The Interconnected World of Climate Change and Financial Risks
As the world converges for the COP 28 Summit, it's clear that climate change is not just an environmental issue but a complex financial one. As countries strive to limit global temperature rise and pursue net-zero emissions, the implications for financial markets and institutions are far-reaching. This summit, therefore, becomes a pivotal arena where climate commitments translate into financial directives and opportunities. The policies and agreements forged at COP 28 will have significant effects on industries, investments, and economies worldwide. The transition to a low-carbon economy, while necessary, carries with it financial risks such as stranded assets in traditional energy sectors and equally opportunities arising from the need for massive investments in green technologies as companies reduce their carbon footprint.
Banks have a central role to play as catalysts in the transition to a low-carbon economy. Physical and transitional risks can impact individual banks and the banking system at large, hence underscoring the need for effective risk management strategies that preserve the safety and soundness of banks and the stability of the financial system. Effective risk management will require banks to embed climate change risks into the enterprise risk management frameworks as it is likely to materialize through existing risks including credit, market, liquidity, operational and other risks. In response to these evolving challenges, regulatory authorities are issuing guidance on the management of climate change-related financial risks. In the U.S. The Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation (FDIC), and Federal Reserve Board have finalized interagency principles for managing climate-related financial risks. With a focus on financial institutions with assets over $100 billion, these principles cover governance, risk management, strategic planning, and scenario analysis. Climate change risk is associated with high levels of uncertainty and hence the use of climate change scenarios that consider different time horizons can help organizations build resilience at different levels, strategically, operationally, and financially.
These principles echo the key concepts contained the recently released public consultation by The Basel Committee on Banking Supervision. The paper contains a Pillar 3 disclosure framework for climate-related financial risks. This framework aims to bring clarity to how banks identify, quantify, and manage climate-related financial risks. The proposed changes urge banks to align their risk management and disclosure practices with the evolving realities of climate change. Whilst Pillar 3 disclosure requirements are key for market efficiency, creating transparency about a bank’s risk profile for market participants and reducing information asymmetries, data quality remains an ongoing challenge for banks. There is thus a fine line to be tread between promoting transparency through disclosure and ensuring it is done with data of acceptable quality, accuracy, and consistency.
As we witness the unfolding of COP 28, it is clear that the future of financial services is inextricably linked to how we address climate change. The Basel Committee's initiative and the U.S. interagency guidelines are not just regulatory changes; they represent a fundamental shift in understanding the interconnectedness of environmental and financial health. For financial institutions and fintech firms alike, navigating this new landscape requires an agile, informed, and proactive approach, aligning business and risk strategies with the urgent need for climate resilience and sustainability.