“Netting zero” # 3: technology and management of climate-related financial risks (“CRFRM”)
Introduction: necessity and invention
The global financial services industry (“FS”) is expected to play an important role in efforts to address climate change. 38 banks around the world signed the Collective commitment to climate action (“CCCA”) and committed to align their portfolios to achieve a net zero economy and meet temperature targets in the Paris Agreement.
In the United Kingdom, the Supervisory statement from the prudential regulatory authority (SS3 / 19) sets expectations on how banks and insurers should manage climate-related financial risks (“CRFR”). This statement was followed by the British government Green finance strategy and the Financial Conduct Authority Feedback statement on green finance.
Both publications made explicit points linking finance and technology in the context of climate change. In particular, the FCA argued that it had previously consulted on improving access to “long-term patient capital investment opportunities in unit-linked funds… because enabling greater innovation and access to a wide range of investment opportunities is… likely to be important for funding the cost of the transition to a greener economy [e.g. for] start-up developing innovative technologies …“
As explained in our February article on transition risks, climate change is already increasing risk exposures for financial services companies. Likewise, there is an expanding global market for carbon neutral products and results, which must necessarily provide them with opportunities.
This article examines issues related to the principle that financial services firms are able to support technologies related to climate risk.
Our April article on FS industry issues in the transition to a net zero economy has highlighted four key areas in which businesses need to act:
Fit for purpose?
At first glance, technology has an obvious role to play for FS companies to take the above actions. In principle, it seems that technology can make the most of current data and systems – or upgrade them – and create entirely new systems for the specific purpose of CRFRM. Developments in artificial intelligence, blockchain, cloud computing and big data have clear potential to improve or replace current methodologies, such as for example:
- the design of environmental / carbon parameters relating to physical and financial assets;
- aggregation and sharing of public / open data;
- portfolio selection;
- media keyword tracking to monitor trends from a public or social perspective;
- specialized climate-related products (for example ‘green bonds‘), services and businesses, especially for organizations and projects that could have been rejected previously.
However, a recent FCA Report on Managing Technological Change identified some technology improvement issues in the FS itself, primarily due to “legacy” systems (i.e. “an outdated application, technology, or programming language that is still in use instead of versions upgrades available “):
- “… Technological change is more difficult to implement without disruption when it comes to existing infrastructure”; and
- “Businesses still rely heavily on manual testing and processes to bring about technological change.”
The FCA has already noted similar difficulties in the UK FS industry (see for example itsSector views‘), and the banking and insurance sectors have been the subject of unfavorable public comments in this regard – see for example:
‘Cart / horse’ / ‘Chicken / egg’
While one should not overstate the effect of legacy IT from the FS industry as a potential hindrance to the CRFRM, it is reasonable to question whether achieving an effective CRFRM requires that a company first ensures that it has – through procurement, change management or both – the relevant IT.
In addition, FS firms may find themselves at an even earlier stage, whereby the essential concepts for the management of the CRFRM must first be established so that the IT can be put in place to operate the CRFRM. .
Last month, the Bank for International Settlements (“BIS”) published “Climate-related financial risks – measurement methodologies“. Its main findings included points on data entry and analysis methodology that require technological improvements from financial services firms:
- “On the measurement side, assess [CRFR] will require new and unique data types …:
- … translate climate risk factors into economic risk factors;
- …linking [these] climate-adjusted economic risk [“CAER”] exposure factors; and
- … translate[ing] CAER factors and financial risk exposures.
- Mapping climate risk factors and financial exposures also requires classifying and differentiating risks between exposures. These … justify additional investments …
- … new and more granular data collections … for physical and transition risk assessments …[including]…
- geolocated data capturing the risks of physical damage associated with acute or chronic physical risks …
- the transition risks associated with actions to adapt to climate change at the level of industrial sectors and their constituent companies …
- financial data, especially for very granular data collections to capture exposures of small and large financial institutions.
- Gaps include the quantity and quality of data reported by … counterparties (especially small firms), as well as issues related to the consistency of risk assessments at the portfolio and exposure level.
- [There are also] the challenges of applying consistent risk differentiation between individual exposures at a sufficient level of granularity across jurisdictions, as well as a lack of convergence in data standards limiting the comparability of exposures for international assets [institutions].
- In terms of methodologies, approaches adapted to capture [CRFR] will require additional investment, in particular to take into account the uncertainty covering three areas:
- the inherent future uncertainty inherent in projections of physical and transition risk factors and the guarantee of standardized scenarios;
- measurement uncertainty related to data gaps, which may limit the relevance of retests to calibrate loss or damage functions; and
- model-based uncertainty, with more work required for a robust quantitative assessment of identified climate risk factors and their impacts … including risks to counterparties, assets, liquidity and operations. ”
The BIS report explains that “the systemic nature of climate change could involve many interconnections and feedback loops, non-linearities and tipping points. Methodological work areas warranting additional investments include granular analysis of climate risk exposure …[and] enhanced scenario analysis capabilities linking climate science to financial modeling. “
For the BIS, the future holds “both the prospect of climate-related risks and possible political and technological shocks, as well as changes in market and customer sentiment …”, which could lead to a range of climate-related financial risks and exposures that FS companies will need to manage.
In other words, an effective CRFRM will involve a synthesis of responses to both climate risk action and climate risk management response. The complexity of this synthesis makes efficient technology vital for FS companies.
First published by Thomson Reuters Regulatory Intelligence on May 17, 2021 by Jeremy irving.