What does being responsible for climate risk really mean?
21 October 2019
It’s clear that climate risk is an issue the PRA wants firms to take seriously and address urgently. The prudential regulator wants firms to recognise that climate change, and society’s response to it, present financial risks. These could arise through physical risks such as increased instances of extreme weather events, but the regulator is also particularly concerned about the shorter-term transition risks that could impact the financial system as we move towards a lower-carbon economy.
To help focus attention, back in April this year, the PRA told firms they would need to identify and allocate responsibility for managing climate risk to a Senior Manager by the middle of October. That deadline has now passed, so it’s timely to consider what this really means for Senior Managers and the broader implications for their firm under the UK Senior Managers & Certification Regime (SMCR).
It might sound obvious, but it’s important the appointed Senior Manager understands what the responsibility for managing climate risk means for them and their firm’s wider governance framework. Climate risk is an area that many firms are still in the early stages of understanding, so for the Senior Manager and the firm it’s likely that this responsibility requires greater consideration than those that cover more familiar ground.
As leading practice on managing climate risk emerges we’re likely to get more steer from regulators in the coming months on what’s expected of firms, particularly in relation to more technical areas such as scenario analysis, stress testing and how this should integrate into a firm’s risk management framework. Despite current levels of uncertainty, it’s likely that there will be an expectation that firms establish robust governance in place as a starting point.
For Senior Managers, it’s going to be important to understand what “reasonable steps” look like to support them with the discharge of their new responsibility for the firm’s risks from climate change. To support this, we encourage Senior Managers to think about what controls they need to have in place to support them in their role. This is likely to include for example, clear climate-related reporting lines; production of MI that includes relevant climate-related data; and updated terms of reference for governance committees to reflect responsibilities to consider climate risks.
It’s also important for Senior Managers to think holistically about how climate-related risks are identified and managed. In doing so, they should consider the different ways that climate risks are likely to have an impact: credit risk, operational risk, market risk, reputational risk and beyond. The Senior Manager Function that we have seen most commonly appointed for managing climate risk is CRO, but climate change is an issue that has relevance across nearly all functions within firms, so Senior Managers should also think about how their firm can take a cross-functional approach to managing climate risk and the structures that are required to support this. In particular, Senior Managers should think about the important role that the first line has in understanding, identifying and managing climate-related impacts with their clients. Those within the first line will also have a crucial role to play in understanding climate-related opportunities for their firm and transitioning assets to a low-carbon, low risk and high growth portfolio over time. Senior Managers should think about how they can help to build capacity within the first line to encourage this process.
The FCA recently published a stocktake following its review into the embeddedness of SMCR in the banking sector. The review highlights that Senior Managers expressed concern about their understanding of reasonable steps in the context of their business. It’s important for Senior Managers to be comfortable there is a robust control framework in place to support them, so that they can be happy they are taking reasonable steps to discharge against this new responsibility for the risk arising from climate risk. Given managing climate risk is a new area, it’s likely that Senior Managers will have some scope to innovate in developing risk management approaches; we’ve seen signs from the PRA that it is open to learning from the market as it develops.
More broadly, it’s important that firms think about getting their wider governance framework in place - in particular to ensure that the board has the appropriate level of oversight and challenge. For most firms, this is likely to mean that there needs to be board-level training to help board members understand the climate risks facing their business. While most people have some understanding of the issues climate change brings, board members have a responsibility to think in a meaningful way about the physical, transition and liability climate-related risks facing their business and what can be done to manage these risks.
For boards, a good place to start is the World Economic Forum’s Climate Governance Principles, developed in partnership with PwC. Boards can use these principles to think about whether they have the right skills, level of accountability and structures in place to steer their firm through the risks that climate change could present over the short, medium and long-term.
As firms consider the governance challenges climate risk presents, we recommend considering the following questions:
- Does your appointed Senior Manager have the right skills and experience to manage climate risk? If not, how can they acquire the necessary knowledge?
- Has your Senior Manager’s Statement of Responsibility been updated?
- Are your Board Terms of Reference up-to-date?
- Does the Senior Manager with responsibility for the firm’s financial risk from climate change become a Board member or attend?
- What do your NEDs need to know about climate change and the associated risks? How can NEDs play a complementary role in supporting executives in managing climate-related risks?
Like the more technical aspects of managing climate risk, it’s likely that expectations on what constitutes good climate governance will evolve quickly as regulators and firms develop their understanding. For an idea of the possible direction of travel on governance, financial services firms might want to look at examples from other industries, such as consumer goods, where there are instances of the variable component of executive remuneration being linked to climate-related and other environmental targets.
While there is a recognition that approaches to managing climate risks will evolve, there is some urgency here too. Reflecting this, we understand the PRA will be engaging with Senior Managers from as early as November to talk to them about what they’re doing in the capacity of their new responsibility. During those conversations, it will be important that Senior Managers are able to articulate the approach they and their firm are taking to managing climate risks and how this could evolve over time. Senior Managers should also be prepared to provide a clear view on how their firm plans to implement the initial plan on managing climate risk that the PRA required firms to have in place by 15th October.