Briefing

Briefing — Climate Financial Risk

Financial Institutions such as asset managers, banks and insurers rely on the disclosures made by corporations in their decisions to invest, lend or insure; in turn, these financial institutions now need to identify, assess and manage their own climate change related risks and/or the risks of products that they manage on behalf of clients.

In this process, it is important that financial institutions consider not only the risk that climate change might pose to their business model and financials; but also how the institution’s investing, lending or underwriting choices might themselves have climate change risk implications. 

The endpoint to this process of identifying and managing risk is the disclosure of climate change related risk in a ‘decision-useful’ way to investors, credit rating agencies, customers and regulators. Regulated financial institutions in the UK are already mandated to report material issues under a number of different pieces of legislation and from different bodies; environmental risk is already considered a material issue, and so now too and separately is climate change related risk. A goal is for financial institutions to have the data, tools, process and governance to be able to produce and disclose their climate change related Risk Appetite and Capital Allocation; this is still at an early stage. 

The materiality of climate change related financial risk should be considered and assessed at the Board level of financial institutions, and explicitly considered in the Terms of Reference for Board Committees; and should be integrated into Key Performance/Risk Indicators managed by Chief Financial and Risk Officers. 

Proper management of climate change related financial risk requires financial institutions to identify risk exposures, both transition and physical, then model and quantify the risk, and integrate the results into existing risk management frameworks for the standard risk types: market/credit/operational/underwriting & reserving/reputational. The exposure needs to be quantified and translated into financial metrics whose impact on financial statements, capital ratios and market valuations can be measured. Value-at-risk (VaR) methodology should be extended to Climate Value-at-risk (CVaR). This work is of value not only for the purpose of external reporting and disclosure but also for operational decision making and strategic planning within financial institutions. 

Risk management strategy should be informed by and stress tested with scenario analysis. Scenarios are not predictions; they explore the potential range of climate outcomes and analyse the effect of alternative states in a structured way. Financial institutions should disclose their scenario selection; it is at the moment difficult to compare climate-related disclosures.

Innovation around climate change related financial risk includes defining the much-needed data infrastructure and ensuring it can operate at scale, bridging the current considerable data gaps and improving modeling tools and approaches. 

There also needs to be transformative financing from the institutional and retail sector (rather than from public funds) invested into new resilient zero-carbon solutions in infrastructure, assets and services, such as retrofitting buildings, electricity grid modernization to support high renewable energy loads, and electric powered surface transport.

Leave a Reply