Principles For Climate Related Risk

Guest Post by James Kline (first posted on CERM ® RISK INSIGHTS – reposted here with permission)

On December 8, 2022, the Federal Reserve System published Principles for Climate-Related Financial Risk Management for Large Financial Institutions in the Federal Register. This piece discusses the principles published in the register.

Purpose

The purpose of the publication of the principles is to receive comments on the high-level framework for the safe and sound management of exposures to climate-related financial risks and the consequences of transitioning to a lower carbon economy. (1) The guidance is for financial institutions with $100 billion in assets.

The principles have been reviewed by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. This was done so all principles are consistent among organizations.

Risks Identified

The Federal Reserve indicates that “Effective risk management practices should be appropriate to the size of the financial institution and the nature, scope and risk of its activities” (2) Further, risk management practices need to be common sensical.

The types of climate events that require risk management include hurricanes, wildfires, floods, heatwaves, and chronic shifts in climate including higher than average temperatures and changes in participations patterns.

The types of risk associated with a transition to a lower carbon economy are those that could affect households, communities, businesses, and governments due to property damage, or altering income.

The register lists risks area an organization should consider when developing mitigative strategies. These are:

1. Climate-related financial risks
2. Liquidity Risk – climate related risk which could adversely impact the organization’s liquidity.
3. Data Risk Management – having the capabilities of identifying and managing data related to environmental impact on the organization.
4. Operational Risk – how climate related issues could adversely impact daily operations.
5. Legal/Regulatory Risk – consider how risk mitigation efforts affect and are affected by laws and regulations governing the organization. For instance, does the mitigation effort adversely and disproportionately affect communities on a prohibited basis such as race and ethnicity.

Questions to be Answered

As noted above, comments are being sought on the general principles set forth in this post. The Federal Reserve wants comments on three questions.

1. In what ways, if any, could the draft principles be revised to better address challenges a financial institution may face in managing climate-related risks?
2. Are there areas where the draft principles should be more or less specific given the current data availability and understanding of climate-related financial risks? What other aspects of climate-related financial risk management, if any, should the Board consider?
3. What challenges, if any, could financial institutions face in incorporating these draft principles into their risk management framework?

To respond to these questions would require a treatise of considerable length and complexity. I would also have to deal with two basic questions. Should the federal government be involved in mandating climate-related risk management? Is there really a climate-related crisis that requires such action? Both questions are contentious.

To avoid too much controversy and a lengthy discussion I will make some general observations and let the reader decide if he/she wishes to respond to the above questions.

Observations

1. The Biden Administration is pushing climate-related risk. This is a government wide approach, as noted in the fact that the principles presented are consistent with those adopted by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.
2. While the focus is on climate -related risks, the administration is pushing an Enterprise Risk Management (ERM) approach. This can be seen in the identification of Data Risk Management, Operational Risk, and Legal/Regulatory Risk as Climate- related risks. This can also be seen in NIST’s approach to cyber-security. (3)
3. Most of the institutions impacted by these principles probably take climate-related risks into account. These organizations are not small, localized institutions. They are regional, national, or international organizations. Thus, the adverse impact of hurricanes, draughts, wildfires, and floods, which are generally geographic specific, are already factored into their lending calculations and operations.
4. The most problematic issue is the transition to a lower carbon economy. The extent to which financial institutions are discouraged from lending to fossil fuel related industries can run afoul of an organization’s fiduciary responsibility to manage customer’s money wisely. It might also subject the organization to discriminatory lawsuits.

Endnotes

1. S. Federal Register, 2022, Principles for Climate-Related Financial Risk Management for Large Financial Institutions, Vol 67, No 235, docket no OP – 1793. Page 75267.
2. Ibid page 75268. https://www.govinfo.gov/content/pkg/FR-2022012-08/pdf/2022-26648pdf.
3. Cyber Security and Enterprise Risk Management, CERM Insights #393, November 14, 2022.

BIO

James J. Kline has a PhD from Portland State University. He has worked for the federal, state, and local government. He has consulted on economic, quality and workforce development issues. He has authored numerous articles on quality and risk management. His book “Enterprise Risk Management in Government: Implementing ISO 31000:2018” is available on Amazon. He edited “Quality Disrupted” which is also available on Amazon. He can be contacted on LinkedIn or jamesjk1236@outlook.com