The fallout from the subprime crisis permeated – and travelled across – all risk types. From the seeds of operational risk failures in underwriting processes, problems migrated to credit and market risk in the collateralised debt market, and ultimately reputations were damaged once the scale of the losses was announced.

The risks posed by environmental issues and climate change are similar in nature. Banks face pressure to reduce their carbon footprints by employing greener operational polices, while lending officers need to consider the credit and market risks associated with investing in environmentally sensitive sectors. Failure to properly engage in the risk issues around climate change can lead to serious reputational, legal and regulatory problems for firms. Perceptions of risk are broadening, from the traditional silo approach to taking a more enterprise-wide view of a bank's exposure and how different risk types interact and affect one another. The effects of climate change have an impact on all forms of risk in financial services firms. Here, we address the impact on credit and market risk management.

Financial services firms are on the front line of the effects of climate change. Over the past 12 to 18 months this has been realised as green issues remain firmly on the media and political agenda for banks.

Much of the increased attention on environmental risk and how it relates to financial services firms has come from the Equator Principles – industry guidelines for assessing the environmental risks of project finance initiatives – which were initially drafted in June 2003 and revised in July 2006. "In only four years the Equator Principles moved from having 10 member banks to 55 banks. That is still a tiny proportion of the banking business compared with mainstream syndicated lending, but it has raised awareness of environmental risk in banks, which might have started to look at ways to include different types of screening for environment risk in their lending processes," says Chris Bray, head of environment risk at Barclays in London.

The Forge Group – a group of UK banks and insurers – released guidance on climate change for financial services firms in 2007, providing facts about the implications of climate change on the industry and practical advice for different sectors of the organisation, including risk management. The United Nations Environment Programme for Financial Institutions Initiative and the British Bankers' Association also have working groups on the issue of climate change and environmental risk. Industry groups such as these can lobby regulators and legislators to ensure that future policy decisions not only address the issues but also present an economically viable solution within which the banks can participate.

The general consensus is that banks need to make sure they have a good understanding of how climate change and other environmental issues affect their businesses. Much of this is only just being thought about by most banks, but some – unsurprisingly the larger global banks – are streets ahead.

A recent report, Corporate governance and climate change: the banking sector, by the Ceres investor coalition, analysed climate change governance practices at 40 of the world's banks. It found that a growing number of European, US and Japanese banks are responding to the risks and opportunities presented by climate change.

They were doing this primarily by setting internal greenhouse gas reduction targets, boosting climate-related equity research, and increasing lending and financing for clean energy projects. Most of these positive actions have been conducted over the past 12 to 18 months. Most notable was the fact that the banks have issued almost 100 research reports related to climate change and related investment and regulatory strategies, which demonstrates the importance that the top tier of the industry attaches to this issue. The five highest-scoring banks were HSBC, ABN Amro, Barclays, HBOS and Deutsche Bank, closely followed by Citigroup, Bank of America and the Royal Bank of Scotland.

But it was not all good news. Many banks have done little to elevate climate change as a governance priority. Not so surprising was the fact that no bank has set a policy to avoid investment in carbon-intensive projects such as coal-fired power stations. Banks will always find a way to lend money, even to environmentally sensitive companies, but they can at least ensure any potential fallout from environmental risk is identified and mitigated against.

Another recent report from Oliver Wyman, Climate change: risks and opportunities for global financial services, argues that banks should be putting polices in place now to protect against long-term erosion of value due to climate change and related environmental issues. In the long term, climate change will contribute to an increase in defaults and a decline in asset value in credit portfolios, warns the report, but banks with their risk expertise are well placed to encourage robust risk management controls and take advantage of the investment potential of new carbon and green energy markets, products and services. But they need to prepare for this now.

"Financial services firms should be reviewing the impact of climate change on their portfolios, stress-testing their portfolios against those implications and thinking from a strategic point of view about what the implications might be for the future," says David Knipe, a director at strategy consultants Oliver Wyman and co-author of its report on climate change. "Banks need to think in a much deeper sense about the issue and about how they position their organisation, because there will be profound impacts on business lines and some will be more successful than others. In general, banks are advantaged holders of risk, so they should do well from the introduction of increased risk into the fabric of society as a result of climate change."

Although the effects of climate change are multifaceted and for the most part impossible to predict accurately, the report is right to point out that firms need to be looking at the long-term consequences of climate change, specifically in view of their lending practices. Banks will be hit hardest through their investment in other industries more directly affected by climate change. If the credit risk profiles of their borrowers alter as a result of changes to the fundamentals of certain industry sectors, banks need to understand how their overall portfolio risk is changing.

"The biggest impact on banks of environmental risk will be indirect – it will come through their customers," says Richard Cooper, head of corporate responsibility at Lloyds TSB in London. "That is where you need to do some horizon scanning and think about the effects on different sectors, what legislation might emerge and how that will affect your customers. If you are not up to date and keeping track of that, you are not lending with the benefit of all the information you need."

Environment risk teams were initially set up to protect against direct lender liability, and it is here, and in credit risk, that banks need to focus their attention.

"Environmental risk management is not corporate philanthropy," says Bray. " It is not about the bank wanting to be seen to be an eco bank. It is about understanding the extent to which environmental issues represent a risk, cost, or liability to the organisation. Primarily they are environmental issues that affect the viability of the institutions to which we are lending and would inhibit their ability to repay us."

That said, the Ceres report showed that only a handful of the 40 banks studied have begun to integrate climate risks into their lending business by pricing carbon into their finance decisions. Although this would be the ideal scenario, pricing green risk has never been an exact science.

"The environmental component of the risk represented by the potential borrower is only one of many, so it is very difficult to isolate that component and then price that bit alone," says Phil Case, assistant director, sustainability and climate change, at PricewaterhouseCoopers in London. " Moreover, if something goes wrong and a bank has data that shows money has been lost as a result of environmental issues, quite often it is not the tipping point or the reason the company went down."

The dearth of accurate historical data means that climate change effects cannot be modelled, which is why it is so hard to price green risk into a loan. "There are two dimensions to risk management: one is understanding the severity of the impact; the other is the likelihood and the timescale," says Bray. "We are struggling on the latter because of the paucity of information about when the effects of climate change will become more significant."

Some banks are trying, however, with varying degrees of success. "Some have said that they price environmental risk into a loan, but that has usually been a rather blunt instrument, which is achieved by just adding half a point on to the interest rate as a blanket loading for certain sectors that are more environmentally sensitive than others," says Case. "But banks are in a competitive market and if they load half a per cent for one industry and the bank down the road does not, they will not win the business."

The addition of climate change and related environmental issues into the environmental risk pricing process will make this even more difficult, especially without accurate data, reliable modelling and scientific consensus on the effects.

UK bank Lloyds TSB has had a specific policy and process in place for calculating environmental risks across its lending portfolio since the 1990s. This was originally designed to consider the risk to the bank of cleaning up contaminated or polluted sites of insolvent creditors. More recently, however, it has been evolving, with a real focus being placed on the added risk of climate change.

"On the credit side, we are looking at our lending portfolio to prepare for changes that could potentially come into force in five, 10 or 15 years that we ought to be planning for now," says Cooper. "This is not a knee-jerk reaction that we need to get out of certain sectors altogether, but just about being aware of the potential impact environmental changes could have on certain sectors over a mid-to-long term and building that into our calculations to decide if we really want to be as heavily involved in those sectors, or would we be better placed switching the balance slightly."

Lloyds TSB's environmental risk policy classifies clients as high or low risk according to their industry sector. High-risk clients are flagged for greater due diligence by the environmental risk team into where their risks lie, and what mitigation and management systems are in place to deal with it.

"If we feel the environmental risks are not being properly managed or the risk is sufficiently high to create a concern, we would involve an environmental consultant in the process to conduct a more detailed assessment and devise a practical action plan," explains Cooper. "Environmental risk is certainly not foremost in the sales decision process; having said that, if a borrower is in a sector where there is a high environmental risk, we would expect them to be managing those risks properly. But we will always try to find a solution that allows us to lend, as opposed to introducing a hurdle which prevents that."

Barclays has a different approach. Rather than implementing a high-level environmental risk prescriptive policy, it prefers to assess every case individually. "A lot of it is to do with managing information and maintaining an awareness of what is happening in the environment arena," says Bray. "It really is a case of making sure the relevant information is available for the people who are making the business decisions. We put a lot of the responsibility for collecting information on our lending officers. Those who are chasing the business and sanctioning the lending should be aware of the potential environmental risks associated with given clients and given sectors."

Raising awareness of environmental risk and educating staff, specifically sales staff, is key for Barclays. "Educating people is an ongoing process to ensure they are aware of what environmental risks are," adds Bray. "We have backed this up internally with a series of environmental and social risk briefing notes. While some banks have specific policies on particularly emotionally environmentally sensitive sectors – things like forestry, mining, and oil and gas – we have guidance notes in place for something like 50 commercial activities, which are refreshed and reviewed all the time in light of new research and legislation. The next environmental risk to overlay will be to assess if any of those sectors are more at risk from climate change, the agriculture sector for example, so we can start to understand what sort of questions we should be asking clients to consider."

One example Bray gives is of a proposal to finance a hydro-electric dam that is being fed by glacial melt water. This project assumed an operating life of more than 40 years, but the engineering report did not take into account the state of the glacier in 40 years' time. "It is these sorts of questions we need to be asking now. This seems so obvious, but few are asking these basic questions as part of the due diligence process," says Bray.

It is clear that there needs to be a step change in lending practices to account for the increased risk to financial services. But only the most agile and proactive firms will reap the benefit from the changing economic environment.

Victoria Pennington is deputy editor of OpRisk & Compliance, the monthly magazine that covers regulatory initiatives and features on implementing operational risk and compliance frameworks within financial services firms.

A version of this article first appeared at OpRisk & Compliance