Pushed largely by significant and widespread investor demand and facilitated by myriad voluntary disclosure frameworks, financial services companies are working toward measuring, monitoring, and mitigating their climate-related financial risk. Regulatory expectations in this area have experienced sweeping changes that will continue, with rigor, into 2022 under existing and expanded jurisdictional authority. Federal financial agencies must develop, and execute on, a strategy to quantify, disclose, and mitigate the financial risk of climate change on both public and private assets. Public policy seeks to advance “consistent, clear, intelligible, comparable, and accurate disclosure of climate-related financial risk,” and “to mitigate that risk and its drivers, while accounting for addressing disparate impacts on disadvantaged communities and communities of color.”
Explore here insights from the KPMG report Ten key regulatory challenges of 2022.
of US CEOs said they are seeing significant demand for increased reporting and transparency on ESG issues today from stakeholders.
Source: KPMG 2021 US CEO Outlook Survey
Rapid changes: Climate and sustainability
Control production, consistency, and issuance of all climate and sustainability reporting (financial and non-financial), as well any disclosed metrics and measurements.
Without effective climate governance structures in place, a company may struggle to make climate-informed strategic decisions, manage climate-related risks, and establish and track climate-related metrics and targets. Climate risk is an issue that drives financial risk and opportunity; good governance should intrinsically include effective climate governance. For many companies, however, climate-related financial risk is a complex issue that entails grappling with scientific, macroeconomic, and policy uncertainties across broad time scales and beyond board terms.
Regulators expect companies to:
- Establish an enterprise-wide governance structure to oversee clear and transparent internal and external monitoring and reporting (i.e. metrics & targets). The governance structure should include members from a wide array of business areas and all three lines of defense embedded within: LOBs, Risk, Finance (Treasury, Controllers), HR, Legal, CSR/IR, Internal Audit.
- Ensure that Board members, senior management, and other relevant staff have sufficient knowledge, skills, experience, and background to make informed decisions regarding the materiality of climate-related threats and opportunities and integration of climate risk management across the organization.
- Identify and procure both internal and external data, ensuring completeness and accuracy as well as appropriate data lineage for use in external reporting. Data systems must be able to appropriately measure and audit. Reported commitments and claims must match practices.
- Align financial and non-financial reporting disclosures; nonfinancial reporting processes should be “auditable” and as robust as financial reporting standards.
Identify and develop qualitative and quantitative metrics and targets; hold business units, risk functions, and management responsible for integration and performance.
Climate-related financial reporting is rapidly evolving, pressured by demands from investors and other stakeholders, commitments by companies to achieve climate-related goals, calls for comparability and standardization, and efforts to increase the availability of data for metrics and disclosures. In the near term, multiple reporting frameworks (voluntary) are available to guide the development of metrics and targets though U.S. regulators are refining their expectations and beginning to detail more specific requirements.
SEC is taking the lead. The SEC:
- Expects to release proposed disclosure requirements (end of 2021, beginning of 2022) that will include qualitative and quantitative disclosures, including data to support advertised claims about operations and progress on climate-related goals.
- States that mandatory disclosures will result in more consistent and comparable disclosures.
- Set climate-related examination priorities in areas of proxy voting and best interest, business continuity, compliance with existing rules (e.g., 2010 Climate Guidance), and advertising (e.g., Names Rule) as well as misconduct related to material gaps or misstatements in disclosures of climate-related risks.
- Has an investor-protection focus to ensure that firms adhere to their own ESG claims and investors understand what they are getting when they choose a particular adviser, fund, strategy, or product.
Regarding metrics and targets, regulators expect companies to:
- Integrate climate risk into each risk discipline (e.g., credit, market, strategic, operational, legal, and reputational), including developing climate risk appetite statements consistent with existing enterprise risk appetites- these statements should be quantifiable.
- Integrate climate/sustainability into business unit strategy/growth as well as risk management (diligence, ongoing monitoring); new sustainability products/delivery channels/services should be measurable and demonstrable.
- Develop a roadmap to capture third-party/counterparty emissions data (i.e. scope 3) on an on-going basis (currently part of various reporting regimes, including TCFD, SASB, CDP, GRI).
- Consider tying Board and/or senior management incentives and compensation to climate-related targets and relative performance.
Develop initial assumptions and models for climate and sustainability inclusive of climate scenarios and/or stress tests (and in keeping with jurisdictional and global obligations).
Although there are not yet formal regulatory requirements in the US to conduct climate-related scenario analysis or stress testing, regulators do expect financial institutions to have systems in place to identify, measure, control, and monitor material risks, including climate risks. Globally, climate scenario analysis is emerging as a vital tool in assessing the impact of climate-related risks on financial institutions and financial stability more broadly.
- Treasury and FRB have each acknowledged the learning curve and data gaps associated with building climate risk models but believe this is not a reason to be tentative; the process will be iterative and will inform subsequent modelling, data requirements, and disclosure. Disclosures are perceived to be an “important first step” in closing data gaps.
- Regulatory agencies are actively collaborating with international organizations and regulatory jurisdictions to develop climate scenarios and best practices for climate-related risk management; learnings from applications in other jurisdictions will be useful to expectations applied in the United States. FRB has released research papers on climate stress testing models, and separately anticipates issuing supervisory guidance for large financial institutions.
- Climate risks can manifest as traditional microprudential risks, including through credit, market, operational, legal, and reputational risk. Steps to consider:
- Perform materiality assessment on existing portfolios, identify assets (both entity and customer) that are at high risk of acute perils (i.e., physical risks – hurricanes, wildfires, droughts) or impacted by policy, technology, or behavioral changes (i.e., transition risk).
- Begin to identify different climate scenarios to layer into current loss forecasting estimates; climate scenarios should stand alone from economic or stress test scenarios and be specific to climate impact.
- While transition risk is difficult to model in the long term, FRB suggests it may be modelled in much the same way as economic modelling of policy changes; organizations should begin to understand the impact of a shift to net-zero emissions by 2050 to their own businesses and client base. Focus initially on qualitative inputs and switch to more quantitative/modeled approaches as more data becomes available (and at a more granular level).
Explore the potential for disproportionate climate risk-related impacts across customers/communities and/or geographies and industries; factor learnings into strategy, operations, and risk management.
Climate risk-related impacts and many of the efforts to control them (such as advancing net zero emissions goals and making climate resiliency investments) can exacerbate existing vulnerabilities. Physical risk events (e.g., floods, fires, storms, or rising sea levels) are geographically concentrated and can have spillover effects that place additional burden on vulnerable individuals, businesses, and municipalities such as spikes in insurance rates; impaired values, and potentially impaired usability, of properties and infrastructure; and investor abandonment. Transition risks (e.g., policy changes, consumer behavioral preferences) may initiate abrupt repricing events and result in stranded assets and impaired values.
Policy makers, regulators, institutions, and industry groups are all exploring options, such as:
- Incorporating “climate equity” and “climate justice” into the debate on the impacts of climate risk (both physical and transition risk). Companies should develop models and metrics to measure the impact of these types of initiatives (positive and negative) and develop strategies to address.
- Adapting the CRA to incorporate and incentivize activities that support climate resilience when meeting the credit and community development needs of LMI communities (NY DFS has adopted such a rule for state-owned institutions).
- Incorporating climate-related financial risks into underwriting standards, loan terms and conditions, and asset management and servicing procedures for federal lending policies and programs.
- Working with state insurance regulators to examine the potential for “major disruptions” of private insurance coverage in regions particularly vulnerable to climate events.
Ten Key Regulatory Challenges of 2022
The year 2022 brings high levels of risk and regulatory supervision and enforcement. Regulatory “perimeters” continue to expand, and regulatory expectations are rapidly increasing. All financial services companies should expect high levels of supervision and enforcement activity across ten key challenge areas. Read the full report to learn more.