Hong Kong proposes climate risk management guidelines for banks
On 20 July 2021, the Hong Kong Monetary Authority (HKMA) issued draft guidelines (the Draft Guidelines) on the management of climate-related risks by authorised institutions (AIs). The Draft Guidelines further develop the HKMA’s approach to climate risk, initially outlined in its June 2020 White Paper on Green and Sustainable Banking, and incorporate leading international standards and practices to provide comprehensive climate risk management guidance for banks in the areas of governance, strategy, risk management and disclosure.
In this Blog Post, we highlight key aspects of the Draft Guidelines and takeaways for AIs considering how to approach these new proposals in Hong Kong. For more information about evolving regulatory approaches to climate disclosure and risk management around the world, please see our comprehensive analysis, Climate Disclosure and Risk Management: Global Approaches.
The HKMA’s Climate Risk Framework
The HKMA has drawn upon the work of the Task Force on Climate-related Financial Disclosures (TCFD), the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and the Basel Committee on Banking Supervision to develop its approach to climate-related risks. Conceptually, the HKMA adopts the TCFD approach to classifying climate-related risks into both physical and transition risks, with an additional category of liability risks:
- Physical Risks include the impacts of climate and weather-related events and long-term progressive shifts in climate (e.g., heatwaves, floods and sea-level rise).
- Transition Risks include the financial risks related to the process of adjusting to a lower-carbon economy (e.g., changes in climate policy, technological changes and changes in market sentiment).
- Liability Risks are associated with emerging legal cases related to climate change (e.g., individuals seeking compensation from financial institutions that finance companies with activities having negative environmental impacts).
Against this framework for understanding climate-related risk, the HKMA highlights several unique characteristics of climate change that differentiate it from conventional financial risks, including:
- Far reaching breadth and magnitude: Climate change will affect all agents in the economy, across all sectors and geographies.
- Foreseeability, but uncertainty as to timing and outcome: There is a high degree of certainty that physical and transition risks will materialise, but the exact timing, outcome and future pathway of these risks remain uncertain.
- Irreversibility: There is high degree of confidence that climate change will have irreversible effects once a threshold amount of greenhouse gasses are emitted into the atmosphere.
- Dependency on short-term actions: The magnitude of impact will be determined by actions taken today by a wide range of stakeholders, including governments, central banks and supervisors, financial market participants, firms and individual households.
In light of these significant differences, climate-related physical, transition and liability risks must be managed differently from other conventional financial risks.
The following sections of this Blog Post highlight key takeaways from the Draft Guidelines for AIs as they design and develop an approach to the unique challenges presented by climate change.
Governance: Key Takeaways
- Climate Risk is a Board-Level Issue: While senior management is responsible for the proper functioning of an AI’s risk management framework, including with respect to climate-related risks, the board is primarily responsible for an AI’s climate resilience.
- Climate Capacity & Culture are Key: Both the board and senior management should understand global, regional and local climate-related developments and consider the related impacts on the AI. The board should also cultivate a risk culture that embeds climate-related considerations into the AI’s business activities and decision-making process.
- Consider Setting Climate Goals: AIs will not be required to set climate goals, but the HKMA notes that failure to address stakeholders’ climate-related concerns can impair competitiveness, reputation and long-term resilience. Accordingly, the HKMA encourages AIs to actively explore setting clear climate goals in line with global and local developments. A climate goal could take the form of a public commitment to reduce Scope 1, 2 and/or 3 greenhouse gas emissions against a benchmark over a period of time.
- Incorporate Climate into Existing Risk Appetite: The board should review and consider how to integrate climate risk into the existing risk appetite framework. In doing so, the HKMA suggests considering the risks posed by climate change over different time horizons, as well as AIs’ strategic goals, risk-taking capacity and the results of any relevant materiality assessment, stress testing exercise and scenario analysis.
Strategy: Key Takeaways
- Climate Risk is a Strategic Issue: Given the unique characteristics of climate change highlighted above, physical and transition impacts will broadly affect the business environment and the deployment of resources going forward. AIs must formulate and implement a dedicated and effective climate strategy to remain competitive and resilient as risks and opportunities evolve.
- Consider a Range of Strategic Factors: The HKMA asks AIs to consider the influence of internal and external factors when formulating climate strategies. Internal factors include existing climate capacity among staff and management, risk management structures and data systems. External factors include government policies and regulation, emerging technology and stakeholder sentiments. These strategies should incorporate input from various stakeholders, ranging from clients to regulators, and consider long time horizons of over 10 years.
- Implement Climate Strategy Across Business Functions: To implement climate strategies effectively, organizational structures and business processes should support effective co-ordination among different business and operating units. The HKMA suggests establishing inter-departmental climate-related working groups. In any event, each unit taking part in climate strategy implementation should have clearly defined roles and responsibilities.
- Consider Climate-related Remuneration & Resources: Remuneration policies and practices should align with an AI’s climate strategy. The HKMA asks AIs to consider specifically integrating climate into their remuneration systems, for example by linking variable remuneration to the achievement of climate-related targets (e.g., greenhouse gas emission reduction targets). AIs are also encouraged to devise a plan to enhance their data collection processes, as the HKMA notes the current data systems of AIs may not be adequate to properly manage the unique characteristics of climate-related risks.
Risk Management: Key Takeaways
- Address Climate Risk Management Systematically: The HKMA expects AIs to put in place and regularly review documented policies and procedures to manage climate-related risks in a proactive manner. AIs should allocate risk management responsibilities across the three lines of defence: (1) the business units where risks are taken, (2) risk management and compliance functions and (3) internal audit.
- Leverage Existing Approach to Traditional Risk Types: The HKMA asks AIs to identify the potential effects of climate-related risks through the lens of traditional risks types including credit, market, liquidity, operational, legal, reputational and strategic risks. AIs can refer to existing HKMA guidance on these risk types, in addition to the Draft Guidelines, to develop appropriate responses.
- Assess Impacts at Portfolio, Counterparty and Operational Levels: AIs should assess material climate-related impacts at different levels. For example, AIs can refer to guidance from the TCFD and national economic and meteorological data to determine geographies and business sectors that are at relatively higher risk of climate-related impacts. At the portfolio level, AIs can identify high risk portfolios based on exposure to these geographies and sectors, while counterparty-level assessments might seek to identify concentration risk with respect to the same areas. At the operational level, AIs should assess whether their own facilities, operations and major outsourced arrangements are prone to physical risks.
- Begin Scenario Analysis and Stress Testing: AIs should build their capability to measure climate-related risks using various methodologies and tools and adopt climate-focused scenario analysis and stress testing. While the HKMA will account for the nature, scale and complexity of an AI’s business activities in assessing these arrangements, it is clear AIs should start implementing relevant programs now. Analyses should consider a range of scenarios and may incorporate the climate-related scenarios developed by the NGFS and the Representative Concentration Pathways developed by the Intergovernmental Panel on Climate Change.
- Monitor and Report Exposures at Portfolio, Counterparty and Operational Levels: AIs should ensure risk exposures are consistent with the board-approved risk appetite at all levels. At the portfolio level, AIs can monitor simple metrics including percentage of exposures to high-risk sectors and carbon intensity of financed projects. At the counterparty level, AIs can develop and regularly refer to a list of high-risk counterparties to control exposures. At the operational level, AIs can monitor and assess internal metrics. In all cases, the board and senior management should review timely and regular reports on climate-related risk exposures.
- Control and Mitigate Risk As Appropriate: AIs should control and mitigate risk at the sectoral, counterparty and operational levels. Sectoral measures may include lending thresholds and exclusion policies. At the counterparty level, AIs can reflect climate-related risks in pricing decisions and loan-to-value limits. Operationally, AIs should consider measures to safeguard business continuity in the case of extreme weather events.
Disclosure: Key Takeaways
- Adopt the TCFD Recommendations by 2023: The HKMA has explicitly endorsed the implementation of the Recommendations of the TCFD in the Draft Guidelines, and AIs should now prepare to make climate-related disclosures aligned with the TCFD Recommendations. The HKMA expects AIs to make their first TCFD-aligned annual disclosures by mid-2023 and, in any event, no later than 2025.
Comment Period and Implementation Period
The Draft Guidelines are open for comment until 20 August 2021, following which the HKMA will review comments received and issue final guidelines. The HKMA currently proposes a 12-month period for AIs to implement the final guidelines. While the regulator will take a pragmatic approach to reviewing AIs’ progress in light of the practical challenges of implementation, the HKMA may approach individual AIs to understand their work plan and progress during the implementation period.