In Parker Fitzgerald’s latest whitepaper, “Climate Risk Management in Financial Services“, we examine the unique characteristics of climate change risk and explore how financial institutions can act now to lay the foundation for future outperformance.
Climate change has long been on the radar of regulators, policymakers, non-governmental organisations (NGOs) and sustainable investors. It may affect individual companies’ financial resilience as well as the stability of the overall financial system. Climate change risks can result from the physical consequences of future climatic conditions as well as from the transition to a low carbon economy. Another focus area is the role the financial sector is expected to play in financing the green transition given the huge amount of investment required.
These considerations have led to increased scrutiny regarding how financial institutions address climate change related risks and how well positioned they are to take advantage of the opportunities. In April 2019, the Prudential Regulation Authority (PRA) published supervisory statement (SS3/19) which outlined their expectations regarding financial institutions’ governance, risk management, scenario analysis and disclosure of climate change risks. Three months later, the UK government published its Green Finance Strategy, stressing the role of the financial sector in supporting the green transition. In October, the Financial Conduct Authority (FCA) further published a Feedback Statement focusing on transparency of climate change risks and opportunities, their incorporation into decision making and the availability and quality of green finance products.
Coupled with heightening regulatory expectations, there is also rising pressure from climate conscious investors for financial institutions to improve their climate change disclosures in line with the recommendations of Financial Stability Board led Task Force on Climate-related Financial Disclosures (TCFD). Financial institutions need to better demonstrate how they are incorporating climate risk into their risk management and decision making to respond to these developments.
Climate change risk is different
Uncertainties around the impact of climate change may limit the ability of financial institutions to fully prepare. However, this makes the role of effective climate change risk management more, not less, critical. Strong climate change risk management will help to navigate the long term impacts even where climate risks are not currently perceived as material or that there is too much uncertainty for specific actions to be justified. Having an effective climate risk management should not only be about managing the financial impact. It should also provide valuable insights about how company’s strategy may need to adapt to the new risks and opportunities that climate change may create.
Overall, strong climate risk management should help companies to improve new business risk selection and to reposition themselves strategically, which will ultimately lead to a stronger risk return profile over the medium term. In addition, such a company should perform better at times of climate related disruption as it will be better placed to take advantage of any recovery following such a disruption. If financial institutions are committed to effective enterprise risk management, they will need to develop new ways of approaching and addressing climate change risks, which exhibit a number of distinct features, including:
- The characteristics of many traditional risks are likely to alter due to climate change. For example, relying on the existence of home insurance to mitigate flood risk in mortgage lending may become insufficient if properties or locations become uninsurable at reasonable cost;
- The fact that climate change risk drivers may not appear material today should not lead to false comfort as future regulation and technological developments and climatic changes may significantly increase their materiality;
- Uncertainty requires continuous review of which risk drivers need to be monitored and managed;
- Climate change is a source of a systemic risk as it can affect negatively many different exposures at the same time leading to significant accumulations;
- There is a propensity for sudden shocks, which may catch unaware those who believe there is ample time to adapt given the long-term horizon of climate change.
Laying the foundation for outperformance
Incorporating climate change risks into the existing risk management framework is likely to be the best way to ensure that the impact of climate change is properly considered in decision making. For many financial institutions, this will be challenging and the process may take many years. Each firm must therefore carefully define its priorities and development path.
Financial institutions should start with the following steps to lay the foundation for future outperformance:
- Ensure adequate coverage of and accountability for climate change at board and executive levels;
- Recognise the unique characteristics and challenges climate change presents for risk management;
- Start early rather than wait for the best practices to emerge and uncertainties of impact to reduce – uncertainty will never go away and best practice will continuously advance;
Identify and explore the most material climate drivers for the current business model but be mindful that this will evolve over time;
- Develop all elements of climate change risk management simultaneously as they are interconnected;
- Outline the roadmap and investments required to develop the required data infrastructure, which is likely to be the biggest challenge for most financial institutions;
- Approach climate change with the mindset that it can help to improve risk selection now, which should then translate in better future risk adjusted performance;
- Consider the many opportunities climate change will present – climate change risk management can provide the tools and insights to take advantage of them.
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