When I was a student, I especially looked forward to new year countdown events. With school examinations behind me and a long holiday ahead, I always enjoyed the festive mood during winter time. Although Hong Kong was hit by a cold snap last week during the Christmas holidays, I think you would agree that in recent years, winter temperatures in Hong Kong have been on a rising trend. We even had a tropical cyclone this month. Abnormal weather is not unique to Hong Kong. Global warming has led to imbalances in the climate system. As polar ice caps continue to melt, not only polar bears are starving, the survival of mankind is also increasingly under threat.
The culprit of global warming is greenhouse gases emitted by human activities, particularly carbon dioxide. Ever since the industrial revolution, we have been increasingly relying on fossil fuels such as coal and petroleum as the main source of energy. Carbon which has been underground is thus released to the atmosphere in the form of carbon dioxide, thereby enhancing the greenhouse effect. Immediate actions should be taken to reduce greenhouse gas emissions and reverse the global warming trend, otherwise humanity as well as the entire global ecosystems will face irreparable consequences. As such, parties to the 2015 Paris Agreement have committed to gradually reducing emissions and eventually achieving carbon neutrality around mid-century1. Mainland China plans to hit “carbon emission peak”2 by 2030 and achieve “carbon neutrality” by 2060. Hong Kong has also devised a roadmap to carbon neutrality and aims at reducing carbon emissions by 50% by 2035 and achieving carbon neutrality by 2050.
To achieve “carbon neutrality”, we must undertake structural transition, phasing out high emission industrial activities and allocating resources to develop new energy technology. Meanwhile, we must enhance our resilience to extreme weather so as to mitigate the threat of climate change on humans. In order to achieve all these, we will need capital. The Paris Agreement is a watershed in global efforts to combat climate change, as one of its major achievements is encouraging the financial industry to support the cause by channelling funds to projects that are in line with the carbon neutrality goal. This means that the financial industry has to strengthen climate risk management. It also highlights the unique and significant role of the financial industry in addressing climate risks.
How can the financial industry help mitigate climate risks? Perhaps we can start from climate risk stress testing. In the beginning of 2021, 20 major retail banks and 7 branches of international banking groups participated in a pilot exercise on climate risk stress test (CRST) launched by the HKMA. This exercise aims at assessing the climate resilience of the banking sector as a whole and facilitating capability building of participating banks and banking practitioners for managing climate risks.
The CRST comprises three scenarios. First, natural disasters resulted from frequent occurrences of extreme weather events may lead to financial losses to banks and borrowers, thereby impacting on the robustness of banks. For instance, storm surge brought about by tropical cyclones may affect the valuation of certain properties or even the quality of the mortgage loans on these properties. Second, orderly transition - carbon neutral policies are implemented in an orderly manner. Structural change is carried out gradually with the phasing out of high emission industries and gradual adoption of new energy technology. The CRST aims at reviewing the impact on banks’ asset quality in the course of the waning of certain old industries. Third, disorderly transition - carbon reduction progress significantly lags behind the targets set out in the roadmap to carbon neutrality and structural change has to be carried out in a relatively short period of time, with high emission industries discontinued and investment in new energy equipment. Similarly, the CRST aims at assessing the impact of such an abrupt transition on banks. The risks under the first scenario are called “physical risks”, that is, risks arising from natural disasters associated with climate change. For the second and third scenarios, the risks are called “transition risks”, that is, risks arising from structural change in the course of carbon reduction.
The HKMA announced the CRST results today. The results show that we cannot afford to ignore the impact of climate risks on banks. For example, expected credit losses on exposures related to residential mortgages and high emission industries under all three scenarios were projected to increase sharply, undermining banks’ profitability and capital positions. Let’s take domestic systemically important banks as an example. Under the disorderly transition scenario, the capital adequacy ratio (CAR) of these banks would drop by three percentage points on average in a period of five years, which means banks will need more working capital. Banks’ operation would also be disrupted under the physical risk scenario. Of course, given the strong capital buffers built up by the banks in Hong Kong, they will be able to withstand such shocks. However, the stress test also shows that banks must put in place a systematic approach to manage climate risks and support clients’ transition so as to avoid the potential shocks envisaged under the CRST scenarios.
Prompt action is required to facilitate proper climate risk management by banks. Following an industry consultation, the HKMA issued a module on climate risk management under the Supervisory Policy Manual today. Simply put, banks are required to have sufficient understanding of how climate risks are transmitted. They should also be able to measure, monitor, disclose and manage climate risks in an effective and proper manner, taking into account their business models. As climate risks are different from traditional financial risks, banks will need to collect more data, for instance, emission data from their clients, in order to assess the impact of the emission reduction and transition on them. Moreover, banks should also enhance their forward-looking risk analytics capability. Under the traditional financial risk management approach, analysis is often carried in a backward-looking manner using historical data to assess risks. However, climate risk analysis is different. As in the CRST mentioned above, banks should have forward-looking scenario analytics capability. Furthermore, they may have to seek expert advice from time to time. For example, in physical risk analysis, banks may have to rely on judgements made by experts such as meteorologists and civil engineers. As such, data and talent are two major challenges that banks will have to overcome when enhancing their capability to manage climate risks. To support banks and the financial industry as a whole to develop green finance and strengthen their climate risk management capability, the Green and Sustainable Finance Cross-Agency Steering Group has launched the Centre for Green and Sustainable Finance, which will serve as a repository for resources, data and analytics. The centre’s priorities are to promote capacity building and develop data repository and enhance analytics capability.
Climate change is a big and complex issue. In order to achieve carbon neutrality, everyone in the community has a role to play. I am sure that as a member of the financial industry, banks can contribute tremendously in combating global warming. I believe that the CRST and the policy manual on climate risk management can provide banks with useful experience and guidance. As the year is coming to a close, I sincerely hope that banks will put more efforts into climate risk management in the coming year and head towards the goal of carbon neutrality together with their clients and different stakeholders, while contributing to the sustainable development of our society and creating a greener and more liveable environment for the next generation.
Hong Kong Monetary Authority
30 December 2021
1 “Carbon neutrality” is a state of net-zero carbon dioxide emissions. Specifically, it refers to the balancing of the emissions and removals of carbon dioxide through carbon reduction.
2 Hitting “carbon emission peak” refers to the commitment by the Mainland to bring carbon emissions to a historical peak before 2030 and then gradually reduce carbon emissions.