- As climate risk rises on the agenda, financial institutions have to manage their response to balance the physical and transition risks they face
- Physical risks pose the greatest risk to humanity, but the necessary action to respond have consequences for society that also need to be addressed to create a Just Transition
- Ignoring the risk doesn’t make it go away, so climate risks have to be considered in every economic decision
“There is no question in my mind the frequency of events is giving us real evidence that climate change is investment risk. No company should be surprised about how this is evolving and changing. We are going to see a seismic reallocation of capital.”
- Larry Fink, CEO, BlackRock
The world is headed to a 4° C temperature rise based on the current operating trajectory of global companies, according to an analysis by J. Safra Sarasin. The lack of action in addressing climate change is a cause for concern for coming years, not to mention for future generations. It is also an urgent reminder that climate risks should be viewed as essential for financial institutions, whatever their expectations are for climate mitigation efforts.
Climate financial risk is coming. It’s now just a question of how resilient companies and financial institutions are, whether more of the impact is due to the transition or from physical risks becoming realized. The likelihood that climate change could exceed the 2° C threshold that is the basis for global commitments means that the option to do nothing and be a free rider on the actions of governments or other companies is no longer available.
The Covid-19 pandemic has shown clearly how the realization of likely but uncertain future events can quickly materialize into big losses. Climate change will be realized in a different way. It will have some globally relevant impacts, but it will also have localized impacts of varying timings and intensities. This will affect how financial institutions think about their risk in different scenarios, where some common global factors combine with the unique local environment. Every financial institution will be affected and they should begin assessing and responding to their risks now.
One way to think about the transition is to visualize each business sitting on a climate risk seesaw. Where they sit on the seesaw will determine how much they will be impacted by the physical and transition climate risks. The important thing to recognize is that it’s not a trade-off between accepting physical or transition risk. Both are going to happen, and every company will be affected to some degree by both, but in differing levels of intensity.
Every financial institutions and investor will have to evaluate how different direct and indirect climate risks affect their financed companies. Some companies may be extremely susceptible to physical risks, having infrastructure or real estate located in flood-prone areas, for example. The most immediate clear-and-present danger to their future profitability or solvency is from physical risk, and if they are on the end of the seesaw, even small changes will have a dramatic impact on their business survival.
Other businesses will be on the opposite side of the seesaw and face very little climate-related physical risks, but huge transition-related risks, such as pipeline operators in areas with flooding or storm risk. The primary risk is in the decline in demand that a transition away from fossil fuels will create. However, at each end of the spectrum, these companies will face a multitude of direct and indirect climate-related risks of varying magnitudes.
From an outside perspective looking at the world as a whole, the physical risks have the most overwhelming urgency due to their permanent impact that threatens humanity. However, that doesn’t negate the impact of transition risks that will be created in the process of mitigating physical risks. The ability to successfully mitigate the most severe physical risks will be determined by the success at ensuring a ‘Just Transition’.
Like dealing with climate change or achieving the Sustainable Development Goals, the key to solving the problem requires starting with an appreciation that everything is interrelated. The balance between the speed of transition and its economic and social impacts can’t be known ahead of time. It will be influenced significantly by the speed and intensity of climate impacts that will continually shape our expectations about the level of disruption to ‘business as usual’ to achieve climate stability in comparison with the value of time lost as climate-related disasters pile up.
The purpose of measuring climate-related financial risks for both companies and financial institutions is to understand where that risk exposure is greatest. It is also necessary to identify how quickly they can reduce their exposure to both physical risk and transition risk, and in so doing contribute to the achievement of global targets with a minimum of economic and social disruption.
Sitting as closely as possible above the fulcrum on the seesaw is the point where the combination of physical and transition risk is minimized. For financial institutions, this should be the goal in their balance of risk and return. Climate-related risk will never be completely eliminated, but in order for it to be limited globally, it needs to be considered in every economic decision. Ignoring the risk doesn’t make it go away.
When there is a recognition that we must come to terms with the risk, the next step is prioritization. RFI’s recent research showing the most significant location of transition risk exposure within Malaysia’s financial sector provides a high-level starting point.
We believe that ‘good’ in responsible finance starts with a systematic approach to measuring and managing the risk. It’s critical to have governance systems in place that integrate the risks, measurement processes to provide consistent and useful data, and clear and transparent disclosure about how well governance and measurement processes are achieving their purpose.
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