Lean, Green, Risk Machines

"It could be argued that big business got us into this mess, but they are also likely to be the ones that get us out of it in the end," says Stephan Harrison, director of Climate Change Risk Management (CCRM), a scientific climate change consultancy developed at Oxford and Exeter University. Even climate change scientists recognise that the leading financial services institutions have the necessary political leverage and economic force to help fight climate change. And thanks to the media’s ongoing obsession with all things green, raised consumer awareness is driving demand for green financial products and institutions. Being green has become an essential requirement for all financial services firms; doing nothing is now a major reputational risk issue.

The UK-based Carbon Disclosure Project (CDP) is an independent, not-for-profit organisation that is working to build a dialogue between shareholders and the corporations they invest in, about the implications climate change could have for shareholder value and commercial operations. This is well supported by the asset management businesses of global banks – from ABN Amro all the way to Zurich Kantonal Bank.

In late March, Merrill Lynch announced a three-year global partnership with CDP – the lobby group will benefit from its expertise in capital markets, carbon trading, investment banking and advisory services to accelerate the collection and disclosure of key corporate climate change data from more and more companies.
It will also play an important part in enabling CDP to pursue new projects to expand its reach and raise awareness of the importance of corporate climate change reporting and accounting. Previously, Merrill Lynch used CDP data to launch the investment bank’s Capital Protected Carbon Leaders Europe Index Certificate in 2007.

Every year, CDP sends out a request to thousands of companies to disclose their greenhouse gas emissions and report on their strategy for dealing with risks and opportunities associated with climate change. CDP 5 was conducted in 2007, and some 79 per cent of respondents said they considered climate change to present a real commercial risk. The risks identified were grouped into four primary categories: physical, regulatory, competitive, and reputational.

The physical risks associated with climate change to financial institutions will be considered in the final article in the series.

The associated regulatory risks are more difficult for banks to predict and plan for, as climate change legislation is now moving very quickly.

"There are two main risks associated with climate change, one is the actual physical change of the climate but the other is the change in the regulatory environment," says Alexander Pohl, London-based senior project manager, environmental risks, HSBC Insurance Brokers. "The regulatory environment has been very reactive to the scientific evidence and arguments around climate change. The introduction of congestion charging and the low emission zone in London happened very quickly, and regulatory changes such as these can change some of our client industries overnight."

Industry guidelines

There are currently 13 climate change bills in front of the US House and Senate; most propose carbon capping or carbon trading programmes. In advance of this legislation, Citi, JP Morgan Chase and Morgan Stanley recently launched the Carbon Principles, climate change guidelines for advisers and lenders to power companies in the US. "The Carbon Principles were developed ahead of impending legislation in the US and will allow us to finance and approach contracts from utility companies in a more environmentally positive way," says Swati Patel, head of citizenship for EMEA at Citi in London.

Similar to the Equator Principles – industry guidelines for assessing the environmental risks of project finance initiatives – the Carbon Principles incorporate an enhanced due diligence framework to help lenders better understand and evaluate the potential carbon risks associated with coal plant investments and for the three banks to factor these risks and potential mitigants into the final financing decision. The signatory financial institutions have pledged to: encourage their clients to invest in cost-effective energy efficiency measures, taking into consideration the value of avoiding carbon emissions; encourage clients to invest in low-carbon, renewable technology; and consider investments in conventional or advanced generating facilities to ensure reliable electric power supply to the US market. The principles also support regulatory and legislative changes that facilitate carbon capture and storage to further reduce CO2 emissions from the electricity sector.

As one of the signatories to the Carbon Principles, Citi regards itself as taking a leadership role in the defence against climate change. "Citi has been instrumental pushing the green agenda forward, especially in the past year," says Patel. "Ten months ago Citi announced a $50 billion commitment to climate change over the next 10 years, which will include investment in clean energy technology and reassess how we look at green issues. One of the main driving forces for this investment has been from our clients; they want us to look at green issues because they are already looking at them from their own individual perspectives."

HSBC has embarked on perhaps the most high-profile green campaign through the launch of green investment products and involvement in many international climate change initiatives. "HSBC took a strategic decision a few years ago that they didn't want to just follow the market, they wanted to be trailblazers," says Pohl. "Over the past few years, HSBC has become carbon neutral, we are a leading advocate of the Equator Principles, and have participated in a number of leadership UN initiatives and the HSBC Climate Partnership – where we have pledged $100m over five years to work with four world-class environmental charities too."

HSBC also recently appointed the high-profile climate change economist Nick Stern as its specialist adviser to the board of directors on a number of strategic areas around economics and climate change.

Involvement in international climate change initiatives such as these addresses both the competitive and the reputational risks categories flagged by the CDP. Financial services firms need to raise both their awareness of the direct impact of climate change on their business model and their profile as a green institution to cater to client demand, which at the same time allows them to remain competitive with their peers, many of whom are following similar green policies.

That said, banks are adopting widely varying ways of implementing green policies and procedures. The most savvy are introducing green procedures that allow them to maximise opportunities. "For every major risk associated with climate change there is also a major opportunity," says Harrison. "Sensible financial institutions will presumably be doing an audit of the risks they face but also thinking seriously about some of the ways they can engage in emerging markets and reduce their carbon footprint, if only because they know their customers will demand it and give them extra space in the market."

New priorities

At HSBC, climate change risk has been identified as a priority for this reason. Pohl says: "One of our strategic areas is sustainability, and we pride ourselves in managing it comprehensively as we have everything from the Equator Principles to lending guidelines, through to having it built into our specific business unit level operational risk matrixes. HSBC has looked at all its direct impacts and put in processes and procedures to manage those.

"We have a number of strategies around climate change from an opportunity perspective. So if we can help companies doing brown field redevelopment from a lending perspective and an insurance perspective, suddenly a risk we have learned how to manage very well becomes a strategic opportunity," he adds.

As well as working on the Carbon Principles, Citi has established a carbon trading desk within its commodities business in response to demand from clients, which it is also making use of to become carbon neutral. Traders are getting excited about a global emissions scheme that is predicted to be worth $1 trillion within 20 years. But HSBC's Pohl is not so convinced due to the regulatory uncertainty. "Climate change is creating new regulatory drivers and that is where a lot of the uncertainty is," he says. "On the one hand a number of banks have invested heavily into carbon trading and carbon funds, but the regulatory environment is only certain until 2012."

Aside from the business opportunities it presents, managing the reputational risk is likely to be the most difficult. "Citi has several internal and external green initiatives, which could be considered as a part of a holistic approach to the management of reputational risk," says John Wertheim, EMEA regional head of op risk at Citi in London. "Internally, Citi has focused on building and maintaining environmentally friendly offices as well as encouraging staff to contribute to energy saving initiatives. However, the more material components around reputational risk management relate to how we do business, who we do business with and how we manage business relationships."

A recent PricewaterhouseCoopers (PwC) survey found that respondents regarded reputational risk as the greatest threat to their market value. But financial services organisations are finding it difficult to build such hard-to-measure risks into conventional risk monitoring, analysis and mitigation procedures.

Having environmental policies in place is one way to demonstrate green credentials. "Leading companies have started to formally integrate consideration of corporate responsibility risks into existing risk management systems (including integration into Op Risk Registers), and have followed the 'gross risk, less mitigation measures in place equals net risk' approach, prioritising management attention on residual material net risks," says Phil Case, assistant director, sustainability and climate change at PwC in London. "A further development has been the trend for companies to convene specialist Reputational Risk Committees, accompanied by governance structures that seek to ensure issues with potential for reputation risk are elevated to the correct level for decisions to be made."

HSBC includes environmental impact as part of its internal op risk framework in the group's risk identification matrix. "When our businesses are asked to carry out their self assessment activity to assess impact and likelihood and effectiveness of controls they should be taking climate change and environmental issues into account," says David Breden, London-based managing director, HSBC operational risk consultancy, strategic risk consultancy practice, HSBC Insurance Brokers. "When we look at the potential impact of climate change on our businesses, it is very difficult to predict what the world will look like. This makes it ideal for scenario analysis, which allows the business to explore the impact of a certain set of circumstances. This should lead to considering possible management responses, so for example if the business model proposes you should expand mortgage lending in southern Europe, and your climate change scenario suggests increasing desertification in that area in the next 20 years, then that will probably make you revisit your business strategy."

No regrets

Scientists warn against depending on climate change models, however, as there are too many uncertainties of the impact on a regional level. "One of the big emerging issues is about uncertainties in projections of climate change, especially at the regional level," says Harrison. "Every time I talk to businesses, I tell them not to be uncritically swayed by the climate models, because they are large scale and tell you about the large-scale evolution of the climate system. But climate models display real uncertainty at the regional level, which is the information businesses need to determine what is going to happen to their clients and supply chains in the future."

But this doesn't translate well when you are trying to model climate risk, which is a problem. "Rather than refer to climate models, firms should be looking at 'no regret' strategies," he adds. "Firms should base their policies on a broad range of probabilities or projections."

As with many risk management programmes, compliance with green process can be tracked automatically. "Having these polices and principles in place helps us to understand environmental issues and deal with them appropriately," says Citi's Patel. "For example, we use an environmental and social risk management system, the Environmental and Social Risk Register, that looks at all our policies and helps us understand our risks from an environmental perspective and to then put it into a qualitative format we can use to advise senior management. To date we have got all this information from 14,000 touchpoints both internally and externally, and we have 500 managers trained to use it."

Green issues could also become a legal obligation, particularly for senior managers. "HSBC publishes a sustainability report that is voluntary, but under the UK Companies Act Operating and Financial Review guidelines, the review you do as part of your annual report has to identify all material risks to the business; environmental-related risks are included in those material risks," says Pohl. "

Looking further forwards still, it is conceivable that the evolution of Pillar II of the Basel II Accord, which refers to the management of all other material risks, climate risk or green risk could become a recognised risk that has to be measured, managed and mitigated against. But some are not so convinced. "Pillar II does refer to reputational risk – which may be argued to encompass green risk – but it is very difficult to quantify," says Wertheim. " Notwithstanding the lack of quantitative measures, there is no lack of attention to the management of reputational risk at Citi."

One thing is clear; banks need to fundamentally shift the way they look at climate change risk and think beyond their traditional exposures if they want to remain in business.

Victoria Pennington is deputy editor of OpRisk & Compliance, the monthly magazine that covers regulatory initiatives and features on implementing operational risk and compliance frameworks within financial services firms.

A version of this article first appeared at OpRisk & Compliance