The role of climate change as a source of financial risk
At the World Economic Forum 2020 in Davos Deutsche Bank presented a report asking how much humanity is willing to give up economic growth and development in the quest for saving the environment. They argue that there is only limited awareness on the extent of necessary personal sacrifices each has to make to reach climate targets. In other words, a prospering future humanity and mitigating climate change are two incompatible concepts. Nevertheless, there is also growing awareness that it is highly likely that climate change will have adverse effects on all industries due to its systemic nature. This in turn would have a major impact on financial markets and hence global economic stability. What this means is that climate change can be considered a source of financial risk that needs to be priced in when evaluating assets such as a company’s shares. According to the Financial Stability Board – an organization supervising the global financial system – climate risks are currently not sufficiently factored-in due to insufficient information on the long-term impact of climate change on economic activities.
In this article, we will look at the financial implications of climate change on both financial and non-financial organizations, resulting climate-related risks and opportunities and a high-level approach on how climate change can be evaluated as a source of financial risk.
Financial implications of climate change
Climate change can be viewed as a risk with highly uncertain outcomes playing out over long periods of time. Due to its long-term nature, the majority of organizations currently does not consider climate change as a risk requiring immediate attention. Additionally, most organizations do not conduct strategic planning for time horizons exceeding five years. This is problematic since the transition to limit global warming to 2-degree Celsius will likely lead to disruptive changes in several industries, thereby threatening economic stability. If organizations are not sufficiently prepared for these changes, there might be sudden losses in asset values similar to the last financial crisis. To avoid such a scenario, organizations and investors should consider long-term capital allocations and strategies.
The Financial Stability Board estimates that the transition will require 1 trillion USD in investment a year for the foreseeable future to finance the shift away from fossil fuels and related assets. This will alter risk return profiles of most organizations, whereby the magnitude of impact on an organization will be directly related to its exposure to climate change, climate policy and new technologies. According to the Economist Intelligence Unit, the Value at Risk – the potential capital loss over a given time horizon at a specific probability – of total global assets lies between 4.2 and 43 trillion USD between now and the end of the century. Furthermore, they expect overall weaker economic growth due to profound economic transformation coupled with resource constraints. While it can be expected that this will lead to generally lower asset returns, this will be particularly true for economic activities not viable anymore in the future.
In specific, the Financial Stability Board identifies four categories how the financial position of an organization can be impacted covering income generation and associated costs, company valuation and financing capacity. Firstly, transition and physical risks can lead to decreased revenues due to reduced demand for certain products and services. Secondly, expenditures can increase, depending on an organization’s flexibility to adapt its cost structure. Thirdly, valuation of assets and liabilities can change. Fourthly, changes in risk profiles can alter an organization’s capacity to raise capital.
Climate-related risks and opportunities
To help organizations structure their analysis around climate change as a financial risk, the Financial Stability Board defines two categories of risk – transition risks and physical risks. Transition risks are associated with risks arising from adaption needs in the fields of policy, technology and market. Physical risks are directly driven by climate change, either through specific events such as cyclones or long-term changes such as rising sea levels.
Within the category of transition risks, it can be differentiated between policy and legal risk, technology risk, market risk and reputational risk. Policy risk can arise from constraining activities with an adverse effect on the decarbonisation of the economy while promoting others contributing to it. Litigation risk may stem from an organization’s failure to adapt to climate change while not adequately disclosing climate-related risks. Technology risk is the threat of substitution through new technologies. Market risk is primarily reflected in shifts in supply and demand for certain products once climate-related risks and opportunities are increasingly considered. Finally, reputational risk may arise from consumers becoming reluctant to buy products from certain companies due to public stigmatization of their activities.
Apart from risks, the transition also offers opportunities in the fields of resource efficiency, energy source, products and services, markets and organizational resiliency. Resource efficiency and low-emission energy sources are both opportunities for organizations to reduce their operating costs and carbon footprint while increasing their self-sufficiency in terms of energy needs. As for products and services, companies may gain a competitive advantage by offering innovative low-emission solutions. This should also enable them to access new markets, thereby diversifying their operations and hence reducing their exposure to climate-related risks. Finally, organizations can increase their climate change resilience by investing in initiatives that contribute to a decarbonised economy.
Approach to evaluate climate change as a source of financial risk
It has been explained that the long-term consequences of climate change are highly uncertain. Due to this, it makes sense to apply a scenario analysis approach to evaluate different outcomes. Moreover, it sets the base for the ability to provide investors with better information while enabling comparison between organizations. Once relevant scenarios are identified, they can be used to analyse, assess and manage business, financial and strategic implications requiring attention to mitigate climate-related risks early on. In addition, it helps organizations gain a better understanding of their external environment, thereby enabling them to react quicker to disruptive changes.
Regarding scenario choice the Financial Stability Board recommends applying a 2-degree Celsius scenario in line with the Paris Agreement. Next, critical input parameters, assumptions and analytical approaches have to be determined to develop relevant scenarios. Time frames should last from short, medium to long term, up to 2050. Ideally, milestones are defined when specific targets should be reached. Lastly, the gathered insights can be prepared for investors to inform them, among others, about an organization’s climate change strategy, the applied risk management framework to detect, assess and manage climate-related risks and how it measures them.
Conclusion
Concluding it can be stated that pursuing a sustainable transition in line with the Paris Agreement is not what inhibits economic growth but what enables human prosperity in the long term. If such efforts are not pursued, financial markets might be affected in a way that threatens global economic stability. Therefore, it is important that organizations assess the vulnerability of their operations under different climate change scenarios and how they can take advantage of climate-related opportunities. Through taking a long-term approach, it should be possible to anticipate major changes caused by either transition or physical risks, thereby avoiding sudden unexpected economic shocks. Ultimately, it is important that disclosure requirements are enhanced such that organizations have to disclose climate-related risks periodically. This will enable an open dialogue between politics, business, investors and the public.