Bank Negara Malaysia asks financial institutions for a substantial investment on climate risk management
Some of the most momentous announcements from Malaysia’s Joint Committee on Climate Change (JC3) conference last week came towards the end of Bank Negara Malaysia Governor Nor Shamsiah Mohd Yunus’s speech. She outlined three regulatory moves that she said Bank Negara will be taking in the ‘near term’, which she had earlier indicated would require financial institutions to commit “substantial investments to build the capacity and culture needed to make long-term shifts in business activities that support and are aligned with climate mitigation and adaptation”.
The three near-term priorities she announced for Bank Negara are:
- Considering using Pillar 2 capital requirements and supervisory assessments to encourage better climate-related risk management by ‘outlier’ financial institutions with inadequate consideration of climate risks to ‘reduce the substantial divergence’ they see now
- Begin preparations to implement industry-wide climate change stress tests at the counterparty level using the Climate Change and Principle-based Taxonomy and Bank Negara macroeconomic modeling of climate shocks ‘based on defined climate scenarios’
- Finalizing plans this year for mandatory disclosure by financial institutions of their climate-related risks.
This should be a wake-up call for financial institutions that are taking a narrow approach to climate and sustainability issues, especially climate. A limited approach may continue to work for some time on localized issues to connect with and signal support for stakeholders groups, but it falls far short of what regulators are beginning to expect. Corporate social responsibility projects are not an adequate response to climate stress tests and mandatory disclosures, let alone the possibility of increased capital requirements and additional supervisory assessments for financial institutions that lag behind.
The movement by regulators towards mandatory disclosure, stress testing and linking climate-related risk management with capital requirements fits into the process that we described in our inaugural financed emissions country report on Malaysia. We concluded this with a call for financial institutions to take our findings, and “supplement top-down analysis with bottom-up analysis of their own GHG emissions exposure through their financing and investment assets [and] top-down analyses of specific sectors driven by ‘issue-based’ analysis”.
This isn’t the end; it is just the beginning. The UNPRI’s Inevitable Policy Response influenced our analysis, and is a useful conceptual framework for understanding how financial institutions can stay ahead of the curve on climate-related risks (physical, transition and regulatory). It starts from the long-term of what must happen by 2030 to meet the Paris Agreement targets and works back until today to link long-term changes with a near-term case for action.
What is incontrovertible is that there will have to be dramatic action to address climate change to avoid the ‘hothouse world’ of massive negative physical impacts. Avoiding this outcome requires either an orderly transition beginning today where greenhouse gas emissions gradually rise in cost till they are in line with social and environmental costs, or costs rise very quickly once the physical impacts grow severe. In the former case, the there is less risk of discontinuity, while in the the ‘too little, too late’ response to avoid the worst physical effects of climate change will come with much higher cost compared to an orderly response.
Looking forward, it’s hard to pick what is the most likely path, but it is much easier to understand the mechanics involved by working backwards from 2030. Countries are making their final Paris Agreement targets in 2025, and as we see with the pre-COP 26 targets, countries are increasing their ambition as the agreement called for. In 2023, there will be a Global Stocktake of GHG emissions that can be compared with targets set this year and what’s needed by 2030 to stay within a 1.5° or 2° C temperature rise. By 2023 it will be much more apparent the likelihood of an orderly or disorderly transition and regulators will respond.
Today regulators like Bank Negara Malaysia are telling financial institutions to invest in the capacity to prepare for the likely outcomes. They understand the challenge involved in preparing for the likely risks of our future climate trajectory. Either there is a gradual rise in costs for GHG emissions intensive business under an orderly scenario or their explicit emissions costs won’t be affected for the time being, but will come suddenly with rapid internalization of external costs through carbon taxation (national or trade-related) and the direct regulation of emissions.
In either scenario, the effect for companies that financial institutions must be prepared for will include:
- A gradual erosion of profitability for GHG emissions intensive companies
- A growing embedded risk from their GHG emissions footprint, or
- significant invest made to transitioning their business model to become more resilient and less risky.
The Inevitable Policy Response is seen when regulations move from voluntary to mandatory disclosure framework, or when they go from ‘comply or explain’ to regulatory stress testing and on to higher capital requirements. This is playing out today, and it’s coordinated with skills sharing among regulators through, among other forum, the Network for Greening the Financial System (NGFS).
The path remains spelled out the same (an inevitable response) that will either follow an orderly or disorderly track. Regulators’ policy response will be dictated by whether financial institutions are prepared for an orderly or disorderly pathway and what corrective action is seen as sufficient to get them to make the substantial investments needed for their own preparations. Viewed in this light, financial institutions should expect significant additional regulation, especially if they are lagging behind what regulators are saying they expect from the industry.