Climate change risk has the potential to destabilize financial markets unless financial institutions (FIs) build their capabilities for risk management in this domain. As the world moves towards a net-zero economy aligned with the Paris Agreement, financial risks and opportunities related to climate change can affect financial market efficiency and investment decisions. Greater oversight of climate risk can lead to better decision-making.
Momentum to disclose climate risk data is building because the window of time to respond and adapt to climate change is shrinking. For a long time, business managers tended to view climate change risks as issues we’d face 30 to 50 years in the future, but now it’s impossible to do so. Today’s natural disasters and extreme temperatures are already impacting businesses, while governments are taking swift action to uphold their nationally determined contributions (NDCs) under the Paris agreement.
Meanwhile, as former governor of the Bank of England Mark Carney pointed out in his famous 2015 Tragedy of the Horizon speech, the 2-6 year monetary-policy cycle for business decision-making is insufficient for dealing with the complexity of climate change challenges. This is why climate risk models, which use a longer timeline for future projections, should play an important role in decision-making across all sectors and sizes of business.
One of the main concerns among financial institutions is that investments may be overvalued. The subprime mortgage financial crisis showed that even limited sectoral market inefficiencies can reflect systemic risks. Banks, insurers, and investment funds are responding to the knowledge gap by developing their climate risk management capabilities not only for their own operations but across their entire portfolios.
Climate risk assessment primarily consists of quantifying and disclosing physical and transition risks according to different future atmospheric warming scenarios. Physical risks are the direct costs related to the impacts of weather, floods, droughts, and natural disasters on operations, immovable property, and real assets. Transition risks relate to the financial impacts of policies and regulations, emerging technologies, reputational shifts, and litigation.
Unlike traditional risk assessment, climate scenario analysis extends decades into the future. Preparing scenario analyses requires complex data models that FIs may lack the capability to produce internally. This is why The Climate Service (TCS) developed its financial risk assessment tool to assist private firms with TCFD reporting. Subscribers to the Climanomics(R) Platform can prepare accurate predictions of the financial impacts of physical and transition risks for different atmospheric warming scenarios as far ahead as the year 2100.
TCS serves a range of clients across the Financial Services industry. The Climanomics® platform is used to assess the physical and transition risks and opportunities from climate change inequities, commercial mortgage-backed securities, real estate, agricultural assets, municipal, sovereign, and corporate bonds, and more for asset managers and owners. It is also used to assess the climate risk in the lending portfolios of global banks.
2015 - The Task Force on Climate-related Financial Disclosures (TCFD) is established by the Financial sustainability Board (FSB) to promote voluntary disclosure of climate risks to businesses.
2015 - Mark Carney, former governor of the Bank of England, gives the speech, “Breaking the tragedy of the horizon—climate change and financial stability” to the insurance market Lloyd’s of London. It urges insurance companies to broaden the timeline of their forecasting risk beyond the short-term lens of 2-6 years ahead. Carney argues this will help business adapt to:
He also encourages financial institutions to improve their knowledge of climate risks and the credibility of technological breakthroughs to avoid issues of undervalued losses.
2016 - The U.K. requires ESG reporting by companies with over 500 employees.
2016 - France requires institutional investors to provide ESG and risk management disclosures for their investments.
2016 - Hong Kong establishes an ESG requirement to ‘comply or explain’ for publicly traded companies.
2017 - The Alliance of CEO Climate Leaders calls for G20 governments to formally adopt and inform policy decisions based on the recommendations of the TCFD. The group consists of global CEOs representing “US$4.9 trillion in assets under management and US$700 billion in revenue.”
2017 - The Climate Action 100+ five-year initiative begins. It engages the world’s top 100 greenhouse gas emitting companies to align with the Paris agreement in terms of governance, disclosure, and action.
2019 - The UK establishes a task force as part of its Green Finance Strategy to establish a policy requiring TCFD reporting, which will go into effect for the entire economy by 2025.
2020 - New Zealand requires publicly listed companies and large insurers, banks, and investment managers to disclose their climate risk through TCFD reporting.
2020 - China establishes mandatory environmental reporting.
2020 - The Monetary Authority of Singapore (MAS) establishes guidelines for financial institutions (FIs) to report on climate risk similar to those of the TCFD recommendations.
2020 - Blackrock’s CEO Larry Fink requires the companies it invests in to disclose climate-related risk in line with the TCFD recommendations, and warned investors it would vote against the Boards of companies that fail to do so.
2020 - The U.S. Commodities Future Trading Committee releases a report on Managing Climate Risk in the U.S. Financial System.
2021 - EU’s Sustainable Finance Disclosure Regulation (SFDR), which requires European financial services firms to provide ESG disclosure, comes into effect.
In 2020, the World Bank Group and Columbia University produced a report for pension funds identifying the areas around the world most exposed to climate risk. The report calls for pension funds to play a role in financing the estimated climate change mitigation costs ($1.6 to $3.8 trillion) and adaptation costs ($180 billion) to prevent the catastrophic effects of atmospheric heating.
One of the key motivations for financing these costs is the alternative: potential portfolio loss of $10.7 trillion from climate change linked financial risks. In terms of opportunities, “green” investment opportunities of $2.1 trillion are expected to emerge.
The report recommends pension funds realign their fiduciary responsibility and policies in line with climate risk, develop means of portfolio diversification, and enhance knowledge about these risks among regulators. Some of the current options to investors for adapting their traditional portfolio strategies include:
The Swiss Finance Institute surveyed 1,018 executives of institutional investors with 11% of the institutions responsible for more than $100bn in assets and 57% for more than $20bn to understand perceptions toward climate risk reporting. When asked whether climate risk reporting is more important than financial reporting, 27% said yes, while 51% consider them equally important.
Respondents to the survey indicated that they feel the quantity and quality of data available about the climate risks is insufficient. They expressed concern related to the mispricing of equities, which may be underpriced based on climate-related risk.
Mispricing can result from a number of causes, according to a report by the InterAmerican Development Bank: “(1) existing conventions failing to account for environmental considerations, especially in terms of standard disclosures and widespread risk measurement practices based on modern portfolio theory; (2) endemic short-termism; and (3) outdated interpretations of fiduciary duty.”
Investors in the Swiss Finance Study noted that physical risks were the least understood in terms of mispricing, a perception confirmed by a Hutchins Center working paper. It suggests climate change data is skewed towards the energy and fossil fuel industries reporting on their transition risks, while physical risk disclosure is lacking, particularly in municipal finance.
Central banks and regulators can help mitigate the financial shocks of climate change. The Network for Greening the Financial System (NGFS), a group of 89 central banks and supervisors and 13 observers, was established in 2017 to both manage risk and mobilize capital for low-carbon investments to support the goals of the Paris agreement. It plays a role in defining and promoting best practices.
While U.S. regulators are not yet members of the Network, a recent report from the bipartisan U.S. Commodities Futures Trading Commission (CFTC) recommended a number of measures to help minimize climate-related market risk. These include:
Central banks of fossil fuel exporting countries without diversified economies face unique challenges, according to an article written by Rabah Arezki, chief of commodities for the IMF. He notes the amount of oil, natural gas, and coal reserves of private fossil fuel producers contain three to four times the amount of carbon dioxide that can be emitted into the atmosphere according to a 2 degree Celsius warming scenario.
Central banks can facilitate the transition of financial assets accumulated by fossil fuel exporters to improve economic diversification by adopting structural, financial, and interest-rate policies that aid these shifts.
Private banks also play a key role in economic diversification. Green finance for infrastructure, climate adaptation, and other climate-related investments, especially for financing the adaptation of cities, at-risk communities, and developing countries will improve global climate resilience. Public-private capital mobilization is an attractive solution to help meet these needs.
Wells Fargo, for example, currently allocates 50% of its investments towards transitioning to a low carbon economy in the form of “renewables, energy-efficiency technologies, green buildings, green bonds, and low-emission vehicles.” In a partnership with the National Renewable Energy Laboratory, a non-profit research organization, it established the $30 million Wells Fargo Innovation Incubator to scale and commercialize clean technology and sustainable agriculture.
Wells Fargo also invested in The Climate Service as part of its accelerator program to assist financial institutions in improving their assessment of climate-related financial risk. The partnership won the Tearsheet’s Bank / Fintech Social Impact Award, citing a joint project using the TCS Climanomics(R) Platform to assess the climate risk of affordable housing in a major U.S. city.
The insurance industry is particularly prone to risk for real assets due to the growing intensity and frequency of storms, floods, drought, and extreme weather. These issues impact insurability as well as insurance premium costs.
Sea level rise, in particular, poses a challenge considering 40% of the global population lives within 100 kilometers of the coast. In some cases, communities lack the necessary financial means for adaptation, which can render entire regions at risk and lead to widespread migration.
Yet, the insurance industry is perhaps more equipped to assess climate risk than other industries. Insurance firms already use catastrophe risk modeling to understand the impacts of natural disasters. Yet, there are key differences between catastrophe risk modeling and scenario analysis, which make the risk assessment strategies complementary.
Learn how to incorporate the Climanomics(R) Platform into your climate risk management strategy by contacting us today.
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