What this means:

The growing concern among financial regulators about climate-related and environmental risks is down to a growing understanding of the systemic threat they pose to the financial system, not necessarily through the event itself, but the consequences of it.

For example, a flood in and of itself might be mildly disruptive to a credit union, but the knock-on consequence may be a sizeable number of members will be unable to insure their homes in future creating financial risk, particularly where mortgage lending has been provided.

This ‘transmission’ of climate risks into financial risks has been described by the Network for Greening the Financial System (‘NGFS’).

The process for managing climate-related and environmental risks will be familiar to credit unions, who should broadly follow the 4 steps of:

Identification – consider plausible events linked to climate change like flooding and then consider the potential knock-on consequences. In the example below we map various climate risks through plausible transmission channels to show how they might manifest as credit risk;

Assess – as with all other risks, prioritise based on a risk assessment which will generally be a form of Likelihood X Impact.

Integrate – ensure climate risks are integrated into the credit union’s overall risk management framework.

Manage – as part of the existing risk management framework, continually monitor and mitigate climate risks.

Unique characteristics

In approaching climate-related and environmental risks, it will be helpful to consider their unique characteristics. These are considered in depth by the TCFD but in essence we should be conscious that these risks are novel in nature (i.e. we have no frame of reference and our understanding will evolve over time). We will likely also be required to consider their impacts over much longer time-frames than would be common for our traditional risks.

Scenario Analysis

A scenario analysis is a useful tool for strategic and risk-management decision making under complex and uncertain conditions. It involves considering a potential future scenario for society, and then rating the likelihood of our identified risks and opportunities being realised under that scenario.

The NGFS have designed a number of hypothetical and plausible scenarios with climate scientists and economists. They provide a common and up-todate reference point for understanding how climate change (physical risk) and climate policy and technology trends (transition risk) could evolve in different futures.

Each scenario was chosen to show a range of higher and lower risk outcomes. They are used by NGFS for central banks and supervisors. An example of the scenarios they have identified are set out below;

Worked example for credit unions

In the basic example below, risks are rated for their likelihood under two scenarios described by the NGFS. Notice how, where Net Zero is achieved, the likelihood of physical risks is lower as the worst consequences of climate change are averted but the transitional risks are higher because this comes at the cost of stricter policy interventions. By contrast, in scenario 2, if current policies only stay in force, physical risks are higher but there is no change to transitional risks relating to policy intervention.

Steps that won’t take much effort:

• Begin the process of identifying risks and opportunities. Remember to not necessarily be on the look out just for events themselves like increased temperatures, instead think through to the knock on consequences of how those increased temperatures will impact agri-borrowers for example.
• Categorise risks and opportunities under physical (climate change) and transitional (policy, technology, market and regulatory change).
• Begin the process of assessing and prioritising the risks and opportunities identified using an Impact X Likelihood score or other methodology that is familiar to you. Especially in the beginning, the goal should not be to determine an exhaustive list, instead try to identify which are the smaller number of key risks with the potential to put the lights out.

Steps that will have a big impact:

• Integrate climate-related and environmental risks into your overall risk framework. Insofar as possible, map the risks to your existing risk categories, as in the example given above where different physical and transitional risks manifest themselves as a credit risk.
• Choose relevant scenarios, the work of the NGFS is incredibly helpful in this regard. Analyse each of your identified risks and opportunities under your chose scenarios.
• Ensure all staff involved in the management of risk, and all officers responsible for the oversight of risk are familiar with the unique characteristics of climate-related and environmental risks and have undertaken sufficient training where necessary.

Resources:

Risk Workshop from the TCFD –

https://assets.bbhub.io/company/sites/60/2022/02/TCFD-Risk-Management-Workshop.pdf

Scenario Analysis Portal from the NGFS –

https://www.ngfs.net/ngfs-scenarios-portal/