The Bank of England is even of the opinion that climate change represents the tragedy of the horizon: “by the time it is clear that climate change is creating risks that we want to reduce, it may already be too late to act” [1]. This article provides a summary of the type of financial risks resulting from climate change, various initiatives within the financial industry relating to the shift towards a low-carbon economy, and an outlook for the assessment of climate change risks in the future.

At the December 2015 Paris Agreement conference, strict measures to limit the rise in global temperatures were agreed upon. By signing the Paris Agreement, governments from all over the world committed themselves to paving a more sustainable path for the planet and the economy. If no action is taken and the emission of greenhouse gasses is not reduced, research finds that per 2100, the temperature will have increased by 3°C to 5°C².. Climate change affects the availability of resources, the supply and demand for products and services and the performance of physical assets. Worldwide economic costs from natural disasters already exceeded the 30-year average of USD 140 billion per annum in seven out of the last ten years. Extreme weather circumstances influence health and damage infrastructure and private properties, thereby reducing wealth and limiting productivity. According to Frank Elderson, Executive Director at the DNB, this can disrupt economic activity and trade, lead to resource shortages and shift capital from more productive uses to reconstruction and replacement³.

According to the Bank of England, financial risks from climate change come down to two primary risk factors⁴:

Increasing concerns about climate change has led to a shift in the perception of climate risk among companies and investors. Where in the past analysis of climate-related issues was limited to sectors directly linked to fossil fuels and carbon emissions, it is currently being recognized that climate-related risk exposures concern all sectors, including financials. Banks are particularly vulnerable to climate-related risks as they are tied to every market sector through their lending practices.

Financial risks

• Physical risks. The first risk factor concerns physical risks caused by climate and weather-related events such as droughts and a sea level rise. Potential consequences are large financial losses due to damage to property, land and infrastructure. This could lead to impairment of asset values and borrowers’ creditworthiness. For example, as of January 2019, Dutch financial institutions have EUR 97 billion invested in companies active in areas with water scarcity⁵. These institutions can face distress if the water scarcity turns into water shortages. Another consequence of extreme climate and weather-related events is the increase in insurance claims: in the US alone, the insurance industry paid out USD 135 billion from natural catastrophes in 2017, almost three times higher than the annual average of USD 49 billion.
• Transition risks. The second risk factor comprises transition risks resulting from the process of moving towards a low-carbon economy. Revaluation of assets because of changes in policy, technology and sentiment could destabilize markets, tighten financial conditions and lead to procyclicality of losses. The impact of the transition is not limited to energy companies: transportation, agriculture, real estate and infrastructure companies are also affected. An example of transition risk is a decrease in financial return from stocks of energy companies if the energy transition undermines the value of oil stocks. Another example is a decrease in the value of real estate due to higher sustainability requirements.

These two climate-related risk factors increase credit risk, market risk and operational risk and have distinctive elements from other risk factors that lead to a number of unique challenges. Firstly, financial risks from physical and transition risk factors may be more far-reaching in breadth and magnitude than other types of risks as they are relevant to virtually all business lines, sectors and geographies, and little diversification is present. Secondly, there is uncertainty in timing of when financial risks may be realized. The possibility exists that the risk impact falls outside of current business planning horizons. Thirdly, despite the uncertainty surrounding the exact impact of climate change risks, combinations of physical and transition risk factors do lead to financial risk. Finally, the magnitude of the future impact is largely dependent on short-term actions.

Initiatives

Many parties in the financial sector acknowledge that although the main responsibility for ensuring the success of the Paris Agreement and limiting climate change lies with governments, central banks and supervisors also have responsibilities. Consequently, climate change and the inherent financial risks are increasingly receiving attention, which is evidenced by the various recent initiatives related to this topic.

Banks and regulators

The Network of Central Banks and Supervisors for Greening the Financial System (NGFS) is an international cooperation between central banks and regulators⁶. NGFS aims to increase the financial sector’s efforts to achieve the Paris climate goals, for example by raising capital for green and low-carbon investments. NGFS additionally maps out what is needed for climate risk management. DNB and central banks and regulators of China, Germany, France, Mexico, Singapore, UK and Sweden were involved from the start of NGFS in 2017. The ECB, EBA, EIB and EIOPA are currently also part of the network. In the first progress report of October 2018, NGFS acknowledged that regulators and central banks increased their efforts to understand and estimate the extent of climate and environmental risks. They also noted, however, that there is still a long way to go.

In their first comprehensive report of April 2019, NGFS drafted the following six recommendations for central banks, supervisors, policymakers and financial institutions, which reflect best practices to support the Paris Agreement⁷:

1. Integrating climate-related risks into financial stability monitoring and micro-supervision;
2. Integrating sustainability factors into own-portfolio management;
3. Bridging the data gaps by public authorities by making relevant data to Climate Risk Assessment (CRA) publicly available in a data repository;
4. Building awareness and intellectual capacity and encouraging technical assistance and knowledge sharing;
5. Achieving robust and internationally consistent climate and environment-related disclosure;
6. Supporting the development of a taxonomy of economic activities.

All these recommendations require the joint action of central banks and supervisors. They aim to integrate and implement earlier identified needs and best practices to ensure a smooth transition towards a greener financial system and a low-carbon economy. Recommendations 1 and 5, which are two of the main recommendations, require further substantiation.

• The first recommendation consists of two parts. Firstly, it entails investigating climate-related financial risks in the financial system. This can be achieved by (i) mapping physical and transition risk channels to key risk indicators, (ii) performing scenario analysis of multiple plausible future scenarios to quantify the risks across the financial system and provide insight in the extent of disruption to current business models in multiple sectors and (iii) assessing how to include the consequences of climate change in macroeconomic forecasting and stability monitoring. Secondly, it underlines the need to integrate climate-related risks into prudential supervision, including engaging with financial firms and setting supervisory expectations to guide financial firms.
• The fifth recommendation stresses the importance of a robust and internationally consistent climate and environmental disclosure framework. NGFS supports the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD⁸) and urges financial institutions and companies that issue public debt or equity to align their disclosures with these recommendations. To encourage this, NGFS emphasizes the need for policymakers and supervisors to take actions in order to achieve a broader application of the TCFD recommendations and the growth of an internationally consistent environmental disclosure framework.

Future deliverables of NGFS consist of drafting a handbook on climate and environmental risk management, voluntary guidelines on scenario-based climate change risk analysis and best practices for including sustainability criteria into central banks’ portfolio management.

Asset managers

To achieve the climate goals of the Paris Agreement, €180 billion is required on an annual basis⁵. It is not possible to acquire such a large amount from the public sector alone and currently only a fraction of investor capital is being invested sustainably. Research from Morningstar shows that 11.6% of investor capital in the stock market and 5.6% in the bond market is invested sustainably⁹. Figure 1 shows that even though the percentage of capital invested in sustainable investment funds (stocks and bonds) is growing in recent years, it is still worryingly low.

Figure 1: Percentage of invested capital in Europe in traditional and sustainable investment funds (shares and bonds). Source: Morningstar [9].

The current levels of investment are not enough to support an environmentally and socially sustainable economic system. As a result, the European Commission (EC) has raised four initiatives through the Technical Expert Group on sustainable finance (TEG) that are designed to increase sustainable financing¹⁰. The first initiative is the issuance of two kinds of green (low-carbon) benchmarks. Offering funds or trackers on these indices would lead to an increase in cash flows towards sustainable companies. Secondly, an EU taxonomy for climate change mitigation and climate change adaptation has been developed. Thirdly, to enable investors to determine to what extent each investment is aligned with the climate goals, a list of economic activities that contribute to the execution of the Paris Agreement has been drafted. Finally, new disclosure requirements should enhance visibility of how investment firms integrated sustainability into their investment policy and create awareness of the climate risks the investors are exposed to.

Insurance firms

Within the insurance sector, the Prudential Regulation Authority (PRA) requires insurers to follow a strategic approach to manage the financial risks from climate change. To support this, in July 2018, the Bank of England (BoE) formed a joint working group focusing on providing practical assistance on the assessment of financial risks resulting from climate changes. In May 2019, the working group issued a six-stage framework that helps insurers in assessing, managing and reporting physical climate risk exposure due to extreme weather events¹¹. Practical guidance is provided in the form of several case studies, illustrating how considering the financial impacts can better inform risk management decisions.

Authorities

Another initiative is the Climate Financial Risk Forum (CFRF), a joint initiative of the PRA and the Financial Conduct Authority (FCA)¹². The forum consists of senior representatives of the UK financial sector from banks, insurers and asset managers. CFRF aims to build capacity and share best practices across financial regulators and the industry to enhance responses to the financial climate change risks. The forum set up four working groups focusing on risk management, scenario analysis, disclosure and innovation. The purpose of these working groups, which consist of CFRF members as well as other experts such as academia, is to provide practical guidance on each of the four focus areas.

Current status and outlook

On 5 June 2019, the TCFD published a Status Report assessing a disclosure review on the extent to which 1,100 companies included information aligned with these TCFD recommendations in their 2018 reports. The report also assessed a survey on companies’ efforts to live up to TCFD recommendations and users’ opinion on the usefulness of climate-related disclosures for decision-making¹³. Based on the disclosure review and the survey, TCFD concluded that, while some of the results were encouraging, not enough companies are disclosing climate change-linked financial information that is useful for decision-making. More specifically, it was found that:

• “Disclosure of climate-related financial information has increased, but is still insufficient for investors;
• More clarity is needed on the potential financial impact of climate-related issues on companies;
• Of companies using scenarios, the majority do not disclose information on the resilience of their strategies;
• Mainstreaming climate-related issues requires the involvement of multiple functions.”

Further, the BoE finds that despite the progress, there is still a long way to go: while many banks are incorporating the most immediate physical risks to their business models and assess exposures to transition risks, many of them are not there yet in their identification and measurement of the financial risks. They stress that governments, financial firms, central banks and supervisors should work together internationally and domestically, private sector and public sector, to achieve a smooth transition to a low-carbon economy. Mark Carney, Governor of the BoE, is optimistic and argues that, conditional on the amount of effort, it should possible to manage the financial climate risks in an orderly, effective and productive manner⁴.

With respect to the future, Frank Elderson made the following claim: “Now that European banking supervision has entered a more mature phase, we need to retain a forward-looking strategy and develop a long-term vision. Focusing on greening the financial system must be a part of this.”³.

References

¹ https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/avoiding-the-storm-climate-change-and-the-financial-system-speech-by-sarah-breeden.pdf
² https://public.wmo.int/en/media/press-release/wmo-climate-statement-past-4-years-warmest-record
³ https://www.bankingsupervision.europa.eu/press/interviews/date/2019/html/ssm.in190515~d1ab906d59.en.html
⁴ https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/report/transition-in-thinking-the-impact-of-climate-change-on-the-uk-banking-sector.pdf
⁵ https://fd.nl/achtergrond/1294617/beleggers-moeten-met-de-billen-bloot-over-klimaatrisico-s
⁶ https://www.dnb.nl/over-dnb/samenwerking/network-greening-financial-system/index.jsp
⁷ https://www.banque-france.fr/sites/default/files/media/2019/04/17/ngfs_first_comprehensive_report_-_17042019_0.pdf
⁸ https://www.fsb-tcfd.org/publications/final-recommendations-report/
⁹ http://www.morningstar.nl/nl/
¹⁰ https://ec.europa.eu/info/publications/sustainable-finance-technical-expert-group_en
¹¹ https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/publication/2019/a-framework-for-assessing-financial-impacts-of-physical-climate-change.pdf
¹² https://www.bankofengland.co.uk/news/2019/march/first-meeting-of-the-pra-and-fca-joint-climate-financial-risk-forum
¹³ https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-2017-TCFD-Report-11052018.pdf

The new EU directive regulating alternative investment funds management (AIFMD) meant that asset manager ACTIAM had to make substantial changes to its risk management, a major operation that had to be carried out in a short period of time.

ACTIAM was founded on 1 July 2014 after a merger between SNS Asset Management (SNS AM) and SNS Beleggingsfondsen Beheer (SBB, Investment funds management). The company now has more than EUR 50 billion assets under management for insurers, banks and pension funds. Among them are Reaal, Zwitserleven, ASN Bank and SNS Bank. “Responsible asset management is our specialism,” says Rob Verheul, COO at ACTIAM. “We manage all our investment categories in a responsible fashion. We have made doing business in a responsible way core to our investment process. It is in our DNA and we are proud of it. “ACTIAM originates from the Hollandse Koopmansbank (Dutch Merchant Bank) and has more than earned its reputation as a responsible asset manager. It has managed the ASN equity fund for more than 20 years. In 2013, this fund was awarded the Golden Bull for the best investment fund, and in 2015 was deemed the best equity fund in the world. Verheul says: “We do not invest in companies who do not trade in a sustainable way and we let people know through our website which companies we exclude. The universe in which we invest is therefore not as big as that of many other players, but we have already proved that social and financial returns go hand in hand.”

According to Bart Harmsen, head of risk management at ACTIAM, it is not a question of just excluding the insufficiently sustainable companies. “We try to encourage these companies to become more sustainable. We keep many lines of contact open in order to bring about improvements in that area.”

Growth ambition

As a part of VIVAT Insurance, ACTIAM considers Zwitserleven and Reaal (also part of VIVAT Insurances) just as much a client as ASN Bank and SNS Bank, says Verheul. “We have also close commercial contracts with them, just as with our other external clients. We have seen that the combination of professionalism, flexibility and sustainability has created a lot of interest for our funds from institutional investors. The legislator gives us a helping hand here, since pension funds are required to use part of their capital for sustainable investments.”
As administrator of institutional investment funds, ACTIAM’s name is well-known in this market segment. Our ambition is to grow in the retail market as well, says Verheul. “We are investigating whether funds for institutional investors could also be made suitable for retail investors. Our name recognition among a larger audience will then grow as a matter of course.”

Tougher demands

Under VIVAT Insurances, ACTIAM operates independently, with its own license, policy and statutory board. “Even though SNS AM and SBB have worked together for years, with this merger we are creating one expertise centre for our clients,” Verheul explains. “By doing this, we are creating even more commercial and operational strength and we can more easily comply with legislation and regulations.” Tougher demands on fund management as a result of new legislation and regulations in the AIFMD (Alternative Investment Fund Managers Directive) were important reasons for the merger. This legislation requires that a fund manager may not outsource both its portfolio management and its risk management. Verheul explains: “The fund manager (SBB) would therefore have to go to great lengths to rig up its risk management. Asset management was already outsourced to ACTIAM (at the time SNS AM). If we had not integrated SBB and SNS AM, the cost to the client would have been much higher than it is now. The costs of the merger are small by comparison. We are trying to absorb these by working more efficiently.”

Gap analysis

The AIFMD legislation sets out best practices in the area of risk and liquidity management, among others. As far as ACTIAM was concerned, this guideline had an impact on many different levels. “Most of them were under control,” says Verheul, “but we were not able to make the changes for the risk management part on our own. We could see that the scale of changes necessary within risk management was too great for our own staff to contend with. We had discussions with a number of contenders, but Zanders was selected fairly quickly. During the very first meeting they showed their pragmatic, down to earth approach. No standard consultant-talk, but serious people who gave the impression they would get on with it and deliver something of real useful value.”

Time was of the essence: ACTIAM had to be AIFMD compliant by 22 July 2014 and have its risk policy implemented, otherwise obtaining the license would be under threat. So, article for article, a speedy start was made on analyzing the legal texts; what was written down exactly, and what is the impact of them for ACTIAM? And as far as the risk management parts were concerned, where were the gaps as far as the guidelines went? And that’s how the risk management and risk methodology were assessed, a process during which hundreds of pages were read and analyzed. Zanders consultant Mark van Maaren says: “Early on we involved the front office, as well as others, in the development of risk policies, risk methodology and risk reporting. They made a valuable contribution and their involvement facilitated the acceptance of the risk framework.” During the whole process the strategy was developed gradually and the levels of risk became clearer. Beforehand, Verheul expressed progress in terms of a target figure: “We wanted to achieve 6.5 on reaching compliance, then we wanted to take our time in order to make it an 8.” In that way the inaccuracies in some reports, which were a result of tight deadlines, were corrected, while the reporting process itself was speeded up.

With constant to-ing and fro-ing, i.e. by involving front office, a large number of issues were solved.

Jasper van Eijk, Partner at Zanders

This way most of the interest rate sensitivities on fixed interest instruments could be calculated, but a number of rates differed to what front office saw. By constantly going back to departments involved, the results were fine-tuned.

Internal involvement

In a short time frame a lot had to happen on both sides, but the interaction was ideal, Verheul thinks. “And what is so good is that we have improved the whole ACTIAM risk management framework. We are much more aware of the whole spectrum since it had much more impact than just the AIFMD part.” Harmsen nods in agreement: “The risk policy was also immediately adopted by the business and, as a result, the quality of thinking in terms of risk in the organization was given an enormous boost.” Van Maaren adds: “ACTIAM’s board’s strong commitment was an important factor in the success of the project. All directors gave up a lot of time to review and discuss the risk strategy, the preparation of risk reports and the development of risk methodology. Quick decisions were also made where there were issues within the project.” Van Eijk also felt the interaction within the organization was a success factor. “This was at all levels within the organization. The formulated policy had to take form by setting up models, methods and systems. But due to the limited timeframe we had to do this in parallel. This demands good co-ordination to get all cross-references tied in. Thanks to a pragmatic approach and the broad internal involvement, this was achieved.” The deadline was reached; ACTIAM was AIFMD compliant as of 22 July 2014.

Stick to the plan

For monitoring risk, ACTIAM used the existing risk management system, Dimension, from supplier Simcorp, of which Zanders implemented the new risk module. Verheul says: “We want the whole organization to use this system and the starting point was to include the whole risk reporting process in this system. Zanders firstly evaluated the suitability of this module for implementation of risk reporting together with ACTIAM and Simcorp before starting the implementation process.”
It symbolizes the secret of success of the whole journey, Verheul thinks: “Make considered choices and then stick to the plan. Don’t fall into the trap of implementing another system just because a report is easier to print for example, as this always leads to different problems. In retrospect, it all went very well, but there was a lot of pressure on everyone involved. All in all we are very pleased with the whole project. If we had to do it again then we would do it the same way.”

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