Central Bank to Increase its Focus on Ability of Banks, Insurers and Investment Funds to Respond to Climate Change Risks

The impact of Covid-19 has served as a stark reminder that the best run, successful and profitable businesses can be severely impacted by threats that emerge from the external environment. Larger financial services firms tend to be very cognisant of the dangers posed by external threats to the business. While it is often the case that major external risks cannot be controlled or avoided, proactive firms can take steps to understand the risk, and where possible mitigate the impact of the risk on the business.

Global Risks Report

Since 2006, the Global Risks Report has been published by the World Economic Forum to coincide with its annual meeting in the Swiss alpine town of Davos. The Global Risks Report analyses changes occurring in the global risks landscape, puts a spotlight on the interconnectedness of risks, and reflects upon strategies that could be deployed in order to mitigate those risks to the global economy.

The Global Risks Report incorporates the results of the Global Risks Perception Survey. The Survey reflects the views of the World Economic Forum’s network of business, government, civil society and thought leaders in respect of the imminence and likely impact of risks that could occur within the next 10 years and could cause significant negative impact for several countries or industries.

While the 2021 Report calls out “infectious diseases” as being the number one global risk when assessed by reference to impact, interestingly, a lookback at the survey respondents’ readout on global risks by impact over the past ten years reveals that infectious diseases featured only once previously – in 2015, when it was ranked in second place, perhaps prompted as reaction to the 2014 Ebola crisis in West Africa.

Climate Change

Looking at the top risks by likelihood, “extreme weather” and “climate action failure” have featured as the first and second-place risks (respectively) in each of the past three years.

According to the authors, “climate change—to which no one is immune, nor can the world vaccinate against it—continues to be catastrophic: “climate action failure” is the most impactful and second most likely long-term risk” (p.16). While Global CO2 emissions fell by 9% in the first half of 2020 (as a result of COVID-19 lockdowns), the authors assert that a similar decrease in emissions is required every year for the next decade to maintain progress towards limiting global warming to 1.5°C and avoid the worst effects of climate change (pp.23-24).

For the past number of years, the economic dangers posed by climate change have been in the crosshairs of regulatory authorities at regional level as well as national level.

Banking

The ECB has committed itself to making banks manage their climate-related and environmental risks more effectively and will require banks to disclose these risks more transparently. According to the ECB (18 Nov 2020), the effect of climate change and environmental degradation “will also increasingly be reflected in banks’ balance sheets through both physical risks caused by weather events such as flooding, droughts and storms, and transition risks caused by the adjustment towards a less-polluting, more environmentally friendly economy.” The ECB subsequently published (27 Nov 2020) its guide on climate-related and environmental risks which outlines how the ECB expects banks to consider these risks in their strategy, governance and risk management and how banks are expected to disclose them under the current prudential framework. In the early part of 2021, it is expected that banks will be required to conduct a self-assessment in light of the supervisory expectations outlined in the guide and to draw up action plans on that basis. The banks’ self-assessments and action plans will be subjected to review and challenge by the ECB.

Insurance

The impact of climate change on the insurance sector has been a strong priority area of EIOPA. Climate change will impact insurers in a number of ways – principally through an increase in insured property losses caused by extreme weather events, a rise in sea levels and so on. Losses arising from extensive climate-related claims might cause insurers to cease to provide cover for certain types of risk – leaving consumers and businesses exposed to those risks. This could have wider consequences for the economy. Severe losses could cause severe financial stress and ultimately trigger the collapse of some insurers.

Insurers will also feel the effects of climate change in the context of challenges around long-term asset management, particularly in terms of a move away from investments in areas such as fossil fuel extraction, carbon‐intensive industries, vehicle production and also the energy sector which have tended to produce strong investment returns.

In recent weeks (15 Dec 2020), EIOPA published its sensitivity analysis of climate-change related transition risks in the investment portfolio of European insurers. The report quantifies potential climate-change related transition risks for the insurance industry and presents insights into possible impacts on these investments as economies transition away from fossil fuel-dependent energy production and carbon-intensive production. While EIOPA has found that the overall impact on the balance sheets of the insurance sector is counter‐balanced both by investments in renewable energy and the fact that insurers’ portfolios are generally well diversified, EIOPA has signalled that it will work with national supervisors on the risks identified.

Central Bank of Ireland

For some time now, the Central Bank of Ireland (“CBI”) has been airing its concerns regarding the likely impact climate change and the transition to a low-carbon economy will have on the financial services sector as well as on consumers. Governor Makhlouf signalled (20 Nov 2019) that the CBI would increasingly be embedding climate risk issues into its financial stability assessments and supervision. He also indicated that the CBI would be engaging with regulated firms and ensuring that they are aware of their exposures and that they are incorporating climate-related risks into prudent risk management and investment practices. In a recent address (25 Jan 2021), the Governor of the CBI again alluded to the importance of climate change in the context of the CBI’s priorities: “we must also look beyond the pandemic to improve our understanding of longer term risks, strengthening our frameworks accordingly and rebuilding resilience. We will also increase our focus on emerging issues, such as technology and innovation and climate change.”.

According to Vasileios Madouros, Director of Financial Stability at CBI, “there is still much further to go to ensure that regulated firms manage climate-related risks appropriately – in a way that becomes integrated into their practices and part of their business as usual risk assessment. ” (29 Feb 2020)

While it remains the responsibility of government, policy makers and business leaders to drive the transition to a low-carbon economy, the CBI views climate change as a potential source of risk to financial stability. With the ECB and EIOPA looking over its shoulder, the CBI feels the weight of its responsibility to ensure that the transition to a low-carbon economy is a smooth one. Therefore, banks, insurers, and investment funds can expect that the Central Bank will be turning up the temperature around their own preparedness for the new future.