In December 2019, Bank Negara Malaysia (BNM) issued a discussion paper on “Climate Change and Principle-based Taxonomy”¹. The discussion paper highlights the risks arising from climate change and environmental degradation to the economy. It outlines guidance for financial institutions in identifying these risks and classifying economic activities that contribute positively to climate change objectives.

According to BNM, 10.3% of the total assets of banks and 24.4% of the total assets of insurance companies and takaful operators are potentially exposed to climate change effects. This amounts to 11.7% total exposure for financial institutions. In quantitative terms, RM8 billion in damages have been sustained as a result of over 50 natural disasters which have occurred with increased frequency and severity over the last 20 years². The gravity of the risks that climate change poses to our economy is strikingly clear.

It is not surprising therefore that BNM has accorded this area attention given that one of its main objectives is to “maintain monetary and financial stability as it contributes to a healthy economy and sustainable growth”³. The discussion paper follows a trend of climate change and environment-focused initiatives issued by regulators:

• In September 2019 the Joint Committee on Climate Change was established by BNM and the Securities Commission Malaysia (SC) to drive and coordinate the financial industry’s collective response to climate risks⁴.
• The SC has issued bond and sukuk frameworks for sustainable and environmentally conscious financing⁵.
  
  

Risk

In the discussion paper, BNM identifies three dimensions of risk arising from climate change and its impacts:

• Physical risks;
• Transition risks; and
• Liability
  
  

Physical risks

Physical risks are caused by events related to climate change which damage property, reduce productivity and disrupt trade. Downside risks to capital goods and production capacity will negatively impact businesses, causing balance-sheet erosion in a chain reaction which has repercussions for the institutions who finance them. Financial institutions also need to be conscious of the effect physical risks may have on collateral value, which will inform recovery value.

Examples include:

• Damage devaluation of assets/investments;
• Early retirement or abandonment of assets;
• Reconstruction/replacement of damaged infrastructure;
• Wider economic deterioration (lower demand, productivity and output);
• Disruption to business operations, trade and supply chain;
• Lower household and business income;
• Displacement or forced migration; and
• Increase in insurance premiums and takaful contribution as well as higher than expected insurance/takaful

BNM warns that these physical risks are often not well-accounted for by financial institutions, resulting in the risks of climate-related events being under-priced.

Transition risks

Transitions risks arise from the economy and broader society shifting towards lower- carbon activities, which require extensive policy, legal, technology and market changes. These changes may include:

• Legal/regulatory framework
• Disclosure requirements, implementation of carbon pricing;
• Technological advancements
  • Reducing cost of renewable energy;
• Consumer sentiments
  • Certification schemes, fossil fuel divestment campaigns.

Examples of transition risks include:

• Stranded, obsolescence, or unanticipated devaluation of assets;
• Asset replacement costs;
• Revaluation of financial assets;
• Threat to viability of business;
• Higher business operation cost;
• Impact on pricing and demand; and
• Increase in default

Liability risks

These are legal risks such as claims for loss and damage which result from the negative consequences of physical and transitions risks materialising. The insurance and takaful sectors are particularly exposed to liability risks arising from climate-related events.

BNM warns that physical risks, transitional risks and liability risks caused by climate- related events transmit increased risk to other types of conventional risks, such as credit risks, market risks, liquidity risks, insurance risks, operational risks and strategic risks.

Economic activity

BNM also expects financial institutions to factor climate change risks into their business models and implement measures to protect against these risks, and further cautions that failure to do so could lead to significantly depressed investment values going forward. In order to facilitate this, BNM has outlined a framework for assessing economic activities according to five Guiding Principles (GPs):

• GP1: Climate change mitigation:
  • These are economic activities with the objective to avoid, reduce or enable others to avoid or reduce greenhouse gas emissions in the atmosphere. Examples of economic activities include:
    • Increase contribution of renewable energy in power generation;
    • Optimise energy consumption;
    • Encourage low carbon transport and mobility;
    • Promote green
• GP2: Climate change adaption:
  • Economic activities with the objective of increasing resilience against the negative physical effects of climate change. Examples include
    • Implement measures to increase own resilience, such as early warning systems for flooding;
    • The adaptation of other economic activities to mitigate physical effects of climate change, such as the development of technology.
• GP3: No significant harm to the environment:
  • Economic activities should not cause unintended harm to the environment, such as pollution, deforestation, or large amounts of waste.
• GP4: Remedial efforts to promote transition:
  • Financial institutions are expected to consider the remedial efforts and initiatives by business to transition to a more climate-change conscious business model and stratregy.
• GP5: Prohibited activities:
  • Financial institutions must ensure that economic activities do not contravene environmental laws and This includes, but is not limited to, the National Policy on the Environment, National Forestry Act 1984, Fisheries Act 1985, National Parks Act 1980, Environmental Quality Act 1974 and its regulations and orders. Examples of prohibited activities include:
    • Illegal waste management including release of untreated toxic and hazardous industrial waste;
    • Operations which use fire for land clearance;
    • Illegal deforestation;
    • Activities within, adjacent to, or upstream of designated protected areas and habitats of rare/endangered species; and
    • Drift net fishing or fishing with the use of explosive.

To ensure economic activities are environmentally sustainable, BNM encourages financial institutions to leverage on third party verification and certification. The discussion paper includes a table with examples of different certification and verifications for respective industries.

In order to quantify the assessment of economic activities, BNM introduced a category framework based on the guiding principles above. There are five categories which scale from positive to negative, with Category 1 applicable to economic activity which:

• supports substantial reduction or avoidance of greenhouse emissions or enables others to do the same, or increases resilience to mitigate the physical effects of climate change and
• does not cause harm to the environment.

Category 6 involves prohibited economic activity.

In assessing, classifying and subsequently participating in these economic activities, financial institutions are expected to conduct holistic due diligence assessments, consider the potential impacts to the wider eco-system and ensure that they do not acquire a track record of environmentally damaging practices.

Application

The discussion paper underwent a period of public consultation, with BNM hoping to collect feedback from financial institutions before finalising a policy document on Climate Change and Principle-Based Taxonomy. No date for the issuance of a final policy document has been indicated for now. However, financial institutions both in Malaysia and in markets across the world not have waited in applying a similar approach to the one set out by BNM.

• In his 2020 Letter to Shareholders, the CEO of BlackRock, Larry Fink, outlined a similar position. He announced that the world’s largest asset manager will adopt sustainability as its standard for investing,making sustainability “integral to the way BlackRock manages risk, constructs portfolios, designs products, and engages with companies”⁶.
  • The letter specifically identifies the risk to financial markets arising from transition risk how “the global transition to a low-carbon economy could affect a company’s long-term profitability”.
• In Malaysia, 28 financial institutions participated in the Green Technology Financing Scheme,a financing scheme now in its second extension which focuses on providing soft loans to support the development of green technology in Malaysia⁷.
• A wave of sustainability and environment-focused projects in Malaysia have been financed, including:
  • Merdeka 118, a skyscraper project by PNB⁸ in central KL which is targeting a triple platinum rating with the Leadership in Energy and Environmental Design, GreenRE and Green Building Index certification, making it the first project in Malaysia to earn such a rating⁹.
  • A five megawatt-peak solar farm in Padang Besar, Perlis, by Cenergi Sunseap Energy Solutions Sdn Bhd, a joint venture between Cenergi EE Holdings Sdn Bhd and Singapore-based Sunseap International Pte Ltd¹⁰.

There are clearly signs that financial institutions are already factoring climate-change risks into their business model, assessing economic activities through the lens of sustainability, and adjusting their strategies accordingly. As the trend continues and policies such as the discussion paper on Climate Change and Principle-Based Taxonomy come into force, the shift towards sustainable and environment focused financing will only intensify.

Written By:

Jonathan Ross Silva

Financial Services Practice Group

For further information regarding financial services matters, please contact our Financial Services Practice Group.