Climate risk management – there’s still work to do

The Prudential Regulation Authority’s (PRA) 2024 ‘Dear CFO’ letter summarising the thematic feedback from the round of written auditor reporting for IFRS 9, again (as in 2022 and 2023) emphasises the importance of identifying risks of material misstatement in the context of climate risks. For Climate related risks the letter is broken down into 3 key areas:

• Observations of best practice in the market
• Short-term areas of focus
• Medium-term areas of focus

Best practices and areas for improvement

The PRA noted several best practices emerging among firms in addressing climate risks in loan portfolios. These include:

• Expanding risk assessments: Some firms have broadened the range of loan portfolios, including unsecured loans, which are subject to formal climate risk assessments.
• Increased use of quantitative analysis: Firms are using quantitative reviews to identify immediate and emerging risks and to assess the most relevant risk drivers for key portfolios.
• Considering additional risk drivers: More firms are examining risks beyond the obvious ones, such as supply chain disruptions and refinancing risks, as they relate to climate factors.
• Climate risk horizon scanning: Inclusion of climate related risk into the horizon scanning process and consideration of the impact from potential changes in policy.

Again, the PRA called out the need for some firms to expand their assessment on portfolios to include a more bottom-up approach that allows risk assessments to consider drivers that could impact borrowers’ ability to service their debt and underlying collateral values. The letter refers to the consideration of impact on both PD and LGD as best practice.

A dynamic balance sheet approach to climate related risk is also identified with concerns that a static balance sheet approach may underestimate some of the risk – particularly at points of future refinance.

On the corporate side, the better practice called out was the development of frameworks to support these assessments. Frameworks such as scorecards that helped with the identification of counterparties where climate change was expected to have an impact.

Near-term areas of focus

Given the best practice described above, areas of focus on the near-term were:

• For firms to challenge the completeness of the climate-related risk drivers used to identify potential impacts and those portfolios most at risk – which includes the consideration of a dynamic balance sheet approach.
• Review the completeness of model assumptions and overlays to ensure the risk of under prediction is low.
• Enhance and utilise analytical approaches to ensure the identification and quantification of climate risks are robust and less reliant on qualitative risk assessments and required PMAs are supported by data driven quantitative analysis.
• Increase the granularity of portfolio assessment, aligned to a bottom-up approach that consider the impacts on PD, LGD and EAD exploring sector level vulnerabilities to climate risk.
• For corporate exposures, ensure the assessment of climate risk is embedded into BAU processes including ensuring the right level of challenge is given to understand a firm’s overall exposure to climate related risks – and how this may impact ECL.
• Consider and include climate related information in economic scenarios – either through the incorporation of climate related variables, or a range of climate-based downside scenarios.

Medium-term areas of focus

Over the medium-term the PRA expects firms to focus on:

• Enhancement of underlying data and models to ensure climate related risk are included in individual loan ECL estimates.
• Develop stronger second line capabilities that allow the risk teams to understand and challenge how models and scenarios are used to calculate ECL climate-related risk drivers.

How 4most can help?

• 4most’s award winning SME Green Scorecard approach allows lenders to develop scorecards focused on ESG outputs and allows an assessment and ranking individual portfolio This allows lenders to understand the level of climate related risks on their portfolio and any high risk/concentration issues they may have, in turn, allowing the lender to know where to focus their resources.
• 4most’s default approach to climate risk modelling is a bottom-up approach that allows the individual assessment of account and counter party risks on both PD and LGD aligned with a top-down view of the climate related macro-economic impacts. The module-based approach allows for the model to be built around firms existing IFRS9/Stress Testing models.
• Watch this space – we will soon be launching our climate scenario development tool that allows users to create their own tailored bespoke scenarios – allowing for a wider range of sensitivity testing and impact assessment.

Get in touch if you are interested in learning more about how we can support your organisation manage climate related risks – info@4-most.co.uk.