Risk identification and long-term capture: Climate risk into the future
Dirk Effenberger, Head of Investment Risk, UBS
Below is an insight into what can be expected from Dirk’s session at Climate Stress Testing 2023.
The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.
Why is it important to identify and capture long-term climate risks?
Higher temperatures, biodiversity loss, or more frequent natural disasters are just a few climate change phenomena that could change the way we do business, live, and behave in the coming decades. Therefore, it is vital to identify, understand, and capture the risks that come along with climate change.
Climate-related events can damage and disrupt businesses and affect companies’ stakeholders. For example, from an investor’s point of view, it is key to understand how different investment positions are exposed to those risks and how a portfolio’s composition can cushion financial losses from climate-related events. Examples of long-term risk drivers are:
Changing regulatory rules: Governments around the globe have imposed policies prohibiting, limiting, or subsidizing certain economic activities, for instance, the European Union Emissions Trading System (EU ETS). Businesses falling behind on adequately adjusting to the new playbook can face legal and financial consequences.
Changing consumer preferences: Consumer preferences have turned toward more environmentally friendly products and services, forcing companies to adapt accordingly. Missing out on this trend can lead to financial losses and reputational damage.
As mentioned above, risks threaten the status quo but can also open up new opportunities. For example, physical disruptions from climate events (e.g., heat waves and increased sea levels) can change consumer behavior, boost technological advancements, or open doors to engage in sustainable investments.
What are the key risks that need to be identified to conduct a stress test?
The Task Force on Climate-related Financial Disclosure (TCFD) provides an ideal framework to identify exposure to environmental risk across different channels. The TCFD Framework distinguishes between physical risks and transition risks, defining sub-categories for each.
Examples of physical risk include weather events related to climate change (acute drivers) and longer-term shifts in climate patterns (chronic drivers), which could impact a company’s financials and investor returns. On the one hand, acute drivers can be classified as acts of nature like natural disasters or extreme weather events. Such events are wildcards as they are very unpredictable. On the other hand, chronic drivers revolve around more extreme weather patterns, increased temperatures, and rising sea levels able to trigger natural resource crises, including a lack of minerals or food. For instance, we are currently experiencing the largest rice crisis in the past 20 years, driving up food prices around the globe.
Meanwhile, transition risks stem from business drivers (consumer preferences, technology, and policy and regulation) required to transform from a high-carbon economy to a low-carbon one. Those risks include biodiversity loss, ecosystem collapse, or irreversible environmental damage.
Both physical and transition risks affect economies on the micro (businesses and households) and macro level, translating into five key risks, namely:
- Credit risk (defaults by businesses and households)
- Market risk (repricing of asset classes, like equities)
- Underwriting risk (increased insured losses and insurance gaps)
- Operational risk (supply chain disruptions, forced facility closure)
- Reputational risk
- Liquidity risks (increased demand for liquidity, refinancing risks)
What role do diversification and hedging strategies play in response to climate stress test outcomes?
Like for any other financial risk mitigation, hedging strategies as well as diversification can be effective tools in protecting a portfolio or business against climate risks. However, the effectiveness of these tools depends on an individual systematic risk scenario analysis.
In addition to traditional hedging instruments, one specific way to hedge against weather risks is through weather derivatives. These include various types, such as temperature derivatives, precipitation derivatives, or tropical cyclone derivatives to name a few. Let’s take the rice crisis as an example of how to use a hedging strategy. Aside from the war in Ukraine, the main driver for the issue is bad weather conditions in China and Pakistan with heavy monsoon rains and floods. For example, an investor or rice producers could utilize precipitation derivatives to offset harvest losses from floods in Pakistan around monsoon months. Precipitation derivatives protect crops against precipitation and pay when rainfall levels significantly deviate from historical averages. This was the case for Pakistan when rainfall levels exceeded historical averages by 160% (in June) and 70% (in July).
How has our understanding of climate issues evolved, and how might this impact future regulatory expectations?
Our understanding of climate change issues has evolved from observing and acknowledging human influence in the last century toward joint global action to decarbonize toward net-zero as stipulated in the Paris Agreement in 2015. Now, we see advancements in climate science, increased public awareness and activism, as well as technological innovations to protect the planet from climate change. Also, regulatory requirements for businesses have tightened. In addition, financial institutions acting as money flow gatekeepers are increasingly considering environmental, social, and governance (ESG) factors in investment decisions and offer corresponding products.
Going forward, climate-related regulatory actions will change constantly as…
- Industry and regulators’ understanding of climate change will massively improve.
- Our understanding of the impact of existing rules will improve (should current measures not deliver the desired effects, it is more likely that governments and the public become more vocal on stricter regulatory controls).
- Future climate events could call for more regulatory control (the 2008 GFC is an example of kickstarting regulatory change for the financial industry).
- Societies and politicians reset their priorities around climate change relative to other requirements and needs.