Paul Dobbs, financial risk expert at consulting firm Sionic warns why banks cannot afford to focus only on the immediate crisis of the coronavirus pandemic but must also address long term climate change
The coronavirus covid-19 pandemic has had almost instant impact. The global economy has ground to a standstill, financial markets have been in free fall and companies (global and domestic) are struggling to survive.
But, while covid-19 requires immediate attention from governments, businesses and citizens, other even greater risks remain very real. Policy makers, banks and financial institutions must not lose sight of climate change, which will continue to manifest unless coordinated efforts increase to address long term issues. Covid-19 will impact the global economy for months if not years; climate change will impact the global economy over years and decades, if not centuries.
In fact, given these uncertain and volatile times, the need for forward planning and scenario analysis has never been more important for banks and financial institutions. With climate change risk (both physical risk and transition risk) looking to impact financial and price stability via supply shocks and capital losses, banks and financial institutions must be better prepared to handle the increased levels of market risk, credit risk, operational risk and to some degree liquidity risk. And in order to prepare, it remains imperative that banks and financial institutions invest more time and resources on this issue as soon as possible.
Damaging effects
Given the pandemic, is now the right time to act on climate risk?
Yes. There are large time lags before climate change damage becomes apparent and irreversible: the most damaging effects will be felt far beyond the traditional short-term time horizons of policymakers and other economic and financial decision-makers. Climate-related risks are not simply black swans, ie tail risk events.
The combination of complex chain reactions between degraded ecological conditions and unpredictable social, economic and political responses, and the risk of triggering tipping points, means that climate change represents a colossal and potentially irreversible risk of staggering complexity.
Even today’s tragic events are a perfect example of what lies ahead. The collapse in oil prices and the demand shock inflicted by the coronavirus crisis offers financial institutions a live test run of an extreme climate risk stress scenario. Zacharias Sautner, professor of finance at the Frankfurt School of Finance and Management, said the recent tumult should push banks “to prepare for a similar shock because of climate change”. The causes may differ, but the financial impacts on industries such as oil and gas or equity/bond valuations in the energy sector could be similar.
Many in the financial circles are familiar with the term ‘black swan events’ and as a result risk management functions across banks and financial institutions have developed sophisticated scenarios sets and stress testing frameworks. Climate change risk will present its own unpredictable events better known as green swan – but as the BIS recently pointed out, it will differ from black swan events in three regards:
- Although climate change impacts are highly uncertain, “there is a high degree of certainty that some combination of physical and transition risks will materialise in the future.”
- Climate catastrophes are even more serious than most systemic financial crises: they pose an existential threat to humanity.
- The complexity related to climate change is of a higher order than for black swans: the complex chain reactions and cascade effects associated with both physical and transition risks could generate fundamentally unpredictable environmental, geopolitical, social and economic dynamics.
- Just like the financial landscape today, climate change risk presents many uncertainties and as a result scenario analysis can play a crucial role in helping to answer some of the pressing questions, what are the risks relevant to your business and how might these risks evolve over time (under certain scenarios – 2 degrees shift, a sudden introduction of carbon policies). Scenario analysis should also be developed to assess forward looking impacts, which can then help facilitate initial dialogue of the long-term impacts of the business – assisting banks and financial institutions in their communication to board members, investors, stakeholders, regulators.
It is also important to highlight that scenarios analysis will not only be important to understand the key financial risks to your organisation, it will also play a vital role in areas such as:
• carbon tax impacts
• weather pattern shifts
• movements in the supply chains
• changing consumer preferences
• mass migration impacts in the socio-economic landscape
• your business model
Uncertain parameters
Unfortunately, addressing climate change risk is not without its challenges. Traditional approaches to risk management, consisting of extrapolating historical data based on assumptions of normal distributions, are largely irrelevant to assess future climate-related risks.
Forward-looking approaches remain highly sensitive to a broad set of uncertain parameters involving the choice of a scenario regarding how technologies, policies, behaviours, macroeconomic variables and climate patterns will interact in the future. As a result, hundreds, if not thousands of variables need to be considered at the national, local, and even postcode levels, as the distribution of events and impacts can be extremely granular – for example tornadoes and flooding.
Even the guiding principles of identifying, managing and mitigating climate change risks edicted by the Task Force on Climate Related Financial Disclosures (TCFD) (which all regulatory and supervisory bodies align with), they also recognise that key challenges remain in implementing scenario analysis/stress testing including:
• lack of appropriately granular, business-relevant data and tools supporting scenario analysis;
• difficulty determining scenarios, particularly business-oriented scenarios, and connecting climate-related scenarios to business requirements;
• difficulties quantifying climate-related risks and opportunities on business operations and finances; and
• challenges around how to characterise resiliency.
And there is hope: During the development of Sionic’s ESG database, we identified credible scenario methodologies around credit risk, focusing on an array of industries and sectors by key players in the market. That said, it does not mean that the development of scenarios should be considered a finished product. Financial firms alike will increasingly be required to rely on them to explore their potential vulnerabilities. It is important to remember that scenarios represent plausible future pathways under uncertainty. Scenarios are not associated with probabilities, nor do they represent a collectively exhaustive set of potential outcomes or actual forecasts.
Stress tests
The concept of ‘risk’ refers to something that has a calculable probability, whereas uncertainty refers to the possibility of outcomes that do not lend themselves to probability measurement (Knight (2009) [1921], Keynes (1936)), such as “green swan” events. As a result, qualitative applications for scenario design will also provide essential help which can begin today.
Furthermore, proposals around the incoming regulatory stress testing requirements can also assist the industry. I highlighted in my previous article that policy makers and central banks are already introducing guidelines around climate change stress testing, with the Bank of England (BoE) releasing their 2021 Biennial Exploratory Scenario (BES) exercise. The objective of the BES is to test the resilience of the largest banks and insurers to the physical and transition risks associated with different possible climate scenarios, and the financial system’s exposure more broadly to climate-related risk. Although contribution to such an exercise is on a voluntary basis, if the Bank of England see a lack of uptake, they will not hesitate to make it compulsory sooner rather than later.
The BES proposal differs from traditional stress tests in several areas:
• the wide-ranging impact of climate related financial risks, requiring broader participation;
• the range of possible pathways and climate outcomes, requiring multiple scenarios;
• the interaction with the real economy, requiring counterparty level analysis and;
• the longer timeframe over which risks materialise, requiring multi decade analysis.
The focus of the Bank of England is on sizing risks, rather than testing firms’ capital adequacy or setting capital requirements. The Bank intends for the 2021 BES to be a learning exercise. Expertise in modelling these risks is in its infancy, so this exercise will develop the capabilities of both the Bank and the firms involved (banks, but also data and IT vendors).
Banks and financial institutions should not underestimate the amount of work required here given current stress testing exercises are already highly time consuming. The fact that in the near term, new data sources will need to be identified, additional scenarios via new risk factors must be created, new models will require development while new reporting streams will ultimately need to be operational, will result in more time and investment being allocated.
Even though the financial sector is still in its infancy with regards to climate change risk, banks should not wait for regulators to drive. Banks and financial institutions should first review their portfolios to break them down and understand their sensitivities to climate change risk. A heatmap will provide a good visual indication of the industries/sectors most exposed to climate change risk.
Different sectors and industries will be impacted by different vulnerabilities resulting from climate change risk. Mapping these vulnerabilities to portfolio segments will be crucial to better monitor, manage and mitigate these risks when scenario design starts. With the release of the scenario types imminent (both the BoE and the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), to be followed shortly by the European Banking Authority), banks and financial institutions must start identifying their key data immediately.
Although non-financial data may not be as prevalent as financial data, one just needs to know where to look as there is data available across key sectors.
There will be many across the industry who feel that given recent events, climate change risk like other current regulations will be pushed back on the agenda. The fact is, there is only a finite number of years to act before it becomes too late. Should this be left until the last minute the scale of change via new policy change will result in a larger proportion of assets being stranded creating a contagion of much bigger losses for both banks and investors. As such, with the probability of increasing losses on the horizon (both through physical risks and transition risks) combined with increasing social awareness about climate change risk, means financial institutions must ensure that their risk management and future actions do not give rise to reputational risks.
It is not unconceivable that the Basel Committee, the European Commission (as part of its green initiatives) or the Bank of England / Prudential Regulation Authority (PRA), could impose higher risk weights for loans to companies that harm the environment or give capital relief to banks for green lending.
