A Status Report On Financial Institutions’ Experiences .

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Network for Greening the Financial SystemTechnical documentA Status Report on FinancialInstitutions’ Experiencesfrom working with green,non green and brownfinancial assets and a potentialrisk differentialMay 2020

NGFSTechnical documentMAY 2020This report has been coordinated by the NGFS Secretariat/Banque de France.For more details, go to www.ngfs.netand to the NGFS Twitter account @NGFS , or contact the NGFS t

Table of ContentsExecutive summary1.2.3.3Introduction: Why focus on potential risk differentialsbetween green, non-green and brown?6Classification principles71.1. What is green and what is brown?71.2. Most respondents use a voluntary classification or principle81.3. Alternative views on the use of the taxonomies and classifications10Respondents’ views on the risk aspect and risk assessmentsperformed by the industry102.1. Various motives for engaging in climate- and environment-related issues102.2.  The results of backward-looking approaches are not conclusive yet on a riskdifferential122.3.  Forward-looking approaches may be a better tool for capturing thisemerging risk.15Integration of climate- and environment-related risks into riskmonitoring appears to be a challenge for the respondents153.1. The path towards integration into risk assessment and monitoring153.2. Identified challenges and obstacles17Tentative conclusions and high-level messages to financialinstitutions19Appendix I : Defining green and brown – sector, asset, activityand value-chain aspects21Appendix II : Case study: Practical application – internalclassification25Appendix III : A summary of the Chinese taxonomy27Appendix IV : The Brazilian classification framework28Acknowledgements292NGFS REPORT

Executive summaryA point-in-time survey of how financial institutions aretracking green, non-green and brown risk profiles It is important for financial institutions to consider allrelevant risks in order to avoid suffering unexpected losses.Such losses could potentially have a negative impact onthe stability of the financial system. Against the backdropof the increasing impact from climate- and environmentrelated risks in the financial system1, financial supervisorsneed to understand how these risks are taken into accountby supervised institutions.Therefore, with the help of a select group of financialinstitutions, the NGFS has performed a survey to assesswhether a risk differential could be detected between green,non-green and brown2 financial assets. This survey focuseson the work performed by financial institutions to trackspecific risk profiles of green, non-green and brownfinancial assets (loans and bonds), develop specificrisk metrics and analyse potential risk differentials.It aims to present a point-in-time snapshot of currentpractices among financial institutions, based on theinformation these institutions have obtained up untilnow. Forty-nine banks from the following jurisdictionshave submitted their answers (anonymised in this report):Brazil, Belgium, China, Denmark, Finland, France, Germany,Greece, Japan, Malaysia, Morocco, the Netherlands, Portugal,Spain, Sweden, Switzerland, Thailand, the UK, and onesupranational. We have also received answers from fiveinsurance companies in Malaysia. shows that the institutions have not establishedany strong conclusions on a risk differential betweengreen and brownundertake a climate- and environment-related riskassessment. Most of the institutions have undertakenan operational commitment towards greening theirbalance sheets, with 57% of the respondents undertakingcommitments that affect their daily operations either bylimiting their exposure to brown assets or by setting greenor positive-impact targets. However, the survey responseshighlight that the underlying justification is not basedon an attested financial risk differential betweengreen and brown assets but rather on a more diffuseperception of risks. Most banks tend to consider theiractions to be part of their corporate social responsibilityor mitigation measures for reputational, business modelor legal risks.Backward-looking studies on a potential risk differentialhave only been performed by five respondents. Anotherthree respondents (banks) indicated that they conductedbackward-looking analysis with ESG or energy rating ofhousing loans, but not strictly using green or brown criteria.In both cases, they failed to reach strong conclusions on arisk differential between green and brown assets. Thesestudies have been limited to sub-sectors and performed ona project-basis rather than at counterparty level. Overall,it appears that it is only possible to track the risk profile ofgreen, non-green and brown assets in very few jurisdictions.An important reason for this is that the prerequisites, e.g.a clear taxonomy and available granular data, are not yetin place in most jurisdictions. These results illustrate thechallenges for banks and insurance companies to assesstheir exposure in the absence of common classificationsand the inherent limits of backward-looking analysisin a rapidly developing area.The striking result from the study was the diversityof methods, results and motivations for whether to1  See NGFS first comprehensive report “A call for action: Climate change as a source of financial risk”, April 20192  As of yet, there are no clear, uniform definitions of the commonly used terms “green”, “non-green” and “brown” are being used . We abstain fromadhering to any particular definition. Please see section III.NGFS REPORT3

Using national or international taxonomies and/orprinciples is the most common approach for classifyinggreen and brown assets In its first comprehensive report, the NGFS established theneed for a clear taxonomy3 as a prerequisite for a betterunderstanding of possible risk differentials betweendifferent types of assets4. Given the the lack of an officialtaxonomy in the majority of jurisdictions, the mostcommon approach among the respondents has beento implement and use an international or nationalclassification in the form of a voluntary classificationor principle. The second most frequent approach isto use an internally developed classification. There isa wide variety of approaches to classify assets, the mostcommon being to classify the assets by the use-of-proceedsmethod. The survey shows a growing use of climaterelated taxonomies among the respondents: only 15%of the respondents did not use any taxonomy or voluntaryprinciple, and the majority of them are consideringimplementing an international/national taxonomy in thefuture. but there are some challenges to overcome whenclassifying financial assetsThe majority of the institutions only apply their internalclassification to a part of their assets within each assetcategory (bonds or loans). Several respondents highlightthat they encounter different challenges when tryingto classify different types of assets (e.g. loans, bonds,investments). For loans in particular, whilst the classificationof single purpose loans (e.g. within project finance) mayseem quite obvious, loans for general corporate purposeshave a weaker direct link to a physical asset or a projectand seem more difficult to classify.Lack of harmonised client data and a lack of internalresources are other main challengesMany respondents stressed the lack of harmonisedclient data as the main obstacle for defining thegreenness of an asset. One root cause identified by somerespondents is the lack of legal disclosure requirementsfor companies to report verified data on a sector-specificbasis, but respondents also highlighted some limitationsof international or internal taxonomies and classifications.The respondents stressed the internal challenges posedto their organisations. The integration of climate- andenvironment-related risk assessment into their usual riskanalysis requires the build-up of internal knowledge aswell as investment to adapt existing IT systems to trackthis emerging risk.Different views on methodologies for assessing theeffective riskiness of green and brown assets The respondents provided a number of comments onwhat methodology characteristics are important forassessing the effective riskiness of green or brown assets.In particular, diverging views were expressed with regardto the question of compatibility with existing methodsor models. Some respondents take the position thatclimate-related risks can be considered in existing internalrating-based approach (IRB) standards, while others feelthat the different timeframes do not allow for this5. Somerespondents highlighted the need to consider long horizonsin a forward-looking approach through scenario analysisand forward-looking assessment of relative riskiness.In terms of the development of methodologies for theassessment of the vulnerability of counterpartiesto climate- or environment-related risks, respondentsbroadly agreed that the methodologies should considerkey environmental issues that could impact therepayment ability of clients or the value of an asset.For economic sectors, the sensitivity to key parameterscould be assessed. However, according to some institutions,it may be necessary to go deeper than the sectoral leveland perform risk assessment at an individual or corporatelevel. Some institutions are currently working on integratingcounterparty ESG factors into their credit processes and,subsequently, their risk management frameworks.3  A taxonomy can be defined as a system for organising objects into groups that share similar qualities.4  See NGFS’s first comprehensive report, “A call for action: Climate change as a source of financial risk”, April 2019, Recommendation No 6.5  The IRB model uses a time horizon of one year, but climate risks are expected to fully materialise over a longer time frame.4NGFS REPORT

Respondents mentioned a variety of environmental riskmonitoring measures including ESG scoring, Risk AppetiteStatement (RAS) limit setting, an internal capital allocationmodel, and environmental veto systems. and some respondents have entirely different viewsA few of the respondents consider monitoring of thespecific risk profiles of green or brown assets is not –and should not be – a priority in their on-going work onclimate-related challenges. Some institutions also raiseddoubts on the relevance of monitoring risk profilesbased on green and brown classifications and insistedon other more decisive risk factors.Forward-looking studies still at an early stageForward-looking studies to assess how different climatescenarios can affect different kinds of activities and assetswere performed at the portfolio level by twelve respondents(22%). Of these forward-looking studies, scenario analysesand stress tests are the most common. These types ofanalyses are typically at an early stage and often stem frominternational initiatives such as the TCFD and the UNEP FIpilot, in which some respondents participated.Tentative conclusions and high-level messages tofinancial institutionsThe survey does not allow us to conclude on a riskdifferential between green and brown assets. Overall, itappears that in all but a few jurisdictions the prerequisitesfor tracking the risk profile of green or brown assets arenot yet in place. The vast majority of institutions cannotyet conclude on the relationship between greenness andcredit risk, pending further analyses, which require a bettertagging of exposures and meaningful performance data.With those prerequisites in place, it should be possible toexpand the risk management tools already in use for moretraditional risk categories to comprise climate-related andenvironmental risks. Given the increasing magnitude ofclimate change and its impact on the financial system,forward-looking methodologies are necessary to assessthe impact on individual financial institutions.NGFS REPORT5

Why focus on potentialrisk differentialsbetween green,non-green and brown?Most local and regional prudential frameworks are based onBCBS and IAIS1 standards for banks and insurance companies.The BCBS guidelines Principles for the Management of CreditRisk2 state inter alia, that banks should identify and analyseexisting and potential risks inherent in any product oractivity3.Against the backdrop of the increasing impact fromclimate and environmental risks on the financial system4,supervisors need to better understand how and to whatextent such risks translate to financial risks. An importantpart of this work is to analyse the potential risk differentialsbetween green, non-green, and brown financial assets andhow financial institutions take these risks into account intheir credit assessments.If, for example, a consistent link between brown financialassets (such as loans or bonds) and higher default ratescould be established, financial institutions holding suchassets would need to safeguard themselves against thisincreased default risk. This would mean for example, closerrisk monitoring and setting aside more economic capital.5Regulators would probably also need to consider increasingregulatory capital requirements6 held against these assetsin order to safeguard financial stability.In 2018, the NGFS performed a preliminary stock-take ofstudies conducted by market participants on credit riskdifferentials between green, non-green and brown financialassets. The findings showed that it was not possible todraw any general conclusions on potential risk differentialsbased on the studies conducted so far. These studies alsopointed to differing results depending on the financialassets that had been surveyed, the geography and theunderlying factors the study had been able to control for.Based on this, the NGFS pointed to the need for furtherfact-gathering and analyses.The NGFS therefore decided to perform an exploratory datacollection from selected institutions. The original intentionwas to analyse the collected data, and assess whether a riskdifferential could be detected between green, non-green,brown and non-brown financial assets. However, due tothe lack of relevant and comparable data, the scope andmethodology were slightly altered. In the end, this surveydoes not allow a conclusion on a risk differential betweengreen and brown assets. However, it provides a usefuland encouraging snapshot of the current practicesamong a sample of financial institutions around theglobe to monitor climate-related financial risks andthe challenges these institutions are facing.Scope and methodology of the exerciseThe scope has been to collect information from financialinstitutions7 on how they have responded to the need totake the emerging climate-related risks into account intheir risk assessment.Given that a number of the prerequisites financialinstitutions need to do this are lacking, the exercise wasconfined to tracking the respondents’ experiences onspecific risk profiles of green and brown financial assets(loans and bonds), and the extent to which they havedeveloped specific risk metrics and analysing if respondentsdetected any potential risk differentials between such assets.1  The Basel Committee on Banking Supervision (BCBS) is the primary global standard setter for the prudential regulation of banks.The InternationalAssociation of Insurance Supervisors (IAIS) is responsible for the regulatory cooperation regarding the spervision of the insurance sector.2  https://www.bis.org/publ/bcbs75.htm3  Principle 3, article 234  See i.a. the NGFS first comprehensive report, April 20195  Economic capital is the amount of capital needed to cover a financial institution s risks in a going concern. It is basically a function of Probability ofDefault (PD), Loss Given Default (LGD) Exposure at Default (EAD) and a factor covering for unexpected losses.6  Regulatory capital is calculated along the same principles as economic capital but has been adapted to cover regulatory issues.7 In this report we define financial institutions as only banks and insurance companies.6NGFS REPORT

This exercise aims to present a point-in-time snapshot ofcurrent practices among financial institutions based oninformation they have obtained up to now.Another objective has been to collect information on thedifferent methodologies used to classify and assess climateand environmental risks at the asset, activity, borrowerand/or industry level. The aim is to arrive at a snapshot ofcurrent leading practices in financial institutions and alsodescribe challenges encountered.An information request was sent to large internationalbanks identified by members and observers of the NGFS,(in one jurisdiction it was also sent to large insurancecompanies). The request for participation was on a voluntaryand anonymous basis. Names of individual institutionstherefore do not appear in this report.1.  Classification principles1.1.  What is green and what is brown?An important starting point in the analysis of risk differentialsis defining what is meant by green, non-green and brownlabels. As the NGFS concluded in its comprehensive reportin 2019, there is no clear definition of these labels. The NGFSidentified a clear taxonomy around green, non-green, brownand non-brown activities as a prerequisite for deepeningits analytical work on, amongst other issues, possible riskdifferentials between different types of assets.8 Whileefforts are being made to move in this direction, mostjurisdictions9 did not have an official taxonomy in use atthe time this survey was conducted. This was also reflectedin the respondents’ answers.In their replies, respondents used different terms, suchas climate, climate- and environmental, green, and thebroader ESG. In some cases, respondents also incorporateddifferent aspects into the same term. As a result, it is possiblethat respondents are categorising the same asset differently.For example, some respondents define palm oil asgreen since it could replace aircraft fuel. This representsa pure climate perspective. Other financial institutionsconsider palm oil to be unsustainable, referring to theenvironmental problems that are related to deforestationand monoculture issues associated with palm oil treeplantations.Another important aspect in the analyses of risk differentialsis the need to clarify if the labels used are applied to physicalassets, financial assets or activities, as this also affectshow and to what extent it is possible to analyse how thegreenness or brownness affects e.g. the credit risk of acounterparty. This is further elaborated upon in Appendix 1.This chapter aims to outline the different definitions andtaxonomies used or developed by industry participantsthemselves in the absence of a common global taxonomytaking the above-mentioned challenges into account.It should not be seen as a complete description oftaxonomies and classification systems. To learn moreabout each of the taxonomies, classifications and principlesdescribed in this chapter, interested readers are referred torelevant webpages or Appendices 3 and 4 of this report.Furthermore, the chapter does not aim to compare orevaluate different approaches.Taxonomies, classifications and principlesThe following definitions will be used throughout thereport, and each taxonomy, classification, and principlehas been assigned to one of the definitions: Taxonomy A taxonomy (established or underdevelopment) that has been awarded an official statusand is mandatory. We identified the following taxonomiesas applicable to the respondents of our survey:– The EU Taxonomy10– The Chinese Taxonomy118  See NGFS’s first comprehensive report, “A call for action: Climate change as a source of financial risk”, April 2019, Recommendation No 6.9  Please see exceptions listed below under the definition of “taxonomy”.10  The European Parliament and the president of the European Council agreed on the text of a EU-wide taxonomy in December 2019. -finance-teg-taxonomy en (Accessed 2020-01-16)11  Please see Anne

A point-in-time survey of how financial institutions are tracking green, non-green and brown risk profiles It is important for financial institutions to consider all relevant risks in order to avoid suffering unexpected losses. Such losses could potentially have a negative impact on the stability of the financial system. Against the backdrop

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