Impact of climate change on financial institutions

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