We are getting used to seeing banks considering climate risk. After all, it is closely related to other types of risks that financial institutions mitigate and manage. There are two main types of risks associated with climate:
- Physical risk of financial losses directly related to climate change-related extreme weather events.
- Transition risk of financial losses incurred through moving to a low-carbon economy.
Environmental changes have always contributed to financial losses for banks. For example, there have long been risks of agricultural loans not being repaid because drought resulted in poor yields. However, this risk is increasing as more people are exposed to extreme weather events or possible penalties for failing to meet environmental regulations. Climate risk will affect the market for loans, insurance risk, stock markets and bond markets. And so it is critical for banks to consider it a long-term issue.
Analyzing possible risk impact scenarios
The European Central Bank suggests that almost no bank in the eurozone is adequately prepared for the risks posed by climate change. It, therefore, plans to conduct stress tests among banks to assess readiness. The bank has already developed a preliminary methodology and will be testing it over the next few months. Peter Plochan, the SAS climate risk expert, suggests that banks should assess the climate change exposures in their portfolios. Then they can link global temperature rise and other climate-related factors to macroeconomic aspects.
However, climate change is not all about risk. It also provides opportunities for banks, for example, investing in new technologies such as carbon capture and better power cells. New recommendations suggest that the best approach is to integrate climate risk into existing risk management frameworks, examining both operational risks and those relating to products and clients.
Perhaps the biggest question is how to identify and forecast possible risks and opportunities. Analytics, including both artificial intelligence (AI) and machine learning, might be useful tools. They will enable banks to model scenarios in the context of climate change and plan for different levels of risk. This is happening across sectors but is likely to be easiest in industries that already use these tools and have achieved measurable business benefits. Banks and financial institutions have used analytics for years in many key areas, including credit risk analysis, fraud analysis, customer service and customer experience.
An evolving situation
However, climate risk is a relatively new area. The European Central Bank has suggested that it is going to be important to develop a shared approach to stress testing and risk management across the sector. This will mean examining the potential impacts of different climate pathways over several decades. The task is complex because there is very little historical data to use in the analysis and real uncertainty about long time horizons. The situation is evolving, and approaches to it need to be flexible too.
It is likely that methodologies and good practice will emerge over time, as will the data that will form the basis for statistical and analytical analyses. It is important to remember that analytical models are only as good as the data we feed them with. We, therefore, have to bear in mind the risk of taking an inadequate or incomplete approach to the process of building and using a model. Having to adapt to the new recommendations is not going to be easy. Indeed, in the short term, it would probably be considerably more profitable not to take any action. However we all know that we need to protect the future of our children and future generations - and this may be expensive.
Creating opportunities through action
Companies used to see corporate social responsibility as a way to gain credibility in the eyes of the market. Similarly, rising consumer ecological awareness may push organizations, including banks, to join the "Net Zero" elite and make climate risk an important topic. Companies should see this transformation as a business opportunity and a chance to remodel processes and increase profits.
Companies may be trying to be green to improve their image among customers. But customers may also be willing to pay a higher price for green products. It may be possible to improve the margin for loans and investments among banks, all within the framework of a sustainable business strategy.
The European Financial Congress concluded that the European Green Deal would be a way to meet climate requirements. But it would also generate additional opportunities for innovation in the economy. Recognizing and taking advantage of those opportunities is up to individual organizations.
Visit the Climate Risk Hub to learn more about climate risk impact on your business.