Outlook Changeable

Paul Fisher examines some of the challenges and opportunities facing
financial services companies as climate change moves centre stage in risk

By Paul Fisher, Chairman of the Board of Trustees, London Institute of
Banking and Finance. Paul is also a Senior Associate with the University
of Cambridge Institute for Sustainability Leadership (CISL), which
launched the Cambridge Centre for Sustainable Finance in 2016.

Until recently, climate change was mostly a social and political issue for
a minority. In the past couple of years it has become a hard commercial
risk consideration in the financial sector.

The insurance industry has been on the case for some time, based on its
catastrophe modeling resources. The wider asset management sector is
increasingly involved because of the risks of abrupt changes in asset
price. Banking is already under pressure in some countries from new
responsibilities placed on the lender.

This pressure is ramping up. In the next few months, G20 finance ministers
and central bank governors will be presented with recommendations on
disclosure standards for climate risks, from the Task Force on
Climate-Related Financial Disclosures – a globally convened, private
sector group set up by the Financial Stability Board. Their report will
focus on the information that companies should disclose to enable
investors to assess how exposed they are to risks arising from climate

These risks include both the impacts of physical events like storms and
droughts, should climate change proceed unchecked, as well as the policy,
technology and even sentiment changes that will result if it is to be
mitigated. These risks could crystalise abruptly – we already have some
examples – causing rapid adjustment in prices, stranded assets and even
financial instability. The connections leading to these events could be

Take, for example, the case of US firm Peabody Energy, the world’s largest
private sector coal producer by output, which filed for bankruptcy earlier
in 2016. The firm cited “unprecedented” factors such as a steep decline in
prices and lacklustre demand from China. But another important part of the
picture was the intense competition from cheap gas in the United States
encouraged in part by the US government’s broader decarbonisation plan.

Useful, early disclosures of change by affected firms can help reduce the
number of shocks and lessen the reaction to those that do occur. They can
also directly drive down carbon emissions via the power of transparency.

However, disclosure in itself is not enough. Investors need to make sense
of the data and there are some important innovations to help them do so,
reviewed in a recent Cambridge Centre for Sustainable Finance report for
the G20 . For example, insurers are modelling the impact that extreme
weather events can have on food prices, showing how plausible scenarios
can result in sustained depressions of U.S. and European stock markets of
up to 10 per cent.

Central banks are thinking and writing about how these scenarios could
affect monetary and financial stability. Groups of investors are pooling
resources, building models that reveal how the margins of multinational
companies are impacted across their operations by different combinations
of energy and carbon regulation. And credit rating agencies are using
insurance data to show that climate change could increase the
damage-to-value ratio for a sovereign by an average of 25 per cent given a
climate related catastrophe.

This represents important innovation. Financial institutions have been
addressing environmental risks in a low-key fashion for many years.
However, this has mainly focused on ensuring that their clients or
investments are not violating local pollution laws or causing so much
damage to the environment that they could lose their license to operate.
Now, there is a growing recognition that traditional approaches are
insufficient to deal with environmental and related political risks as
the scale, likelihood and interconnectedness of extreme events grows.

Innovating thorough-going environmental risk management into mainstream
financial practice has challenges and there is good reason for regulatory
attention. While the FSB Task Force is addressing the issue of consistent
data disclosure, knowing how to process that data by connecting scenario
analysis to financial impacts requires multi-disciplinary expertise that
is not often found within a single institution. Much of what is labelled
as ‘”environmental” risk is considered novel – or, worse, not “believed” –
by some senior management and so the necessary resources to bring together
the necessary expertise are not always made available.

The transition of the economy to a zero carbon footing will require
investment by financial services firms, but is not just a source of costs
and compliance – it also brings business opportunity. For example, the
Chinese government has ensured that the G20 has prioritised green finance
during its 2016 chairmanship of the G20. It set up a study group that
considered how to make private funding accessible to support the huge
investments required to mitigate climate change and clean up the
environment. China alone says it needs around $460 billion annually to
finance its green investment programme.

Mobilizing green finance at that sort of scale will only be possible when
financial decisions are sensitized to environmental risks. G20 Leaders
want greater efforts to encourage and facilitate knowledge sharing on
environmental and financial risks. Public, private and academic
institutions must work together in a focused manner. Great skill will be
needed to cross boundaries so that deep pockets of expertise can be made
relevant to others. We all have an interest as individuals in this
happening. It is also an increasingly urgent commercial imperative.

Published in the December 2016 – January 2017 edition of Financial World.