Reviewing the increased focus on climate change and reflecting within operational risk

Phil Cliff, former Head of Climate, M&G

Below is an insight into what can be expected from Phil’s session at New Generation Operational Risk Europe 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.

What factors do you think have created an increased focus on climate risk?

The constant coverage of climate related disasters across newswires reflects the reality that climate change is a real and tangible concern for today’s society.

Swiss Re’s report on the costs of climate provides a seminal view of the extent to which losses incurred from future physical climate events could impact economic activity. The long and short of it is that climate change could reduce Global GDP by 18% in 2050[1]. The IPCC reports, compiled by the prominent climate scientists, demonstrate that in the next 30 years there is significant risk of reaching climate change ‘tipping points’ beyond which the earth will become an increasingly inhospitable home for life as we know it in the second half of the century.

It is unsurprising that in Davos this January, world leaders voted “The failure to set and meet national net-zero targets” in their top 5 Global Risks for 2023. The recent physical risk events such as the Californian, Australian, and Mediterranean droughts and fires have brought a stark realisation of one of the impacts climate has on the developed world. It is a little-known fact that the fires on the West Coast of the US were directly linked to the bankruptcy of PG&E-utility. The $30bn legal claims brought against it for its alleged role in causing the Californian wildfires forced it into Chapter 11.

In the World Economic Forum Global Risk Report 2023 on a 2-year near-term view, climate and environmental risks numbered 5 of the top 10 (figure 1 below). Climate adaptation rose up the rankings this year, reflecting that whilst many commitments are increasing to reduce emissions, in total they are inadequate to limit warming to a rise to 1.5°C above pre-industrial times.

Figure 1: Global risks ranked by severity over the short term (2 years)

The climate transition is initiated by the clean power transition, and because thermal coal power is the largest contributor to climate change according to the IEA.[2] In response to this, some states in the US have a multitude of measures to promote the clean power transition and the closure of thermal coal power plants by 2030, which would mean early retirement and likely write offs of those assets –  otherwise termed as ‘stranded assets’. These effects on utility companies are termed ‘transition’ risks – both for the utility companies, and their providers of capital. The EU regulation and carbon trading system has contributed to the successful reduction in EU emissions over the past decade, as a result of the early retirement of thermal coal assets before the end of their engineering useful life and serves as a likely precedent for other regions.[3]

Global Financial Regulators and standard setters (such as the Basel Climate principles) are investing significant resources, mindful of mitigating the sector systemic risk impacts on and from climate. [4]

It has not gone unnoticed that Climate Finance is a rapidly growing segment of the financial markets[5]. A swathe of financial firms have committed to climate target setting initiatives. Across the spectrum of finance these include the Net Zero Banking Alliance (NZBA), the Net Zero Insurance Alliance (NZIA), the Net Zero Asset Managers Initiative (NZAMi), the Net Zero Asset Owners Alliance (NZAOA), the Science Based Targets Initiative (SBTi), and GFANZ (Glasgow Financial Allianz for Net Zero). The scale of capital committed to developing climate targets is mammoth; 301 asset management firms who manage $59trillion of assets have made the commitment. The Net Zero Banking Alliance now represents 496 banks, being 40% of the world’s banking assets, and includes many of the world’s largest global banks.[6].

Regulators are alive to the risks of making excessive claims and investigations are on the rise on both sides of the Atlantic[7]. It is also expected that fines will follow and affect reputations.[8]

Finally, there is also a “growing appetite from civil society, non-governmental organisations (“NGOs”), as well as governments to impose a duty of care on companies, especially those that are perceived to materially contributing to climate change”.[9] Climate litigation for alleged climate misstatements is an increasing issue and impact for boards, investors, underwriters and the public[10].

What does a climate risk assessment look like, and how can this be used to avoid further operational risks?

Climate emission baselining and scenario analysis are the preliminary steps to beginning a climate risk assessment. Data quality and availability, and the methodology of aggregation are on their own journey – with some asset classes mature and others at the formulaic stage.

Operational risk assessments necessarily vary based on the operations, the inherent climate risks associated with those operations, and the corporate objectives: by way of example the risk assessment may relate to the overall corporate strategy, a specific  operational risk, or a portfolio exposed to particular physical risks in a particular geography.

Each of these are evolving in their breadth and degree of sophistication, and as such the level of risk appraisal across asset classes. It follows that climate risk assessments are commonly limited to a partial imperfect identification and quantification of climate financial risk for a financial entity. Scenario analysis is, after all, not a forecast but an exploration of what can happen, driven by known relevant material climate related variables and their effects upon financial outcomes such as Value at Risk (VAR) and probability of default.

Understandably climate risk assessment is rapidly evolving, including with the sharing of best practice. Best practice revolves around broadening and embedding climate assessments into operational processes and evolving to mitigate corporate change. Tapping into these resources and networks will be a key enabling activity.

For banks and other financial institutions, the expectation is that climate integration across institutions and their operational processes will be highly dynamic, and that there will continue to be a resourcing challenge in filling the climate capabilities required for effective climate risk management across the 3 lines of defence.

How do climate change scenarios transmit into operational risk scenarios?

Several climate scenarios have been developed by central banks, the Network for Greening of the Financial System (NGFS) and other bodies such as the IEA, the IPCC, the RCP’s and the Committee on Climate Change (UK). They are based upon three main recognised families of scenarios, which are: Orderly; Disorderly and Hothouse. Each describes a climate transition narrative. Each model is different in its approach to granularity and aspects of strengths and weaknesses for particular use cases.

These have been further developed by economists/finance to incorporate macro-economic variables and make them adaptable for use in assessing how each scenario may follow through into financial impacts through time on varying asset classes.

Both the broad scenarios and the inputs to run a scenario model will help with conducting stress tests for banks when evaluating factors such as capital adequacy, liquidity, baseline strategy, and resilience and sensitivity of portfolios to key climate related variables.

Whilst in many cases other factors such as interest rates will remain the primary sensitive factors, the longer-term success of mitigating risk and seizing climate opportunities for banks will be best served by broadening and deepening climate risk and opportunity assessments into bank operations.

What impact is climate change having on banks reputations?

Climate finance and societal expectations are evolving rapidly.

The rise of climate greenwashing research and reporting has resulted in a rising number of instances of related financial sector headlines. This makes it high-risk for risk managers, and one which is unlikely to be limited to reputational risk. Investigations, fines and litigation are evident today. Banks who are not doing what they said, deemed to not be doing enough (judged in retrospect)[11], and those who are financing harmful activities will be the focus of attention from NGO’s, potentially regulators and the legislative agenda.