Climate-related Risk Drivers and their Transmission Channels

After completing this reading, you should be able to:

• Describe climate-related risk drivers and explain how those drivers give rise to different types of risks for banks.
• Compare physical and transition risk drivers related to climate change.
• Assess the potential impact of different microeconomic and macroeconomic drivers of climate risk.
• Describe and assess factors that can amplify the impact of climate-related risks on banks as well as potential mitigants for these risks.

Climate-related Risk Drivers

Climate-related risks refer to climatic changes that could potentially give rise to financial risks. These risks have increased significantly over the last 100 years due to global warming, which has, in turn, increased the frequency of extreme weather events. The result is loss of lives, diminished livelihoods, reduced production in plants and animals, and damaged infrastructure, among other adverse impacts.

Climate risk drivers can be grouped into one of two categories:

• Physical risks.
• Transition risks.

Physical Risks

Physical risks are tied to weather and climatic changes that impact the economy. They can be subdivided further into acute risks, which come about due to extreme weather events, or chronic risks associated with long-term progressive shifts in climate. Acute physical risks include wildfires, heatwaves, floods, storms, hurricanes, typhoons, and cyclones. Chronic physical risks include rising sea levels, ocean acidification, and rising temperatures. Prolonged periods of high temperatures can also lead to desertification.

Physical climate risks may occur with a significant time lag. What’s more, severity differs from one event to another. Human activity and day-to-day decisions, to an extent, affect exposure to physical risks. Nevertheless, it’s impossible to control the location, timing, and magnitude of specific physical events.

Transition Risks

Transition risks refer to societal disruptions arising from adjustments towards a low-carbon economy. Migration to a low-carbon economy comes with a host of changes that impact not just working conditions but also the products manufactured.

Sources of transition risk include:

• Changes in public sector policies.
• Innovation and modifications in the affordability of existing technologies (e.g., that make renewable energies cheaper or allow for the removal of atmospheric GHG emissions).
• Investor preference for greener tools and resources.

Banks have been caught up in these risks, a situation that has given them the incentive to deploy risk-monitoring tools in an attempt to mitigate or eliminate risk effects. However, the sheer scale and synchronous nature of transition-related changes mean it isn’t easy to keep up, and the impact can be greater than previously anticipated. It is noteworthy that transition risk drivers vary from one economy to another depending on the existing levels of technology and mechanization.

Let’s now briefly look at examples of transition risk drivers.

Climate Policies

In recent years, countries worldwide have put a lot of effort toward finding solutions to risks resulting from climate change. Through the Paris Agreement, an international treaty that enjoys the support of 191 countries (and the European Union), nations have pledged to take a host of measures and enact policies that reduce GHG emissions and adopt low-carbon economies. Some countries have gone as far as barring the importation of certain products while setting deadlines for the manufacture of certain local goods. For example, the UK has pledged to reduce greenhouse gas emissions by at least 100% of 1990 levels (net zero) by 2050.

Technology

There’s been a sustained push around the world to replace old technology with new technology and tools that emit little greenhouse gases. For example, counties are encouraging automobile producers to ditch the production of gas-dependent cars in favor of electric models, which emit less carbon into the atmosphere. The problem is that some of the proposed technological changes might force companies to ditch proven long-term business models and adopt the use of resources that may become more expensive over time. On the upside, firms that are quick to adopt the changes stand to benefit from public goodwill and favorable government policies. The government can also impose taxes on the use of certain resources.

Investor Sentiment

Investors are increasingly factoring climate risks into their investment decisions, a trend that may reflect pressure from non-governmental organizations and environmental groups. Indeed, some of the world’s largest asset managers are already incorporating climate change into investment decision-making and investment approaches. For corporations directly impacted by climate change, both their bond and equity offerings will be subject to valuation and re-valuation as investors change their assessment of the underlying climatic risks.

Consumer Sentiment

Adapting to a low-carbon economy requires a change in human behavior. Climate-friendly consumption would, for example, lead to more climate-friendly transportation, manufacturing, and energy use. Evidence indicates that there is a shift in consumer behavior already underway. Clients of retail banks may ask that their savings or investments be directed to institutions with more eco-friendly policies or projects that contribute to the environment. A growing awareness of, and explicit demand for, climate-friendly financial products and investment could spur corporations and banks to change their business strategies, notwithstanding potential regulatory or supervisory approaches. In the same vein, investors’ and consumers’ expectations of hazards (e.g., flooding), climate policies, or technological changes may lead to changes in their preferences and consequently impact the price of assets.

Assessing the Potential Impact of Different Microeconomic and Macroeconomic Drivers of Climate Risk

There’s a clear link between climate risk drivers and financial risk for banks. The causal chains linking climate risk drivers to the financial risks the banking sector faces are known as transmission channels. Put differently, transmission channels present the avenues through which climate change can expose banks to financial risk. These transmission channels can either be macroeconomic or microeconomic.

Microeconomic Channels

Microeconomic transmission channels refer to the causal chains by which climate risk drivers affect various individual counterparties doing business with banks, potentially exposing banks and the entire financial system to climate-related financial risk. They include the direct effects of climate change on banks, particularly events that disrupt operations and the ability of banks to raise funds for day-to-day business. In addition, they include the indirect effects on name-specific assets such as bonds, single-name CDS, and equities.

Macroeconomic transmission channels are the avenues through which climate risk drivers affect macroeconomic factors such as inflation, labor productivity, GDP, and economic growth. These factors may, in turn, have an effect on the economy in which banks operate.

The following are various microeconomic transmission channels and the financial risk they create:

Credit Risk

Households

• Severe weather can damage bank-funded property. This, in turn, increases the probability of default non-performing asset ratios and lowers bank equity ratios.
• Banks using residential real estate as collateral for mortgages may see their credit risk increase if such property is damaged by adverse weather or rising sea levels.

Corporates

• There’s evidence that severe weather events (physical risks) reduce corporate profitability and potentially increase credit risk to lenders.
• Agricultural entities funded by banks can be hit by high temperatures and precipitation, leading to low yields and problems repaying debt.

Sovereigns and Subnational Institutions

• Physical risk events may lead to lower tax revenues for sovereigns and supranational institutions resulting from impaired corporates, reduced household income, and an overall reduction in output. This, in turn, increases the risk of default and the loss given default for banks with sovereign and municipal exposures.

Government Policy

• Transitioning toward a low-carbon economy may lower the productivity and profitability of corporates, affecting their creditworthiness.

Technological Change

• Carbon-intensive technologies may be subjected to heavy taxation to discourage their use. Thus, any firm that continues to rely on such technologies may find itself unable to compete against those that quickly adopt newer, more efficient technology. Credit-related losses may be higher for banks exposed to companies that cannot adapt to carbon-neutral economies.

Sentiment

As more and more consumers embrace less carbon-intensive products, producers that stick with the high GHS emission products may see a decline in sales. As such, banks exposed to such producers may see an increase in credit risk.

Market Risk

• Physical and transition risks can alter or reveal new information about future economic conditions that will affect the price and value of financial assets. This may result in downward price shocks and an increase in market volatility.
• Climate risk could also lead to a breakdown of long-established correlations between financial assets. This would render hedging methods ineffective and reduce the ability of banks to manage their market risks.

Liquidity Risk

• Banks’ liquidity risk may be affected directly as a result of climate risk drivers, either through their ability to raise funds or liquidate assets or indirectly as a result of customer demands liquidity.
• Households and corporations affected by physical risks may withdraw deposits or borrow funds to cover recovery and other cash-flow needs. Such actions may put a bank under unprecedented liquidity pressure for banks.

Operational Risk

Physical Risk

• Banks’ operational ability may be reduced if physical hazards destroy transportation and communication infrastructure.
• Banks and corporations may also see increased legal and regulatory compliance risks resulting from transition risks.

Macroeconomic Channels

When considering macroeconomic factors, climate risk is expected to have the greatest impact on credit and market risks.

• Credit risk: First, there is likely to be a climate-related increase in human mortality, a situation that may result in reduced labor productivity. Second, empirical evidence suggests climate risk has pushed the cost of debt up by 117 basis points in developing countries. This means the affected industries may find it difficult to recover from disasters and honor their financial obligations with counterparties, including banks. In addition, increased borrowing costs could bring about higher taxes, lower government spending, and reduced productivity levels, all of which may indirectly impact the credit risk for banks.
• Market risk: At this point, there’s little research that seeks to establish how the interaction between macroeconomic factors and climate-related risks can affect the market risk for banks. However, some evidence suggests that changes in government policy might affect the value of assets in certain industries that significantly contribute to the overall economy.

Factors That Can Amplify the Impact of Climate-related Risks on Banks

The following factors can amplify the impact of climate-related risks:

Risk Drivers Interactions

Interactions exist across both physical and transition risk drivers. One area where we’ve seen such interactions is the simultaneous introduction of climate-mitigating policies (e.g., preference for electric vehicles over those that use gas) and technological breakthroughs.

Financial Amplifiers

Certain financial amplifiers have the potential to increase the impact of climate-related financial risks on banks. The materialization of climate-related risks on bank balance sheets might be amplified by behavioral choices within the financial system and interactions with the real economy. A good example of a financial amplifier is the absence of insurance or its unaffordability. If bank-funded assets aren’t insured, damage caused by climate-related events could result in a loss for the bank and result in a difficult recovery plan for the borrower.

Multiple Channels

Some risk drivers may impact banks through more than one transmission channel, a situation that amplifies climate-related financial risks. Notably, the interaction between microeconomic and macroeconomic transmission channels can worsen an already dire situation. An example of this would be where a physical risk results in the destruction of houses, thereby affecting the creditworthiness of a bank’s customers while also impacting the aggregate credit risk for banks.

Mitigants

Mitigants can mitigate and offset banks’ exposure to climate-related financial risks through proactive and reactive actions. Proactive actions are the pre-emptive steps banks take to reduce their vulnerability to climate-related risks. Good examples would be diversification and strategic asset allocation. A bank might increase investment in sustainable companies, particularly those that have embraced less carbon-intensive business practices and technology.

Reactive actions include actions taken as a response to climate risks already embedded in balance sheet exposures. They include insurance and reinsurance, hedging, securitization, and asset sales that enable a bank to reduce its exposure to high-risk assets.

Question 

Consider a multinational corporation, EarthSpan Inc., which has its manufacturing units in a coastal region prone to cyclones and its largest consumer base in a highly developed country committed to implementing stringent green policies. Given the company’s present context, EarthSpan Inc. faces an assortment of climate change risks. As a risk manager, you’ve been asked to analyze these risks. Which of the following combinations accurately describes the physical and transition risks EarthSpan Inc. may encounter?

A. Physical risk: Reduction in consumer demand due to changing preferences; Transition risk: Infrastructure damage due to cyclones.

B. Physical risk: Damage to manufacturing units due to cyclones; Transition risk: Technological obsolescence due to shifting renewable energy technology.
C. Physical risk: Technological obsolescence due to green policies; Transition risk: Rising sea levels affecting manufacturing units.

D. Physical risk: Decrease in investor interest due to climate concerns; Transition risk: Flooding of manufacturing units.

Solution

The correct answer is B. 

Physical risks associated with climate change relate to changes in weather and climate patterns that directly affect economies and organizations. EarthSpan Inc., having its manufacturing units in a cyclone-prone region, faces a physical risk of infrastructure damage due to cyclones. This risk, categorized as an acute physical risk, is derived from extreme weather events.

Transition risks are those that arise from the societal shift towards a low-carbon economy. These risks encompass changes in technology, policy, and societal behavior towards a more eco-friendly stance. With its largest consumer base in a country implementing stringent green policies, EarthSpan Inc. could face a transition risk of technological obsolescence, as the shift towards renewable energy technology may outdate their current manufacturing processes.

Option A is incorrect because it incorrectly identifies a reduction in consumer demand due to changing preferences as a physical risk. In reality, this would fall under transition risk, as it reflects changes in consumer behavior driven by evolving societal sentiments and preferences. In the same vein, infrastructure damage due to cyclones is actually a physical risk as it pertains to the impact of extreme weather events on the organization’s physical assets.

Option C is incorrect because it misclassifies technological obsolescence due to green policies as a physical risk. Technological obsolescence is a transition risk, as it arises from changes in technology and regulations related to the transition to a low-carbon economy. Rising sea levels affecting manufacturing units, on the other hand, is a physical risk, as it pertains to the direct impact of climate-related changes on the organization’s physical infrastructure.

Option D is incorrect because it incorrectly identifies a decrease in investor interest due to climate concerns as a physical risk. This is actually a transition risk, as it relates to changes in investor sentiment and their assessment of the organization’s exposure to climate-related risks. Flooding of manufacturing units, however, is as a physical risk, as it pertains to the direct impact of climate-related events on the organization’s physical assets.