Over the past year, it has been rare to see a day without a climate change risk - related announcement by a financial institution, banking industry organisation or regulator. And a number of them touch on governance issues.

 

For example, the EBA “sees a need for institutions to proportionately incorporate ESG risks in their internal governance arrangements.” In its Discussion Paper on management and supervision of ESG risks, it states  that “those governance arrangements should cover the management body and its ‘tone at the top’, remuneration policies aligned with long-term interests, business strategy, objectives and values of the institution. There should also be a clear allocation of tasks and responsibilities related to those risks as drivers of prudential risk, and adequate internal capabilities and arrangements for effective management of climate-related risks.”

In Switzerland, the FINMA proposal on disclosure also has an impact, as banks will need to provide information about how they identify, monitor and manage climate change risk, as well their governance structure and risk management framework around it. The Swiss Bankers Association has also published a position paper on sustainable finance in Switzerland.

Banks need to set up proper governance around climate change risk. So what does that mean in practice?  

1. Responsibility clearly assigned at board level

Climate change risk and its impact on other financial and non-financial risks will eventually become a standing item on the agenda at board meetings; therefore there should be clear ownership by the board, and one individual should be tasked specifically with oversight of this issue.  Climate change risk should not be dealt with just as a corporate governance issue, but should also be monitored and managed as a strategic opportunity and key risk driver.

The management of climate change risk and its implications for the bank should also become a regular item on the agendas of board committees, such as its risk committee, audit committee, remuneration committee and nomination committee (See figure below).

2. A senior executive accountable for climate risk management

In the UK, the Prudential regulation authority (PRA) went beyond issuing recommendations and requires the responsibility for the financial implications of climate change risk to be assigned to a Senior Manager governed by the Senior Management Function (SMF) regime. That means that climate change risk is explicitly included in the SMF’s statement of responsibilities.

Which senior manager is best placed to take on the responsibility for climate change risk?

It could be the CEO, or another member of the senior executive team, such as the CRO, COO or CFO. Or it could be a new C-suite member: a Chief Sustainability Officer (CSO)¹. Choosing who should be responsible will depend on several factors:

• The progress made so far by the bank on its journey to tackle climate change risk. If it is at an early stage, the CEO might take charge, in order to establish climate change risk as a priority concern. If the bank is already well advanced in taking measures to deal with climate change risk, it may be appropriate to give the responsibility to the CRO for instance.
• The expectations of the investors and clients. If they consider that climate change risk is a major concern and that the bank is acting too slowly, appointing a CSO may be an appropriate solution.
• Individual Motivation. The individual senior executive most passionate about the need to tackle climate change may be the best choice, in order to ensure commitment.
• Where expertise resides. Although concerns about climate change are still relatively new, the availability of training and certification in the subject is increasing and some individuals may therefore be more qualified than others for the role.

3. Alignment of incentives

No change of behaviour and shift in priorities is complete without an alignment in remuneration structure. A change in the incentive structure at board and senior executive level will result in the management of climate change risk becoming embedded in a bank’s strategy. Key metrics targets such as a ‘green asset ratio’ (as proposed by the EBA), or GHG emissions targets could be introduced to drive change.

4. Gaining confidence in the effectiveness of climate change risk management

As it is still an emerging issue, banks might struggle to gather and report relevant and reliable data about climate change risk. Boards of directors have to establish an internal control system for managing the risk, and seek regular assurance from the bank’s control functions or internal/external auditors about its effectiveness.

For the integration of climate change risk into a bank’s governance, there is no ‘one size fits all’ and the optimal framework will depend on the size of the bank, its clients and risk exposures, and also on its maturity in terms of sustainability strategy. But what is clear is that it is an issue that cannot be ignored going forward.

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¹Future of the Chief Sustainability Officer, survey by Deloitte and the IIF, February 2021

 

 

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