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Paul Sherlock Risk Management

There is little doubt that climate change is well and truly transforming both our lives and those of future generations for years to come. However, the effect it will have on businesses is also predicted to bring about financial risks which organisations need to be mindful of and prepare for.

This is because the financial risks arising from climate change will impact all industries, sectors and firms, presenting unique challenges which need a strategic approach.

The financial risks have distinctive characteristics, which are far-reaching in breadth and magnitude, have uncertain and extended time horizons, are foreseeable and their significance depends on taking short-term actions.

Financial risks arising from climate change can be defined as physical or transitional.

Physical

As Co2 levels increase, the global temperature is rising, leading to a change in climate patterns and a higher frequency of floods, storms, wildfires and hurricanes. This will ultimately result in more financial risks as businesses make higher than expected insurance claims for damaged assets, alongside loss of income, defaulting on loans, suffering general business disruption and losing productivity.

For all firms, these climate-related factors can manifest as credit, market and operational risks, including reputational risk and risk to assets and liabilities. Such risk factors are likely to be relevant to multiple lines of business, sectors and geographies.

Transitional

With the transition to a low-carbon economy, the value of traditionally lucrative investments in fossil fuels such as oil and gas will decrease. Changes in policy, technology and market sentiment may drive changes in the value of assets and liabilities for banks and insurers.

Drivers include government policies that increase the price of carbon emissions, as may be emerging in Europe, rapid changes in the transportation market from low carbon fuels and energy storage as is being seen for electric vehicles and legal liability risks such as those seen in recent climate-related lawsuits.

The introduction of regulations

In response to these commercial threats, the Prudential Regulatory Authority (PRA) released a Supervisory Statement SS3/19 on 15th April 2019 requiring firms to assign senior manager accountability. This was alongside a high level plan as to how all UK banks and insurers should manage climate-related financial risks by October 2019.

This SS is in alignment with PRA´s commitment to enhancing its approach to supervising the financial risks from climate change and to enhancing the resilience of the UK financial system by supporting an orderly market transition to a low-carbon economy.

Specifically, the PRA expects to see that a firm’s board understands and assesses the financial risks from climate change that affect the firm, and is able to address and oversee these risks from within the firm’s overall business strategy and risk appetite.

More recently, the number of additional sources of information on this topic has increased. The Task Force on Climate-related Financial Disclosures (TCFD) describes four pillars to try to stave off the potential risks; Governance, Strategy, Risk Management and Metrics & Targets.

These pillars provide risk managers with an approach which can be adapted and applied to identify, report and manage financial risks arising from climate change.

What does this mean for firms?

The PRA would like to ensure that boards are engaged and equipped and it requires firms to embed the consideration of the financial risks from climate change in their governance arrangements.

Boards of directors, with their long-term stewardship duties, are a crucial element in the governance of climate-related risks and opportunities. Firms will need to ensure that their boards have the right knowledge and tools to discharge this duty in relation to climate change and are supported by an appropriate governance structure.

The PRA also expects that firms designate clear accountability for financial risks arising from climate change within the board and sub-committees, ensure that any individuals or committees designated with this accountability are sufficiently qualified or trained in and ensure that boards are supplied with a sufficient amount of high-quality, relevant information from senior management.

These steps should enable boards to effectively debate and take decisions in a way that is comprehensively informed by climate risk.

Embedding climate into risk management

Regulatory expectations have ultimately increased in response to the climate change crisis. This means the need for proactive risk management will require greater focus across all firms so that expectations can be firmly embedded into a company’s culture and existing risk management frameworks, policies and reports.

Firms should approach climate risk in the same way that they approach any other financial risk across all three lines of defence. Accordingly, they are expected to identify, measure, monitor, manage and report on exposure to climate risk. Specifically, as part of Regulatory reporting, the PRA expects firms to include at a minimum:

  • All material exposures relating to the financial risks from climate change.
  • An assessment of how the firm has determined the material exposure(s) in the context of their business.

The PRA intends to consult on specific risk management issues in future, so firms can expect to see more detail on areas including risk metrics, how to approach gaps in data, and impacts on specific risk categories such as market risk, credit risk and liquidity risk.

Embedding climate within existing risk management practices requires an appropriate governance structure, a good knowledge of the nature of climate risks, a strategic view of the material climate-related risks to the firm under different scenarios and tracking of relevant metrics and targets.

It is this mindfulness of the issues in hand which will help to mitigate financial risks, keeping them to a minimum so that businesses can successfully navigate this particular threat and continue to thrive.

If you would like to discuss the impact of climate change on your business in more detail, please get in touch with Paul Sherlock our Director of Risk & Compliance: psherlock@merje.com

We would like to thank Sukhdeep Dehal a Risk Management professional for his generous contributions and insights which have helped to shape this article.