Climate risk: the danger is becoming clearer
19 July 2022
Growing suspicions relating to greenwashing, the consequences of natural disasters, disinvestment from polluting sectors of activity… financial institutions are not immune to climate risks. And while the threat is growing, it is far from always predictable.
In the US, concern is growing among financial institutions active in the sustainable investment segment. Despite the absence of a formal framework like the EU’s Taxonomy or SFDR, the Securities Exchange Commission (SEC) has made the fight against greenwashing a priority. In the space of a few months, it opened investigations into some of the big names in international finance. Prior to the BaFin investigation earlier this year, the SEC launched an investigation into DWS in 2021, the asset management subsidiary of Deutsche Bank, suspecting it of having sold investment products as “sustainable” without taking ESG criteria into account. A month earlier, Bank of New York Mellon paid US$1.5 million to avoid an investigation following accusations that certain funds had been marketed as having been screened for ESG criteria but had not.
In cases like these, in addition to the financial risk of misrepresentation, a financial institution’s reputation could suffer the most damage. Climate change is mobilising investors, and many are putting their money to work for this cause, but the guarantees remain weak. No national or international legislation is currently sufficient to avoid false ESG definitions.
The framework that the EU is putting in place based on a taxonomy and information provided by financial institutions and companies on ESG is of great value for the development of this market.
Chief Economist for the European Stability Mechanism, Rolf Strauch considers climate change and the risks it entails to be “the greatest challenge of our time”. Last February, the ESM joined the Network of Central Banks and Supervisors for Greening the Financial System as an observer. In its investment approach, the institution applies the UN Principles for Responsible Investment. Strauch is, however, confident about the guidelines that Europe is gradually developing to rigorously define sustainable investments. “The framework that the EU is putting in place based on a taxonomy and information provided by financial institutions and companies on ESG is of great value for the development of this market. It provides clear standards and therefore reliable information.”
As robust rules are developed, climate risk managers will have to worry less about greenwashing. The task remains, however, sufficiently complex despite the reprieve on the way as Strauch points out. Global warming will undoubtedly impact the financial sector, particularly through the devaluation of assets and the costs it entails for companies, but also in terms of the role it will have to play in the transition to a low-carbon economy. “We know that the efforts that need to be made at the macro level to address climate change are huge. Much of the money has to come from the private sector, which means that financial institutions need to engage here.”
While the financial sector will undoubtedly not be the first to be impacted by climate change, it will be affected with a delay through the consequences suffered by its clients, be they private or corporate. Either they will be directly affected by damage caused by weather events that impact on their finances or business activities, or, in the case of companies with a negative impact on the environment, new, stricter regulations, political decisions or changes in consumer attitudes will affect the smooth running of their business.
There are therefore two main risk factors in relation to climate change: physical risk and transition risk.
The physical risk concerns the costs and financial losses resulting from extreme weather events (droughts, floods, hurricanes, etc.), the frequency of which is increasing.
Transition risk refers to a company’s loss of value caused by the ongoing shift towards a low-carbon economy. Some will be affected by new regulations on CO2 emissions, others by a technological innovation that makes theirs obsolete for example.
One of the major impacts of transition risk is the emergence of stranded assets.
“One of the major impacts of transition risk is the emergence of stranded assets,” explains Strauch. “This happens when investments made in the past no longer achieve the same degree of profitability and therefore reinvestment becomes scarce. This is notably an issue in the energy sector. The risk is that valuations will fall, putting financial institutions at risk.”
Whether it is to secure their investments or to reduce their climate impact, many financial firms are starting to make clear choices. Many have, for example, chosen to no longer invest in or insure new carbon intensive projects. Choices such as these are obviously in line with the desire to achieve a decarbonised global economy, but they increase the credit and market risk of institutions that finance, often historically, a sector as important as fossil fuels.
The financial threats associated with the transition can be kept under close review and mitigated. Risk managers have them on the radar and are building scenarios to avoid complications. The risks associated with weather events, on the other hand, are much more complex. Their degree of probability remains very difficult to assess. Notably, there remain immense challenges in modelling transition and other climate-related risks accurately. This level of uncertainty in measuring climate effects requires new methodologies that take into account a wide range of variables, including a significantly longer timeline in terms of risk calibration.
The insurance sector is at the forefront of climate risk. Products are being adapted to climate change, however there is no clear understanding of how the situation will truly develop. This feeling of having to navigate in the dark is confirmed by Annick Felten, Chief Risk Officer at Foyer. “The risk is certain, but the impact on our portfolio is difficult to quantify at this stage. We therefore simulate scenarios and apply stress tests based on events that have taken place also abroad and the data that has emerged from them. We have to collect as much information as possible.”
There is indeed an urgent need to act. Swiss Re estimates that the costs linked to natural disasters in the world reached $270 billion in 2021 alone. Over the last decade, the total bill has exceeded $2 trillion and this is only likely to increase.