Gaining Perspective on Climate: Financial Firms Should Understand Their Focus When Assessing Risk

Climate change can be viewed through many different lenses – but two key perspectives are particularly helpful for risk professionals: understanding your institution’s impact on the climate and the climate’s impact on your institution. It’s important to know which of the two perspectives you are focusing on before you start trying to measure and manage these risks.

Your Impact on the Climate

The first perspective is how you impact the climate. This relates to all activities that directly or indirectly contribute to climate change, such as emissions from transport, heating, deforestation, and food production.

The Greenhouse Gas Protocol is a commonly used standard to understand companies’ greenhouse gas emissions (GHG). These can be either direct emissions – from, for example, manufacturing processes or generating electricity, heat or steam – or indirect emissions, which are broken down into further categories, namely: (i) emissions from the generation of purchased electricity and (ii) other indirect emissions, such as those generated from business travel, supply chains, or the use of products and services that the company sells.

The Climate’s Impact on You

The second perspective is how the changing climate impacts your organization. This includes physical risks from the changing climate, and transition risks and opportunities arising from the move to a lower-carbon economy, due to changes in policy and laws, technology, supply and demand, and reputational impacts.

The Task Force on Climate-Related Financial Disclosures (TCFD) recommendations is the best known global framework to look at the climate from this perspective. In 2015, the Financial Stability Board established the Task Force, which developed voluntary, consistent, climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders. A key tenet of TCFD is that published information should be ‘decision useful’ –  in other words, it should be consistent, comparable, reliable, and clear so that it can be used to assess and price climate-related risks and opportunities.

So Which Perspective Has the Most Financial Risk for Financial Institutions?

The question is made more complex by the interaction between the two perspectives, which are inter-related over long time periods. The more we impact the climate, the more it will change and impact us in turn. This relationship is exemplified by a TFCD recommendation to disclose GHG emissions in line with the Greenhouse Gas Protocol, as organizations with significant emissions are likely to be impacted more significantly by transition risk than other organizations. This means that a protocol designed to report a company’s impact on the climate can also be used to report the impact of the climate on the company.

Notwithstanding this, the main financial risk for most financial institutions is how the climate impacts them. The transition and physical risks their counterparties/customers (e.g. corporates and households), and the firms they invest in, are exposed to are the main focus. (More on how those companies should be assessing their own risks below.)

Greenhouse gas emissions from a financial institution’s own operations mainly come from travel and office buildings. The emissions from these sources are relatively low, consequently the financial risks from these emissions, relating to the costs of reducing and/or offsetting the emissions or a carbon tax on the emissions, are also relatively low. Nevertheless, financial institutions should understand how their operations affect the climate. And in many jurisdictions companies are required to disclose this.

In Europe this has been referred to as “double materiality”, in the context that some companies need to report how they are affected by the climate, and they also need to report how their activities affect the climate.

Turning to the main risk, how will financial institution’s counterparties/customers/firms they invest in be affected?

We should note that non-financial corporates should be assessing their own risk from both perspectives:

• Corporates should assess how their operations affect the climate because their emissions could not only give rise to reputational risk and liability risk, but their emissions are also a proxy for their exposure to transition risk. Because generally, industries with high greenhouse gas emissions are more likely to be impacted by a transition to a lower carbon world, than those with low greenhouse gas emissions, due to changing regulation and societal expectations and via carbon pricing. For example, road transport uses substantially more energy than rail and could consequently be expected to be more impacted by a transition to a low carbon economy. (Notwithstanding this, there may be some lower carbon intensity companies in high GHG sectors which will fare better than their competitors.)
• Corporates should assess how the climate directly affects them so they can understand their financial exposure to physical risks, which could disrupt not just their buildings, but also their manufacturing processes, supply chains, and customers.

Retail customers are also increasingly required to understand both perspectives:

• For example, to reduce domestic GHG emissions, new standards increasingly require better insulation, or more efficient use of electricity and heating. In the UK, for example, houses need to have a minimum level of energy efficiency or they can’t be rented out.
• The changing climate is putting housing increasingly at risk due to increasing physical risks.

Both Perspectives Are Important

Counterparties across the real economy are being affected by both their impact on the climate and the climate’s impact on their operations, which will in turn impact financial institutions. Therefore, financial institutions need a strong grasp of both perspectives so they can assess the risks and opportunities of their customers and the firms they invest in.

At the portfolio and/or balance sheet level, financial institutions are also increasingly making commitments to make their portfolios net zero or align them with Paris objectives. Although this assesses the portfolio or balance sheet’s impact on the climate, data about the climate’s impact on the portfolio or balance sheet is also needed to undertake this assessment – creating another connection between the two climate risk perspectives.

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 modeling at banks. She also previously worked at a UK regulator, where she was responsible for counterparty credit risk during the last financial crisis.