Introduction to Climate Risk Management

What is the key risk faced by business, finance and society over the next 10 years?

According to the 2020 World Economic Forum Global Risks Report, climate change - and specifically the risk of failing to take action on climate change - is the key risk faced by business, finance and society over the next 10 years.

What is the TCFD and how is it addressing climate change?

The Task Force on Climate-Related Financial Disclosure (TCFD) was established in 2015 by the Financial Stability Board to develop voluntary, climate-related financial risk disclosures for use by companies providing information to investors, lenders, insurers, and other stakeholders.

The TCFD published its recommendations in 2017. As of 2019, nearly 800 large issuers had agreed to align their public reporting with the TCFD’s guidelines, and there has been increasing pressure from policymakers, regulators and business groups in many countries to promote alignment.

Which climate-related risks is our financial system most exposed to?

• Extreme weather events
• Asset impairment
• Stranded asset risk

What are the three categories of climate-related risks, adopted by the TCFD?

1. Physical Risks
   • Physical risks arise from the direct impacts of climate-related hazards, such as droughts, floods and storms.
   • These cause significant and quantifiable economic damage, disrupt supply chains and trade, and leave communities facing substantial costs for clean-up and redevelopment.
   • Classified as either:
     • Acute risks - severe, short-term impacts (cyclones and tropical storms)
     • Chronic risks - more gradual, longer-term impacts (rising temperatures and sea levels)
2. Transition Risks
   • Transition risks arise from the shift to a low carbon economy, and can lead to significant losses in economic value due to impaired or stranded assets.
   • The TCFD divides transition risks into four categories:
     • Risks from developments in climate policy, legislation and regulation - e.g. significant increase in carbon pricing.
     • Risks from new, lower-carbon technologies which substitute for existing products and services - e.g. renewables replacing fossil fuels.
     • Risks from changing consumer behaviour and investor sentiment, leading to changes in demand for products & services and in investment.
     • Reputational risks where organisations suffer from association with high carbon methods of production and distribution - leading to falling demand and revenues.
3. Liability Risks
   • Liability risks arise from parties who have suffered loss or damage from the effects of climate change and seek compensation from those they hold responsible.
   • These include costs that arise from legal claims prompted by poor environmental management, from claims against emitters of greenhouse gases and also the potential costs that may arise from legal challenges led by activists seeking to pressure companies and governments to do more to prevent climate change.

What is stranded asset risk and what is its potential impact on financial markets?

A stranded asset is one that has suffered from a significant (or total) loss of economic value, in this context because of an abrupt change to a low carbon world.

Stranded assets could have a very significant impact across financial markets; financial services firms are major investors in, and lenders to a wide range of sectors with a heavy dependency on fossil fuels.

Potential losses from stranded assets caused by climate-related risks are difficult to estimate because they depend on different scenarios regarding the speed of transition, legal liabilities and how asset owners might respond. Estimates of potential losses are $20trillion or more just at the European level. Central banks and regulators consider an abrupt transition as a systemic threat to the stability of the financial sector.

What are the regulatory responses to climate-related risks?

There has been increasing pressure from policymakers, regulators and others to promote alignment with the TCFD’s recommendations on the disclosure of climate-related risks:

• UK - all listed companies and large asset owners will be expected to disclose climate-related financial risks by 2022
• France - Article 173 of the Energy Transition law is to be amended to align reporting and disclosure with the TCFD
• European level - the updated Non-Financial Reporting Directive, which sets out minimum requirements for risk disclosures for more than 6,000 European companies, has been aligned with the TCFD
• 2,000 signatories to the UN Principles for Responsible Investment - the world’s largest fund and investment managers - will be expected to follow the TCFD’s recommendations from 2020

It seems likely that the current voluntary nature of disclosures will, over time, become mandatory, at least for financial institutions, listed companies and large asset owners, and become part of the regulatory framework in many major markets.

How can organisations quantify climate risks?

1. Scenario analysis 
   • Scenario analysis is a method for developing strategic plans that are more flexible or robust in a range of future states
   • Risk managers may use a scale that categorises an extreme scenario (4 degrees of global warming), an intermediate scenario (3 degrees) and a best-case scenario (2 degrees)
2. Stress tests
   • Stress tests assess the resilience of financial institutions’ balance sheets to significant shocks