Challenges of the next stage on the path to climate action

In a relatively short period of time, society has accelerated its awareness of the need to incorporate sustainability as a fundamental pillar of how we act. In a coordinated manner, at international level we have defined ambitious objectives that, with a strong sense of urgency, point to a far-reaching change in our productive economies in order to avoid the adverse consequences of climate change. Regulators and supervisors have also become aware of the risks arising from climate change, both at the level of individual portfolios and at systemic level, and are increasing requirements for financial institutions regarding the analysis and management of these risks.

For their part, banks have moved to take the lead and to assume their share of the complex challenge of reducing the impact of our actions on the climate. This entails:

• First, a realignment of their credit portfolios, with a strengthened commitment to sustainable finance, enabling them to seize opportunities in key sectors.
• In addition, it is essential for financial institutions to integrate into their decision-making the identification, assessment and management of the financial and non-financial risks induced by climate change.

Both the proper measurement of emissions and the analysis and management of risks involve the use of models and methodologies which, while bearing some resemblance to general equilibrium macroeconomic models or scenario analysis, must be adjusted to accommodate three characteristics inherent to climate change:

1. the past cannot be used to predict the future,
2. time horizons extend over decades, minimising the confidence margin of traditional models, and
3. they must be sufficiently flexible to incorporate external information derived from expert opinion or scientific knowledge.

Despite their complexity and limitations, these models can help facilitate decision-making in uncertain environments, which may lead to a reallocation of portfolios as well as an adjustment in asset prices as climate risks are incorporated.

In general terms, we can conclude that the lack of an adequate classification of ESG criteria and the risk they may generate, the absence of data, methodological complexity, the mismatch between the time horizon of today’s decisions and their impact in the future, as well as the multitude of data providers and rating agencies, are some common obstacles across the different methodologies analysed, which undoubtedly hinders appropriate progress in integrating ESG criteria into banks’ risk management.

Finally, there are also other types of challenges for climate risks to be fully integrated into traditional banking risk management:

• The first of these challenges relates to the need to strengthen knowledge and training in a comprehensive manner across all teams on aspects related to sustainable finance, and more specifically among risk analysts and executives, so that they can properly interpret the constraints of the models used.
• Second, it is necessary to address climate risks in a comprehensive and strategic manner, avoiding potential biases arising, for example, from complacency that could lead institutions to develop their own methodologies lacking the necessary rigour, but which might give the impression that the problem is being solved.
• Lastly, there is a fundamental challenge in ensuring the production and disclosure of homogeneous, high-quality information that covers a sufficiently broad perimeter to encompass the entire value chain of an economic activity.

In short, the full integration of ESG factors into decision-making, and more specifically climate considerations, poses fundamental challenges for companies and financial institutions. In this necessary transformation process to address the risks arising from climate change, and the opportunities that are also generated, Spanish banking has demonstrated firm resolve and a high level of commitment. The objective is now clear, and the route to achieve it has begun to be mapped out.

Here you can view the full document ‘Assessment of the Spanish banking sector’s commitment to climate action‘