By Laura Canevari
In late October, 2019, Acclimatise led a training workshop which aimed to strengthen the governance and risk management structures of Mexican banks, in relation to social, environmental and climate risks. The training workshop was funded by the Inter-American Development Bank and the GIZ (the German Corporation for International Cooperation), with the support of the Asociación de Bancos de México (ABM) and was held in Mexico City. Facilitated by Laura Canevari of Acclimatise, and Dr Chiara Trabacchi, an independent consultant, the training was well attended by more than 40 representatives from over 20 banks. This included: Banco Azteca, Bancomext, Bancoppel, Banobras, Banorte Banregio, CIBanco, Fira, Nafin Santander and Scotiabank, among others. The Mexican banking regulator – Banxico – was also in attendance during the event which served as a reminder to participants that aligning to best governance and risk management practices and to the TCFD recommendations will help ensure their sustained viability and competitiveness and that of Mexico.
This article reviews the rich array of findings from this training workshop, including lessons drawn for important sectors of the Mexican economy, including tourism, real estate and agriculture. While these findings focus on the Mexican context, other banks may find them useful as they begin their own journeys with climate risk governance and management.
Getting started: understanding environmental, social and climate (ES&C) risks and current management systems
During the first day, drivers of environmental, social and climate (ES&C) risks were discussed and key factors that differentiate climate from other types of risks introduced (such as their far-reaching nature, irreversibility, dependence on short term actions and foreseeable nature). In addition, the training reviewed the various channels through which physical and transition climate risks transfer to the economy and to the financial system. Finally, market and regulatory trends in climate risk governance and risk management were reviewed.
Banks were provided with the opportunity, during the first day, to use a new self-assessment tool from IDB and Acclimatise, which allows banks to identify gaps in their governance and management systems for ES&C risks. The tool enables users to assess their existing systems against an international benchmark on best practices, in order to develop a roadmap on priorities and steps they need to take to improve their practices.
This first application of the self-assessment tool, and reflections stemming from the work with five pilot banks who completed their assessment in the previous weeks, showed that Mexican banks are at different levels of maturity in their development of ES&C governance and risk management structures. Most are still in the very early stages of this process. Few banks have consolidated ES&C governance and risk management best practices or have started to incorporate climate risks into their existing processes and procedures. Most participants lack direct oversight from the Board on ES&C risks, and have not yet assigned clear roles and responsibilities for the identification, evaluation and management of these risks and their integration at higher levels of strategy and financial planning. Several factors were found to have influenced the current status, in particular: lack of awareness on the financial implications of physical and transition risks on portfolio performance across different departments; lack of awareness around the potential benefits of incorporating ES&C risk management into existing processes; lack of resources and data to establish a baseline on portfolio risk exposure; short termism; and a lack of an established culture among Mexican banks to plan strategically and manage social and environmental risks.
Appraising financial climate risks: a sectoral approach
Activities on the second and third days of the workshop raised awareness among participating banks to help overcome these barriers. Bank participants reflected on the implications of climate change to important sectors of the Mexican economy, and on financial portfolios. With facilitation from Acclimatise, working groups performed an initial analysis of climate risk exposure in the tourism, real estate, energy and agriculture sectors in order to identify and reflect on the types of credit, market and operational risks that could become material for each. The working groups also explored how climate scenario analysis can be used to better understand and plan for these risks. From these exercises, the following lessons were drawn for each sector:
Key climate hazards generating physical risks to tourism operations in Mexico include hurricanes and floods, as well as global warming, ocean acidification and an increased incidence of drought and forest fires. Transition risks facing Mexican banks, on the other hand, include the potential effects of new legislation on energy prices and changes in consumer behavior. These hazards can affect a bank’s clients through increased operational costs, reduced tourism volumes and earnings, increase of insurance premiums and losses in assets value. Reduced tourism rates and changes in consumer preferences could also reduce opportunities for new businesses and, in the worst scenarios, could lead to business interruption.
Key climate hazards affecting Mexican real estate include; coastal erosion (caused by sea level rise and storms), drought and forest fires; increased residential cooling costs (due to increases in temperature and the incidence or urban heat islands); damage from hurricanes, tropical cyclones and flooding; and potential human migration. On the transition risk side, changes in regulation for water and solid waste management as well as new urban planning standards and the development of carbon markets were noted as key risks. Combined, these risks can increase the costs of construction and insurance, increase reputational risks, induce reductions in property prices and affect business continuity. For financial institutions, these risks can expose banks to credit risks through their effect on loan-to-value ratios and affect the mortgages market.
Physical climate impacts were found to affect the entire energy value chain in Mexico, from generation and transmission to storage. In particular, changes in rainfall patterns and associated floods and droughts were identified as a threat to energy generation and infrastructure. On the transition risk side, changes to the price of carbon and government reforms (particularly in relation to the CELs market (i.e. market for clean energy certifications) and the Energy Transition Law and the General Law on Climate Change) could affect the price of energy and the demand for oil and gas. Potential impacts to the sector could also diminish the ability of PEMEX, a Mexican oil company, to repay the Mexican government and lead to default.
In terms of physical risks, participants identified key climate hazards affecting agriculture including: the potential reduction of yield productivity (due to changes in temperature and rainfall patterns); increased production costs associated to water shortages; the salinisation of productive soils due to both sea level rise and over extraction of groundwater resources; and increased damage in transport routes, storage facilities and equipment due to flooding. Transition risks also include: changes in regulation and the transition to low carbon technologies, which could lead to the potential increase in fuel prices (affecting the production cost of herbicides and fertilisers), as well as the increased cost of other key inputs, such as energy and water.
These risks can result in a reduction in revenue and EBITDA, due to reductions in the quality and volume of the produce, and increases in CAPEX and costs to adjust practices to new technologies and increased premium of parametric insurance. These impacts can result in greater price volatility of agricultural commodities and changes in the probability of default of a bank’s clients.
Formulating actions to overcome the challenges posed by physical and transition risks and to take advantage of emerging opportunities
During the sectoral working groups, several priority areas were identified as necessary to strengthen banks’ abilities to face emerging climate risks. The development of internal technical capabilities was found to be key: bank officials, starting with those handling client relations, must be able to identify and evaluate climate risks at the transaction level. Exclusion lists and contractual clauses can be updated to better account for ES&C risks and to support climate-proofing of future lending transactions. Banks also recognised the importance of developing cross-departmental working groups and bringing together the expertise and knowledge of different units (e.g. operational risk, credit risk, sustainability and new products) for the appraisal of climate risks and opportunities. They reflected on the opportunities that can originate from an adequate appraisal of client risks and how the banking sector can act as catalyzer of change through the development of financial products that respond to client’s need to adapt to a changing climate and to transit to a low carbon economy.
By exploring the saliency and utility of different tools available, the banks were able to compare different approaches to scenario analysis (for both physical and transition risks) and to debate how outputs from scenario analysis could inform financial planning. Several challenges that need to be tackled in order to mainstream scenario analysis into risk management processes were identified, including limited available data, resources and metrics. Banks agreed that greater foresight and understanding on the evolution of transition and physical risks and on the climate impacts to their clients can be important for the development of new products in the banking sector. Furthermore, banks agreed that client engagement can help determine the extent to which investments are already climate proofed. Several banks seemed reluctant to incorporate new ES&C risk management requirements and expressed a fear of losing clients if they were to reinforce their risk management practices. Their concern was that clients may perceive such requirements to be heavy handed in an environment where ES&C risk management is not being mandated or enforced by the regulator. Banxico, however, noted that it is in the best interest of banks to strengthen ES&C risk management practices and to work with their clients. Banxico also encouraged banks to extend their time horizons to match the long-term horizons of client investment needs.
Learning from others in the sector
Across all three days of the workshop training, participating banks had myriad opportunities to learn from the experiences of their peers and to reflect on the steps required to help Mexican financial institutions strengthen their governance and risk management processes, in alignment with the TCFD recommendations. On the first day, representatives from several banks reflected on their experience using assessment tools to appraise and manage social and environmental risks. On the second day, another panel reflected on the business case of integrating ES&C risks into financial planning and the importance of having the support from high level officials. The panel suggested the Board of directors need to promote the integration of climate considerations into governance and risk management structures. On the second and third days, banks also benefitted from presentations by 2 Degrees investing initiative (2Dii) and from South American regional bank who is a known leader on the governance and risk management of climate-related financial risks. 2Dii provided a useful overview of the PACTA tool they developed in partnership with the Principles for Responsible Investing (PRI), which can be used to analyse different energy transition scenarios.
This training workshop has helped raise awareness on the relevance of climate risks to the financial sector in Mexico and strengthened the institutional capacity of banks around governance and risk management systems. The training has left participating banks with an increased ability to align with the TCFD Recommendations and implement them. These are crucial steps to help Mexican financial institutions be on par with international best practices. Acclimatise will continue to work with these institutions with the aim of strengthening their institutional capacities and improving their response to emerging realities of a changing climate.