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Fortune will favor banks that adjust for climate risks

Climate Quantified|Environmental
Climate Risk and Resilience

By Irem Yerdelen and Carmela Inneo | April 19, 2021

We can expect 2021 to be a year of significant climate-related financial and regulatory developments that will further strengthen the global financial system.

Since his inauguration in January, President Biden and his administration have made climate change a policy priority domestically and internationally. Lawmakers meanwhile have followed the White House’s lead by filing several pieces of legislation that push the Securities and Exchange Commission to demand the disclosure of information on climate-related financial risks from listed companies. This legislation would shine a light on the financial impacts of a warming world climate-related risks on company balance sheets, along with all the other material categories of risk shareholders care about.

Although the U.S. took a step back from climate policy in recent years, it’s now a question of when, not if, regulation on climate disclosures will change for the financial sector. But what does this mean for banks and how can risk professionals and strategists respond and what lessons can be learned from other jurisdictions?

Regulators around the world are increasingly leaning on the financial services sector in recognition that climate-related risks could undermine global economic stability. In 2015, the Financial Stability Board, an international body that monitors and makes recommendations about the global financial system, set up the Task Force for Climate-Related Disclosures in acknowledgement that climate-related risks are material to the financial sector, with the potential to trigger another global financial crisis.

In the U.K., the TCFD’s recommendations have been adopted as mandatory reporting government frameworks for public listed companies on a ‘comply or explain’ basis from 2021 and will be across the economy within a few years. In 2016, France implemented Article 173, which requires institutional investors, whether asset owners or managers, to disclose climate-related risks.

Although steps in the same disclosure direction have been slow in the U.S., there are strong signals that the world’s largest economy could soon catch up — even as they face fierce opposition. In December 2020, the Federal Reserve joined the Network for Greening the Financial System, a group of central banks and supervisors. In March, the Securities and Exchange Commission launched a consultation to evaluate climate change disclosures and announced a taskforce to address “disclosure gaps that threaten investors and the market.” The Commodity Futures Trading Commission has established a counterpart climate risk unit.

Meanwhile, a series of climate-risk-related legislation has been submitted to Congress, some of which is expected to make it into the large infrastructure bill that is likely to be considered by lawmakers in the fall.

Broadly speaking, three main triggers for climate-related financial risks have been identified: physical, transition and liability risks.

Physical risks refer to the acute and chronic effects of climate change. Acute impacts include increased frequency and intensity of wildfires, floods and cyclones, while chronic impacts include temperature rises, changes in rainfall, sea level rises or even changes in soil and agricultural productivity.

Transition risks, and linked opportunities, relate to policy and regulatory changes when moving toward a greener economy. These risks may have a direct impact on the value of assets, such as a decrease in the price of oil, or a greater emphasis on technology developments, e.g., electric vehicles or battery storage.

Liability risks can activate potential legal actions brought by claimants who have suffered loss or damage arising from climate change. There have been several claims against fossil fuel companies and their investors, but this is an emerging area set to grow over the coming decades as the impacts of climate change become more palpable.

Many of these risks are interrelated and can amplify one another. A useful recent example regarding the chains of transmission is the bankruptcy of PG&E in California, widely considered as the largest climate-related bankruptcy to date. While the wildfires delivered the first-order impact (physical) that affected the company’s balance sheet due to power outages, the second-order impact of transition risks resulted in billions in losses for shareholders, insurers, customers, creditors and taxpayers.

But what pushed the company to file for bankruptcy centered on the ensuing class action lawsuit (liability). Although in a California context, such a bankruptcy is unlikely to trigger systemic financial shocks that cascade through the economy (transition risk), in other geographies or industries, the failure of a utility or another type of business might pose such a threat, with risks most often flowing back to the public finances.

Climate change may have an impact on a bank’s own assets and operations, but the bigger issue is the risks that banks face from their borrowers. These impacts on borrowers can cause changes in their revenues and asset values, which increase their probability of default and property depreciation, leading to increased credit risks for banks.

The good news is there are already many tools and techniques in the marketplace to help identify, quantify and ultimately manage climate-related risks and opportunities, including the upside of the transition to a low-carbon economy.

For example, a relatively simple heatmapping exercise will reveal the concentration of climate-related risks in a bank’s investment or credit portfolio. This data analysis exercise could show that a bank’s mortgage loan book might be heavily weighted toward locations at more risk of wildfires or floods in a warmer world. On the commercial lending side, banks might be more exposed to financial risks from reduced demand for oil or other fossil fuels.

While the financial impacts on physical assets are already being felt, banks can no longer take the view that a lending horizon of one to three years will spare them potential financial pain in a transition to a low carbon economy. Banks should consider the exposure of their own investments and credit portfolios across longer strategic horizons, not just over the next business cycle. By applying science, data and analytics, they will be able to identify their exposure to risks they cannot bear, while subsequently being able to manage, transfer and/or mitigate those risks, and building on new business continuity and business growth opportunities.

As the U.S. re-engages in the global climate debate by re-joining the Paris Agreement and repositions its international leadership on climate change, we can expect more U.S. action in the lead up to the Conference of the Parties 26th meeting co-hosted by the U.K. and Italy in November.

We can expect 2021 to be a year of significant climate-related financial and regulatory developments that will further strengthen the global financial system. Fortune will favor the banks that are climate-risk adjusted.

The original article was originally published by American Banker

Authors

Director, Corporate Client Engagement Leader, Climate And Resilience Hub In Americas, Willis Towers Watson

North American Financial Institution Industry Leader, Willis Towers Watson

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