Climate Change and Financial Risk

After completing this reading you should be able to:

• Discuss the history of climate change-related risks for the financial sector, including the Paris Agreement (2015), and distinguish the significance of Article 2.1 c as it pertains to the financial system.
• Distinguish the causes of potential mispricing of climate change risk and the impact of relevant history and data, non-normal probability distributions, kurtoses, skew, “black swan” events, and risk materialization time horizons on pricing as compared to traditional investment risk analysis.
• Discuss recent reporting and disclosure requirements under Article 173 of the French Energy Transition Act and the impact of The European Commission Sustainable Finance Action Plan on the allocation of capital towards sustainable investments and inclusion of climate and environmental factors in financial institutions’ risk management policies.

History of Climate Change

In the past, financial regulators and market players perceived climate change as a series of frequent weather disruptions. These disruptions were seen to be easily addressed by the operational risk framework if severe. In actuality, climate change includes extreme and acute climatic events such as warming air, and increasing sea temperatures as well as chronic, slower-moving changes that impact economic activity, such as shifts in water availability or rainfall patterns that affect agricultural production. The negative impact of climate change on economies has increased costs making investors and regulators increasingly aware of climate change risks.

Climate change in the financial sector was first studied in the early 2000s as part of a social and environmental risk appraisal. This appraisal project was sort of a refutation of climate change. It was focusing more on risk from the project to the environment rather than vice versa. This project was mostly aimed at managing the companies’ reputational risks as nonprofit organizations (NGOs) raised concerns about energy projects causing environmental pollution.

The Paris Agreement (2015)

The Paris Agreement is a landmark environmental accord within the United Nations Framework Convention on Climate Change (UNFCCC). It was signed by roughly every nation in 2015, and it deals with greenhouse-gas-emissions mitigation and adaptation.

The agreement’s long-term temperature goal is to limit the increase in global average temperature to below \(2^0\) C above the preindustrial level and pursue means to limit the rise to \(1.5^0\) C. The pact is also aimed at increasing the ability of participants to adapt to the unfavorable effects of climate change and provide consistent financial flows towards low greenhouse gas emissions and developments which are flexible to climate change.

According to the Paris Agreement, it is the responsibility of every country to adapt mitigation approaches for global warming. Every country is to provide without compulsion a report on its contribution to the regulation of global warming.

Climate Change Risks

Climate change risks are categorized into two: transition risks and physical risks.

Transition Risks

Transition risks are economic risks emanating from mitigation challenges as sectors decarbonize. They can be policy and legal risks, technology risks, market risks, and reputational risks. The initiation of the Intergovernmental Panel on Climate Change (IPCC) is being challenged on the efforts for complete decarbonization. Creating low-carbon societies will invalidate some industries and benefit others. To manage the transition risks, one must have a clear understanding of the nature of the economic changes.

The forces of transition risks are liabilities, government policies, and new technology. Government policies have a proportionate ability to change industry dynamics as they can stop extractive activities such as mountaintop removal or promote green energy through subsidies and renewable generation targets.

The following diagram illustrates the potential impacts of increased transitional risk on banks:

Physical Risks

Physical risks are threats arising from the physical impacts of climate change. They range from uncontrollable fires to dangerous tropical storms. Physical hazards can be (acute) extreme events, e.g., fires and hurricanes or (chronic) incremental events, which are long-term environmental impacts.

Financial institutions are concerned with the increasing severity of these disasters. Banks and investors have seen major assets being washed away or being consumed by fire.

The first effects of climate change give a picture of the most dangerous consequences that are to take place later. If this initial effect is a rise in temperature, the effects are largely felt because warming leads to a global change in climate, but with huge geographical and temporal differences. The change in weather will result in modifications of the climate patterns and other related impacts.

The following diagram illustrates the potential impacts of increased physical risk on banks:

Causes of Potential Mispricing of Climate Change Risks

Alongside environmental concerns, many business institutions are concerned that financial markets misprice climate risk; thus, exposing global economies to systemic and financial losses. The climate-related risks must be captured by the risk management frameworks and be given attention just like any other risk. Climate change risk parameters are not being obtained because of the following reasons.

1. Unprecedented phenomena: This happens when climate change being experienced is a unique phenomenon to the modern economies. It means there are neither records nor experiences of the likely response of the financial systems to the changes. Therefore, the missing historical data hinders the comparison of past and future occurrences; thus, impairing statistical risk analysis.
2. Radical uncertainty: The fundamental uncertainty needs to be accounted for in economic analysis. The difference between risk and uncertainty is the ability to assess probabilities for possible events. Transition climate risks broadly involve radical changes whose realizations are characterized by complexity and multiplicity. Thus, making climate change risks non-predictable, immeasurable, and unquantifiable.
3. Non-normal probabilities: Most risk and pricing modeling approaches assume that the underlying data is normally distributed. However, modeling approaches to climate change risks involve distributions with higher probabilities for extreme risks relative to the usual normal distributions. Additionally, the distributions are highly skewed and have a significant kurtosis, with black swans as the norm. This makes it complicated to price climate change risks.
4. Bounded rationality: This aspect is related to the fundamental limitations of the markets. Market players need to construct a simplified model of the universe in the face of complexity. However, if the simplifications are satisfactory at a limited scale, the generalization of the approaches may lead to a misread of reality; thus, ruling out an optimal answer to climate change.
5. A discrepancy in time horizons: Climate change has been felt and acknowledged in various institutions across the globe. Risk materialization time horizons for climate change are long when compared to the usual horizons in finance. Investment portfolios display a typical turnover of about 1-2 years, and the financial analysis is generally limited to 3-5 years, while most portfolio managers’ incentives are on an annual basis. The long-term investors have shorter time horizons, while short-term investors are exposed to longer time horizons.

It is worth noting that financial decisions based on traditional risk pricing would be misinformed. Thus, this causes two problems: the financial institutions cannot do their part to orient markets in the right direction to fight climate change, and they are potentially overexposed to risk, causing systemic instability.

Methodologies to Manage Climate-Related Risks

The alarming severity of the climate risks to the financial system has made banks and investments to device mechanisms to deal with the menace. In this section, we shall have an overview of the stress test and scenario analysis approaches.

1. Regulatory stress tests: These are analyses conducted under hypothetical unfavorable economic scenarios designed to investigate whether or not a financial institution has adequate capital to be resilient to the impact of abrupt changes. They help in projecting the investment risk and the adequacy of assets. Moreover, in the case of climate risks, stress tests aids in measuring ways in which a climate crisis would affect the financial system. They capture how an initial economic shock, such as a plunge in the financial sector, can be extended throughout the financial system.
2. Scenario analysis: This is the process of approximating the expected value of a portfolio after a given period, disregarding the values of the portfolio security. It is an essential but challenging component of understanding and preparing for the influence of climate change on assets, markets, and economies. It proposes a ‘what-if’ analysis under a specific possible future that can be repeated with different assumptions. The weaknesses of this exercise are the long-time horizon required, which leads to disregard for the current resilience of the institution, complex feedback loops, varying timescales, and multiple interacting factors that determine how global climate change unveils.

Reporting and Disclosure of Climate-Related Risks

In this section, we will discuss Article 173 of the French Energy Transition Act and the European Commission Sustainable Finance Action Plan.

Article 173 of the French Energy Transition Act

The Energy Transition for Green Growth (ETGG) Act was adopted in August 2015. The Act made a turning point in carbon reporting. It gives a way of mitigating climate change and diversifying the energy mix and aims at reducing greenhouse gas emissions and energy consumption.

Under this article, a new specific reporting is required on climate change, from both non-financial companies and financial institutions themselves. Its provision for institutional investors was globally acknowledged and opened the way to similar discussions in many other scopes. The provisions of the French Energy Transition Act are:

1. The need for collective reporting requirements for companies: This addresses the financial risks related to the effects of climate change and the measures taken to reduce them. It also includes the consequences on the climate of the company’s activities and of the use of goods and services it produces.
2. The need for a climate risks assessment and reporting requirements for financial institutions: This addresses the risk of excessive leverage and the risks evidenced in the framework of the regularly implemented stress tests, to be disclosed in the mandatory annual risk report.
3. The disclosure requirements for institutional investors: The following are addressed in the disclosures:
   1. Information on how the investors’ investment decision-making process takes environmental, social, and governance (ESG) criteria into consideration. Also, the means implemented to contribute to the energy and ecological transition.
   2. Exposure to climate-related risks.
   3. GHG emissions associated with assets owned.
   4. Contribution to the international and French climate goals.

Since its implementation, several reviews have been published to analyze the progress of the financial institutions in the new reporting requirement, which gives a broad diversity in the methodologies and approaches followed by financial institutions.

Although the provisions of the law seemed extraordinary, its implementation has been regarded unsatisfying because it has not met its preset expectations in the reporting exercise. It does not uncover the strategies and risk exposures, according to the regulator’s expectations.

The European Commission Sustainable Finance Action Plan

This action plan is one of the most significant regulatory measures for climate-related financial risks. The European Commission (EC) created a High-Level Expert Group on Sustainable Finance (HLEG) in December 2016. The group was made up of twenty senior experts from civil society, the finance sector, and the observers from European and international institutions. The HLEG’s mandate was to provide advice to the EC on how to:

1. Direct the flow of public and private capital towards sustainable investments;
2. Pinpoint the steps to be taken to protect the stability of the financial system from environment-related risks; and
3. Establish these policies on a pan-European scale.

The action plan on sustainable finance was formed based on the recommendations of the HLEG.

The action plan on the sustainable finance adopted in the EC had three objectives:

1. To refocus capital flows towards sustainable investment, to attain sustainable growth;
2. To channel sustainability into risk management; and
3. To strengthen transparency and long-term aspect in financial and economic activity.

The EC adopted a package of measures considering the key actions given in the action plan. The kit includes a proposal for a European Union (EU) taxonomy regulation.

To mobilize central regulation for climate change and sustainability, the EC explores the practicability of and risks related to climate and other environmental factors in institutions’ risk management policies and the potential measurement of capital requirements of banks. This is aimed at defending the consistency and efficiency of the prudential framework and financial stability.

The action plan opens the way to provisions that would operate similarly by either decreasing or increasing capital requirements for holdings related activities that should be invested in priority for a transition.