All listed entities, banks included, need to publish periodical financial statements about their operations. Aside of highlighting the financial performance of the company, the statements also list various other key components contributing to the overall results. This includes risks to the business. So far, the statements have not included climate and its impact as a risk factor for the financial performance of a firm.
The unmissable climate crisis has manifested in a very real risk to all walks of life globally and institutions are not insulated from it. The risks from climate change have a bearing on institutional and financial stability and the November 2020 publication by the International Accounting Standards Board (IASB) has reinforced the climate imperatives.
Financial Reporting: Evaluation and Evolution
For the banking industry, managing as well as clearly reporting climate risks to the overall system is crucial to ensure transparency and avoid any significant reputational risks for the shareholders and the larger financial markets. The well-pronounced observations from central banks, regulators, IASB etc. should ensure a sharper focus from the banking industry to address the situation. Apart from IASB, select regulators in jurisdictions like the UK have been vociferous about climate considerations in financial reporting.
International accounting standards IFRS/IASB have also been updated to include climate related risk. For instance, as part of IFRS9, the banks need to consider financial risk and related climate change reporting impacting their loan portfolio. This is essential to outline the potential impact on loan servicing, adherence to covenants, and stressed collateral valuations. With adverse climate impact, mortgage insurance premiums may skyrocket (owing to instances of repeated climate catastrophes) consequently insurance providers would have to factor and cover for elevated liability costs. While IFRS7 prescribes banks disclose risks within their instruments and exposures, as well as their climate change risk disclosure with the related concentration (credit, market, other risks).
As banks graduate to fully incorporate climate factors in their financial statement reporting, here are some steps to consider:
1. Look Inward for Data Centricity
2. Stress Tests, Scenario Analysis: Banks must also include climate-related risk consideration (including managing climate risk in the financial system) as part of their enterprise risk management framework. Additionally, they need detailed mitigation plans, along with conducting stress testing, AI based modeling with scenario analysis incorporating baseline, adverse and outlier scenarios matched to confidence intervals.
3. Using KPIs and Metrics: By mirroring climate related financial disclosures, banks can build organization-wide metrics, KPIs and analytics. It can then cascade to individual business units and divisions. Enabling tools from forums like Science Based Targets initiative (SBTi) and Partnership for Carbon Accounting Financials (PCAF) can also be reviewed.
The banks can institutionalize climate related financial statement disclosures by evaluating the data and business and subsequently determine what suits them best. They can also empanel select climate change and financial risk reporting use-cases to perform PoCs in order to ascertain what works best for the organization. Post that banks will need to document and institutionalize the lessons learned, which can then form the basis for a strategic enterprise wide implementation.
Going forward climate aligned financial reporting, may become more vociferous and pronounced, both from regulators and the executive branch of the government as investors, deposit holders, loan seekers demand to know how their financial wealth aids/impedes climate goals (GenZ customers included). In summation, climate change and financial risk constitute two sides of the same coin, and banks must prepare to align with self-initiated climate glazed financial reporting.