By Ingrid Goodspeed, Governor of the South African Institute of Financial Markets
Powerful images of blue skies and clear mountain vistas circulated rapidly and widely following Covid-19 lockdowns. Many are calling for cleaner air to be a permanent feature of a post-pandemic world, calls that are strongly supported by public concern that the damage to health from poor air made the pandemic worse.
In an article titled “Beyond the crisis” Kristalina Georgieva, the Managing Director of the IMF appealed for a green recovery, for policies to reshape the world and build a future that is greener (low carbon footprints), smarter (technology-rich transformation) and fairer (greater income equality and investment in education and training). As she said in a recent interview “… if you don’t like the pandemic, you are not going to like the climate crisis at all”.
To achieve a greener future will require a clear understanding of the connection between climate change and the financial system, not least the how climate change and climate-related risk impact financial stability and the resilience of individual financial institutions and how financial institutions should manage climate risk – craft climate-risk management frameworks and formulate climate-risk appetites, strategies and capabilities.
Initially focus internationally was on promoting better disclosure of climate-related financial risks. In 2017 the Financial Stability Board’s Task Force on Climate-related Financial Disclosures published recommendations for voluntary public disclosure of climate-related risks and opportunities to provide investors, lenders, insurance underwriters, and other stakeholders with the metrics and information needed to establish the potential financial impacts of climate change. However now, international standard-setting bodies such as the Basel Committee for Bank Supervision, International Association of Insurance Supervisors and International Organisation of Securities Commissions are doing work to address the challenges to regulators in supervising and regulating climate-related risk including macroprudential supervision; supervisory review and reporting; governance and the role of the board; risk management; capital requirements and stress-testing.
Since 2019 international regulators such as the UK’s Prudential Regulatory Authority and Germany’s BAFin require banks to manage climate risk and embed it into their risk-management frameworks. The European Banking Authority has recently (April 2020) published draft regulatory technical standards on sustainability-related disclosures and its multi-year action plan “Financing sustainable growth” aims to redirect capital flows to sustainable investment; assess and manage financial risks from climate change; and encourage transparency and long-termism in financial and economic activity. The United States, Canada, and Hong Kong are also considering incorporating climate risk into their supervisory regimes.
In South Africa, National Treasury seeks to encourage the allocation of capital to more sustainable carbon-reduced development that support the real economy. To this end on 15 May 2020 it published for comment (by 30 June 2020) a draft technical paper “Financing a sustainable economy”. The draft paper has not been widely reported on, which is not surprising given the focus on the numbers and impact of the pandemic. Nonetheless it is an important paper that attempts to establish a framework for financial institutions to better disclose green initiatives and investments to improve stakeholders understanding of the extent of financial institutions’ exposure to climate risk. The paper has a number of recommendations for each industry – banking, retirement funds, collective investment schemes, private equity, capital markets and insurance.
Recommendations common to all industries and that require both regulatory and industry action include to:
- Co-develop (regulators and industry) or adopt technical guidance, standards and norms to identify, monitor, report and mitigate environmental and social risks, including climate-related risks. These should incorporate the disclosure recommendations of the TCFD.
- Develop a benchmark climate risk scenario for use in stress tests.
- Develop or adopt a classification for green, social and sustainable finance initiatives, consistent with international developments, to build credibility, foster investment and enable effective monitoring and disclosure of performance.
- Disclose progress in environmental and social risk management, including climate risks, in supervision activities carried out by the Prudential Authority and Financial Services Conduct Authority.
- Incorporate voluntary codes of principles, or acknowledged benchmarks for good practice, into regulatory regimes.
- Work with the Institute of Directors, trustees, professional and industry associations and academic institutes to upskill board directors to identify and manage long-term risks and sustainability challenges.
- Build capacity across the financial sector and in the implementing arms of government to ensure environmental and social risks are addressed within local infrastructure and development planning, capital raising and insurance planning.
- Finalise an action plan to give effect to the recommendations, using a technical working group to be comprised of regulators and industry representatives.
Initial thoughts on the technical paper are that
- Although enhancing financial stability through a better understanding of environmental and social, including climate change, is an objective of the paper it is not clear how this is to be achieved or what the role should be of the South African Reserve Bank (SARB), which as macro-prudential regulator has primary responsibility for protecting and enhancing financial stability. Presumedly stipulations of the Financial Sector Regulation Act will apply. Interestingly the May 2020 Financial Stability Review dealt with climate change and assessed that there is a low but increasing probability that it will cause financial instability in the future should there be no policy intervention.
- The paper does not discuss the
impact of climate risk on financial sector objectives other than the safety and
soundness of the financial system and financial institutions. These other objectives
include financial inclusion, consumer protection, market integrity and the combating
of financial crime. For example:
- financially-excluded groups, often the poorest and most marginalised, are more exposed and vulnerable to climate-related shocks because they have fewer resources and support from the financial system. Furthermore the move to promote financial inclusion by moving to cashless payment solutions could reduce the impact of climate-change, although the indirect environmental cost of technologies that underpin such solutions e.g., smartphones, vast data centres, should be borne in mind.
- With the increasing consumer demand for “green” financial services, structured treating-customers-fairly provisions may be required for these products.
- Financial markets will be required to respond to and support the transition to a low-carbon economy with adequate disclosures of climate-related risks and opportunities for transparent and efficient price formation.
- The paper does not consider the transverse nature of climate risk i.e., that it is a risk that impacts a wide range of risk types including credit, market, and operational risk. But perhaps this will be left to the Prudential Authority and Financial Sector Conduct Authority to develop.
- The focus of the paper is environmental and social risks, which is a broader concept than climate risk. It might be useful to focus on climate risk alone. As indicated in footnote 3 climate risk is the risk resulting from climate change that could impact the safety and soundness of individual financial institutions and have broader financial stability implications. It is a subset of environmental, social and governance (ESG) risks, but is probably the highest priority ESG risk facing the financial sector.
In June 2020 the SARB published a working paper titled “Climate change and its implications for central banks in emerging and developing economies” It suggests that central bank monetary policy responses could include (i) varying discount rates, which play an important role in determining the viability of climate-related investments; (ii) small scale assets purchases to support sustainable investments and the development of markets for “green” assets (iii) changes to reserve requirements in a cash reserve system to support sustainable investment. Furthermore the paper proposes financial regulatory responses such as (i) changing certain macroprudential tools to facilitate a low-carbon economy e.g., by altering the risk weights of “green” assets; (ii) increasing the disclosure of climate-related risks; (iii) prescribing that a proportion of domestic assets should be used for sustainable investment. Clearly implementation of such recommendations should not compromise financial stability.
The focus of financial sector policymakers
and regulators on climate risk and how it impacts their objectives of ensuring
the safety, soundness and conduct of the sector has increased substantially in
the last couple of years. Initially this led to an increase in climate-related
reporting requirements but has more recently indicated an intention to integrate
the consideration of climate-related financial risk into the regulation and
supervision of financial institutions.
 Climate risk is the risk resulting from climate change that could impact the safety and soundness of individual financial institutions and have broader financial stability implications. It is a subset of environmental, social and governance (ESG) risks, but is probably the highest priority ESG risk facing the financial sector
 The Financial Stability Board is an international body that promotes global financial stability (www.fsb.org)