As the cost of climate change increases and a business-as-usual approach becomes untenable, there is still a great deal of uncertainty among financial firms about how climate change will affect their businesses.
A recent survey by the GARP Risk Institute found that only 6% of companies believe climate risk is fully priced in, although “quite a few of them think it’s partially priced in,” said Jo Paisley, president of GARP Risk Institute, opposite Yahoo Finance (video above). “And I think what we’re seeing in the risk industry and in the finance industry is just a growing awareness, a growing understanding of the risks.”
For the third year in a row, 78 financial companies worldwide were surveyed, including 47 banks, 20 asset managers and 11 other companies in the insurance and financial market infrastructure sector.
Companies identified the availability of reliable models and data as well as regulatory uncertainty as the greatest challenges in developing their climate risk strategies.
Two types of risk
Financial risks from climate change can generally be divided into two categories: physical risks and transition risks.
The GARP survey found that financial firms prioritize transition risks over physical risks or portfolio alignment. They are also more confident in the short term than in the long term when it comes to managing climate risks: three quarters of companies said that they will be more confident about the resilience of their climate strategies in the next one to five years than in the next 10-15 years.
Transitional risks are likely to have a greater impact on assets in the short term, while physical risks are likely to have a greater impact on economic performance in the medium to long term, according to a report by the CRO Forum. GARP has also found that insufficient short-term voluntary corporate actions increase the likelihood of more aggressive government policies.
The extent of the transition risks largely depends on how effectively governments and companies can coordinate the reduction of CO2 emissions in different sectors. A slower transition could be more expensive – by trillions of dollars – than a faster transition, found a working paper from the Oxford Institute for New Economic Thinking.
Physical risks – such as property damage from weather events – also depend on how quickly these transitions occur, since the physical risks only increase with each degree of warming. Worse still is the risk of crossing dangerous tipping points that could lead to cascading irreversible changes in the global climate system.
The US government as well as other governments around the world are focusing on climate risk.
In April, Sen. Elizabeth Warren (D-MA) and Rep. Sean Casten (D-IL) passed legislation requiring companies to increase the information they disclose about climate-related risks.
The SEC and the Treasury Department are also reviewing climate risk disclosure. Treasury Secretary Janet Yellen, who recently reiterated that climate change is an “existential threat that needs to be addressed,” will lead regulators in verifying that financial firms are adequately addressing climate risk.
This year the Bank of England (the UK’s central bank) launched a stress test on UK banks and insurers to assess their resilience to various pathways to climate change. The San Francisco Fed President also said the Fed’s role is “to anticipate the changes that lie ahead and understand their implications,” although the central bank’s role at the moment is to “listen, study and to adapt to everything that comes in our way ”.
“Increasing sophistication” in assessing climate risks
Compared to previous years, the GARP survey showed that financial companies have refined their models for assessing climate risks. This was particularly the case with those who introduced a scenario analysis in which companies look at a variety of transition paths.
Climate change scenario analysis differs in several key ways from other methods that banks use. Climate change scenarios typically take place over longer time horizons. The most common horizon companies used in this year’s survey was 10-30 years.
The scenario analysis also includes extrapolating the financial impact from the physical variables measured by scientists. For example, scenario analysis could be used to quantify the macroeconomic impact of a 1-2 foot rise in sea level.
“You also need good quality data,” said Paisley. “You have to be able to model this. And these things take time to develop. So we see the emergence of a new professional level of expertise. Companies also learn from each other. I think you will see an increasing level of sophistication over time. I definitely hope so. “
One positive trend that Paisley noted was that companies are not just using scenario analysis, they are “actually taking action based on it.”
For example, many companies made changes to risk management, portfolio composition, product offering and disclosure. In addition, financial companies are increasingly aligning their CO2 reduction targets with the Paris Agreement target of limiting global warming to 1.5 ° C.
Additionally, “we’re seeing a lot of product innovation,” said Paisley. “So new products come onto the market or existing products are changed. We are also seeing companies increasing their workforce to try to better equip themselves. And I think the other notable point is that we’re seeing a lot more interest in regulators, which is probably what really drives the minds of these financial firms. “
Grace is Assistant Editor for Yahoo Finance and UX Writer for Yahoo Products.
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