Financial services regulatory: consultations on climate-related risks

Friday 22 April 2022

Kevin J Lambie
BLG, Toronto, Ontario

The regulatory landscape for financial institutions continues to change. Responsible authorities, such as Canada’s Office of the Superintendent of Financial Institutions (OSFI), are assessing their rules, frameworks and guidance with respect to climate-related risks.

New directives will soon be issued to federally regulated financial institutions (FRFIs) and federally regulated pension plans (FRPPs), though opportunities are available to consult with various regulators and intergovernmental bodies.

Consultations within Canada

The OSFI report

The OSFI's report, ‘Navigating Uncertainty in Climate Change: Promoting Preparedness and Resilience to Climate-Related Risks’ (the ‘OSFI report’),[1] published earlier this year, aims to guide the development of regulatory and supervisory approaches that meet the authority’s mandate of protecting regulated entities while also facilitating such institutions to compete efficiently.

The OFSI report acknowledges that building climate-related risks into a FRFI's business operations requires (among other steps):

  1. an appetite for climate-related risks that aligns with the FRFI's objectives;
  2. an understanding of the dynamic nature and magnitude of the FRFI's climate-related risk exposures;
  3. a strategy that adheres to climate-related risk appetite and is consistent with the nature, size, complexity and risk tolerance of the FRFI; and
  4. periodic reassessments of the climate-related risk strategy.

The OSFI report encourages FRFIs to assess material risk exposure through the Own Risk and Solvency Assessment and the Internal Capital Adequacy Assessment Process. The OSFI is presently exploring how oversight of steps one, two and three may strengthen the preparedness and resilience of FRFIs.

After a three-month consultation, the OSFI reviewed responses from FRFIs and FRPPs. Based on these responses,[2] the OFSI noted that:

  • Standardising taxonomy, measurement methodologies and metrics across the industry can help FRFIs and FRPPs improve their definition, identification and measurement of climate-related risks, as well as management of these risks. Many respondents believe the OSFI has an important role to play in facilitating such standards.
  • FRFIs are at varying levels of maturity in developing risk appetite and strategy for climate-related risks, with many in the early stages of development.
  • Internal alignment of accountability across the three lines of defence is key to embedding climate-related risk management in a FRFI’s operations.
  • The availability of useful data, analytical tools and skills are key challenges for FRFIs.
  • Use of climate-related scenario analysis and stress testing are still at early stages for many FRFIs.
  • While different standards are available, most respondents who make climate-related financial disclosures follow the Task Force on Climate-related Financial Disclosures’ recommendations.
  • Plan administrators could review the approaches used to evaluate environmental, social and governance factors (including climate change) when selecting investment managers.

For FRFIs, the OSFI agrees that guidance on climate-related risks should be principles-based and consider the Canadian context as well as international developments, such as a recent consultative document by the Basel Committee on Banking Supervision (BCBS).

Stay tuned, as the OSFI expects to communicate next steps on its climate-related policy work shortly.

Outside Canada’s borders

Internationally: the BCBS report

The BCBS report ‘Principles for the effective management and supervision of climate-related financial risks’ (the ‘BCBS report’)[3] conveys approximately 18 principles and 65 recommendations for banks and supervisors to manage climate-related financial risk.

Recommendations include:

  • Banks should take material physical and transition risk drivers into consideration when developing and implementing their business strategies, which includes understanding and assessing a bank’s exposure to structural changes in the economy, financial system and competitive landscape in which the bank operates as a result of climate-related risk drivers.
  • Management of material climate-related financial risks should be embedded in policies, processes and controls across all relevant functions and business units, including, for example, in client onboarding and transaction assessment.
  • Climate-related risk assessments may be undertaken during the client onboarding, credit application and credit review processes. Frontline staff should have sufficient awareness and understanding to identify potential climate-related financial risks.
  • Banks should start building risk analysis capabilities by identifying relevant climate-related risk drivers that may materially impair their financial condition, developing key risk indicators and metrics to quantify exposures to these risks, and assessing the links between climate-related financial risks and traditional financial risk types, such as credit and liquidity risks.
  • Banks should consider actively engaging clients and counterparties and collecting additional data in order to develop a better understanding of their transition strategies and risk profiles.
  • Limitations that prevent full climate risk data assessment should be made explicit to stakeholders (where relevant).
  • Banks should consider a range of risk mitigation options to control or minimise material climate-related credit risks, which may include adjusting credit underwriting criteria, deploying effective management and supervision of climate-related financial risks, targeted client engagement, or imposing loan limitations or restrictions, such as shorter-tenor lending, lower loan-to-value limits or discounted asset valuations.
  • Banks should identify and understand how climate-related risk drivers could impact the value of the financial instruments in their portfolios.
  • Banks should assess the impact of climate-related financial risks on net cash outflows (eg, increased drawdowns of credit lines or accelerated deposit withdrawals) or the value of assets comprising their liquidity buffers.
  • Supervisors should maintain sufficiently frequent contact, as appropriate, with the board and senior management to develop an understanding of, and assess the bank’s long-term approach to, addressing climate-related financial risks in a forward-looking manner.
  • Supervisors should set expectations in a manner proportionate to the nature, scale and complexity of relevant banks’ activities.

United States: the FSOC report

In response to Executive Order 14030: Climate-related Financial Risk, the Financial Stability Oversight Council (FSOC) delivered recommendations to US financial regulators in the Report on Climate-Related Financial Risk (the ‘FSOC report’), including that its members:

  • prioritise internal investments to expand their respective capacities to define, identify, measure, monitor, assess and report on climate-related financial risks and their effects on financial stability;
  • promptly identify and take the appropriate next steps towards ensuring that they have consistent and reliable data to assist in assessing climate-related risks; and
  • review their existing public disclosure requirements and consider updating them to promote the consistency, comparability and the decision-usefulness of information on climate-related risks and opportunities, using scenario analysis as a tool for assessing climate-related financial risks.

The FSOC will form two new bodies – the Climate-related Financial Risk Committee and the Climate-related Financial Risk Advisory Committee – to identify priority areas for assessing and mitigating climate-related risks to the financial system (among other mandates). More regulatory developments in the US will follow.

United Kingdom: Climate Change Adaptation reports

Pursuant to the Climate Change Act, 2008, the Financial Conduct Authority and the Prudential Regulation Authority, along with other UK financial regulators, have published Climate Change Adaptation reports, which discuss current assessments that the financial industry takes to mitigate climate change risks, identify areas of improvement, dissect the climate-related risks to regulated entities, and consider further policy actions that may be necessary.

These consultations and reports are only select examples of ongoing developments in Canada and abroad. Others include guidance on stress testing, taxonomies and more. Financial institutions should monitor these regulatory changes in real time.