The global financial landscape is undergoing significant changes due to the increasing awareness and urgency of climate change. Climate risk testing has become crucial for the banking sector to assess and mitigate risks related to climate change, both in terms of physical and transition risks. Otoritas Jasa Keuangan (OJK) has provided new guidelines through CRMS 2024, urging financial institutions to integrate climate risk assessments into their operations.
Understanding Climate Risk Testing:
Climate risk testing evaluates how both physical and transition risks affect the bank’s portfolio. Physical risks include the damage caused by extreme weather events, while transition risks stem from regulatory, market, and technological shifts towards a low-carbon economy. According to the United Nations Office for Disaster Risk Reduction (UNDRR), extreme weather events related to climate change cost the global economy over $2.5 trillion from 2011 to 2020.
Physical risks are especially pertinent to Indonesia, where frequent floods and rising sea levels threaten major infrastructure and agricultural productivity. Indonesia’s National Disaster Mitigation Agency (BNPB) reports that over 95% of the natural hazards recorded in 2021 were hydrometeorological in nature, including floods and landslides, which resulted in financial losses and displaced communities.
Transition Risks refer to risks arising from policy shifts and market changes as industries transition toward more sustainable practices. As Indonesia commits to achieving net-zero emissions by 2060, sectors such as coal, oil, and natural gas are expected to face significant financial challenges due to stricter regulations and market preferences for renewable energy. Banks with exposure to carbon-intensive sectors face heightened transition risks, as non-compliance with these policies could lead to asset devaluation.
CRMS 2024 Guidelines on Climate Risk Testing:
The CRMS OJK 2024 guidelines encourage banks to adopt scenario analysis to assess how different climate change scenarios (e.g., a 2°C or 4°C rise in global temperatures) could impact their loan portfolios and overall assets. According to the Intergovernmental Panel on Climate Change (IPCC), a global temperature rise of 2°C could result in economic losses ranging from 0.2% to 2.0% of global GDP by 2100 .
This scenario analysis helps financial institutions model potential climate risks and integrate them into their long-term planning, thereby reducing exposure to sectors most vulnerable to climate-related disruptions.
Steps to Implement Climate Risk Testing:
- Risk Identification: Banks must first identify which sectors, industries, and geographic regions are most vulnerable to climate risks. For instance, the agricultural sector, a key contributor to Indonesia’s economy, is projected to experience a 13.3% drop in productivity by 2050 due to increased temperatures, drought, and flooding.
- Scenario Analysis: Scenario analysis allows banks to predict the financial impact of various climate-related risks. In its 2021 assessment, the European Central Bank estimated that European banks could see capital shortfalls of up to €70 billion in a severe climate stress scenario .
- Quantifying Financial Impact: Banks must measure potential financial losses associated with physical and transition risks, such as decreased collateral values, loan defaults, and increased insurance premiums.
- Risk Mitigation Strategies: Banks can reduce their exposure by diversifying portfolios away from carbon-intensive industries and increasing investments in sustainable sectors. For example, Indonesia’s renewable energy sector is set to grow as the country aims to derive 23% of its energy from renewable sources by 2025 .
In conclusion climate risk testing is essential to ensuring the long-term resilience of the banking sector. By implementing the CRMS OJK 2024 guidelines, banks can better understand and manage the financial risks posed by climate change, safeguard their assets, and align their portfolios with Indonesia’s sustainability goals.
