Banks should consider incorporating long-term climate risks into their compensation policies, according to a new set of principles released by the Basel Committee on Banking Supervision, the primary global standard and policy setter for the banking industry.

In the new publication, “principles for the effective management and supervision of climate-related financial risks,” the Basel committee sets out a series of guidelines for banks and regulators to follow in order to address the interrelated physical and transition climate risks to the global banking system. The publication follows a process, initiated in April 2020 which included assessing existing regulatory and supervisory initiatives on climate-related financial risks, and analyzing the risk features of climate change and its potential impact on banks and the banking system.

The compensation recommendation forms part of the committee’s proposed corporate governance principles, which guides banks to “take material physical and transition risk drivers into consideration when developing and implementing their business strategies,” including assessing the short- and long-term impacts of these risks on business models as well as the banks’ exposure to structural economic changes.

The principle adds that these assessments “may warrant changes to its compensation policies, taking into account that these should be in line with the business and risk strategy, objectives, values and long-term interests of the bank.”

Many banks have already moved to incorporate sustainability factors, including climate risk into their compensation and bonus structures, according to Alexandra Beidas, Global Head of Employment & Incentives at London-based global law firm Linklaters, while noting that most current practices “are generally focussed on estimating potential risk impact or assessing performance on environmental targets within a particular year.”

Beidas added:

“The Basel principles could lead to more firms deciding to adjust pay or clawback pay if climate related financial risks transpire and possibly extending deferral periods to ensure they are long enough to capture the long term horizons of climate related risk.”

The publication outlines 18 principles in all, including the clear assignment of responsibility for climate-related risks to board members and committees, the incorporation of climate-related financial risks into banks’ internal control frameworks and into capital and liquidity adequacy assessments, monitoring and reporting systems, and the performance of scenario analysis to assess the resilience of business models to a range of climate-related pathways. Six of the principles apply to regulators and supervisors in overseeing banks’ climate-related risk management policies and practices.

Click here to view the Basel Committee report.