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When measuring credit losses, include data on climate change

Monday January 30 2023

The maturity or term of the financial asset is essential when determining what information to analyse for ECL. FILE PHOTO | SHUTTERSTOCK

Organisations with financial assets carried at amortised costs on their balance sheet should estimate the expected credit losses (ECL) on those assets at every financial reporting date.

This requirement is in line with IFRS 9, the ‘financial instruments’ standard.

The standard requires organisations to consider historical, current and forward-looking information (including macro-economic data) when measuring the ECL on applicable financial assets such as bonds, loans and advances, mortgages and other debt instruments.

Also read: Capturing new and emerging risks in estimating credit losses

ECL measurements are determined using reasonable and supportable information without undue cost or effort at the reporting date.

In the context of climate change, considered a global phenomenon referring to long-term shifts in temperatures and weather patterns, it translates to economic impacts on businesses and society at a local and international level.

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Therefore, considering all the information available on climate-change effects and efforts to transition to lower carbon economies, organisations should consider the impact of climate change when estimating ECL on their financial assets.

The maturity or term of the financial asset is essential when determining what information to analyse for ECL.

Examples of climate change data organisations could consider for ECL measurement include the following:

Economic forecasts are an essential source of climate change data that provide organisations with the impact of climate change on economies.

ESG (environmental, social and governance) ratings assess the impact of ESG on the credit risk ratings of borrowers and different counterparties.

Annual reports or sustainability reports specific to varying entities with disclosures on climate change risk and strategy aligned to recommendations of the TCFD (Taskforce on Climate-Related Financial Disclosures) are also a good source of climate change data for ECL measurement.

Data on the effects of past extreme weather events, like wildfires or floods, are helpful when estimating possible future losses.

Also, information on climate-related exposures and risks provided to regulators could be beneficial.

Also read: Top banks save Sh51bn from unpaid loan losses

Other countries ahead of the curve with responses to the effect of climate change could provide organisations with information on the impacts of laws and regulations on borrowers.