Climate change: financial risk

Climate change, and more specifically, the risks of inaction in the face of climate change, have been reported for many years but have become progressively part of our daily awareness as a result of – primarily – the news of regular extreme weather events across the globe.

The change needed cannot result only from the small improvements we individually choose to make: complete and rapid structural and systemic change is required as we transition to a low carbon economy and aim to meet the standards of the Paris Climate Agreement. Firms that choose not to address climate change, or do not do so quickly enough, are and will continue to face material financial losses.

Central banks, regulators and policy makers recognise that climate change is a source of financial stability risk and have been responding with unprecedented levels of standards, regulation, and legislation. The purpose of this must be two-fold: (1) ensuring the stability of the financial system (managing risk) while (2) encouraging capital allocations towards sustainable investments to support the low carbon transition (positive change).

Much has been said about COP26 but we have already moved on. The important factor is how financial institutions engage with, respond to, and implement the many significant initiatives that were discussed in Glasgow to ensure that the outcome is an accelerated, transparent flow of capital towards climate adaptation issues. 

What are climate-related financial risks?

The Taskforce on Climate-related Financial Disclosures (TCFD) divided these risks into two main categories:

• Physical risks: these may be event driven (acute risks), including extreme weather events such as flooding, as well as other longer-term changes in climate patterns (chronic risks). Physical risks may, for example, cause direct damage to assets and disrupt supply chains, quality of output, potentially erode the value of financial assets and/or increase liabilities.
• Transition risks: these relate to the process of moving towards a low- carbon economy, including regulatory changes designed to mitigate and adapt to climate change, improvements in technology, or shifts in market standards away from - and the obsoletion of - high carbon emitting industries (eg fossil fuels). Transition risks may result in varied losses, including stranded assets, reputational damage, and litigation and other legal costs.  

Both physical and transition risks give rise to a third category: liability risks. As discussed in the section [   ], we are seeing increasing litigation and activism focussed on holding companies responsible for environmental damage or their lack of behavioural change.

The entire economy is subject to these risks, with financial institutions as a result becoming increasingly destabilised both from internal and external pressures.

The Glasgow Climate Pact does not go as far as many hoped, but it does look to address some of these risks at a national level by requesting that countries revisit and strengthen their climate action plans, known as nationally determined contributions (NDCs), for 2030 in time for COP27 in Egypt in November 2022.

What are climate-related financial opportunities?

The carrot for institutions comes in the form of the enormous opportunity for those entities who are best placed to adapt to the low carbon economy and to take advantage of the changing policy landscape and market needs needs during the move to net zero.

The cost of attaining net zero by 2050 is estimated to be between $100 trillion and $150 trillion. Mark Carney noted that “only mainstream private finance can match the scale of climate action needed for the net zero transition”.

While ensuring the stabilisation of the financial system through the management of risk, and discouraging investment in activities that will not contribute to the solution, positive action is also needed to push economies towards investment in low carbon alternatives, new technologies and sustainable products and services.

Organisations that innovate and develop new products, that seek investment in low emission products and services, and that improve their own energy efficiencies, will be more resilient and better able to adapt to the low-carbon future. To this end, the Glasgow Financial Alliance for Net Zero (GFANZ), comprising membership of more than 450 asset managers, banks and insurers, has committed over $130 trillion of private capital to transforming the economy for net zero by 2050.

What are immediate considerations for financial institutions?

The Network for Greening the Financial System (NGFS), a group of central banks and supervisors has stated that “climate-related risks are a source of financial risk [and it] falls squarely within the mandates of central banks and supervisors, to ensure the financial system is resilient to these risks.” As at the date of publication, the NGFS consists of 95 members and 15 observers.

However, although there is enormous momentum in how central banks and regulators are responding to climate change, there is also widespread divergence in approach. The implications of a piecemeal solution will impact the way in which organisations and financial institutions react and adapt. To date, the proposed solutions have focused on disclosure, governance, and risk resilience. To ensure that the GFANZ commitments are reached, we expect to see a more joined up approach – including through policy initiatives announced at COP – across the market players and a strengthening of the information and tools the market needs to support the transition.

In seeking to comply with the myriad of standards, we see the main considerations for financial institutions as:

1. Monitor international regulatory developments

The EU has been a clear first mover with detailed disclosure requirements for financial institutions and other large organisations. The impact of these rules (particularly the Sustainable Finance Disclosure Regulation, the Taxonomy Regulation and the revised Non-Financial Reporting Directive) have wide ranging implications for both financial institutions and the companies in which they are invested. Within the EU, France has taken a strict line on the ability of asset managers to market sustainability labelled products to retail investors if they do not meet very high standards of compliance. The UK will follow a TCFD approach, already a widely accepted voluntary code, which may become the global mandatory standard. These are but a couple of examples of changes we are seeing across the globe.

Institutions must keep a close understanding of the divergent rules from a legal and compliance perspective – many rules have an extra-territorial impact. It is also crucial to know the landscape so as to engage with home regulators, to keep up with shifting market standards, to have an early appreciation of the compliance burden and issues,  and to consider the impacts which may follow in their own jurisdictions.

The announced formation of the International Sustainability Standards Board (the ISSB) is a crucial step forward towards a harmonised approach, as this will be the body responsible for developing global standards of disclosure – building on TCFD. How existing regulation will fit in or be adapted is a key point to watch but we expect that there will be swift implementation once the standards are developed.

2. Look inward, as well as outward

We see a huge number of sustainability focussed financial products being issued. However, taking advantage of the market trends while not also considering how to embed climate and other sustainability risks into governance and risk structures, will begin to negatively impact financial institutions from a reputation and supervisory perspective.

Financial institutions should be setting standards from board level, with climate considerations integrated into every aspect of the business. Developing a detailed climate policy with a focus on strategy, governance and risk will help to drive wider change and keep financial institutions prepared for – or ahead of – challenging supervisory and prudential requirements.

Any successful net zero strategy must be embedded throughout the business and financial institutions will need to deal with the challenges of building up adequate resources, identifying their carbon footprint (including Scope 3) and accessing the necessary, correct data as well as the gaps therein. 

3. Identify the compliance challenges as early as possible

With a focus on disclosure, one of the main challenges facing institutions is data. Many of the metrics to be disclosed are currently underdeveloped or not required to be reported by underlying organisations. In addition, the requirements of different jurisdictions may result in institutions being obliged to report on a number of different standards: in short order this may change with the ISSB.

It is well accepted that there will be significant data gaps as reporting requirements evolve and methodologies for data capture improve. Some of the issues arising are how to:

• Identify all of the required metrics and any efficiencies to be gained from an international or group perspective
• Ensure a compliant and robust strategy for gathering and reporting data
• Identify where estimates and third-party providers can be used
• Involve all relevant business lines – legal, compliance, risk, product, and reporting to name a few.
• Consider liability issues where data is (1) lacking, (2) obtained from third parties, or (3) subject to change.

4. Consider the possible reputational and market risks alongside the strict letter of the law – ie, do more than you need to.

The climate-related financial risks discussed above are compounded by the reputational and market risks of not acting quickly enough to become part of the solution. The risks of greenwashing – either real or perceived – should be a central consideration in the development of internal strategies for ensuring that firms are doing what they say they are doing. Points to consider are:

• Developing an integrated understanding of climate and sustainability risks as they apply to your business.
• Being clear internally as to the organisation's risk parameters and terminology around sustainability.
• Reviewing governance policies and processes, including remuneration.
• Ensuring that all staff have the appropriate level of training.
• Verification of all disclosures on sustainability.
• Ensuring board level accountability and involvement in product disclosure.

Regardless of the strict requirements of any applicable law, investors and climate groups will increasingly hold financial institutions to account for their public statements and for their failures.

It is imperative that the reputational and legal risks are managed as closely as the physical and transitional risks of climate change.