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1 Editors I Editors Ma Jun (Special Advisor to PBC Governor; Chair of NGFS Supervision Workstream; Director of Center for Green Finance Development at PBC School of Tsinghua University) Ben Caldecott (Director, Oxford Sustainable Finance Programme COP26 Strategy Advisor for Finance, Cabinet Office, UK Government) Ulrich Volz (Director of the SOAS Centre for Sustainable Finance Senior Research Fellow at the German Development Institute) Disclaimer II Disclaimer With the exception of chapter 1, the views and opinions expressed in this volume are those of the authors alone and do not reflect those of the Central Banks and Supervisors Network for Greening the Financial System (NGFS) or the editors. Table of Contents III Table of Contents Table of Contents IV Table of Contents V List of acronyms VI List of acronyms AAL Average Annual Loss BAU Business-as-Usual BCBS The Basel Committee on Banking Supervision BGS Brown-Green-Score BMBF German Federal Ministry of Education and Research BMG Brown-Minus-Green CARIMA Carbon Risk Management CGE Computable General Equilibrium COGs Cost of Goods Sold DSCR Debt Service Coverage Ratio EAD Exposure at Default EBITDA Earnings Before Interests, Taxes, Depreciation and Amortization EL Expected Loss EP Exceedance Probability EPR Extended Producer Responsibility ERA Environmental Risk Analysis ESG Environmental, Social and Governance EVs Electric Vehicles FIs Financial Institutions GIZ The Deutsche Gesellschaft fr Internationale Zusammenarbeit GmbH IAMs Integrated Assessment Models IAIS International Association of Insurance Supervisor ICBC Industrial and Commence Bank of China IEA International Energy Agency IIASA The International Institute for Applied Systems Analysis IOs International Organizations List of acronyms VII IPCC Intergovernmental Panel on Climate Change IPSF International Platforms for Sustainable Finance IRB Internal Ratings Based Approach JGCRI Joint Global Change Research Institute KRI Key Risk Indicators LGD Loss Given Default LTV Loan-to-Value NCD Natural Capital Declaration NCRA Natural Capital Risk Assessment NGFS The Network of Central Banks and Supervisors for Greening the Financial System NPLs Non-Performing Loans OECD Organization for Economic Co-operation and Development PD Probability of Default PIK Potsdam Institute for Climate Research RCRA Resource Conversation and Recovery Act RMS Risk Management Solutions RCP Representative Concentration Pathway SSPs Shared Socioeconomic Pathways TCFD Task Force on Climate-related Financial Disclosures TEV Total Economic Value UNEP United Nations Environment Programme VaR Value-at-Risk VfU Verein fr Umweltmanagement und Nachhaltigkeit in Finanzinstituten e.V. / German Association for Environmental Management and Sustainability in Financial Institutions Glossary VIII Glossary1 Business-as-usual (BAU) Also referred as Baseline or Reference, describing scenarios based on the assumption that no mitigation policies or measures will be implemented beyond those that are already in force or legislated or will be adopted.2 Collateral An asset or third-party commitment used by a collateral provider to secure an obligation vis-vis a collateral taker.3 Credit risk The potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.4 Environmentally unsustainable asset Polluting or high carbon asset, according to the terminology commonly used in the financial industry. ESG integration An SRI strategy that aims at enhancing traditional financial (risk) analysis by systematically including ESG criteria in the investment analysis to enhance risk-adjusted returns.5 ESG scoring The scoring methodologies assessing a companys performance in environmental, social and governance aspects based on different approaches, such as generating a final numeric score based on weighted scores of indicators in the three dimensions.6 Exposure The inventory of elements/assets exposed to a hazard or risk.7 Green asset Asset that provides environmental benefits in the broader context of environmentally sustainable development.8 1 Definitions, unless otherwise indicated, are taken from the occasional papers or this report. 2 Adapted from IPCC reports (Allen, M. R., Barros, V. R., Broome, J., Cramer, W., Christ, R., Church, J. A., Dubash, N. K. (2014). IPCC fifth assessment synthesis report-climate change 2014 synthesis report. Intergovernmental Panel on Climate Change, Geneva, Switzerland.). Note that BAU is defined at a general conceptual level here, thus the acute definition of it depends on the purposes of the studies and varies in terms of detailed assumptions. 3 Adapted from glossary of online database of European Central Bank (2020), All Glossary Entries, retrieved April 2020 from ecb.europa.eu/home/glossary/html/glossc.en.html 4 Adapted from BCBS. (2000). Principles for the Management of Credit Risk. 5 Adapted from NGFS. (2019). A sustainable and responsible investment guide for central banks portfolio management. 6 Note that ESG scoring methodologies vary according to users and purposes, thus the definition here is a general conclusion based on some ESG scoring practices by institutions like AXA Investment Managers (2020), Our framework and scoring methodology. retrieved from axa- methodology 7 Adapted from background papers commissioned by the Global Commission on Adaptation to inform its 2019 flagship report: Stadtmueller, D., Jarzabkowski, P., Iyahen, E., Chalkias, K., Clarke, D., (b) the debtor is assessed as unlikely to pay its credit obligations in full without realization of collateral, regardless of the existence of any past-due amount or of the number of days past due.13 Operational risk The risk of losses resulting from inadequate or failed internal processes, people and systems or from events, including legal risks, but excluding strategic and reputational risks.14 Physical risks Economic costs and financial losses resulting from the increasing severity and frequency of extreme climate change-related weather events (such as heat waves, landslides, floods, wildfires and storms) as well as longer term progressive shifts of the climate (such as changes in precipitation, extreme weather variability, ocean acidification, and rising sea levels and average temperatures), and rises in sea levels. In addition, losses of ecosystem services (e.g., desertification, water shortage, degradation of soil quality or marine ecology), as well as environmental incidents (e.g., major chemical leakages or oil spills to air, soil and water/ocean) also fall into the category of physical risks.15 9 Adapted from background papers commissioned by the Global Commission on Adaptation to inform its 2019 flagship report: Stadtmueller, D., Jarzabkowski, P., Iyahen, E., Chalkias, K., Clarke, D., TCFD (2017), Final Report: Recommendations of the Task Force on Climate-related Financial Disclosure. 17 Adapted from BCBS. (2009). Principles for sound stress testing practices and supervision. 18 Adapted from NGFS. (2019). First comprehensive report: A call for action: Climate change as a source of financial risk. In its work, the NGFS has incorporated the risk associated with emerging legal cases related to climate change for governments, firms and investors, e.g. liability risks, as a subset of physical and transition risks. See also footnote 15. 19 Adapted from Kumar, R. (2014). Strategies of banks and other financial institutions: Theories and cases: Elsevier. 20 Adapted from FSA Japan. (2020). Insurance Underwriting Risk Checklist and Manual. 21 Adapted from background papers commissioned by the Global Commission on Adaptation to inform its 2019 flagship report: Stadtmueller, D., Jarzabkowski, P., Iyahen, E., Chalkias, K., Clarke, D., costs of data and accessing resources to conduct analysis; missing standards and norms that hinder the use and flow of data; a lack of transparency into data and methods used, resulting in a trust deficit among users; and underdeveloped internal capabilities to analyse and interpret data and analysis to aid decision making. The NGFS is committed to helping the entire global financial system quickly overcome these barriers, so environment-related risks can be properly measured and managed, and that is why I am excited to see the publication of our first NGFS Occasional Paper, Case Studies of Environmental Risk Analysis Methodologies. This anthology contains dozens of examples of environmental risk analysis in practice, with chapters written by a wide range of different research providers and practitioners. The methods and tools they describe can be used by wide range of different financial institutions, including banks, asset managers and insurance companies. While we are not recommending any particular service or provider, the point of the paper is to showcase the scale and pace of innovation currently underway. The Occasional Paper is relevant to all central banks, NGFS members, as well as non-members. It offers valuable insight into the state of environmental risk analysis and many technical details that will be helpful for financial institutions and supervisors. The fact that it showcases the adoption of environmental risk analysis by some financial institutions in the world will also serve as an important inspiration for many others to follow suit. The views expressed in the Occasional Paper are those of the individual authors, and do not necessarily reflect the views of the members and observers of the NGFS. Finally, I would like to thank all those that contributed to this report, particularly the editors of this Occasional PaperProf. Ben Caldecott and Prof. Ulrich Volzas well the NGFS Preface XII Secretariat and Dr. Mas team including Dr. Sun Tianyin, Dr. Li Jing, and Zhu Yun for their great efforts in organizing the participating authors and editing this volume. SynopsisofEnvironmentalRiskAnalysisbyFinancialInstitutions 1 SynopsisofEnvironmentalRiskAnalysisby FinancialInstitutions By CentralBanksandSupervisorsNetworkforGreeningtheFinancialSystem 1 1 Introduction ThisNGFSOccasionalPaper, Case Studies of Environmental Risk Analysis Methodologies, aims toprovideacomprehensivereviewofthetoolsandmethodologiesforEnvironmentalRisk Analysis(ERA)usedbyafewdozenfinancial institutions(FIs)includingbanks,assetmanagers andinsurancecompanies.Theterm“environmentalrisks”usedinthisdocumentreferstoboth environment- and climate-related risks. Climate-related risks areasubsetofthebroader categoryofenvironmentalrisks. AsstatedintheApril2019NGFSComprehensiveReport,environment-relatedrisksreferto risks(credit,market,operationalandlegalrisks,etc.)posedbytheexposureoffinancialfirms and/orthefinancialsectortoactivitiesthatmaypotentiallycause or be affected by environmentaldegradation(suchasairpollution,waterpollutionandscarcityoffreshwater, landcontamination,reducedbiodiversityanddeforestation)andactionstoaddressthese environmental challenges. Climate-related risks refer to risks posed by the exposure of financialfirmsand/orthefinancialsectortophysicalortransitionriskscausedbyorrelatedto climatechange(suchasdamagecausedbyextremeweathereventsoradeclineintheasset valuesofcarbonintensivesectors). Environment-andclimate-relatedrisksassociatedwithenvironmentallyunsustainableassets are still underestimated by many FIs, while many green and low-carbon investment opportunitiesareunder-appreciatedbythem,causinganexcessiveallocationoffinancial resources to environmentally unsustainable assets and under-deployment of financial resourcestogreenassets.Thismisallocationofresourcesreflectsmanyinstitutional,policy and technical problems that contribute to the difficulties in measuringandpricing environmentalexternalities.Inareasofgreenfinance,theseproblemsinclude,tonameafew, thelackofcleardefinitionsofgreenandenvironmentallyunsustainableassets,inadequateor lackofuserfriendlyenvironmentalandclimatedata,thelackofpublicknowledgeandcapacity toconductERA,andthelackofpolicyandregulatoryincentivesforgreenfinancialactivities. Basedonthedetailedcasestudiescontainedinthefollowingchapters,thisintroduction providesanaccessiblereviewofthetoolsandmethodologiesdevelopedbyFIs,third-party serviceproviders,researchinstitutionsandNGOs.Thesetoolsandmethodologiescovera wide-range of environmental/climate scenario analyses and stress tests as well as environmental,socialandgovernance(ESG)analysisandnaturalcapitalriskassessment,that canbeusedtoanalyzethepotentialimpactonFIsfromtransitionandphysicalrisksassociated withclimateandotherenvironmentalfactors.Thisintroductionalsoidentifiesmajorbarriers 1 This chapter is a condensed version of NGFS publication on Overview of Environmental Risk Analysis by Financial Institutions. Link: titutions.pdf Chapter 1 2 to the wider adoptions of ERA by the financial services industry and concludes by recommending several steps for stakeholders to help enhance the awareness of the need for ERA, develop capacities and ERA datasets, support pilot projects, and promote the disclosures of ERA results (including stress tests and scenario analyses). The rest of this introduction is divided into four sections. Section 1 presents a taxonomy of environmental risks, explains how these risks may translate into credit, market, underwriting, and operational risks for FIs, and highlights the importance of these risks by reviewing literature on the potential magnitude of financial losses they may cause. Section 2 reviews the ERA tools and methodologies that have been developed by financial institutions, third party services providers, research institutions, and NGOs. Section 3 discusses the major gaps between research and application of ERA tools. Section 4 presents a number of recommendations for stakeholders, including FIs, central banks and regulators, industrial associations, NGOs and academic institutions on how to promote ERA in the financial industry. Classification of environmental risks According to the G20 Green Finance Study Group (2017), NGFS (2019a), and other literatures such as Ma et al. (2018), the environmental and climatic sources of financial risks can be mapped to two key risk categories physical and transition risks2: 1) Physical risks that arise from the impact of extreme climatic events (such as exacerbated extreme weather events), rises in sea levels, losses of ecosystem services (e.g., desertification, water shortage, degradation of soil quality or marine ecology), as well as environmental incidents (e.g., major chemical leaks or oil spills to air, soil, water or ocean); 2) Transition risks that arise from human efforts to address environmental and climate challenges, including changes in public policies, technological breakthroughs, shifts in investor or public sentiments and disruptive business model innovations. Physical and transition risks have many categories and subcategories. For instance, “extreme weather events” as physical risks include tropical cyclones and typhoons
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