Climate Risk Management at Financial Firms: Challenges and Opportunities
By Jo Paisley, Co-President, and Maxine Nelson, Senior Vice President
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By Jo Paisley, Co-President, and Maxine Nelson, Senior Vice President
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.
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
Source: Global Carbon Project (2017)
In the 2015 Paris Agreement, national governments agreed to strengthen the global response to the threat of climate change through three main actions. First, to keep global temperature rises well below 2°C (degrees Celsius) above pre-industrial levels, and to pursue efforts to limit the temperature increase even further to 1.5°C. Second, to strengthen the ability of countries to adapt to climate change and develop low greenhouse gas emission technology. Third, to make finance flows consistent with a pathway toward low greenhouse gas emissions and climate-resilient development. Financial institutions have a key role to play in meeting the third objective.
Scientific studies indicate a relationship between cumulative CO2 emissions and global temperature change. To limit global warming to 2°C, as per the Paris Agreement, CO2 annual global emissions need to decrease over time to be near, or below, zero by the year 2100.
As the European Systemic Risk Board (ESRB) explained in 2016, reducing carbon emissions requires economies to reduce their carbon intensity, which implies a shift away from fossil-fuel based energy and its related physical capital. In a world where this transition occurs gradually, there may be a scenario in which the adjustment costs are manageable, and the repricing of carbon assets does not entail systemic risk.
There are, however, many possible scenarios in which the transition to a low-carbon economy occurs later in the century and hence requires a more abrupt transition, which in turn may impose significant costs on firms and households, raising the prospect of increased systemic risk. As the ESRB notes in its report, these amplified systemic risks could manifest themselves via three main channels: the macroeconomic impact of sudden changes in energy use, the revaluation of carbon-intensive assets, and a rise in the incidence of natural catastrophes.
Given the risks involved and their material consequences, it is not surprising that regulators are now increasing their focus on the implications of climate change for financial institutions.
The discussion about how climate risk affects the financial sector has gained significant momentum over the past five years. Since the Paris Agreement was adopted, regulators have become increasingly interested in both the micro- and macroprudential implications of climate change. Warnings about the potentially destabilizing effects of climate change have been issued by The Financial Stability Board and the G20, as well as central banks, including those in the UK, France, Italy, Australia and The Netherlands.
At a macroprudential level, when China held the G20 presidency in 2016, it added green finance to the agenda. The People's Bank of China has since followed up on the climate initiative by including green finance in its macroprudential assessment, providing incentives for banks to lend to green finance initiatives and to increase green deposits. The PBOC, in conjunction with other China ministries, is also standardizing green disclosures and green credit ratings, and has been trialing an assessment of the green performance of banks since 2018.
In December 2017, to contribute to the development of environment and climate risk management in the financial sector, and to mobilize mainstream finance to support the transition toward a sustainable economy, eight central banks and supervisors established the Network for Greening the Financial System (NGFS). Since its establishment, the NGFS has grown to 36 members and six observers from international organizations. NGFS has organized three workstreams focused on the following areas:
On the microprudential supervisory front, in 2016, DeNederlandesche Bank established a Climate Risk Working Group to manage the financial consequences of climate change-related risks. And in 2019, the UK's regulators — the Prudential Regulation Authority and the Financial Conduct Authority — established the Climate Financial Risk Forum (CFRF). The CFRF aims to advance financial sector responses to the financial risks from climate change, partly by building capacity and sharing best practices across financial regulators and the industry. Its membership comprises senior representatives from across the financial sector (including banks, insurers and asset managers), as well as senior PRA and FCA representatives.
The PRA also recently became the first regulator in the world to publish supervisory expectations that explain how banks and insurance companies need to develop an enhanced approach to managing financial risks derived from climate change. Its Supervisory Statement details how firms can address these risks in their governance and risk management frameworks (see Figure 2).
Figure 2: The PRA's Expectations for the Management of Climate-Driven Financial Risks
Source: PRA Supervisory Statement SS3/19
The ECB's supervisory risk assessment for 2019 describes how climate-related risks are not a short-term financial stability threat for the euro area, but do pose risks to banks. The regulator cites the risks from physical and transition risks to both banks and their customers, and notes that banks need to take adequate action to manage their exposures to such risks.
There has also been a great deal of work on improving disclosures. This not only forces institutions to manage their own climate risks but also provides the market with potentially useful information. One high-profile framework was created by the Task Force on Climate-related Financial Disclosures (TCFD) under the auspices of the Financial Stability Board.
In most G20 jurisdictions, companies with public debt or equity have a legal obligation to disclose material information including climate-related data in their financial filings. Moreover, IOSCO has stated that, when ESG matters are considered material, issuers should disclose the impact or potential impact on their financial performance and value creation. These disclosures should help investors' consideration of climate-related risks.
Central banks are also starting to lead by example by including climate-related risks in their own processes. For example, in 2019, DNB became the first central bank to sign the UN-supported Principles for Responsible Investment (PRI) and the Banque de France became the first central bank to publish information about its own greenhouse gas emissions. This is indicative of policy risk: as more authorities incorporate climate risk in their own processes, there is an increased likelihood that government and regulatory policies will change.
This steadily increasing regulatory interest and focus is requiring firms to address and ultimately demonstrate how they deal with — or plan to deal with — financial risks related to climate change.
Many studies of financial risks stemming from climate change look at those risks as arising through two main channels: physical risk and transition risk (see TCFD and PRA).
Physical Risks
Physical risks arise from climate- and weather-related events. Under all emission scenarios developed to date, the earth's temperature is predicted to increase. The result of that temperature increase will very likely be a more regular occurrence of longer-lasting heat waves and more frequent and intense extreme precipitation events in many regions around the globe. The ocean will continue to warm and acidify, and the global mean sea level will rise (IPCC, 2014). These changes in the physical environment will create physical risks that will impact individuals, businesses and economies, consequently affecting a variety of financial transactions.
This physical risk transmission channel can be further broken down into specific weather events (such as heatwaves, floods, wildfires and storms) and longer-term shifts in climate patterns (such as changes in precipitation and extreme weather variability, rising sea level and increasing mean temperatures). The TCFD refers to the specific weather events as acute risks and the longer-term shifts in climate patterns as chronic risks.
Transition Risks
Transition risks arise from the process of adjusting toward a lower-carbon economy. Policy, technology and laws relating to climate change could alter, prompting a reassessment of the value of a large range of assets as costs and opportunities become apparent. This reassessment could modify the value of assets and liabilities, thereby altering the risk profile of financial institutions.
If voluntary and stepped actions to reduce carbon emissions are delayed into the future, the likelihood of aggressive government policy requirements addressing climate-related issues will rise. As the opportunity to take voluntary steps lessens, the more immediate and demanding government requirements may become, thus increasing transition risks. An informed and steady implementation of policies and initiatives toward reducing global CO2 emissions, resulting from regulatory and corporate actions and incentives, can assist in the timely identification and appropriate management of climate-related transition risks.
Firms will need to examine their portfolios to gain a better understanding of which exposures are most at risk from climate change. Scenario analysis can play a part in this risk identification process, as well as the quantification of those risks.
Given the uncertainty around the future path of emissions, and their associated economic and financial impacts, a natural tool for analyzing these risks is scenario analysis. Indeed, in 2017, following the release of the TCFD paper on scenario analysis, the TCFD and the Bank of England hosted a conference on the use of scenario analysis in assessing climate-related risks and opportunities.
As the conference summary explains, there are two primary types of scenarios fit for this purpose: climate-impact (physical risk) scenarios and transition scenarios. Climate-impact scenarios investigate the effects climate change could have on economies, societies and ecosystems, given an assumed level of emissions; transition scenarios model how economies might adjust given a temperature target and government policy.
These types of scenarios have been piloted by a number of financial institutions. For example, UNEPFI and Oliver Wyman Mercer piloted the use of scenario analysis to assess the transition risk component of a portfolio's credit risk. UNEPFI and Acclimatise, on the other hand, piloted scenario analysis to assess credit risk due to physical risks in part of a loan portfolio, while UNEPFI and Carbon Delta piloted a method asset managers can use to assess the physical and transition risks and opportunities in investment portfolios. (Existing scenario analysis methods for physical and transition risks are reviewed in Section 2 of the report on the UNEPFI/Carbon Delta project.) Meanwhile, risks and opportunities for infrastructure investments are explored in the ClimateWise transition risk framework.
While existing scenario analysis or stress testing frameworks can be leveraged, climate risk scenario analysis differs from the traditional use of these tools in a number of ways. Climate change scenarios typically need longer time horizons, for example, than the three- to five-year time horizons that banks traditionally use to assess their business and their risks.
Moreover, many existing climate change scenarios were constructed to aid policymakers and are described in terms of physical variables such as CO2 emissions, temperature change and sea level rise. They do not generally include specific economic parameters. As such, extensive work is required to translate the changes in the environment they describe into macroeconomic and financial outcomes (e.g., GDP, unemployment and interest rates) that are generally used for stress testing or scenario analysis.
The think tank, 2° Investing Initiative, examined this challenge in its report, Storm Ahead - A Proposal for a Climate Stress Test Scenario. For example, the report notes how the estimated impact on GDP of the physical risks arising from climate change can vary wildly, depending on the modelling approach taken. It also explains how many of the existing climate-risk studies focus on assessing the impact of a “likely” transition, rather than stressing the tail risks. These scenarios may not be appropriate for regulators, who are more likely to want to understand the tail risks from, say, a “too late, too sudden” transition scenario.
It is perhaps not surprising that the recent GARP Risk Institute survey indicated that scenario analysis is the least mature aspect of firms' approaches to managing the financial risks from climate change. An intermediate step, before full scenario analysis, is to consider case studies. A couple of examples are provided below.
Case studies can help raise awareness of the potential impacts on business and supply chains, which could then be developed into more sophisticated scenarios that are relevant for a firm's particular business model or geographical location.
Physical Risks
Changes to the climate are predicted to increase the frequency and severity of storms and precipitation. This will have both direct and indirect impacts.
Direct Effects
An increase in the frequency and severity of storms will impact both residential and commercial real estate: more properties will be flooded, properties in current flood zones will be flooded more often and floods will be more severe. (See the ClimateWise paper for a detailed, flood-related case study.) This will decrease the value of those properties that are held as collateral against loans, thereby increasing the loss given default if the customer cannot repay his or her loan.
Moreover, non-life insurance companies' losses will increase, and to maintain margins insurers will need to raise premiums. If premiums are increased too much, they will become unaffordable or may require government subsidies. Alternatively, if they cannot increase premiums sufficiently to maintain a profit, non-life insurers may simply pull out of markets.
The value of commercial real estate that is held as a long-term income stream by insurers and asset managers will also be impacted.
Indirect Effects
As supply chains become more global, events in parts of the world far away from a company's headquarters or manufacturing sites can have unforeseen impacts on the business. For example, floods in Thailand in 2011 directly affected computer hard-disc drive manufacturers and car manufacturers. The disruption to the hard-disc drive manufacturers, in turn, impacted the manufacturers of electronic goods in a range of companies, from phone manufacturers to electronic equipment manufacturers in the European Union, Japan and the United States.
Aon Benfield's report on the flooding noted that companies that were forced to halt production in Thailand included Toyota, Honda, Mazda, Nissan, Mitsubishi, Sony, Nikon, Sanyo Semiconductor, Canon, Western Digital, Hitachi, Hutchinson, Microsemi, ON Semiconductor and Matsushita. Flooding adversely affected the profitability of all these companies.
Obviously, insurers that provided coverage for these companies suffered business contingency-related losses. And for banks doing business with the companies, the impact on profitability may have translated into a higher probability of default.
Transition Risks
A transition to a lower carbon intensity economy will involve changes across many sectors, including power generation, manufacturing, transportation and construction. The speed at which the transition occurs will affect the scale of disruption for affected industries.
Direct Effects
A study by University College London concluded that about two-thirds of existing coal reserves may need to stay in the ground, as their extraction and use is inconsistent with a 2⁰C emissions scenario. This will create stranded assets – that is, in industries that currently emit carbon intensively (such as carbon-powered electricity generation), assets will be written down or written off before the end of their useful life. For example, if existing coal investments continue, China could have $90 billion of stranded coal assets by 2030.
According to the Institute for Sustainable Development and International Relations, only about 20 to 25 percent of coal-fired plants constructed since 2005 would have made back their investments by 2030. In the future, if there is a change in government policy that forces coal-fired power stations to stop production, this could result in losses to banks that have provided loans to these companies. If insurers and asset managers are holding bonds that these power stations have issued, they could also suffer losses.
Indirect Effects
Many different industries could be indirectly impacted by a transition to a low-carbon economy. For example, if governments decide that the cost of carbon emissions needs to be priced into manufactured products, construction costs will rise due to increased cement and steel costs from the use of coal in their manufacturing process.
The cost of diesel- and petrol-based transport will also increase, which will raise the cost of transporting products to market and may increase their cost to the consumer. This would reduce consumers' cashflow and/ or the profitability of the manufacturer, increasing their probability of default and, correspondingly, reducing the market value of the manufacturer.
However, there are also opportunities in expanding industries, such as electric cars and motorbikes, and more efficient solar, wind and hydroelectric power generation.
A paper published earlier this year by the CRO Forum (2019) — a group comprised of chief risk officers from large, multi-national insurance companies — argues that transition risk is likely to be the biggest area of influence on asset values in the shorter term, whereas the physical effects are likely to be the driving factors influencing asset values and economic performance in the medium to longer term.
Financial risks from climate change will impact firms differently, depending on their business models and particular balance sheets. Banks' assets and liabilities, for example, will likely be affected by physical and transition risks – including impacts on counterparties' operations; the viability of businesses that they are lending to or receiving funds from; changes to collateral values; and changes in customers' ability to repay loans.
When considering the impact of climate change on insurers, an increase in liability risk is a natural first assumption. However, since the investment implications of climate change for insurers are equally as diverse as the insurance implications, insurers, like banks, also need to assess how climate change affects the assets in which they invest.
Asset managers, meanwhile, are facing increased pressure from investors and regulators for climate-related disclosures such as those in the TCFD and the CDP. What's more, the Principles for Responsible Investment, a not-for-profit asset management advocacy group supported by the UN, has also thrown its weight behind climate-related disclosures.
Asset managers, according to the PRI, should show that they have recognized relevant risks (even if they are climate change skeptics); analyze how climate change might affect investment returns over the short, medium and long-term; explicitly manage the risks; interrogate and challenge those who are managing the assets and the companies that are being invested in to ensure that these risks are being effectively managed; and establish processes that enable them to demonstrate the actions they have taken. While these principles may, in some cases, be aspirational, they provide a helpful path forward for investment managers to be able to address climate-related issues on behalf of their firms and their clients.
Section B3 of the final TCFD report provides a useful analysis of the key factors to be considered when assessing climate-related financial risks.
To meet regulators' expectations, financial institutions will need to identify, measure, monitor, manage and report on climate risks. Firms will also be expected to disclose any of these material risks, both publicly and to their regulators.
Climate risk is not a new risk type, but a transverse risk that manifests itself through existing risk types. While the risks for each firm will be different, a useful exercise is to examine existing risk types and consider whether climate risk is sufficiently material to be incorporated and embedded into established risk frameworks. Figure 3 (following page) provides an example of how this might be achieved for some key risks.
Financial risks will typically be greater for long-lived assets and liabilities (e.g., infrastructure, pensions) than for short-term contracts, where risks and pricing can be more readily adjusted. But reputational risks can arise quickly in unpredictable ways and can rapidly affect firms.
There may also be consequential risks, such as concentration risk and asset-liability mismatches. For example, reduced lending to sectors or geographies may lead to increased concentrations in the rest of the financial institution's portfolio.
The more that these types of transverse considerations are embedded into firms' day-to-day governance and risk management processes, the better firms will be able to manage and mitigate the financial risks of climate change.
Figure 3: Examples of Risks and Opportunities
Climate risk is firmly on the agenda of regulators and is now front-and-center for firms to address. It's important for risk managers to understand some basic climate science in order to appreciate the financial risks that may arise from climate change, as well as the scale of uncertainty, as the risks relate not only to firms' clients and counterparties but also to their own processes, procedures and operations.
Climate risk is a “transverse” risk; that is, not a risk in its own right but one that will manifest itself through existing risk channels. Firms can, therefore, use their current risk frameworks to begin to assess the impact of climate change. The recent GRI Survey of Climate Risk Management, which examined the maturity of firms' climate risk management practices, showed a wide range of practices and progress, with many firms only at the start of their journey.
Climate change scenario analysis is one of the least advanced areas. This may partly reflect the difficulty of devising scenarios in terms that are meaningful for understanding financial risks. Linking climate science to macroeconomic and financial outcomes is not an easy task and subject to much debate and analysis.
Firms that have yet to start considering the financial risks arising from climate change should be aware that as global temperatures rise, physical risks will inevitably change the risk profile of a financial institution's balance sheet. Furthermore, the risks to the firm will increase if policy, business or societal pressures demand a faster transition to a low-carbon environment.
To move forward, financial institutions should create and adhere to leading practices for climate risk management. The Dutch Central Bank has offered the following suggestions:
At a practical level, firms need to start by establishing board-level governance and the appropriate senior management ownership. Given the nature of the risk, establishing an internal cross-disciplinary working group can also help bring together different parts of the business to start identification and assessment of climate-related risks. It is preferable for this to be led by the business or the risk management function, rather than the corporate social responsibility team.
Reviewing the resources highlighted in this report can provide a broad overview and context, before focusing on the specific risks affecting a particular firm. Distinguishing physical and transition risks can be helpful in identifying the channels of impact. Moreover, prioritizing asset classes, geographies and sectors that are high risk can improve focus on the most material areas of concern.
Developing in-house expertise on scenarios is also important, not only for risk management but also for disclosure. In summary, much work is still to be done before climate risk management becomes embedded in day-to-day operations.
About the Authors
Jo Paisley, President, GARP Risk Institute, served as the Global Head of Stress Testing at HSBC from 2015-17, and as a stress testing advisor at two other UK banks. As the Director of the Supervisory Risk Specialists Division at the Prudential Regulation Authority, she was also intimately involved in the design and execution of the UK's first concurrent stress test in 2014.
Maxine Nelson, Senior Vice President, GARP Risk Institute, is a leader in risk, capital and regulation. In her career, she has held several senior roles where she was responsible for global capital planning and risk modelling at banks. She also previously worked at a UK regulator, where she was responsible for counterparty credit risk during the last financial crisis.
By Jo Paisley and Maxine Nelson
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