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Climate Risk Management at Financial Firms: Challenges and Opportunities

 

BY JO PAISLEY, CO-PRESIDENT, AND MAXINE NELSON, SENIOR VICE PRESIDENT

Foreword

The treatment of climate risk at financial institutions has changed significantly over the past five years. Whereas it used to be viewed mostly as a reputational risk that could be addressed through the environmental, social and governance (ESG) agenda, climate change is now seen by many firms as a financial risk that needs to be integrated into existing risk management frameworks.

This shift can be at least partially attributed to increasing regulatory attention. But even without this focus, it makes sense for risk managers to consider climate-related risks and opportunities. Research by Mercer and 427, for example, indicates that financial institutions will be among the industries most impacted by climate change. Firms will need to adapt their business strategies in response.

Climate risk will affect different types of firms — e.g., insurers, banks and asset managers — in different ways, reflecting the diverse nature of their business models. As climate risk manifests itself through existing risk types (like credit risk and operational risk), practitioners need to consider how climate-driven financial risks can be embedded into current financial risk management frameworks.

The GARP Risk Institute (GRI) recently undertook a global, cross-sectoral survey of firms' approaches to managing the financial risks associated with climate change. That survey indicated that climate risk management is generally in its infancy, but that firms want to learn and improve their practices. This paper provides a guide to the risk implications of climate change, starting with a brief overview of the current scientific and regulatory context, and then examining the financial risks for different types of financial institutions. It concludes with some practical next steps.

 

Understanding Climate Change

While risk managers do not need to be climate experts, an understanding of the basic climate science and range of possible outcomes and sources of uncertainty is helpful. Though some are skeptical of the magnitude and relevance of climate change, it is important for risk managers to recognize that even an unlikely no-climate-change scenario would involve risks. Asset prices would change and policies already in place likely would be reversed. As always in risk management, what is important is to explore and be prepared for the full range of possible outcomes for businesses and portfolios.

Although the earth's climate has changed over time, there is a body of scientific research that indicates that the increase in the earth's temperature we are currently witnessing is man-made (IPCC, 2014), caused by the release of greenhouse gases into the atmosphere. The most prevalent of these gases is carbon dioxide (CO2), associated with burning fossil fuels, industrial processes, forestry and other land uses, but other gases — such as methane (CH4) and nitrous oxide (N2O) — are also contributing. The convention of using CO2 equivalent emissions to measure greenhouse gas emissions is used in this paper.

Figure 1 shows projections of different possible CO2 emission pathways and the associated potential global temperature increases. It illustrates uncertainty over how emissions will evolve over future years. The evolution will depend upon many factors, such as population and income growth, the energy sources that are used, the energy intensity of production, and policy changes.


Figure 1: Possible CO2 Emission Pathways and Global Temperature increases

challenges and opportunities - Figure1
Source: Global Carbon Project (2017)

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