Climate risk: What is it and why is it important?

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In 2020 alone, the global losses from natural disasters amounted to a staggering US$210 billion! This is just short of the 2020 GDP of Portugal, or a little more than twice the market cap of HSBC, Europe’s largest bank. The causes of these huge losses include drought-fuelled wildfires, severe floods and a record-breaking number of storms. How are natural disasters affecting your financial institution? And is climate change bringing other risks?

A multifaceted risk

When talking about the impact of climate risk on banks, most people consider only the physical impacts. Physical impacts can manifest themselves in the form of natural disasters, like floods, hurricanes or wildfires, or as permanent changes like rising sea levels and desertification. Such radical changes can shock firms and households alike, resulting in reduced asset values and even defaults.

Physical risks still have the largest impact on the banks’ lending portfolio but are far from the only ones. Transitional impacts come in more subtle forms through, for example, changed consumer behaviour, legislation and technological development. Greener and more sustainable products become increasingly more important amongst the average consumer, favouring certain players in the market while other industries are penalized. Alongside a more climate-conscious consumer base and society, supervisors and regulators are increasing their requirements for disclosure and creating climate-based taxation.

The challenges of climate

Working with a concept as wide and complex as climate change is difficult, and it is no surprise that data is key. Going into a new and unchartered area can be hard, as historical data is no longer a good predictor for the future. Not having sufficient current data poses a challenging barrier to meaningful scenarios and accurate, reliable predictions.

Another problem when trying to reach reliable predictions is modelling. How exactly do you relate a temperature increase to a default probability? And how do you identify the idiosyncratic risk as opposed to the systematic risk? There are many ways of trying to model climate change, which also makes it difficult to compare results once you have them. There are also potentially many model dimensions. Not only are the climate changes varying across geography, but the impacts are also varying across industries. This means that the causes and effects will vary over loan portfolios. This adds additional complexity to both the scenario creation and the applicability of the results.

A third challenge from trying to measure the impacts of climate changes is the uncertain time horizon paired with human behaviour. Climate-related financial risk analysis is long-term and often exceeds the time horizon of regular portfolio predictions. When performing long-term analysis, aspects like policies, technological development and human behaviour might alter the projections. These are just some of the challenges a financial institution is facing when trying to measure the financial impacts of climate change.

What do the regulators say?

Regulators are also reacting to this new risk arising from climate change by increasing their expectations of banks through more information disclosure and impact assessments. Additionally, regulators made it mandatory for banks to consider not only how the climate but also a pandemic and other disruptive events might affect your financial institution.

The European Central Bank requires institutions to have clear strategies and processes for assessing the nature and level of the risks to which they are exposed. All while maintaining amounts, types and distribution of internal capital that they consider adequate to cover these risks.

This year, the Bank of England is planning to run a 30-year modelling-horizon stress test of England’s largest banks, insurers and their financial system to test the impacts of climate-related risks. BoE provides three scenarios that each through climate, macroeconomic and financial variables describe the economic implications of various distinct temperature rises and policy action phase-in. Climate variables include physical risk variables – such as temperature pathways, floods and agricultural productivity – and transition risk variables, such as carbon price pathways, emission pathways and commodity/energy prices.

So why is it important?

Climate change continues to be at the top of the global agenda. And it is growing ever more important. Physical and transition risks will affect your business in a material way. Trying to measure and translate climate change into financial impacts while fulfilling increasing demands from regulators is a big challenge. We need a method to measure the balance sheet impact of multiple forward-looking climate scenarios to assess the new risk types. So, when your competent authority, or maybe sooner your own management, comes knocking – what do you do? Will you ask your team for yet another urgent high-priority delivery? Or will you already be on top of it, using climate change to green your balance sheet and turning risk into opportunity?

As the requirements and expectations for managing the risk from climate change get clearer, the business seeks methodologies and execution details. GARP will host a webinar to address this topic. You are welcome to join my colleagues Naeem Siddiqi and Peter Plochan as they discuss climate risk, stress testing, scenario analysis and risk models.

This post was written in collaboration with SAS risk expert Anders Bergvall.

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Joanna Noerholm

Joanna is part of the Nordic Customer Advisory Risk Management team at SAS and holds a Master’s degree in Applied Economics and Finance from Copenhagen Business School. In this role, using advanced analytics she assists Nordic banks in managing their risk challenges, with a special focus on stress testing and scenario analysis.

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