Managing Climate Risk
Climate change is already affecting almost all sectors of the global economy. Heatwaves and droughts are reducing crop yields and increasing demand for electricity. Flooding and higher sea levels are stressing shoreline infrastructure. Storms and temperature swings are straining buildings and transportation networks. The World Bank estimates that by 2030, climate change may push 130 million people into poverty.
Climate change also affects the portfolios of financial institutions (FIs). Climate change presents more risk to some assets than others. Asset type, location, sensitivity to climate, and climate change severity determine the climate change risk of each asset.
FIs already evaluate, manage, and disclose traditional risks such as risks from exchange rate fluctuations, interest rate variability, and rising loan default rates. Now regulators, investors, and other stakeholders are advising FIs to disclose climate risk information. Some FIs are already fully identifying and disclosing climate risk data. Others have not yet begun to evaluate climate risk or are not yet able to implement the new policies and procedures required to disclose climate risk information.
As climate change continues, eventually every government, business and citizen will need to become concerned with climate risk management (CRM). Because most of the world’s investments are channeled through FIs, FIs have an opportunity to take a leading role in CRM as we adapt to climate change and develop a low-carbon economy.
IFC’s Green Banking Academy (GBAC) is an online banking knowledge initiative designed to help financial institutions and the private sector in Europe and Central Asia (ECA) learn about green banking and build green portfolios. Climate risk management (CRM) is another key knowledge area. GBAC advisory services are available to help FIs measure, report, and manage the risks associated with climate change.
“Severe climate change impacts are already happening. Vulnerable people, those marginalized socially and economically, are the most exposed to climate change impacts – and have the fewer resources to adapt.”
Dr. Hoesung Lee, Chair, Intergovernmental Panel on Climate Change (IPCC)
Considering Climate Risks
Two primary types of climate risk are physical and transitional. Physical risks are the risks of direct damage from climate change. Can a building near the ocean withstand a record-setting hurricane? Will there be enough agricultural production to supply a processing plant during a drought? In a winter with no snow, will tourists still fly to an area known for its ski slopes? Transitional climate risks are the risks associated with changes in policies and practices resulting from the transition to a low-carbon economy. How will the value of a coal mine decrease as consumers switch to green power sources? If a coal mine is shut down, how much equity will be lost in housing investments near the mine site? Can a chain of gas filling stations survive the transition to electric vehicles?
Climate risks can be considered on the basis of short-, medium-, and long-term time horizons. Climate change is often thought of as a slow-moving challenge, but even short-term investments are at risk. A sudden storm can cause extensive damage in a short time. In the long run, assessors must also consider “creeping changes” in average conditions, as, for example, sea level rises, putting buildings near the shoreline at higher risk over time.
FIs must consider both loan portfolios and equity investments when assessing climate risk. Climate change may make it difficult for borrowers to repay debt. For example, farm borrowers are at risk of default in times of flooding. A manufacturing business that requires a steady supply of water may default during a severe drought. Equity investments are typically exposed to longer-term risks as climate change affects asset valuations or exit options. For example, an investment in tourism in an area where heat waves become common may lose value over time. In the long term, it may be difficult to find buyers for an equity position in an oil-producing company.
It is useful to consider forecasts of future scenarios when evaluating climate risk. For example, when weather patterns are changing, agricultural loans cannot be assessed solely based on historical weather patterns and production data. In this case, forecasts of future weather patterns along with management’s proven ability to adapt to change are more helpful when evaluating a loan application.
Any aspect of a business can be subject to climate risk.
- Demand for products and services may shift, for example, increased need for electricity during a heat wave, or decreased long-term demand for gasoline by electric vehicle owners.
- Supply of inputs may fluctuate, such as availability of agricultural commodities or access to water for a manufacturing facility.
- Operating expenses such as maintenance may increase as operators prepare for changing weather patterns.
- Insurance costs will increase where the likelihood of damage is increasing.
“Climate risk is investment risk.”
Laurence Fink Chairman and CEO, BlackRock
Climate Risk Management
FIs must be aware of climate risks associated with their portfolios and potential new investments. A climate-diversified portfolio would include assets that will be affected differently by different forecasted climate change scenarios. If a large share of an FI’s portfolio is directed to coastal infrastructure, rising sea levels present a substantial risk. An FI with significant investments in one concentrated location is at risk in the event of a localized weather event.
As well as applying CRM to their portfolios, FIs can work with the borrowers and managers of the assets in their portfolios to assist in CRM. There are many approaches to CRM, many of which will require additional financing. The following are some examples.
- Corporations may adjust their business models to meet future needs. For example, a company that operates gas filling stations may invest in electric vehicle charging infrastructure.
- Owners of at-risk infrastructure may invest to adapt their existing businesses to climate change. For example, a hotel owner may reinforce a building near the ocean or relocate the business to higher ground.
- Businesses may seek out new technology to decrease climate risks in their supply chains. For example, a manufacturing company that relies on large supplies of water may invest in a new production line that uses other inputs and decreases the need for water.
- Business owners may be encouraged to purchase additional insurance products to protect their operations.
Early adopters of these practices will lower their climate-related risks while also gaining an early advantage over competitors in their industries.
Higher temperatures bring more intense and more frequent hurricanes. In May 2022 FedNat Insurance Co. cancelled 68,000 home insurance policies in hurricane-prone areas. FedNat is not the first private sector company to leave this market. After four hurricanes in 2004, Allstate did not renew 94,000 homeowner policies. In 2008 State Farm stopped writing homeowner policies in Florida. Florida homeowners unable to pay higher rates or access government-sponsored insurance will no longer be insured.
Risk Disclosure Requirements
Regulatory bodies, investors, and other stakeholders are becoming increasingly interested in information about climate risk. Ideally, to allow stakeholders to compare risk between portfolios, climate risk information would be prepared consistently across FIs.
In 2017, the Financial Stability Board (FSB), an international body that makes recommendations related to the global financial system, created a Task Force on Climate-Related Financial Disclosure. The Task Force developed recommendations on disclosing climate risk information to stakeholders. The European Central Bank (ECB) is a member of the Financial Stability Board and has recognized climate risk as a key driver of overall risk in the financial sector. The ECB urges FIs to assess their climate-related and environmental (C&E) risks and has created a Guide on climate-related and environmental risk to assist FIs.
The FSB and ECB realize that as well as information about C&E risks, users of these disclosure statements will also need transparent information describing the underlying methodologies used to assess C&E risks. Ultimately, standardized methodologies will be the most helpful approach for all stakeholders.
To date, disclosure requirements are not standardized, and the quality and quantity of C&E risk disclosures prepared by FIs varies greatly. In November 2020, the ECB reported that most of the FIs in its jurisdiction fell short on making full climate risk disclosures. Many institutions provided only general descriptions of potential climate risks. A more useful disclosure would relate these potential risks to the FI’s portfolio and evaluate the FI’s exposures to at-risk sectors of the economy. Ideally, each FI would describe the process it uses to identify and manage C&E risks. This level of disclosure would enable stakeholders to see how these risks have been integrated into each FI’s overall risk management strategy.
Formal disclosure of climate risk information is currently voluntary, but regulations can be expected to change rapidly. The ECB is determined to ensure that FIs prepare more detailed C&E risk reports and has stated that it will eventually use the tools at its disposal to enforce disclosure standards. In the future, FIs that do not disclose climate risks in a transparent manner may face higher reserve requirements than FIs that fully comply.
Financial climate-risk reporting guidelines are being developed at both the international and EU level. It may take time for similar guidelines to be developed and enforced in non-EU countries. FIs outside of the EU have an opportunity to gain a competitive advantage through early adoption of stringent climate risk disclosure policies. Meeting EU standards may provide increased access to EU markets, and investors, borrowers, and other stakeholders may be more eager to do business with FIs in full compliance with ECB disclosure standards.
“Recent regulatory and legislative initiatives reflect growing international awareness of the great value of transparent disclosures on C&E risks. Importantly, many of the banks raising the bar in C&E disclosures are small and medium-sized – showing that remarkable progress is achievable by all. Stricter disclosure regulation is on the way, and time is running out for banks to get ready.”
Frank Elderson, Member of the ECB Executive Board
IFC’s Work in CRM
Managing climate risks is a challenging task. Many FIs do not have staff adequately trained to assess these risks. FIs with many locations and branches may not have consistent assessment methods across the organization. Some FIs have considered climate risks but are not yet prepared to fully manage or disclose these risks.
IFC has experience in this area, and professional staff available to assist FIs. In 2008 IFC began work on case studies analyzing climate risks in several sectors and specific projects. These case studies include assessments of the sector, potential impacts from climate change, and options for project adaptation. IFC’s case studies included economic, social, and environmental factors. For example, after Columbia experienced its worst floods in 60 years, IFC completed a report on the climate risks faced by the port terminal Muelles el Bosque. As well as preparing adaptation options for this port, IFC studied how other ports may be affected by climate change. These case studies, along with other research and direct work with clients, has given IFC the experience required to help financial institutions assess, disclose and manage climate risks.
“At IFC we embrace responsible investing by helping banks manage climate-related physical and transition risk associated with the projects and businesses they are funding, by developing a common assessment framework to help banks to assess their individual ‘greenness baseline.”
Peter Cashion, Global Head of Climate Finance, Financial Institutions Group, IFC
Start Your Green Journey with IFC ECA Green Banking Academy
IFC ECA Green Banking Academy offers advisory services to help FIs properly measure, report, and manage the risks associated with climate change. For more information about the ECA GBAC’s resources and services available to FIs or to schedule an assessment of your climate capabilities, please email firstname.lastname@example.org to contact a member of our team. We are looking forward to working with you. Stay green!