What’s next in addressing climate-related financial risk?

It has become undeniable that banks and other financial institutions will need to grapple with the risks associated with climate change, from a perspective of capital commitment as well as stakeholder disclosures. Last year saw unprecedented recognition that climate change threatens global financial systems, creating risks of physical harm to people, property, and assets (known as “physical risks”), and causing shifts in policy and behavior to mitigate climate change that can increase stressors on certain sectors (“transitional risks”):

• Last May, President Biden ordered financial regulators to assess climate-related financial risk, and to report on their approaches and recommendations to identify and mitigate those risks;
• In October, the Financial Stability Oversight Council (FSOC) issued a report (FSOC Report) detailing the risks posed by climate change to the financial system;
• In November, the acting head of the of the Office of the Comptroller of the Currency (OCC)—the bureau tasked with regulating banks—called on the boards of OCC-regulated banks to “promote and accelerate improvements in climate risk management practices”;
• At COP 26, the UN’s global climate change conference, leaders recognized that the finance community will play a crucial role during the transition to a low carbon future (more details here); and
• By the end of 2021, the OCC and the Basel Committee on Banking Supervision—a global standard setter for the regulation of banks—each released Principles (the OCC’s Draft Principles and the Basel Principles) as guidance for banks (and in the Basel Principles, bank supervisors) for managing climate-related financial risk.

The OCC’s period for feedback on the Draft Principles closed on February 14, 2022, and Basel’s two days later. With those comment periods complete, and with COP26 behind us, we see five trends ahead that will impact how financial institutions consider their climate-related risk in 2022.

(1) Not just large banks

The OCC’s Draft Principles are only applicable to the largest banks—those with over $100 billion in total consolidated assets.  Nonetheless, some commentators (such as the UN Environment Programme Finance Initiative) have highlighted that climate change affects us all and may disproportionately affect smaller banks. Indeed, the OCC requested comments on whether its Draft Principles should apply more broadly, and the Basel Principles and the FSOC Report emphasized the need for risk management systems to be proportional to the size of the bank.  Some commentators, such as the Risk Management Association’s Climate Risk Consortium (RMA), a consortium of large banks, agreed, while others, like the Chamber of Commerce, argued that the Draft Principles should not apply directly to other categories of banks.  Ultimately, the standards applying to the largest banks may foreshadow examiners’ expectations for risk management at smaller banks as well, so banks of all sizes should develop plans to manage their climate-related financial risk.

(2) Importance of disclosures 

The FSOC Report emphasized the importance of better data for investors, market participants, and regulators to assess climate-related financial risk and highlighted the need for “consistent, comparable, and decision-useful climate-related disclosures.”  Secretary of the Treasury, Janet Yellen, noted in her address at COP26 that disclosures will help make the U.S. financial system more resilient to risks posed by climate change.  The SEC has requested feedback on its 2010 Guidance Regarding Disclosure Related to Climate Change, recognizing that current disclosure requirements may need to be updated.  Thus, fulsome disclosures will be an important feature of the climate-related regulatory regime.

(3) Eyes on greenwashing

President Biden recognized in his May executive order that “[t]he intensifying impacts of climate change present physical risk to assets, publicly traded securities, private investments, and companies.”  Janet Yellen acknowledged at COP26 that “[r]ising to this challenge will require the wholesale transformation of our carbon-intensive economies.”  As we increasingly recognize the importance of sustainability, market participants and banking institutions must be wary of exaggerated green claims, in no small part because regulators (in the US and abroad) are paying increasing attention to “greenwashing”—the issuance of false, misleading, or unsubstantiated marketing claims about the environmental friendliness of products or production processes.  Ensuring that all eco-claims and related disclosures are accurate and not misleading will be crucial to avoiding unwanted regulatory scrutiny.

(4) Challenges for implementation

The OCC’s Draft Principles indicate that climate-related financial risk should be factored into a bank’s overall business strategy, risk appetite, and financial, capital, and operational plans.  And the Basel Principles instruct that banks should “incorporate [those] risks into their overall business strategies and risk management frameworks.”  But how to do so is not entirely clear; while the OCC urges banks to consider climate-related financial risk in their governance, policies and procedures, strategic planning, risk management, internal reporting, and scenario analysis, it provides only high-level guidance over five pages.  The Basel Principles are similarly general, offering 12 principles for banks and six for bank supervisors.  Both sets of principles offer useful guidance, but at a level that may make implementation difficult and compliance near-impossible to measure.  Industry commentators like the RMA flagged this and other implementation challenges, requesting a more robustly defined compliance approach that accounts for the time necessary for banks to implement the desired risk management processes, as well as alignment among regulators so that banks are subject to consistent requirements.

Moreover, regulation in this area remains a political issue: the Draft Principles are a significant reversal from the OCC’s proposed rule under President Trump that would have prevented banks from cutting off funding to the oil and gas industry.  As the Institute of International Finance noted in its comments, consistency among regulators will be paramount, as an uncoordinated and rapid dispersal of policies could create a fragmented, and ultimately less effective, policy landscape.  Keeping a close eye on changes to proposed rulemaking, to regulators’ public statements, and to enforcement trends will be critical to understanding how expectations develop and change over the coming years.

(5) Changes ahead

Regulation of climate-related financial risk is still in its infancy.  The OCC indicated that it “plans to elaborate on [its] principles in subsequent guidance” based on feedback received and lessons learned. The SEC’s highly anticipated disclosure rules are expected this year.  And even though the latest round of comments may be over, we expect that regulators will continue to actively seek input from industry on these topics in the coming months and years.  

Stay on top of these developments with Freshfields’ Sustainability Blog, and contact us with any questions.