On Earth Day we discuss Climate Risk and evolving Risk Management practices
As Earth Day approaches we had a chance to catch-up with Graham Davies, Vice President Operational Risk Management at TD Bank Group and RMA Board Member about climate risk and evolving risk management practices.
How do you incorporate climate risk into your risk management framework?
What are the main challenges?
On the one hand climate risk is managed just like any other type of risk, you need to identify, assess, measure, control and monitor climate risks in your institution. However it is also different because it cuts across all risk categories which is known as a transverse risk as it can lead to other types of risk such a credit, operational, reputational, and strategic. Therefore it must be integrated into existing risk management frameworks, practices and governance given the inter-related nature of the risks.
One of the biggest challenges is the measurement component of climate risk. Data availability and consistency is a challenge given all the different sustainability reporting frameworks. Modeling is also in its early stages as there is no historical data available over a longer time horizon to support quantitative assessments. We know that the industry is actively working to address these challenges, and practices will evolve and take time to mature.
Therefore instead of building net new programs, you can look to enhance existing ones such as scenario analysis, credit borrower assessments and new product reviews to include consideration for climate risks.
What role does disclosure such as the Task Force on Climate-related Financial Disclosures (TCFD) play in managing climate risks?
The TCFD helps to drive convergence and consistency of measurement approaches across the industry. The frameworks act as a target state for institutions to build and enhance their measurement practices to meet the recommendations and requirements. The more firms that adopt the TCFD recommendations, or similar reporting frameworks, the more data becomes available to support quantitative assessments, thereby helping to advance modeling and other measurement capabilities.
This in turn enables investors to compare and contrast the climate risk management practices of various institutions and corporations to make informed investment decisions. In my opinion some industry convergence or standardization of reporting frameworks would be beneficial to ensure consistency across the globe. I think firms would appreciate the clarity as well.
What is your view on the various regulatory consultations and pilot projects? Why are there so many and what do they aim to accomplish?
I'm very encouraged by the level of consultation and collaboration that’s taking place. We need to work together to develop meaningful approaches to manage these risks. I encourage peers and regulators to share practices and learn from each other, including other geographies, to continue to build on the developments to date and further the industry's abilities to manage climate risks.
Consultations, like OSFI's recent paper "Navigating Uncertainty in Climate Change", offer a unique opportunity to provide feedback directly to the body, which may help inform the regulatory focus.
Similarly, pilot projects, like the Bank of Canada and OSFI Climate Scenario Analysis Pilot, enable to work in a collaborative fashion with regulators to drive progress in managing these risks, in this case on measuring the impacts of climate transition risks. Every participant or respondent gets to provide their perspective which are all important pieces to being able to complete the puzzle.
How does Canada's zero emissions target change how you evaluate the economics/fundamentals of companies/industries?
Canada's net zero emissions target will drive the transition to a lower carbon economy, which leads to transition risk for financial institutions. This is critical for Canadian FI's to understand and manage given the Canadian economy's reliance on energy and other resources. The question we need to answer is, what is the level of transition risk sitting on my Balance Sheet?
In my view this is a potential new path to default for borrowers and needs to be considered in the credit risk context. Measurement tools, including exposure and concentration limits can help manage this risk, but only if you can measure it. This is where climate scenario analysis comes in to support measurement of these risks.
Strategically you'll see FI's looking at their plans across various sectors, like Oil & Gas, calculating the emissions of their portfolio, setting targets and aligning business strategy. Scenario analysis is a useful tool to pressure test the resilience of that strategy to potential future climate pathways.
In that regards it comes back to Risk Management 101, where you are planning for potential future scenarios and talking about what the organization can do to adjust and adapt where needed.
What would you say are things to look out for down the road in regards to climate risk?
We're on a journey that is going to take time. Development of these new capabilities, including data modeling will evolve over time as we test and learn. The most important thing is to start doing it and adjust as you go. I believe collaboration across institutions, regulators and jurisdictions is key at this stage to ensure we're all learning from each other and moving in the same direction.