In the past century, the Earth’s temperature has increased about 1.2 degrees Celsius. This rate of global warming might sound inconsequential, but it represents a faster rise in the Earth’s temperature than during any other period throughout the past sixty-five million years.
DTCC TV: Addressing climate-related financial risks
These environmental changes could have significant implications, including impacts on global and local economies, as well as the financial markets. It also raises questions with respect to the potential effects of climate change on financial market infrastructures (FMIs). Due to the specific role FMIs play in the global financial markets, their exposure to climate-related risk is distinct from other entities. Additionally, thanks to the processes and controls FMIs employ to preserve financial stability, financial infrastructure providers are well-positioned to address climate-related risks. Because of their systemic importance, FMIs should continue to focus on understanding the magnitude of risks that climate change poses to stakeholders so they can effectively mitigate their exposure.
Understanding Physical Risk, Transition Risk and the Rise of Green Bonds
There are two categories of climate-related physical risk: acute and chronic physical risk. Acute physical risk pertains to growing threats as a result of an increase in the severity or frequency of extreme weather events. These threats may create several negative consequences, including financial losses due to the damage or destruction of real estate, equipment, infrastructure and other assets. Acute physical risks often occur over a period of days or weeks. Chronic physical risk arises from events that typically materialize over longer time periods, impacting economic costs and creating financial losses, such as an increase in temperature and rising sea levels.
When considering these risks, FMIs are directly exposed to acute physical risks, given that extreme weather events could damage or destroy infrastructure and equipment, which may impact operations and/or cause financial losses. Fortunately, FMI business continuity programs have proven to be sufficiently robust to mitigate this type of risk. Their exposure to chronic physical risks, on the other hand, is much more indirect and slow-moving. As such, current FMI risk models should be adequate to cover this type of exposure. Also, FMIs have indirect physical risk exposure via financial institutions that leverage those FMIs.
Separate from physical risk, transition risk refers to the possibility of economic losses associated with the process of shifting towards a low-carbon economy. The entities that are directly exposed to transition risk are primarily carbon-intensive or “brown” companies and their suppliers. However, transition risk could also impact banks and other financial institutions, albeit more indirectly, to the extent they have interests in and financial commitments to such carbon-intensive companies. FMIs, on the other hand, are far less exposed to transition risk, which represents a third-order type of exposure that is even smaller than the impact to financial institutions. Additionally, the risk horizon of FMIs is considerably shorter than that of financial institutions, an important factor for FMIs given that most forms of transition risk often take many years, if not decades, to materialize. As a result, the potential impact of transition risk on FMIs is a third-order effect that does not represent uncovered exposure.
At the same time, the rise of green bonds could have financial risk implications. These fixed-income securities are used to raise capital to fund specific climate-related projects or other activities that promote environmental sustainability. As the market for green bonds and other sustainability-focused debt instruments grows, it is important that the industry conduct adequate due diligence around these investments to ensure they meet their intended purpose. In the absence of this, a so-called “green bubble” could develop and introduce risks to the financial system. From an FMI perspective, green bonds should not be given preferential treatment if used for collateral purposes or with regard to other risk management considerations.
Related: How existing FMI principles can address financial climate change risks
Addressing Climate-related Risks
FMIs are well-equipped to address climate-related risks because their processes and controls are designed to withstand extreme levels of operational and financial stress. In addition, and as mentioned above, FMIs’ short risk horizon makes them less susceptible to certain forms of climate risk that could emerge over longer timeframes. As FMIs look to increase their focus on climate-related risks, CPMI & IOSCO’s Principles for Financial Market Infrastructures (PFMIs) provide effective guidance that FMIs can apply holistically across their functions and operations. In the U.S., the CFTC, Federal Reserve and SEC have implemented these internationally developed standards, which are tailored to help FMIs fulfill their mandate of preserving financial stability.
FMIs should also consider expanding their business continuity plans to include their exposure to climate-related physical risk. Doing so will help to ensure plans and procedures are able to effectively monitor and manage physical risk exposure in the face of global warming. For example, DTCC recently added climate-related trending metrics to its business continuity programs to reduce the company’s operational risk exposure.
When it comes to counterparty credit risk, DTCC has also begun to incorporate an evaluation of each clearing member’s exposure to climate-related financial risk into its overall assessment of credit risk. Specifically, the firm has reviewed climate-related financial risk disclosures from its publicly traded full-service members and has started asking due diligence questions related to physical and transition risk. Currently, the lack of established industry best practices and mandated disclosures by supervisory authorities means that disclosures and responses from clearing members sometimes lack depth and consistency, but we expect the quality of information to improve over time.
In support of this, several regulators around the world have proposed using scenario testing to attempt to quantify climate-related financial risk. While scenario analysis has long been a helpful tool to understand potential impacts of certain events, it relies on having precise quantitative data to input into the scenario, and it is equally dependent on having robust causal relationships between the inputs and the outputs of the scenario testing. Given that neither of these prerequisites are currently well-developed with respect to climate-related risks, the application of scenario testing to analyze this type of risk is currently challenging.
As a way forward, FMIs should continue to bolster their business continuity plans and member assessments to ensure the industry and firms are protected. It is important to note, however, that climate-related risk impacts financial institutions and FMIs in very different ways. First, given the nature of their activities, FMIs are less directly exposed to climate-related transition risk than financial institutions. Second, the risk horizon of FMIs is typically much shorter than that of financial institutions. When it comes to regulatory frameworks, FMIs should continue to focus on the PFMIs, given that these principles are specifically designed to help FMIs fulfill their primary mandate, which is to safeguard financial stability. Continuous risk management enhancements that are guided by the PFMIs as a comprehensive regulatory framework will ensure that FMIs adequately mitigate their exposure to climate-related financial risk and, in doing so, will enable them to continue to protect global financial markets.
For more insights on FMIs and climate-related risk, read the full report from DTCC.
This article was originally published to GARP’s Climate Risk & Sustainability Resource Center on July 13, 2023.