Lessons learned from the existing analyses and practices of financial institutions, credit rating agencies and supervisors. NGFS report finds focus is shifting to forward-looking tools

The period between 2020 and 2030 is a critical decade in determining the trajectory towards net zero. The Intergovernmental Panel on Climate Change’s sixth assessment report has shown that, to limit global warming to 1.5 degrees Celsius, global greenhouse gas emissions must peak by 2025 and be reduced by 45% (relative to 2019 levels) by 2030. Central banks and financial institutions have a key role to play in the net zero transition.

For the next two years, through the work of four workstreams and two task forces, the Network for Greening the Financial System will step up its work on enhancing supervisory practices on climate risks. This will involve improving the design and analysis of climate scenarios, analysing the implications of climate change for monetary policy, providing guidance on central banks to transition towards net zero, studying nature-related financial risks and enhancing capacity building for NGFS members.

During a roundtable hosted by OMFIF’s Sustainable Policy Institute, Gek Choo Goh, executive director, banking department II, Monetary Authority of Singapore, discussed the NGFS microprudential and supervision workstream and how supervisory authorities can integrate environmental risk into their supervision work.

The former workstream chair spoke about the NGFS’ latest report ‘Capturing risk differentials from climate-related risks’, which explored potential credit risk differentials between green and non-green assets and activities. A key finding was that financial institutions’ approaches to classification remain varied, which hampers the accurate and consistent assessment of risk differentials. Further, these classification methods occur at the activity or asset level and therefore do not directly translate to potential green and non-green risk differentials at the counterparty level.

Goh shared that backward-looking data cannot fully account for the longer time horizon and the uncertain and non-linear nature of climate-related risks. This is seen particularly in transition risk as policy-makers, regulators and clients are expected to take accelerated steps towards their commitments in the next decade.

The report has demonstrated a need to shift towards assessing vulnerabilities at the counterparty level in a forward-looking manner, with surveyed institutions increasingly assessing risk through qualitative and quantitative tools and methodologies (such as heat mapping, scoring, concentration analysis or sensitivity and scenario analysis) and moving away from classification of ‘greenness’ at the asset level. Credit rating agencies’ efforts will also help to advance this forward-looking approach as they improve the granularity and transparency of their methodologies to incorporate environmental, social and governance factors into credit ratings.

Goh noted that further work is necessary by supervisors to refine the use of forward-looking tools such as scenario analysis and stress testing in quantifying risks, as well as to examine the relevance of transition plans of green, transition-ready and transition-unprepared companies. More clarity on what a credible transition plan should look like is required, and the NGFS will be examining the role of supervisors through financial institutions’ transition plans. Given the importance of examining the counterparties’ transition readiness, policies to strengthen and make consistent corporate disclosures on emissions and forward-looking transition plans are therefore critical for the appropriate assessment and management of these climate-related risks by financial institutions.

Goh also spoke about the NGFS’ ‘Progress report on the guide for supervisors’ published in October 2021. The report showed progress has been made by NGFS members in integrating climate and environmental risks into their supervisory activities and in defining supervisory expectations for financial institutions.

One of the main observations of the report is that internal alignment in governance is key to the integration of climate and environmental risks into business as usual operations. This includes commitment from senior management and allocating adequate resources to ensure strategy translates into concrete actions. Another observation is the often-cited issue of data gaps and quality hindering development and alignment of risk assessment methodologies and metrics. Efforts are underway to address these issues, such as the International Sustainability Standards Board’s work on a global disclosure baseline standard.

Goh highlighted that scenario analysis will be an increasingly important tool for making sense of the deep uncertainties around climate change and risk assessment. In this regard, capacity building and developing the expertise of various stakeholders – including governments, regulators, financial institutions, large corporates and small- and medium-sized enterprises – is key to fostering a greater understanding of the potential scenarios and evolving robust risk management practices in the world’s transition to net zero.

Article: Emma McGarthy is Head, and Katerina Atkins is Programme Coordinator, Sustainable Policy Institute, OMFIF.