2021 Climate Risk Management Guideline – HKMA

Part 1: Brief introduction

The 2021 Climate Risk Management Guideline was published by the Hong Kong Monetary Authority (HKMA) in July 2021.

• Primary objective

The primary objective is to assess a bank’s climate risk profile and resilience, including adequacy and effectiveness of its risk management framework in addressing climate risk.

• Applicability

The guideline is applicable to all locally incorporated banks and international banking groups operating in Hong Kong.

• Salient features of the guideline include the following:

1. The HKMA categorizes climate risks into transition, physical and liability risks.
2. The Board has primary responsibility for a bank’s climate resilience, including oversight, development and implementation of its risk management framework and overall risk appetite.
3. Risk Appetite Statement (RAS) should be reviewed at least annually, considering the evolving physical and transition impacts arising from climate-related issue.
4. In formulating climate strategy, a time horizon of over 10 years should be adopted to cater for the unique nature of climate risks.
5. Remuneration and other business policies should be consistent with banks’ climate strategy.
6. Bank should embed climate-related risk considerations into their risk management framework with timely and regular reporting to the board.
7. Responsibilities of management climate-related risks should be allocated along three lines of defense.
8. Banks should make climate-related disclosures aligned with the Task Force on Climate-related Financial Disclosure (TCFD).

Part 2: Introduction of Transition Risk

• Definition

Transition risk refers to the financial risks arising because of global governmental and economic shift toward a lower carbon-based economy which can be prompted by, for example, changes in climate policy, technological changes or change in market sentiment.

• Current Situation of GHG

Hong Kong’s total greenhouse gas (GHG) emissions in 2019 was recorded at 40.1mn tons of CO2e, down 2% YoY. Electricity generation remained the major source of emissions, amounting to 65.7% of total emission, following by transport (18.1%) and waste management (7.3%).

• Aim of Hong Kong government

Hong Kong aims to reach carbon neutrality by 2050 with an interim decarbonization target to reduce carbon emissions by 50% before 2035, as compared with the 2005 level. In a bid to achieve the target, the government has launched a series of measures to reduce its carbon footprint, including the Free-in Tariff (FiT) scheme which provides financial incentives to encourage private sector to invest in renewable energy. It is expected that the government will continue to introduce more aggressive actions in the future.

• Hong Kong have started to incorporate climate risk consideration into their risk management framework

HKMA published a study based on sample of syndicated loans in Asia Pacific which shows that banks in the region are estimated to charge high-polluting firms a higher lending spread by 23 basis points (bps) compared with the low-polluting firms, post Paris Agreement. This is economically significant as the transition risk premium is equivalent to a 14% rise in the average lending spread.

The analysis also shows that a green bank would charge an additional loan spread of about 9 bps compared with other banks. The study displayed that a significant share of syndicated loans for all industries is originated in Hong Kong, indicating the banks in Hong Kong have started to incorporate climate risk consideration into their risk management framework.

• Risk criteria & scenario analysis

Risk criteria such as carbon emission, energy usage and sensitivity to climate policy may be applied to assess vulnerability of exposures to transition risk.

In terms of scenario analysis, assumptions might be made for assessing transition risk which may focus on the impact of policy change (e.g. change in carbon price), technological advancements, changes in market sentiment or a combination of these factors.

Part 3: Introduction of Physical Risk

• Definition

Physical risk refers to the economic costs and financial losses resulting from the impact of climate and weather-related events. Direct impact of such events may lead to damage to property or reduced productivity and revenues, indirectly impacts may result in disruption of global supply chain.

• Current situation of physical risk in mainland China and Hong Kong

The 2020 Global China Research Colloquium provides insights that overall facilities in mainland China and Hong Kong have high climate risks. Specifically, while facilities in mainland China have high water stress and flood risks; facilities in Hong Kong have high hurricanes and sea level rise risks.

• How to analyze and monitor physical risk

For analyzing physical risks, banks may focus on the physical location of a client’s business operations and assets, potential physical disruption to the client’s supply chain, as well as the potential implication on collateral valuation.

In addition, in conducting scenario analysis for assessing physical risk impact, assumption may be made based on average global temperature increase, change in mean sea level, and the rising frequency and severity of extreme weather events.

And for monitoring the physical risk exposures of banks facilities, operations, and major outsourced arrangements, it may consider appropriate indicators that provide management with early warning of operational risk issues.

Part 4: Introduction of Liability Risk

• Definition

Liability risk is associated with emerging legal cases related to climate change. This include those seeking compensation from financial institutions which are held responsible for loss and damages resulting from the effects of climate change, or which finance companies with activities having negative environmental impacts.

• Current Situation of pollution offences

In Hong Kong, the enforcement of environmental laws is mainly carried out by the Environmental Protection Department (EPD). According to EPD statistic, it dealt with 19,647 complaints in 2020 and 14,586 YTD August 2021.

Further, the EPD carried out 658 prosecutions and fined USD3.31mn for pollution offences in 2020 and 502 prosecutions and USD1.73mn fine YTD August 2021.

• How to analyze liability risk

The pricing of liability risks is inherently complex as it involves a high proportion of high tail risks and large losses with dynamic regulatory environment. The nature and magnitude of exposures will be unique to each institution.

A report from Minter Ellison in collaboration with the UN, suggested that until meaningful tools are developed to quantify liability risks, it may be prudent to start with a high-level sectoral assessment of climate-related physical risks and litigation exposures across, for example, a bank’s loan book.

This will require collaboration between credit risk managers, sustainability professionals and lawyers. Whilst such proxies are far from perfect, but a failure to include litigation as a factor in climate risk modelling may results in the systemic underpricing of associated risks.