(Source: King & Wood Mallesons Research Institute)

The Basel Committee on Banking Supervision (hereinafter referred to as the "Basel Committee") recently officially released the "Framework for the Voluntary Disclosure of Climate-Related Financial Risks" (hereinafter referred to as the "Climate Risk Disclosure Framework"). Following in-depth consultations with global stakeholders, the Framework shifts from mandatory disclosure requirements envisioned in the 2023 draft to voluntary disclosure standards. This fundamental shift reflects the multiple challenges facing global regulators and the banking industry in addressing ESG issues: geopolitical forces, economic realities, and practical difficulties.

01 The Nature and Dimensions of Climate-Related Financial Risks

Climate-related financial risks refer to the potential financial losses banks face due to physical or transition risks arising from climate change. These risks manifest themselves in multiple dimensions:

Physical risks primarily arise from extreme weather events and climate change-related natural disasters. Physical changes such as floods, droughts, and sea level rise can destroy property, disrupt supply chains, and cause significant losses to banks and their clients. For example, hurricanes can destroy residential and commercial properties used as collateral for bank loans, while wildfires can affect agricultural and forestry assets.

Transition risks arise from the societal changes, policy adjustments, and market trends associated with the transition to a low-carbon economy. These changes can negatively impact investment valuations. These include new government policies (such as carbon taxes or emissions limits), technological innovation (such as the rapid development of renewable energy), and shifting consumer preferences (such as declining demand for fossil fuels). These factors can cause certain assets or business models to depreciate or even become obsolete, resulting in losses for banks with significant exposure to these sectors.

Furthermore, when these physical or transition risks affect banks' exposures through micro- and macroeconomic channels, they can create concentration risks (for example, if a drought in a region causes all agricultural loans to default). Due to the highly interconnected nature of the banking industry, losses in one sector or region can spread rapidly, jeopardizing the stability of the entire financial system.

02 The Evolution of the Basel Prudential Regulatory Framework

As the global body setting bank capital and prudential standards, the Basel Committee has been committed to developing principles for managing climate-related financial risks. The Committee's current work focuses on assessing the extent to which the existing Basel prudential regulatory framework covers climate risks, identifying existing regulatory gaps, and exploring appropriate responses.

In June 2022, the Basel Committee issued 18 principles for climate risk management and supervision to provide comprehensive guidance for banks and their supervisors. These principles not only focus on capital adequacy but also establish a comprehensive risk management system encompassing corporate governance, internal controls, capital liquidity and adequacy, risk management, monitoring and reporting, and scenario analysis.

The Basel framework draws on the experience of international organizations such as the Task Force on Climate-related Financial Disclosures (TCFD) and collaborates with organizations such as the International Sustainability Standards Board (ISSB), the Network for Greening the Finance (NGFS), and the United Nations Environment Programme Finance Initiative to promote the development and improvement of global climate risk management standards.

03 Synergy among the Three Pillars of the Basel Prudential Regulatory Framework

Under the Basel Prudential Regulatory Framework, climate risk governance requires the precise coordination of three pillars: Pillar 1 sets prudential regulatory requirements, including minimum capital and liquidity requirements; Pillar 2 focuses on the supervisory review process, including the assessment of a bank's Internal Capital Adequacy Assessment Process (ICAAP) and other key risk management processes; and Pillar 3 emphasizes strengthening market discipline through disclosure, requiring banks to disclose their risk profiles, capital and liquidity positions, and risk management practices.

Following the 2008 global financial crisis, there has been growing recognition that a lack of transparency and weak market discipline can exacerbate systemic risk. Therefore, Pillar 3 is considered a key element in maintaining financial system stability. Its disclosure requirements are primarily intended to enable market participants, including investors, creditors, and customers, to accurately assess a bank's risk profile and make informed decisions accordingly. By enhancing transparency, Pillar 3 not only strengthens market discipline but also makes comparisons across banks more meaningful. A robust disclosure mechanism facilitates the appropriate pricing of risk and incentivizes banks to prudently manage their risk exposures. Applied to climate risk, Pillar 3 disclosure standards can reveal potential vulnerabilities arising from poor management.

04 Development Process of the Climate Risk Disclosure Framework

The Basel Climate Risk Disclosure Framework focuses on banks' qualitative and quantitative disclosures on climate-related financial risks. The development of this framework dates back to November 2023, when the Basel Committee released a consultation paper exploring how mandatory Pillar 3 disclosure standards could enhance transparency regarding climate-related financial risks and thus safeguard financial stability.

The consultation paper requires banks to disclose two types of information:

Qualitative information: including governance structures, control and oversight procedures, and strategies for addressing significant climate-related financial risks;

Quantitative data: such as total asset value categorized by collateral energy efficiency and financing emissions intensity per unit of output. These disclosures will help market participants, regulators, and others better understand and assess banks' risk exposures, enabling fair comparisons and informed decision-making.

During the consultation process, the Basel Committee received extensive feedback from the banking industry, regulators, and the public sector. Given the complexity and current state of climate risk assessment, particularly challenges in data accuracy, consistency, and quality, some stakeholders have pointed out that the uneven quality of current climate data, immature assessment methodologies, and nascent scenario analysis techniques pose challenges for reliable quantitative disclosure. Furthermore, differences in capacity and readiness across jurisdictions raise concerns about inconsistent implementation standards.

After extensive deliberation, the Basel Committee ultimately decided to adopt a voluntary climate risk disclosure framework, allowing jurisdictions to choose whether to adopt it based on their own circumstances.

05 The Underlying Motivations Behind the Changes to the Climate Risk Disclosure Framework

The Basel Committee's decision to shift from mandatory disclosure requirements to a voluntary climate risk disclosure framework reflects the complex political and economic realities of global climate governance.

The most direct factor influencing this is the evolving political landscape in the United States. With the Trump administration's announcement of its withdrawal from the Paris Agreement, the Federal Reserve has also withdrawn from the Network for Greening the Financial System (NGFS). The United States, the world's largest economy, has been oscillating on climate policy, making the establishment of a globally unified mandatory disclosure standard impractical.

More fundamentally, this adjustment reflects a pragmatic approach to international standard-setting. Given the significant differences in economic development stages, industrial structures, and technological capabilities across countries, overly premature mandatory requirements could lead to regulatory arbitrage or formalistic compliance. While the voluntary framework has lower standards, it provides room for gradual improvement for countries at different levels of development. This maintains the global applicability of the climate risk disclosure framework while also reserving policy space for future standard upgrades.

06 Specific Adjustments and Controversies Regarding the Content of the Climate Risk Disclosure Framework

In addition to changing its overall nature from mandatory to voluntary, the final version of the Basel Climate Risk Disclosure Framework also includes significant revisions to several specific clauses:

In terms of disclosure principles, the original draft's reference to "without regard to materiality assessment" has been revised to "disclosure in material circumstances." This adjustment is intended to align with the traditional materiality principle of Basel Pillar 3, but it has also sparked new controversy: since banks may have significantly different criteria for determining "materiality," the comparability of disclosed information has decreased. This discrepancy will affect horizontal comparisons among market participants.

In terms of disclosure content, the Climate Risk Disclosure Framework shifts its focus from "climate impact projections" to "emissions reduction targets." This shift acknowledges the current uncertainty of climate modeling and instead requires banks to publish specific, verifiable emissions reduction commitments. While this goal-oriented approach is more actionable, critics point out that the lack of unified baseline-setting rules may lead banks to selectively disclose the most easily achievable targets.

Most controversial is the removal of the disclosure requirement for "facilitated emissions" (from the original CRFR5 template). While these emissions do not directly arise from banks' own operations, they provide critical support for high-carbon projects through services such as underwriting bond issuance and M&A advisory. Environmental groups point out that the facilitated emissions of some large investment banks can be hundreds of times greater than their operational emissions, and omitting this data would significantly underestimate the banks' true climate impact. However, others argue that in the absence of a recognized measurement method, mandatory disclosure could lead to a loss of control over data quality.

To balance this, the Climate Risk Disclosure Framework strengthens the qualitative disclosure requirements for governance processes (CRFRA forms). Banks are required to detail how they integrate climate risks into their comprehensive risk management systems, including board oversight mechanisms, risk profile strategies, scenario analysis methods, and incentive mechanisms. This "process over results" approach aims to promote substantive integration of climate risk management, rather than superficial compliance.

07 Long-Term Outlook for the Implementation of the Basel Climate Risk Disclosure Framework

The release of the Basel Climate Risk Disclosure Framework marks a new phase in global banking climate risk management. Its implementation is likely to have multiple impacts:

On the positive side, the Climate Risk Disclosure Framework establishes the first globally accepted benchmark for climate risk disclosure, providing market participants with a fundamental analytical tool. By encouraging leading banks to proactively disclose, it will drive improvements in standards across the industry. The disclosure scope and indicator design established by the framework also provide important references for regulators around the world to develop localized rules.

However, challenges are equally evident: its voluntary nature may lead to uneven disclosure quality, with some banks selectively disclosing favorable information. Differences in regional adoption rates could exacerbate cross-border regulatory arbitrage. Ensuring the reliability of disclosed data will remain a persistent challenge, particularly in the absence of unified auditing standards.

From a broader perspective, the weakening of the Climate Risk Disclosure Framework reflects the deeper difficulties of international coordination in the ESG field. When major economies face fundamental differences on climate policy, any attempt to establish a unified global standard will inevitably involve compromises. While this realistic adjustment reduces the framework's ambition in the short term, it may help maintain sustained international regulatory cooperation.

Despite these challenges, the Basel Climate Risk Disclosure Framework remains a significant milestone towards enhanced disclosure of climate-related financial risks. It aims to promote greater transparency and market discipline, encouraging banks to integrate climate considerations into their core decision-making processes. While far from a definitive solution, it is an important step towards a more resilient and sustainable global banking system.

Practice Areas: Banking and Financing, Structured Derivatives and Derivatives, Debt Capital Markets, Financial Regulation, and Fintech

Ms. Fei has fifteen years of experience in digital assets, structured finance, financial derivatives, syndicated loans, capital markets, asset securitization, and financial regulation. She regularly advises major financial institutions and corporate clients on innovative RWA tokenization projects, structured financing transactions, cross-border derivatives transactions, close-out netting and performance guarantee arrangements, syndicated loans, Basel III regulatory capital instruments, securities financing transactions, and financial regulation. She holds an LLM from Harvard Law School and a BA and MA from the University of Cambridge. Ms. Fei teaches Banking Law at the Faculty of Law at the University of Hong Kong. Her working languages are Chinese and English.

We would like to thank Li Nuoxi for his contributions to this article.