A discussion addressed to CROs and how they could think about setting up a climate risk appetite statement.
Authors: David K Kelly and Johnny D. Mattimore
Introduction
We are all familiar with the concept of an enterprise’s Risk Appetite: a high-level statement of the level of risk a firm is willing to take in order to run its business and achieve its strategic objectives.
Over the years as we have undergone refinement of our understanding of risk, different risks have been incorporated into the overall framework to determine and manage the risk appetite of an enterprise. This has been most pronounced for financial services firms, in particular for banks, asset managers, insurers and related firms.
In this short paper, we examine how to approach the incorporation of Climate Risk into the enterprise risk framework of a financial institution, which may be easily extended to other industry sectors.
Setting the Scene: Asset Managers & Banks
Risk appetite statements for climate change presents several challenges for Chief Risk Officers (CRO) of banks to define. For asset managers, the solution is straightforward as the industry already has easy-to-implement metrics in the form of Environmental, Social and Governance (ESG), provided by the large index providers.
A risk appetite statement for asset managers typically follows the pattern of defining a universe of excluded investments (companies and instruments).
A typical process of determining the excluded investments involves filtering those companies that have shown a low consideration to environmental and social issues and, in places, are poorly governed. The hope, and expectation, is that the communication to potential investors figures keywords such as responsible, sustainable, societal, environmental. The summation of such word usage enables asset managers to engage with investors who genuinely want to make the world a better place.
By contrast, a CRO of a bank has a more subtle challenge as their role in the financial system is to intermediate and to syndicate rather than to invest. For banks, investors do not go to them to satisfy their needs to change the world for the better. However, a bank CEO is still conscious that their institution needs to be seen to be responding to relevant risks, including climate risk trends. While such CEOs may not have an investing ESG mandate, they do have a mandate to examine, design and implement a risk-based approach for those companies they deal with, including those companies’ impact on Climate Risk and hence the overall risk they represent to the bank..
Considerations for a Risk Appetite & Framework
All risk appetite statements need to point to measures that enable a CRO to define what the firm is about and also track progress. Still, it is the role of the CRO to define metrics that lead to a responsible and sustainable portfolio of activities that contribute to making the world a better place.
First, the risk framework of climate change requires a baseline of a combination of targets and policies. Typically, it uses a scenario target (2 degrees temperature increase by 2050 since pre-industrial age) and an associate policy is written into law (carbon neutral by 2050). This first section of the risk appetite is to sign up that the bank’s aggregate activities have to be a net contributor – a leader and not a laggard.
Second, the risk framework of climate change requires a taxonomy and methodology of risk metrics.
For climate risk, the most intuitive parameter is “Temperature Alignment”. If we imagine a budget of how much carbon humanity can emit over the next thirty years to reach the two-degree target, we can disaggregate the tonnage to individual companies. If a company’s carbon footprint is higher than the allocation, its temperature alignment score is higher than 2.0 degrees. Thus, a CRO can in the risk appetite statement set annual targets for either a target for carbon budget or use temperature alignment across their entire risk positions.
Enforcement, Allocation and Differentiation
The most critical element is to define how the CRO can enforce the adherence of the Risk Appetite statement on a wide range of risk-taking business activities.
A simple approach is for the CRO to introduce a transfer mechanism between those that are planning to retain risk that is above the temperature alignment target to those that are, for example, lending to renewables projects.
In the credit space, the risk teams can define a climate change premium, defined as a credit spread adjustment to the loan coupons, providing the right-risk level of incentives to the deal teams. The major outstanding challenge for any credit department is to ensure the integrity of their capital regime as well as not triggering a stampede to “Greenwash” all deals.
The advantage of defining a risk appetite statement in this way is that it leverages off existing, well-established and proven risk-based methodologies, which are scientifically neutral and can easily be used to align incentives.
While having a suite of neutral metrics central to a risk appetite statement, the CRO and their fellow C-suite should also have a broader view of the sets of risks they are willing for their firm would take in and its long-term commitments to its clients. Will they be able to balance, for example, the risk of client litigation in how they fail to support their migration strategy against the risk of not retaining customer deposits or institutional buyers of their own debt?
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