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Quantifying the impacts of climate risk on financial institutions and building capabilities internally

The views and opinions expressed in this article are those of the thought leaders as individuals, and are not attributed to CeFPro or any particular organization.

By Simon Gadd, Group Climate Change Director, Legal & General

What are some physical and transition risks for organizations and how can these be managed?

The physical and transitional risks will vary depending on the business model of the financial institution. For insurers in the life sector, typically, the most material transition risk will be for the organizations asset portfolio, particularly if they have material exposures in high carbon sectors of the economy where the most radical change is required to achieve net zero. The interesting challenge is to identify which companies will embrace the challenge of net zero and evolve their business model to find new profit opportunities (e.g. utility companies moving to renewable energy generation), as opposed to those that are slow to adapt and may be exposed in fast changing market when the world realises it needs to move faster.

Physical risk is more likely to impact firms property and other real asset exposures (either through their direct ownership of these assets or if they provide security to mortgage or other lending), than their operations, particularly if they have long duration asset exposures. For non-life insurers physical risk and the viability of continuing to insure high carbon sectors will have growing importance.

What are some of the difficulties with modelling climate risk?

The difficulties of modelling climate risk are similar to modelling any form of long term risk but are exaggerated by the lack of past experience data, the uncertainty as to how the world will react to climate change and the complex interactions across the global economy.  Any model relies on good quality data and this is not consistently available as yet, with many companies not yet reporting their full carbon footprint. For example, some financial services companies not reporting their scope 3 admissions from their investments, which is omitting their most material contribution to global emissions.  Currently modelling requires lots of proxies for missing data and a wide range of assumptions about how the future will unfold at both a global economy level as well as at a micro company level. This means it is important to put a wide confidence level around any projections and use a range of scenarios to help understand the risks.

How do you imagine that climate risks will shape the future of financial services?

Financial Services has a critical role to play in the world’s response to climate change (see next question), which will create many opportunities, as well as risks. Financial services companies will need to understand how the attitudes and requirements of their clients are changing with respect to climate change and broader ESG issues and evolve their business models and services accordingly.

In what ways can financial institutions contribute to fight against climate change?

Financial institutions have a large influence over where financing flows are directed, via either their own proprietary assets or via the assets they manage on behalf of their clients. Directing more financing at scale towards activities and infrastructure required to decarbonise the economy, and away from perpetuating high carbon activities will be critical. However, this needs to be managed carefully, for example we need to exert influence over high carbon sectors such as energy and utilities to encourage them to change and help them finance their transition, but this is not possible if you have divested from the company.  Financial institutions also need to bring their clients with them on this journey, while also ensuring they deliver against their fiduciary responsibilities. Similarly, non-life insurer’s decisions about what companies, projects and infrastructure they will provide insurance cover to, will be similarly influential. Financial institutions as investors can help support the development and scale up of new technology required to decarbonise various sectors. They also need to extend their scope in to financing the transition within developing world economies, where the greatest challenges lie, although this will test the risk appetite of these institutions without some form of blended finance solutions.

What can an organization do to develop a long-term resilience to severe weather and extreme events?

The most important step is to understand how your business is exposed to weather and other extreme events. This will need access to one of various weather catastrophe type models which can predict at a specific location what is the probability of flood, or other perils, under different temperature warming scenarios. Clearly these models also have limitations as we do not know what the various higher temperature scenarios will actually mean in practice. However, this can help understand where you may have concentrations of exposure and to inform future underwriting of any potential property or infrastructure connected investments.

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Melissa will be speaking at Risk Americas 2023 in NYC on May 22-23.