In financial services, carbon impact is emerging as the “new credit risk” and, along with climate risk, poses a systemic risk for the entire sector. That’s why the impact of carbon emissions needs to be integrated into your company’s overall enterprise risk management framework. It’s the most reliable and effective way to assess, monitor and, ultimately, manage the effects of “contagion.”
To date, the Office of the Comptroller and Currency (OCC) and the Federal Reserve Board (FRB) have not defined carbon emission risk as an independent risk stripe, but they are inching closer. OCC has now included climate risk as part of its FY 2022 operational plan and will assess how the financial risks associated with climate change may affect the safety and soundness of financial institutions. OCC is collaborating with the U.S. Treasury Department’s Financial Stability Oversight Council, which has provided 30 specific recommendations to U.S. financial regulators for identifying climate-related risks to the financial system and building resilience to those risks.
That’s why financial institutions have started designing scenarios to assess the impact of carbon emission risk to their overall systemic risk framework. This will inevitably lead to carbon emission risk being incorporated in the broader Risk Data Aggregation & Reporting (RDAR) processes to provide a comprehensive view of risk for the enterprise.
In this blog, we will discuss how data products can enable this level of integration for the purpose of reporting, governance, management, and regulatory reviews.
Download the diagram below to view the incremental risk data aggregation and reporting required to assess the impact of carbon risk and credit risk. The diagram depicts aggregated reporting for a commercial real estate portfolio, but the concept remains the same for any kind of portfolio. This data-driven approach will help integrate the impact of Carbon emission risk into the overall enterprise risk framework and establish materiality of sectoral financing/exposure as a % of overall Exposure at Default (EAD).
Currently, The Partnership for Carbon Accounting Financials (PCAF) provides guidance covering only on-balance sheet loans and lines of credit. But to effectively integrate carbon emission risk into the overall enterprise risk, banks would have to include non-market related off-balance sheet exposures such as bank guarantees and undrawn facilities. Download the diagram below to see this illustration. The goal is to utilize a conservative approach to cover the broader exposures of the bank, not only limited to cash flows.
A broad view of carbon risk
With this approach, organizations will also be required to assess the of impact of carbon emission risk on business operations as well as strategic and reputation risk categories. They will also need to develop and operationalize strategies for assessing and mitigating associated legal, environment, and competitive risks.
As an example, “earnings at risk” due to emissions will require a data-driven assessment to quantity the impact of carbon emission risk on financial and non-financial risk categories. Additionally, Paris agreement recommends reporting intensity of Carbon emissions and measure emission intensity adjusted profit. This will lead to lenders develop a data driven way to assess a “carbon premium” for their clients who have a higher emission intensity. Taking a data products approach, carbon emission risk management can be modularized. This makes it easier to assess the impact of carbon emission risk to the overall systemic risk framework. This, in turn, will lead to strategic decisions, such as whether a separate carbon loss allowance would be helpful.
In addition, as new focus areas and priorities emerge for monitoring and reporting emission risk, these can be also be addressed incrementally via data products.
| COP 26 Focus area & Risk impact | Role of data products |
|---|---|
| Broader Culture towards Circular Economy and Organization Business strategy/models – new risk metrics |
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| Scope 3 adaptation requires new look at Supply chain partners for better GHG Emission Management, Engagement, and data sharing – new risk correlations |
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Finally, as the process evolves, companies will augment their carbon data products with analytics using AI / machine-learning techniques. They’ll be able to assess the interconnection, interaction and the severity of the impact of carbon emission risk, severity of impact, as well as the probability that occurrences will emerge dynamically and with the aim of continuous maturity improvement.
Footnotes
- Harvard Law School Forum on Corporate Governance Web site, “A Sense of Purpose,” January 2018.
- Business events that potentially have higher impacts from carbon emission related charges.
