by Inge van Dijk
On November second of last year the city of Amsterdam, came very close to disaster. It had been raining heavily for weeks, very unusual even by Dutch standards. Water levels in the waters north of Amsterdam had been rising. On top of that, storm Ciarán was about to reach the coast and drive up the water to even higher levels. Normally, under these circumstances, the sluices around the city drain excess water into the North Sea. But in this case the drainage system malfunctioned. At seven o’ clock that morning, people in some of the lower lying parts of the city saw the water sloshing against their basement windows. By that time the regional water authorities were in full crisis mode and the mayor had been warned. Finally, at half past seven the lock shafts at the sluices were repaired, and the water started to drop slowly. It was just in time: the water could have risen to up to one meter in parts of Amsterdam. Afterwards, the water authorities warned that, although there had been an exceptional combination of factors at play, we are likely to see these kind of water levels more often. Because of extreme weather conditions, caused by climate change. This is just one relative minor example from my home soil. I could have also mentioned the forest fires in Australia, droughts in Africa and central America and cyclones in South East Asia.
But now I ask you to consider the following for a moment. What would you have done if you had a meter or a yard of water in your offices? Ask your staff to go to the recovery site? Or work from home? But their own homes are also flooded. They are in survival mode themselves. And how are they supposed to get from A to B in a flood zone?
This is what physical climate risk looks like in practice. And then there is also transition risk. Perhaps less spectacular, but potentially equally disruptive. Transition risk is the risk companies face as a result of the, sometimes sudden, shift in government policies and regulations, technologies, and consumer preferences. For example, the transition to sustainable policies and consumer and business preferences can disrupt supply and demand for certain types of energy and commodities. As we have seen during the 2022 market turmoil following the start of the war in Ukraine, such disruptions can result in increased market volatility. This can in turn lead to liquidity problems and losses for financial and non-financial companies. It can also make central clearing less accessible, which may raise systemic risk.
Climate risk is not something of the distant future. It is here, and it is here now. We all know it, but perhaps the realisation of what that really means hasn’t fully sunk in yet. But all of us have to deal with this risk; in all parts of the financial system. And unfortunately, climate risk does not make an exception for financial market infrastructures. So managing climate-related risk should be an important part of your risk management. Not only for your own company, but also for the sake of preserving the stability of the financial system. Because you are the backbone of the financial system. If you stop functioning, everything else does too. That’s why we as global community have a particular interest in Financial Market Infrastructures integrating climate-related risk in their risk management.
Climate transition may result in new business opportunities
In addition to risks, the climate transition may result in new business opportunities for FMIs as well. In the case of central counterparties for example, it is likely that certain energy- and commodity products that are currently not always centrally cleared, will see increased demand from investors as their role in the real economy becomes more important. Central counterparties could anticipate on these market developments by extending their product offering.
The big question of course is how to manage climate risk. That’s a question that does not always come with easy answers, I know. But the fact that you are here today shows that you are serious about this risk. That is a good start. And you are not going to regret it. This workshop, organised by CPMI and IOSCO, is meant to inspire you, to inform you, to give you the opportunity to learn from each other. And it offers my colleagues and me the opportunity to listen. To hear about the issues you run into, to hopefully answer questions you have, and to gather input in order to better understand your state of thinking in regards embedding climate risk into your existing risk approaches. CPMI/IOSCO highly values the findings and information from this workshop and will use this to decide about it’s possible future work.
Apart from this workshop, there’s more help out there for you. To start with, the Principles on Financial Market Infrastructures, or PFMI, offer high-level guidance. The PFMI do not explicitly mention climate-related risk, but they can be used as a basis to identify and manage these risks.
Of course the Principles are still pretty high-level and it can be challenging to make the translation to hands-on actions to contain climate risk. We at the Dutch central bank have therefore published a guide to managing climate-related risks, partly as an attempt to promote dialogue with the Dutch FMI sector. The purpose of this guide is to provide good practices and non-binding guidance on how an FMI can organise its processes and procedures to manage climate risk. Through these good practices, we have tried to offer possible ways of applying the Principles to climate risk. The aim is not to create additional standards, but to provide clarity and inspiration to FMI management. We published it mid-October last year, you can find it on our website.
To give you an example, take Principle 2 of the PFMI, on governance. It says: ‘An FMI should have governance arrangements that are clear and transparent, promote the safety and efficiency of the FMI, and support the stability of the broader financial system, other relevant public interest considerations, and the objectives of relevant stakeholders.’ Well, that sentence contains a lot. In our guide, we have made an attempt to translate that to good practices for the governance of climate risk management.
Two good practices
The first good practice is that an FMI considers climate and environmental risks to be a board-level issue. This means that the board – that’s you – embeds climate and environmental risks in the company’s governance, strategy, risk appetite and risk management framework. The board makes sure that climate and environmental risks are regularly put on the agenda of senior management. One of the first items could be to conduct a broad initial materiality analysis. Furthermore, the board could promote a culture of values, standards and behaviour in its organisation that encourages consideration of climate and environmental risks. And you could talk to your ecosystem: your customers, clearing members, clients and service providers about this. Since their interests and views are important to you.
The second good practice, especially when you are a large FMI, is to establish a Corporate Sustainability Office and appoint a Chief Sustainability Officer to address climate risks pro-actively. The main role of this central office is to coordinate, communicate and work with different streams to ensure a consistent climate risk strategy.
So, in short, climate risk is, as the Germans say, ‘Chefsache’: the organisation’s top decision makers should know their stuff about climate risk, they should create a workable policy, and somebody with sufficient powers should be in charge and be made accountable for it.
This is just one example, although it’s a pretty important one. If you get the governance right, a lot of other good things are likely to follow. It is worth mentioning that De Nederlandsche Bank’s initiative to publish a guide does not stand on its own. It is part of European policy makers’ and supervisors’ increased focus on climate risks. As an example, ESMA included climate risks in its latest Stress Test Exercise for central counterparties that was conducted last year. The results will be published in the second half of this year.
I’m wrapping up. All financial institutions, including FMIs, are interconnected in a global system: bankers, investors, liquidity providers, trading venues, central counterparties, central depositories, and payment systems. And as they say, a chain is only as strong as its weakest link. We hope that you, as a link in the chain, remain resilient and strong. And that you take our guidance to heart and include climate risk as a key element in your risk management.
The author, Inge van Dijk, is Director Payments, Cash & Market Infrastructure at De Nederlandsche Bank.
