Transition Risk - Green Finance & Sustainable Business
Climate Risk Management Begins to Drive Investment Decisions
Investing in resilience is imperative to addressing climate change, and may result in lower financing costs
Monday, February 8, 2021
By Stacy Swann
Investing in resilience is not only imperative to addressing climate change; emerging research is starting to show that doing so could result in lower financing costs.
Why? Because managing climate risks and building-in resilience measures is good risk management, and sound risk management reflects well when attracting investors.
The UK Foreign, Commonwealth and Development Office (FCDO) commissioned a Policy Brief which highlights key recommendations and a more detailed Findings Report, entitled Understanding the Role of Climate Risk Transparency on Capital Pricing for Developing Countries. Through research and interviews with investors, these publications look to understand if (and how) climate risks are impacting investor behavior and the cost-of-capital for developing countries. While the report focuses primarily on issues important for investment in developing countries, it has three key takeaways for all investors and risk managers.
1. Climate change is already impacting cost-of-capital - negatively and positively.
These publications highlight important recent research, which indicates that a relationship between climate-risk and cost-of-capital is emerging, specifically for sovereign borrowers. According to the IMF and SOAS, climate vulnerability has already raised the average cost of sovereign debt for some developing countries vulnerable to climate risks. Moreover, in addition to the impacts on sovereign debt, climate risk is also having a measurable effect on a companies’ cost-of-debt in developing countries, underscoring linkages between a country’s ability to manage climate-related risks, the policy environment, and private sector investment.
From a more positive perspective, there is also emerging evidence that investing in resilience can mitigate the negative impacts that climate change may have on cost-of-capital. The report also cites recent IMF Research research that shows when a country proactively invests in climate resilience and structural preparedness, the negative impacts of climate change on sovereign credit ratings (and thus borrowing rates) may be partially mitigated. This may point to a recognition by credit rating agencies that policies that promote investment in resilience are part of sound risk management practices and help reduce overall riskiness. While more research may be needed, it is not unreasonable to extrapolate that, as time passes, the linkages between climate risk and cost-of-capital are likely to be replicated for other asset classes, including municipal bonds and possibly corporate and project finance. As the ability to assess, quantify, and manage climate-related risks improves, the effects of better-informed risk decisions will result in better outcomes, both from a sustainability perspective and financially.
2. TCFD is driving a rapid increase in investor awareness, but not investor understanding of climate risks.
Investor awareness that climate-related risks need to be integrated into overall risk management is rapidly evolving. This is due in part to the rising awareness of the Task Force on Climate-related Financial Disclosures (TCFD) framework and the increasing number of TCFD-aligned disclosures by early adopters. However, investors interviewed feel that, to date, existing climate-related disclosures are not currently consistent or providing sufficient useful or “useable” risk information for them to act. This is true for investors in both developed and developing countries (notwithstanding the rapid evolution in the regulatory landscape, with bodies in the EU, the UK, and Brazil proposing mandatory climate-related financial disclosures within the next year or two).
While awareness is rising rapidly, investors still struggle to fully understand how climate risks will impact them. But there’s progress on this front as well: while TCFD remains largely a voluntary framework for disclosing climate-related risks, the research shows that it is fast becoming the lingua franca for climate-related due diligence by investors of all types, enabling them to increase their level of understanding of how climate-related risks can affect the revenues, costs and asset values of the investments they make, and perhaps more importantly how companies are actively managing such risks.
3. Climate-risk management capacities and skills need to be scaled up. Urgently.
There is a big gap, though. The failure to better understand climate-related risks is directly related to the shortage of capacities and skills within financial institutions and among investors, regulators, and others. It is not that tools don’t exist for risk managers to better understand climate risk. Advancements in climate-risk analytics have evolved rapidly in a short time, and multiple climate-risk software analytics tools exist today. It is complicated because different investors may need to employ different approaches to assessing and quantifying how climate change poses financial risks to their investments over time horizons that are meaningful for them, be they short, medium, or long-term horizons.
But among investors interviewed for the report, many noted that the application of these tools remains bespoke, and only a small number of investors are integrating such tools into the risk management functions or using them consistently in their investment decision-making processes.
It is clear that the climate-risk management capacity in the form of trained risk managers with the skill sets to apply the tools, interpret the risk data and integrate such information to actively manage climate risks is greatly lacking for almost all investor types, as well as for policymakers and regulators. These capacity gaps present headwinds for investors or policymakers seeking to engage in sound climate-related risk management or scale up their investment in resilience or sustainability. And yet, the upsides for addressing such capacity gaps will be significant, not only in terms of better managing climate risks but possibly also in financial terms including a lower cost-of-capital.
Stacy Swann is the CEO and Founding Partner of Climate Finance Advisors, a benefit LLC based in Washington, DC. During her career, Ms. Swann has held senior positions with the World Bank Group, and its private sector arm, the International Finance Corporation (IFC), as well as with the US Department of Treasury, Enron Corporation, and other organizations.