Climate change has continued to be recognized as an environmental issue that poses potential economic and financial risks that could threaten the stability of capital markets. As the world continues to transition from an economy that is heavily dependent on fossil fuels, like coal and oil, to a more sustainable low carbon economy, the financial services sector must adapt to this ever-changing landscape. Financial institutions failing to adapt run the risk of financial fallout as well as potential reputational loss.
DTCC TV: Addressing Climate-Related Risks in FMIs
In the last few years, we have seen firms take initiative to better understand, address and mitigate these risks, including implementing climate-related disclosure requirements as well as conducting climate-specific scenario analysis to assess the effects of climate-related risks on the financial services industry. However, it is important to note that the impact of climate risk on individual organizations can differ based upon the role they play within the industry.
While financial institutions face exposure to climate risk through their financing activities of specific carbon-intensive companies and their direct lending activities, financial market infrastructures (FMIs) have extremely limited exposure to this transition risk. This transition risk is well within the parameters of credit, liquidity, market, operational and other risks that FMIs are already managing. Further, as special purpose intermediaries facilitating the post-trade settlement of financial transactions amongst parties and managing the attendant risks that remain outstanding between execution and settlement, FMIs also face shorter risk horizon exposures than other financial institutions, such as insurance companies or banks.
While a growing number of global regulatory and policymaking actions have focused primarily on banks and other financial institutions that provide credit, given that they are more directly exposed to climate-related financial risks, little attention has been paid to the impact of these risks on FMIs. A recent DTCC white paper looked at climate-related financial risk from the perspective of FMIs and how these risks can be mitigated using current tools and frameworks.
International regulation can help address climate risks
Global regulation has undoubtedly been a key driver in fostering awareness and accountability when it comes to climate risks in financial services. Across the globe, we see regulation increasing to address climate risks in the finance sector.
In APAC, regulators in Australia, China, Hong Kong, Malaysia and Singapore are in the process of introducing requirements and guidelines for financial institutions to manage climate-related risks. While regulatory guidance varies across the Asia Pacific region, climate-related scenario analysis is a key area of focus. Efforts are also underway to align policies with global standards; however, the developing economies in Asia have the added challenge of balancing sustainability objectives with economic and social development goals. Indeed, the increased focus on sustainability also benefits developing economies, as there are lower barriers for them to build even more resilient and sustainable economies and industries from the onset.
The European Union has perhaps been the most proactive when it comes to recognizing and addressing climate risks. The European Green Deal aims to make the EU climate-neutral by 2050 and to achieve this, sustainability targets have been included in policymaking, while a handful of supervisory authorities have incorporated climate-related targets into their mandates, such as the ECB and ESMA.
In the United States, we have seen a more specific focus on the impact of climate risks for FMIs. The rules and regulations that govern the operations of U.S.-based FMIs originate from various domestic and international sources. These include international groups, such as the Board of the International Organization of Securities Commissions (IOSCO) who, in 2012, in partnership with the Committee on Payment and Settlement Systems at the Bank for International Settlements, issued the “Principles for Financial Market Infrastructures” (PFMI), a set of principles for the effective operation and management of FMIs.
Internationally developed standards like the PFMIs contain effective guidance on FMI risk management that these organizations can use to address the emergence of climate-related financial risk in their functions and operations. While not every one of the PFMIs is likely applicable for all FMIs, policymakers and market participants should employ a “reduce, recycle, reuse” practice to make use of existing standards to address climate-related financial risk, both now and in the future.
For example, Principle 2 of the PFMIs states, “An FMI should have governance arrangements that are clear and transparent, promote the safety and efficiency of the FMI, and support the stability of the broader financial system, other relevant public interest considerations, and the objectives of relevant stakeholders.” In observing this principle, we believe that an FMI’s governance should contemplate climate-related financial risk for the purposes of supporting the stability of the broader financial system and the objectives of relevant FMI stakeholders, including an FMI’s participants.
In terms of climate risks, Principle 17 is particularly relevant to climate-related discussions because it addresses the operational risks facing an FMI, and states, “An FMI should identify the plausible sources of operational risk, both internal and external, and mitigate their impact through the use of appropriate systems, policies, procedures and controls.” One of many potential sources of operational risk is physical risk to the FMI’s operations posed by the effects of climate change. Additionally, Key Consideration 7 notes that key participants, including service and utility providers, may pose operational risk to an FMI. Finally, the principle itself mentions the “plausible” sources of operational risk, and Key Consideration 6 discusses “significant” risks of operations being disrupted.
Given their unique position in the financial ecosystem, FMIs are well placed to address and minimize any climate-related risks in accordance with the existing PFMI principles. When considering any new rules or mandates related to FMIs and the impact of climate risk, policymakers should first apply existing FMI regulatory frameworks and standards to effectively mitigate future climate-related financial risk challenges. The PFMIs that were created by CPMI-IOSCO contain effective and adaptative guidance that should be applied for this purpose. This would allow for the identification of new risks sooner, more dynamically, and in a holistic way that evaluates and addresses risks while continuing to protect financial markets.
This article was originally published to Regulation Asia on June 16, 2023.