Assessing the materiality of climate risks – why CROs need to take an ERM approach

In a blog published on May 8, 2024, Frank Elderson of the European Central Bank (ECB) emphasised that materiality assessments in managing climate-related and environmental (C&E) risks are not just a “nice to have” and that, while most banks have now incorporated these into their processes, there is still “much work to be done”.

This assertion marks a significant step in recognising the critical need for a robust framework akin to those established for market risk and credit risk in the financial sector over the past three decades. Reflecting on the evolution of risk management in financial institutions, it becomes evident that a similar enterprise risk management (ERM) framework is essential for effective climate risk assessment and management.

The current state of climate risk management

Today, climate risk management stands at a crossroads. The recognition of climate and environmental risks as systemic threats to financial stability has gained significant traction, yet the frameworks to manage these risks remain in their infancy. Unlike market and credit risks, which have benefited from decades of regulatory refinement and the evolution of best practice, climate risk management is still grappling with fundamental challenges, including data scarcity, modelling complexities, and the integration of climate scenarios into financial analyses. To make substantial progress in climate risk management, it is imperative that CROs adopt a similar enterprise risk management framework.

True ERM encompasses a holistic approach to risk management, integrating various risk types – market, credit, liquidity, operational, and now climate – into a unified strategy. Addressing the supervisory expectations of the ECB as outlined in their "Guide on climate-related and environmental risks" published in November 2020, it is clear that a similar enterprise approach is required for climate risk.

"Materiality assessments are not just a “nice to have” – knowing your risks is a precondition for being able to address them. Most banks have now drawn up materiality assessments that are in line with our supervisory expectations. This is good news, but it is only the first step. A great deal more work lies ahead. By the end of this year, we expect all banks under our supervision to be fully aligned with all our supervisory expectations on the sound management of C&E risks."

- Frank Elderson, Member of the Executive Board of the ECB & Vice Chair of the Supervisory Board of the ECB

Key considerations for the CRO

The article "Climate Risk Reporting For ECB-Regulated Banks– A how-to guide to help European banks analyze and report on their climate risk exposure" by RiskThinking.AI, summarises some of the key expectations of the ECB and provides several important recommendations for banks needing to comply.

Understand the material impact of climate-related risks

Regulators expect financial institutions to understand the potential material impact of climate-related and environmental risks on their business operations across short-, medium-, and long-term horizons. CROs must ensure their institutions have a comprehensive understanding of climate risks which must then be incorporated into the institution's strategy, business model and risk management framework.

Report aggregated climate-related risk data

To facilitate informed decision-making, regulators mandate that institutions report aggregated climate-related risk data. This requirement underscores the necessity for robust data collection, analysis, and reporting mechanisms. CROs must ensure that this data be integrated into regular risk reporting, providing management with a clear picture of the institution's exposure to climate risks and informing strategic decisions.

Integrate climate risks into the credit-granting process

CROs should lead efforts to embed climate risk considerations into all stages of the credit evaluation and approval processes. This expectation aligns with the principles of prudent credit risk management, where potential risks are assessed and mitigated before granting credit. By incorporating climate risk assessments into the credit process, institutions can better manage their exposure to sectors and borrowers vulnerable to climate impacts.

Develop climate stress-testing scenarios

CROs must also spearhead the development and implementation of climate-related stress tests. Stress testing has long been a critical tool in market and credit risk management, helping institutions gauge their resilience to adverse scenarios. From a climate risk perspective, these tests should be designed to capture a full range of plausible scenarios, providing insights into the institution's vulnerabilities and guiding the development of mitigation strategies.

Assess the impact on cash flows and liquidity buffers

Finally, institutions are expected to assess the impact of climate-related risks on their cash flows and liquidity buffers, incorporating these considerations into their liquidity risk management framework. This requirement highlights the interconnected nature of climate risks and financial stability. Effective liquidity risk management ensures that institutions maintain adequate liquidity to meet their obligations, even under adverse climate scenarios.

"Integrating C&E risks into standard risk management is not an easy task. But while demanding, it is far from impossible."

- speech by Frank Elderson: “Making banks resilient to climate and environmental risks – good practices to overcome the remaining stumbling blocks”

The case for an ERM approach to climate risk

The journey of risk management in banking over the past thirty years offers valuable lessons for managing climate and environmental risks today. By adopting an enterprise risk management framework, financial institutions can systematically identify, assess, and mitigate climate-related risks. Regulators' expectations for CROs to focus on understanding material impacts, reporting aggregated data, integrating risks into the credit process, developing stress tests, and assessing impacts on liquidity underscore the need for a comprehensive strategy. This holistic approach will not only enhance financial stability but also contribute to a more sustainable and resilient future.

In 2023, SS&C Algorithmics announced two partnerships with specialist climate risk firms, CLIMAFIN and RiskThinking.AI to enhance its financial risk solutions with climate data and analytics to support the management of physical and transition risks within the award-winning SS&C Algorithmics market, credit and liquidity risk ERM platform. Contact us to find out more.

Join Dr. Andrew Aziz, Paolo Laureti and the SS&C team at RiskMinds International!