Potential Impact of the Biden Administration’s Climate Change Agenda on Financial Institutions

Recently, regulators overseeing the US financial system, including the Federal Reserve Board (the Fed), the New York State Department of Financial Services (NYDFS), and the US Securities and Exchange Commission (SEC), have signaled their plans to increase focus on climate-related risks to the financial sector. Under the new Biden administration, there is reason to believe the momentum toward incorporating risks resulting from climate change into financial institutions’ (FI) risk frameworks will continue.

Summary

In a series of recent public statements, US financial regulators are warning that climate change may pose a system-wide risk to the financial sector. Indeed, the Fed, NYDFS, and the SEC have all made clear that they expect organizations to integrate climate risk into their risk management frameworks, including through reporting of material climate-related risks. Notably, this is not a new requirement. According to existing regulations, publicly traded companies should disclose any potentially material risk, which would include climate-related risks. However, it is significant that the regulators are now explicitly emphasizing climate-related risks as material risks. We expect regulatory oversight of climate risk will increase in the coming months and years. In November 2020, the American people elected Joseph Biden the 46th president of the United States. President Biden has named climate change as one of his top priorities and, as part of that, has proposed increased regulatory oversight over FIs’ risk management practices for climate risk. Against this backdrop, and with Europe and other parts of the world already shifting toward a more regulated regime for climate-related risks, US-regulated FIs are likely to see additional requirements to manage and report climate-related risks in the near future.

What's New?

There has been a heightened awareness of the risks posed to the financial system by climate change among US financial services regulators. For example, in its November 2020 Financial Stability Report, the Fed acknowledged the economic uncertainty arising from climate change and stated its expectation that banks have systems in place to appropriately identify, measure, control, and monitor all of their material risks, which, for many, are likely to extend to climate risks. For example, mortgage institutions may be exposed to unaccounted losses arising from an increase in storm and flood frequency due to climate change as the “expected value” of real estate drops as a result. FIs should ensure that they are appropriately assessing any such risks and conducting frequent stress tests.

In addition, the NYDFS recently sent a letter to all NYDFS-regulated banks, insurance companies, and nondepository entities, emphasizing the need for them to begin incorporating the risks arising from climate change into their risk management and governance frameworks. NYDFS divided climate risks into two types: (1) physical risks, which are those related to damage to property or assets caused by severe weather events and long-term shifts in climate patterns; and (2) transition risks, which stem from losses resulting from the shift toward a lower-carbon economy, driven by policy, regulations, advances in low-carbon technology, or consumer sentiment and liability concerns.

This focus on climate change follows close behind announcements from across the globe urging, and in some cases requiring, increased transparency on climate risk disclosures. For example, in November 2020, the UK endorsed recommendations made this year by the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) and “concluded that the United Kingdom should move toward mandatory TCFD-aligned disclosures across all sectors of the UK economy.” This followed close behind New Zealand’s announcement in September 2020 requiring mandatory climate risk reporting that is in line with the TCFD guidelines. Chair of the TCFD, former New York City Mayor Michael Bloomberg, recently published an op-ed urging President Biden to join TCFD’s global counterparts and establish and adopt “a mandatory standard for global businesses to measure and report the risks they face from climate change.”

Now, with the election of Biden as president, the circumstances are ripe for increased regulation. Throughout the presidential campaign, Biden proposed a number of initiatives addressing climate change. Some of his priorities include:

1. Formation of a National Climate Council that is “co-equal” to the Domestic Policy Council and National Economic Council.
2. Introduction of stress testing for climate risk and accounting for climate change in enterprise-wide risk regulation (i.e., credit risk, liquidity risk, and market risk).
3. Increase regulatory oversight on FIs’ risk management practices for climate risk, including both physical and transition risks.
4. Requirements that all federal regulatory institutions incorporate climate risk into their policies, procedures, and new regulations.  

Given the heightened attention on incorporation of climate-related risks, it is reasonable for FIs to expect regulatory requirements to incorporate these risks into their risk management frameworks.

Impact of Climate Change on Financial Institutions' Enterprise Risk

While we have not yet seen information regarding specific requirements to which FIs will be subject, the DFS letter referenced above may foreshadow the shape of future regulatory expectations. Specifically, NYDFS recommends FIs begin to consider:

1. The financial risks climate change will have on business continuity (e.g., supply chain disruption, changes to investor programs, and sentiments).
2. The impact on communities and customers (e.g., supply chain disruption, changing default rates, customer relocation, and loss of income). 
3. Designating a board/committee member or a member of senior management as accountable for assessing climate risk.  
4. An approach to climate-related financial risk disclosure and to engage with the TCFD framework.
5. An enterprise-wide risk assessment to evaluate climate change and its impacts on credit, market, liquidity, operational, reputational, and strategic risk.

Key Considerations

In elevating climate risk to the level of other business risks, the federal government is likely signaling that FIs, from the top down, need to give climate risk the same attention they would give to, for example, liquidity or credit risk. FIs should do more than treat this merely as a series of boxes to check—rather, they should consider seriously whether climate risk is firmly embedded within the corporation’s risk structure as a whole and institute appropriate risk mitigation strategies and activities. Going forward, FIs should heed the NYDFS recommendation to be proactive, rather than reactive, in assessing and managing their risk from climate change. Some steps FIs should take include hiring a chief climate officer, as well as developing a risk assessment methodology for climate risk and conducting a risk assessment. In addition, FIs should also take steps to estimate their current exposure to climate risk and subsequently decrease exposure by identifying necessary risk mitigation strategies. FIs can draw on guidance provided by industry standard-setters, such as the TCFD and the Partnership for Carbon Accounting Financials (PCAF) to determine the most effective ways to incorporate climate risk into their risk frameworks.

How Guidehouse Can Help

Guidehouse can help FIs identify and address areas of climate-related risk.  We have deep knowledge of both the climate landscape and FIs, as well as the regulatory environment in which they operate. Drawing on this experience, Guidehouse can help FIs assess and manage climate-related risk in a variety of ways. Below are some examples of Guidehouse’s capabilities:

• Impact Assessment: Perform analysis regarding impact from climate change on FIs, given FIs’ unique circumstances.
• Risk Appetite: Assist with development of a risk appetite statement.
• Risk Assessment: Assist with creating and implementing revised risk assessment methodologies to account for climate change and creating action plains tailored to the specific risks the FI faces.
• Portfolio Review: Perform a portfolio review to analyze the processes that might be impacted to identify areas of exposure, decrease exposure, assist in rebalancing of a portfolio, or identify risk mitigation strategies (e.g., originations, securitization), leveraging in particular our expertise as the Secretariat for PCAF, the global, FI industry-led initiative to assess and report on financed emissions. 
• Stress-Testing: Carry out stress tests to ensure banks have appropriate capital allocation, monitoring, and response processes in place to prepare for, identify, and respond to high-impact climate events.
• Periodic Asset Monitoring: Conduct periodic reviews to ensure risk is within appropriate parameters and develop ongoing monitoring reports to track portfolio risk.
• Policy and Procedure Analysis: Define and document processes to identify risk, decrease exposure, and determine thresholds to offload/rebalance portfolios to support investor and regulatory inquiries.  
• Due Diligence: Leverage our broad due diligence capabilities to help companies evaluate the practices of the organizations with which they align themselves or acquire and the relevant risks and opportunities.
• Transparency and Reporting: Draw on our deep corporate and governance expertise, to help clients implement the reporting structures necessary to ensure their stakeholders have the information they need, including TCFD reporting.

Contributing author: Henry Darmstadter.