In early 2020, many in the United States watched the ominous scenes unfold on our televisions. Business and corporations implemented their business continuity programs. Small businesses shuttered to keep customers and employees safe. Economists fretted about the negative economic impacts, fearful that it could drive the economy into a recession. Those with respiratory issues were urged to remain at home, and masks were recommended for all to protect against the invisible dangers lurking in the air. The resultant change in air quality generated unforgettable sunrises and sunsets. Celebrities, musicians and concerned citizens set up fundraisers and telethons.
The 2020 Australian Bushfires were a global news story, before the global pandemic captivated our attention (and our memory). Like the pandemic, scientists have been warning that climate-related events are increasingly likely, however, their pleas were overridden by short term economic concerns.
While COVID-19 is a singular black swan event, climate related black swan events are inevitable, innumerable and even more difficult to predict – metaphorically, a wedge of migratory black swans. The scenes from Australia were repeated later in 2020, as the costliest wildfire season in US history temporarily turned the vistas of San Francisco into images ripped from the movie Bladerunner. Over the last few decades, climate change has contributed to a 78 day increase in the Western US wildfire season and burn duration has grown from 7.1 days to 35 days1. The financial impacts of climate-related events are appearing in financial reports and bankruptcy filings with increasing frequency.
What is Climate Risk Management?
Climate risk management is an emerging discipline in the risk management profession. Broadly, climate risk refers to the physical risks —both acute and chronic – and the transition risks posed by climate change. Climate risk is transverse, impacting and amplifying the traditional domains of financial and strategic risk.
- Chronic risk events are those which are already occurring and are expected to continue to occur. Weather pattern changes, water scarcity and sea level rise would continue, changing how and where we live, food production and global supply chains.
- Acute risk events are the infrequent, severe to catastrophic events that are exacerbated by climate change, including the wildfires in Australia and California, ever more intense tropical cyclones and other strong storms that result in devastating, catastrophic human and financial cost.
- Transition risk captures both the risks and opportunities that are present as the economy decarbonizes. The transition risk is already being felt in the energy industry, with integrated energy firms shifting away from fossil fuels and towards renewables and innovation. It also includes the reduction of subsidies to carbon intense industries and the implementation of carbon pricing schemes. The transportation, consumer goods and services and agriculture sectors are also under pressure to transform to reduce their carbon intensity.
Climate Risk Management – Risks and Opportunities
Market participants and regulators alike view climate risk as a rapidly advancing priority. While regulators in Europe and Asia have been prioritizing climate risk, a wave of regulatory comments and reports indicate that the United States is expected to join other central banks and regulators in mandating action on climate risk.
Of those reports, a September report released by the Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee of the Commodity Futures Trading Commission (CFTC) appears to have captured the attention of market participants and regulators alike. The report highlighted that “climate change poses a major risk to the stability of the US financial system and to its ability to sustain the US Economy”2. In addition to highlighting the economic risks and potential disruptions to economic activity, the report also provides actionable recommendations, noting that mechanisms for regulators to compel financial services firms to implement climate risk management already exist.
Most recently, Fed Chairman Jerome Powell announced in December 2020 that the Federal Reserve System is joining the Network of Central Banks and Supervisors for Greening the Financial System (NGFS)– a key recommendation of the CFTC report. The announcement that the Federal Reserve is joining the NGFS follows the inclusion of climate risks in November’s semi-annual Financial Stability Report, which notes that climate-related risks have not been properly priced into assets and reinforces the conclusion of many other regulatory bodies – that “climate change is likely to increase financial stability risks”3. A more ominous study released by the National Bureau of Economic Research suggests that unmitigated climate change could reduce GDP by 10.5% by 21004.
As regulators become increasingly focused on climate-related risks, asset and investment managers, most prominently BlackRock’s CEO Larry Fink, have asserted the view that environmental stewardship and good governance are inextricably linked and would use their assets under management to reinforce that view5. Recognition of climate-related risks and opportunities has made ESG integration requisite to portfolio risk management. Investors have led ESG investments to outpace the broader market in AUM growth. Corporate borrowers are using performance against ESG metrics to achieve lower costs of capital.
Climate change presents significant opportunity – for both financial markets and corporates. New products and markets are being created across industry, most notably in energy, with the growth of renewables, in agriculture, with alternative meat products and in transportation, with the growth of the electric vehicles. Across the financial services industry, new financial products are being created to support green finance and many new products are needed.
What should firms be doing about Climate Risk?
As investors, regulators, clients and consumers understand the risk of unmitigated climate change and incorporate climate risk management into everyday decision making, financial services firms and other enterprises with exposure to climate change should develop or modify their existing approach to climate risk.
Firms should incorporate climate risk management into existing enterprise structures, processes and technologies:
- Risk Governance and Framework. Firms would need to structure risk governance and risk operating models to meet the risks and opportunities created by climate change. In establishing a risk framework, firms should also establish a climate risk appetite and align a target operating model, with the right people, policies, and technologies to measure, monitor and mitigate climate risk and facilitate conformance with the risk appetite.
- Regulatory Change. The coming year is expected to see new regulations for ESG and climate risk, and existing regulations and disclosures changing from “voluntary” to “involuntary”. New regulations could impact financial services directly and indirectly through changes to their clients and customers. Firms would need to be prepared to comment on proposed regulation and prepare for more aggressive implementation timelines than observed historically.
- Data Integration and Scenario Modelling. The identification and measurement of climate data are nascent and present the most complicated challenges to risk professionals. Climate risk management would require the ability to integrate physical data into financial models. To address this challenge, data requirements would need to be identified, governed, standardized, and integrated into the firm ecosystem. New Models will be needed to quantify the climate risk exposure already unpriced in existing activities.
- Technology and Innovation. Technological innovations have provided an opportunity to better understand the physical world. Quantum computing may enable financial institutions to develop stochastic models translating physical risks into financial risks. Advances in Artificial Intelligence and Machine Learning would facilitate more dynamic models that can adjust to real world observations. Sensor, satellite and other sources of unstructured data would enhance model and forecasting capabilities.
It’s not hyperbole to suggest that climate change constitutes an existential threat both to our way of life and to our global economy. In what seems like a never ending, accelerating litany of transformational challenges to commerce, the transformative requirements of meeting the challenge of climate change may prove to be the greatest challenge in human history – but also the greatest economic opportunity. The time for both preparation and action is now.
- Westerling, A. L., Hidalgo, H. G., Cayan, D. R. & Swetnam, T. W. 2006, ‘Warming and Earlier Spring Increase Western U.S. Forest Wildfire Activity’ Science Vol. 313, Issue 5789, p.940-943 https://science.sciencemag.org/content/313/5789/940
- Climate-Related Market Risk Subcommittee of the Market Risk Advisory Committee of the CFTC (2020) ‘Managing Climate Risk in the US Financial System’ https://www.cftc.gov/sites/default/files/2020-09/9-9-20%20Report%20of%20the%20Subcommittee%20on%20Climate-Related%20Market%20Risk%20-%20Managing%20Climate%20Risk%20in%20the%20U.S.%20Financial%20System%20for%20posting.pdf
- United States Federal Reserve Board (2020) ‘Financial Stability Report – November 2020’ https://www.federalreserve.gov/publications/2020-november-financial-stability-report-purpose.htm
- Kahn, M.E, Mohaddes, K., Ng, R.N.C., Pesaran, M. H., Raissi, M., Yang, J, (2019) Long-Term Macroeconomic Effects of Climate Change: A Cross-Country Analysis http://www.nber.org/papers/w26167 National Bureau of Economic Research , Paper 26167
- Blackrock (2020), Larry Fink CEO Letter – ‘A Fundamental Reshaping of Finance’ https://www.blackrock.com/us/individual/larry-fink-ceo-letter