Managing Climate Risk in Banks – Transition risk, what is it and how does it manifest itself?
Next in our series of articles aimed at helping banks understand the impact of Climate Risk, we’re focusing specifically on the topic of Transition Risk. What is Transition Risk and how does it come about?
To understand Transition Risk, we need to understand how it sits in the overall picture of Climate Risk. Climate Risk is here divided into 2 parts, Transition Risk and Physical Risk. Litigation risk, which is less of a concern for banks, has been excluded here.
What is Physical Risk?
Physical Risk is the risk that extreme weather events and gradual changes in climate may impact the economy by directly affecting the value and prices of assets. Such impact could mean lower real estate values, lower household wealth, lower corporate profitability. This may lead to wider losses within the financial system, further affecting the broader economy. It is widely recognised that Physical Risk will increase over time if no measures are taken to reduce our global carbon footprint.
What is Transition Risk?
Transition Risk is the risk that initiatives aimed at reducing Physical Risk (the transition), themselves introduce business risk caused by societal and economic change. Such initiatives to reduce physical risk can be divided into 3 categories:
- The introduction of and changes to lower carbon and climate-friendly mitigation policies, such as carbon tax, increased legislation, or changes in environmental policy.
- Innovation and technological advances that could have a significant impact on certain businesses within certain sectors, e.g., fossil fuel energy generation. This could result in ‘stranded’ assets.
- Lastly, changes in public sentiment, manifested through changes in demand patterns, preferences, and expectations by society at large. In this respect, reputational risk should not be underestimated for businesses perceived by society as not responding effectively to the ‘climate crisis’.
If such initiatives to reduce Physical Risk over time lead to the devaluation of corporate assets, a reduction in corporate profitability, lower residential property values, and lower household wealth, this is a manifestation of Transition Risk.
The ‘trade-off’ between Transition Risk and Physical Risk
As you can see, there is a clear link between Physical Risk and Transition Risk. Without any changes to policy, no adoption of technological advances, and no change in consumer preferences/behaviour, Physical Risk will increase. But if the nature of transition is extreme, or is late and/or dis-orderly, Physical Risk may be lowered, but Transition Risk will be high. This is well illustrated in the following picture, courtesy of the Bank of England ‘Climate Risk, Biennial 2021 Exploratory Scenario Presentation’.
The picture above illustrates the mechanics and nature of the ‘trade-off’ between Transition Risk and Physical Risk.
For banks and financial institutions, it is imperative to understand what Transition Risk is. Perhaps more importantly, banks must understand how Transition could affect their institutions directly as much as in-directly, as Transition Risk has the potential to impact the wider economy and the financial system in a multitude of ways.
What are the relevant transmission channels?
As banks try to understand and map what their exposure to Transition Risk is, they need to understand the relevant transmission channels, i.e., how Transition Risk cascades through the economy and financial system ultimately affecting the performance of their institution. The following picture is a good illustration of transmission channels from the ‘NGFS Guide for Supervisors’.
When a bank tries to identify and assess what their exposure to Transition Risk is, a key question will be, ‘is the particular exposure subject to and exposed to Transition Risk in the guise of possible changes in:
- Climate risk mitigation policies, and/or
- Technological advances, and/or
- Changes in customer and societal perceptions’
Two additional key aspects to consider are, that if a bank is at risk, what is the sensitivity of the exposure and what is the underlying tenor? This simple example may be easy to grasp but applying these considerations to the entire balance sheet and conveying the results to management in a meaningful way quickly becomes an arduous, if not an impossible task.
How to capture the forward-looking nature of Climate Risk?
What may further complicate risk identification and assessment is the forward-looking nature of Climate Risk, be that either Transition Risk or Physical Risk. The normal planning horizon for banks is, in most cases, 3 to 5 years. Typically, ICAAP, ILAAP, Budgeting and the Strategic Plan may run over 3 years. How then should we incorporate Transition Risk which may run decades into the future?
Supervisors have noted this problem. That capturing the forward-looking nature of Climate Risk in banks is a problem. Hence Supervisors are urging and increasingly mandating banks, as soon as possible, to develop scenario analysis tools and methodologies that will enable them to capture the forward-looking nature of Climate Risk.
“There appear to be significant gaps in banks’ tools and methodologies available to conduct the kind of forward-looking scenario analysis crucial in managing Climate Risk and fulfilling supervisory expectations alike.”
The European Central Bank (ECB) recently conducted a benchmarking exercise asking banks to self-assess their capabilities in relation to published supervisory expectations. The ECB has yet to publish the results of the benchmarking exercise, but according to some comments in a speech by Frank Elderson, Member of the Executive Board of the ECB, and Vice-Chair of the Supervisory Board of the ECB, 90% of banks deem their activities only partially or not at all compliant with the ECB’s supervisory expectations. There appear to be significant gaps in banks’ tools and methodologies available to conduct the kind of forward-looking scenario analysis crucial in managing Climate Risk and fulfilling supervisory expectations alike (Overcoming the tragedy of the horizon: requiring banks to translate 2050 targets into milestones (europa.eu).
MORS Software is a pioneer in the field of scenario analysis for both stress testing and financial planning purposes. With its unique transaction level data integration, and holistic approach to Risk Management, MORS Software is able help its clients monitor and manage Climate Risk transparently. MORS Software customers can measure accordingly the impact on Credit, Liquidity, and Market Risk alike.
Would you like to know more about how we at MORS Software can help you on your journey to managing Climate Risk while simultaneously fulfilling supervisory expectations?