Some of the heat waves and wildfires that were experienced in Europe and in the world in the summer of 2019 are symptoms of a climate that is already changing. These events may cause losses for banks and other financial institutions, which will therefore have to integrate climate change into their decisions. Regulators are also pushing in this direction. However, financial institutions have raised practical difficulties that questioned the feasibility of managing so-called “physical climate risks”.
For Romain Hubert from I4CE, financial actors can overcome difficulties if appropriate resources are provided. But other questions arise about the consequences of climate risk management by these actors. He shares his perspectives on the subject, after three years of research as part of the European ClimINVEST project.
A necessary exercise
Heat waves, wildfires, heavy rains and other climatic events will impact individuals, business activities and perhaps the stability of regions. This may result in difficulties for these actors to repay their loans to banks and provide financial returns to their investors, or result in an increase of insurance claims. As a result, bankers, investors, insurers and other financial actors are themselves exposed to these “physical climate risks” through their activities.
There is an urgent need for financial actors to investigate their exposure to physical climate risk. In 2018, insurers covered only half of the natural damage. With the climate degradation that is now inevitable throughout the coming decades, insurance premiums will increase rapidly and some risks will no longer be “insurable”.
Unfortunately, financial players still have a limited willingness to carry out such analyses. Most consider that the impacts of climate change will occur decades from now, well beyond the horizon of their loans and other financing tools. Financial regulators and supervisors call this the “tragedy of the horizon”.
To address it, regulators are asking financial actors to take these climate risks into account in their financing and investment decisions, and to explain how they do so. This challenges financial actors to find the right methods of analysis and management.
Feasibility issues are not insurmountable for banks: proof by experiment
As financial actors have attempted to analyze and manage their exposure to physical climate risks, they have raised questions of feasibility to the point of wondering whether analyzing and managing physical climate risk was not simply a challenge.
Take the example of banks. It is difficult to quantify the potential losses on a lending activity as a result of climate impacts. However, this financial estimate is traditionally used by risk departments and other teams to account for a risk in their decisions. In addition, it is often difficult to collect the extensive data on individual borrowers that is needed to understand how the borrower is exposed and vulnerable to climate impacts.
However, banks have shown that they can start managing these risks if they set aside their goal of producing a large amount of precisely quantified information on the risk of individual borrowers. The alternative method found by the banks consists of two steps. The bank starts by using a coarse-meshed physical risk rating system, as a first net to identify large pockets of risk exposure. It then asks questions to the borrowers identified as most at risk in the previous step, in order to understand their risk exposure in more detail and make a decision.
This approach is promising. It limits the amount of data needed, and mobilizes the bank to collect missing data while at the same time stimulating the borrower to become aware of and even manage its climate issues. The first step of the method, in the form of a rating, also makes it possible to bypass the difficulty of estimating losses while integrating a logic of evaluation of climate-related financial impacts.
… Provided that everyone dedicates appropriate resources to do so
After three years of work on the ClimINVEST project, we have become convinced that banks have the potential to carry out the analysis of this risk, when some of them even start to manage it. But we have to admit that it will be necessary to mobilize more human resources to ensure that all financial institutions properly take into account all physical climate risks in decisions relating to all their activities.
Human resources need to be mobilized in financial institutions as a priority. They must bring together their risk and CSR departments to organize pilot analyses of their portfolios, in order to build expertise and find processes that are favorable to physical climate risk management. In order to do so, they can rely on experts in these subjects and on free resources such as those made available by ClimINVEST: practical feedback, explanation of available methods, and other educational materials.
The teams of financial institutions also need to collaborate with a larger set of stakeholders. This should help them in particular to continue mapping climate vulnerabilities in various sectors of activity, and to increase access to reliable and harmonized data. In Norway for example, financial institutions and municipalities are collaborating on a “knowledge bank” with restricted access due to confidentiality issues.
To gain momentum, sustained action by financial regulators and supervisors will remain key. Many financial players are dedicating limited resources to climate-related issues and prioritizing the topics to be addressed according to the regulators’ requests.
Another question to be asked now: what will be the consequence of banks’ decisions?
Let’s assume that banks start managing their exposure to physical climate risks. What will be the result? Will they engage in dialogue with the actors most at risk and stimulate or even finance their adaptation efforts? Or will they penalize the most vulnerable by imposing unfavorable conditions on them or even setting them aside? The answer is far from obvious. Some private financial institutions seem ready to consider adaptation finance as a new business opportunity. Nevertheless, a careful exploration of this topic is needed to help clarify the terms of the following debate: who will pay for the cost of financial risk related to climate impacts?