CBK ought to tackle climate change risks

Central Bank of Kenya. FILE PHOTO | NMG 

By REUBEN WAMBUI MUHINDI

Summary

• Climate change is definitely one of the greatest challenges of our century and financial markets are not shielded from the ever increasing effects of climate change.
• Traditionally, central bankers did not wade in the climate change debate with climate change effects always considered more an externality than a pertinent issue within the purview of financial regulation.
• There is however a new global reality as central banks and other market authorities take a keen interest in climate change and low-carbon transition.

Climate change is definitely one of the greatest challenges of our century and financial markets are not shielded from the ever increasing effects of climate change.

Traditionally, central bankers did not wade in the climate change debate with climate change effects always considered more an externality than a pertinent issue within the purview of financial regulation. There is however a new global reality as central banks and other market authorities take a keen interest in climate change and low-carbon transition. A monumental moment was the 2015 speech by Mark Carney, Governor of the Bank of England, where he warned of climate change as a key financial stability risk which if left to chance would lead to financial crisis with current financial risks due to climate change being in no proportion compared to what is to come. This he called “the tragedy of the horizon” because climate change impacts would be felt beyond the traditional horizons of most financial actors.

Globally, there has been a wide industry effort especially in banking and insurance to address this issue. Most notable was the development of recommendations by the Task Force on Climate-related Financial Disclosures (TCFD); recommendations that companies would voluntary adopt in disclosing decision-useful, climate-related financial information. Thereafter, many other initiatives have followed including the Network for Greening the Financial System (NGFS); a network initially established by eight central banks and now with 48 members, being mostly central banks in developed countries.

Until now, the drive for climate change mitigation and adaptation by central banks and capital market regulators has been mostly within developed countries. Within the NGFS for instance, the South African Reserve Bank and the Central Bank of Tunisia are the only published African members, with more central banks expected to join. This reality though is that, climate change is equally an existential risk within developing economies like Kenya and in many cases the risk is disproportionate to the emission levels. This is a huge threat to financial stability in these economies, especially given the risk exposure for banks and insurance companies. As Patrick Jenkins would say, “climate change is the new 9/11 for insurance companies”

Given this evolution, there is a need for the Central Bank of Kenya (CBK), Capital Markets Authority (CMA) and Insurance Regulatory Authority (IRA) to lead Kenya’s financial sector in taking firm action that supports the 2015 Paris Agreement on climate action. More precisely, it is imperative for these regulators to enhance the role of the financial system to manage climate risk and harness the capacity of financiers to allocate capital to green and low-carbon investments. Given the role of banks in capital allocation within the economy, the CBK and overall banking sector will play a very significant role in determining Kenya’s carbon transition.

Risks owing to climate change are two-fold: exposure to extreme weather events such as droughts and storms (physical risk); and the risks associated with energy transition to a low-carbon economy (transition risk). Given climate trends, the magnitude of these risks is unprecedented and without decisive climate action, it is only a short time before banks find themselves with billions in stranded assets, as insurers and reinsurers hit a cliff edge in the face of historic climate-induced natural disasters. Insolvency owing to climate change will be inevitable for many financial actors globally. Granted, regulation can help avert or soften the impending risk. For context as a country, the landslides in West Pokot and current floods across the country, disastrous as they are, would be so tiny in the face of severe climate catastrophes in East Africa.

The CBK can take lead by requiring that banks integrate climate-related risks as part of financial stability monitoring and banking supervision. Banks would have to report on climate-related risk metrics in their risk management and risk reporting processes. As such, banks would be obliged to clearly define their processes for identifying and assessing climate-related risks, set up processes for managing these risks, and demonstrate how these processes are fully integrated into the bank’s overall risk management.

From experience working on climate risk, a good starting point would be for banks to include climate risk within the scope of their Enterprise Risk Management (ERM), before gradually expanding to dedicated climate risk analysis within a broader climate risk strategy in their risk management function; a climate strategy that would define how to tap into climate-related opportunities. A related regulatory aspect would be requiring banks to report their climate risk exposures by including climate risk scenarios in their scenario analysis and stress tests models. Thus banks would have to foremost design or adopt appropriate climate risk scenarios.

As it stands, many banks are already incorporating green guidelines in their credit assessment and have institutionalised ESG principles in their project finance and overall board governance. There has also been much traction in green finance and Governor Dr. Njoroge publicly championed positioning of Nairobi as a global centre for the green assessment of bonds during the NSE listing requirements for green bonds. Recently during the Sustainable Finance Catalyst Awards by the Kenya Bankers Association (KBA), Dr. Njoroge also pledged support for green finance to combat climate change.