered in their management of credit, market, liquidity, operational and other risks.

Principle 16: When assessing supervised banks’ management of climate-related financial risks, supervisors should use appropriate techniques and tools and adequate follow-up action in the event of significant deviation from supervisory expectations.

Principle 17: Supervisors should ensure that they have sufficient resources and capacity to effectively assess the management of climate-related financial risks by supervised banks.

Principle 18: Supervisors should consider using climate risk scenarios themselves, including stress tests, to identify issues across institutions, understand relevant risk factors, size portfolio exposures, identify data gaps, and test the adequacy of risk management approaches.

11.  Conclusion

As the Basel Committee’s document points out, practices should evolve rapidly as our knowledge of climate issues evolves. At this stage, this document is consultative and will potentially evolve, even if the principles themselves can hardly be questioned given the relevance of the content.

While everyone is well aware of these issues for future generations, the implementation of these devices adds to an already extensive list of compliance requirements.

It is nevertheless the social responsibility of institutions to respond positively to these injunctions in the service of more sustainable finance. This is only the beginning of a new subject for institutions …

 

Appendix: Risk Control Issues [4]

The vigilance of institutions depends on their perception of environmental risks and the cost-benefit ratio.

1.   The role of reference lists

Initially, institutions need references, predefined lists, and criteria to help them in this approach and limit the current heterogeneity.

As in the case of LCB-FT, where lists proliferate (List of non-cooperative third countries, list of Politically Exposed Persons, list of countries according to the corruption index published by NGO TI International, etc.), institutions use lists and expect others to adapt their risk-based approach (Global Coal Exit List [5]– GCE, Oil & Gas Exclusion List expected from NGO Urgewald, Trucost [6]Assessment, etc.). This will facilitate the homogenisation of approaches and thus comparability.

2.   Adapted mapping and classification

The classification will make it possible to draw up a client and investment profile and to develop an equivalent risk classification. The classification will make it possible to define a risk profile by crossing a client (issuer) with a project or even a geographical area and to determine decision-making rules. Like the LCB-FT classification, the classification is in line with the institution’s business model.

3.   A proportionate control mechanism

Obviously, whatever the external standards on which the institution relies, the system must be appropriate to the activity of the financial player. Mapping enables a control system that is proportionate to the issues at stake. The controls facilitate the identification of deviations from the Policy in the context of the various investments-financing-investments made.

The control system must be able to rely on appropriate skills. In the area of AML/CFT, former police officers have been recruited. Are we going to see the recruitment of former oil rig managers, fossil fuel specialists from large energy companies, in addition to those who have followed sustainable development-oriented courses?

4.   A relevant frame of reference

Here again, the repository plays a key role, allowing the company and project to be scored according to the level of risk. It will serve as a support for controls and data analysis in order to produce statistics that will become more reliable. The issue of data quality remains an essential subject.

5.   An alert and escalation device

The system is based on scenarios (in connection with various studies published by the ACPR and the EBA, among others) that make it possible to define warning indicators. These indicators will gradually be incorporated into the suitability framework and will be subject to limits and a resilience threshold by 2030. Monitoring, for example, of exposures in relation to the GCEL list or the Global Oil and Gas Exit List (GOGEL) to be published soon (like the indicators used in this report) seems to be a first step to reflect the involvement of governance in these issues.

This will enable the governance bodies to ensure that the risk profile remains within the limits of their appetite for these themes.

 

[1] “Principles for the effective management and supervision of climate related financial risks” Issued for comment by 16 February 2022 – November 2021 – https://www.bis.org/bcbs/publ/d530.pdf

[2] Cf. AFGES News of 10.11.21 “What about the financial commitments of financial actors?

[3]  Risk Appetite Framework

[4] Extract from the AFGES News of 10.11.21 “What about the financial commitments of financial actors?”

[5] GCEL: Global Coal Exit List first published in 2017 at the UN summit (November 2017). Database launched by German NGO Urgewald on companies involved in the thermal coal industry value chain (over 770 companies involved). Next publication on 4 November on gogel.org.

[6] Trucost: non-financial rating agency. It rates companies according to their CO 2 emissions. It also works on their “water” footprint.