How Do ESG Activities Affect Default Risk of Firms?
By Mete Tepe, Per Thastrom, and Robert Chang It is an open question as to how default risk is affected by Environmental, Social, and…
Climate risks can no longer be ignored or considered tail risks. The increased frequency and severity of extreme weather events has prompted the Securities and Exchange Commission (SEC) to issue a proposal intended to protect investors and address public interest. If adopted, the new rules would require SEC registrants to become more transparent about the climate risks they are facing and how they are mitigating these risks.
Operational and legal impacts will be significant for companies of all sizes, however, the complex nature of accounting for risks down to an asset-level, make banks and lenders particularly vulnerable to the proposed rule. Banks and other lenders face a particularly difficult disclosure situation. With regards to their transition risk: their primary emissions are indirect “financed emissions”. These emissions are particularly challenging to measure as they require data at the customer and product levels as well as associated emission factors. Inaccurate reporting on transition risk exposure could lead to serious reputational and compliance risks.
Moreover, the difficulties in assessing the physical risk on portfolios should not be underestimated. For institutions with large portfolios, physical climate risk assessments at the asset level poses challenges. Granular mapping of climate risks to assets through a geospatial layer may be required. Advanced climate models may be needed for forward looking assessments. For transition risk, banks, and lenders face assessment challenges specifically in the context of financed emissions. Financed emissions, are difficult to measure due to numerous data collection and methodology challenges.
We encourage you to download the complete White Paper to better understand the core elements of the SEC proposal and learn more about the implications for financial institutions, with a focus on banks and lenders. We believe that an underappreciated opportunity for climate risk management is to regularly incorporate physical and transition risk assessments into loan reviews. Compliance with the SEC proposal will require robust, auditable, and integrated systems and may naturally fit in the loan review process. We conclude our White Paper by providing key considerations for achieving compliance in fiscal year 2023.