Climate and Sustainability: 2023 Regulatory Challenges

Social and political discord 

Despite socio-political pushes, U.S. regulators will move forward in 2023 with climate-related enhanced supervision and increasingly codified requirements and guidance.  Supervision frameworks are unlikely to be harmonized internationally (though will directionally align), forcing companies to set sustainability and climate priorities based on evolving opportunities and risks.  Frameworks will include:

• SEC’s Climate Risk Disclosures: When finalized, these rules will initiate a foundational shift in climate measurement, metrics, and reporting, which will cause companies (regardless of their public or private status, reporting schedule, or requirements to report) to advance their climate and sustainability risk programs. The proposal has been subject to wide-ranging debate and legal challenges are anticipated.
• Banking Regulators Principles for Climate Risk Management : The FRB, OCC, and FDIC have warned that climate-related financial risk presents unique, serious, and unknown risks to the safety and soundness of all banks of all asset sizes, regardless of complexity or business model. They are looking for institutions to develop risk management frameworks that address six general principles (including governance, strategic planning, and scenario analysis) and all risk pillars. Further they will :
  • Examine for and monitor the development of climate-related financial risk frameworks at supervised banks
  • Conduct a climate scenario pilot analysis to inform supervisors’ and firms’ capabilities
  • Finalize guidance to supervised banks on expectations around identification, measurement, monitoring, management, and governance of climate-related financial risks.  
• CFPB Focus on Disparate Impacts: Guidance indicates a focus on ensuring that transition plans and climate risk mitigation measures consider potentially disparate impacts to households and communities, and particularly to vulnerable populations.
• Global Framework Considerations: Regulatory frameworks and standards deployed in other jurisdictions could complicate the tracking and implementation of regulatory and supervisory requirements in the U.S.; these may include individual jurisdiction frameworks as well as TCFD’s recommended disclosure framework, ISSB’s upcoming sustainability-related disclosure standards, guidance documents from both FSB and BCBS, and EFRAG’s upcoming recommendations for sustainability reporting standards.

Divergence Between State and Federal Rules: Differing/discordant state climate-related regulations may further complicate the management of climate and sustainability programs; examples include California’s law to phase-out sales of new gasoline-powered vehicles, and Texas’ law prohibiting state agencies, local governments, and state public pension funds from contracting with or investing in firms that divest from fossil fuel energy companies.

Risk management and governance

The SEC and the prudential regulators will continue to examine the risk management and governance practices of companies to help ensure the companies are appropriately sizing, mitigating, and escalating climate and sustainability risks.

As these requirements and guidance are finalized and issued, areas of increased scrutiny will include:

• Risk management, including processes for identifying, assessing, and managing climate-related physical and transition risks and impacts, and integration with the overall risk management system and across risk pillars
• Governance, including board and management roles and responsibilities; staffing, skills, and expertise; reporting frequency; critical challenge; and integration with business strategy, risk management, and financial oversight.
• Climate strategy, including consideration of material or potential impacts of climate risks on business strategy; outlook; risk appetite; and financial, capital, or operating plans over short, medium, and long terms.
• Climate-related data aggregation, analysis, measurement, controls, and reporting, including GHG emissions metrics and climate scenario analysis

Alignment of climate-related claims and marketing statements, such as emissions reduction targets or “net-zero” goals, with the company’s climate strategy and activities as well as consistency between financial and nonfinancial disclosures/reporting.
 

Scenario / Stress test analysis

Regulators state that climate scenario analysis is a tool to assess climate-related financial risk and the resilience of a firm under different hypothetical climate scenarios. They further state climate scenario analysis is distinct and separate from bank stress tests. 

• Stress tests are designed to assess whether banks have enough capital to continue lending to households and businesses during transitory shocks to near-term economic and financial conditions.
• In contrast, climate scenario analysis is exploratory in nature, considering a range of possible future climate pathways – described by the agencies as plausible but novel combinations of risk associated with substantial uncertainty, including physical and transition risks over longer terms – that can be used to develop an understanding of how climate-related financial risk may manifest and differ from historical experience as well as expose gaps in methodologies and data.
• Econometric and operating models for credit loss (CECL and CCAR) would require a “rethink” to facilitate the successful assessment, measurement, and response to climate-related risks and opportunities.  
• The FRB will direct a pilot climate scenario analysis exercise in 2023, with hypothetical scenarios being run against the portfolios and strategies of six large banks. The insights and takeaways from the exercise will be shared with other regulators to inform further guidance issuances and supervisory expectations and will serve as a bellwether for institutions of all sizes.

As regulators look to utilize scenario analysis, and encourage their supervised institutions to do the same, they will specifically look at:

• The defined objectives of a firm’s scenario analysis framework and consistency with the overall risk management strategy.
• The use of analysis, various scenarios and parameters, assumptions and scope (portfolio-wide and geographic/sectoral concentrations), as well as projections.
• Oversight (capacity and expertise), validation, and quality control standards.

Investment / Strategic markets

The legislative and regulatory focus on climate risks and impacts has created new avenues to investments, products and services, and strategic markets – this includes green and sustainable bonds and securitizations, tax credits, equity products, offsets (e.g., renewable energy credits or “RECs”), grants, and CRA-qualified lending/investments/services.  

Financial service companies will continue to look at sustainability opportunities for their businesses and their clients, and to build suites of services to capitalize on these regulatory and legislative changes, including:

• Inflation Reduction Act: The largest congressional action on climate to date, with provisions that touch on a mix of energies (including wind, solar, nuclear, hydrogen, oil and gas, and biofuel) and climate-change prevention measures (including carbon capture, battery storage, and clean vehicles), the IRA will spur public and private funding and investment in energy security and climate programs such as onshore clean energy manufacturing, environmental justice in disadvantaged communities, and GHG emissions reduction projects.
• Modernization of the Community Reinvestment Act: When finalized, the rules updates would expand the categories of qualifying community development activities to include mission-driven activities that assist individuals or communities to prepare for, adapt to, and withstand natural or weather-related disasters, or climate-related risks.