Environment and Climate could be sources of Financial Risk

  • 5 September 2019
  • Blog | Risk Management | Green Finance | Blog


There is a growing consensus in recent years among financial institutions worldwide that environment and climate-related risks could be sources of financial risk, through either physical channel – disrupting global markets through physical events and impacts, or transition channel – posing financial risks during the transition to a low-carbon and environmentally- friendly economy.

This consensus has led to collective actions, particularly after the creation of the G20 Green Finance Study Group. In 2017, eight central banks and financial regulators gathered and formed the Network for Greening the Financial System, or the NGFS, aiming to identify, quantify, and regulate financial risks related to the environment and climate change, with three separate workstreams.

The supervisory workstream (WS1) that I am chairing on behalf of the People’s Bank of China, reviews existing supervisory practices for integrating environment and climate risks into micro-prudential supervision, takes stock of the current institutional disclosure frameworks for environmental and climate information, and examines the extent to which default rates differentiate between green and “brown” assets.

Over the past few years, supervisory authorities have attempted to size the financial risks from climate and environment through Environmental Risk Analysis (ERA), using both quantitative and qualitative methods to evaluate short and long-term financial exposures. However, the integration of climate and environment-related factors into prudential supervision is still limited. The most significant barriers include lack of taxonomy of green and/or brown assets and the unavailability of data.

Limited data availability, is, in many cases, due to the absence of a consistent and comparable classification of “green” and “brown” assets, and remains a major barrier towards identifying the default rate differential. So far, only

China and a few other countries have set explicit definition on green loans. Statistics on Chinese green loans reveal an average default rate of 0.34%, which is much lower than the portfolio average of 1.8%. With the support of such evidence, lowering the risk weight for green assets can greatly reduce the financing cost through cutting down the level of provisions for credit losses, as opposed to extra government spending into the credit market, which underscores the importance of further data collection on green loan default rate across jurisdictions.

Meanwhile, as information disclosure is fundamental to supervision, most authorities already have in place or are planning to implement certain environmental disclosure requirements for their entities, but there are still discrepancies across jurisdictions, regarding the content and methodology, while investors and market participants will benefit from a more standardized framework.

The Task Force on Climate-Related Financial Disclosures (TCFD), established by the Financial Stability Board, has made a set of voluntary recommendations. These recommendations have received broad support and recognition from financial institutions and even corporations, which points to the possibility of a global standardized framework on these disclosures.

Challenges remain to be tackled in the coming years. In 2019, the supervisory workstream will continue its work on both the compilation of the current best practices and methods of ERAs, to provide a guidebook for its members, and the exploratory data collection on default rate of both green and “brown” assets within banks and regulators that already possess internal definitions or taxonomies, to help identify the default rate differential. In the broader context of capacity building, it will also provide technical assistance on the establishment of definitions and taxonomies for its members.

Read the Sustainable Finance Report here.