HOW CAN BANKS PREPARE FOR THE CLIMATE-RELATED INVESTMENT STORM AHEAD?

By Amer Khan, Managing Director Europe, Entelligent

 

The Covid-19 crash in March 2020 provided a stark illustration of the degree to which natural disasters can affect the global financial system. Stock markets plunged around the world, with London’s FTSE 100 enduring its lifetime second biggest fall, and the Dow Jones its worst quarter ever. Crude oil prices dropped into negative territory for the first time in history.

As we approach the end of 2020 stock markets have largely recovered, driven by the expectation of vaccines that will effectively combat Covid-19. We cannot however protect ourselves from the effects of unabated climate change with a vaccine. So, what can the financial services industry do to protect itself, and its stakeholders against the impending climate-related investment storm?

Interestingly, as Covid-19 caused stock markets to suffer record investor withdrawals during the first half of 2020, investment banks saw one area of the investment markets flourish: ESG funds experienced record inflows throughout the crisis.

It quickly became clear that the Covid-19 pandemic had amongst other things, caused a shift in attitudes towards investing for a more sustainable future, and an environmentally one.

Amer Khan

Alongside increased investor appetite for climate resilient investments, banks have increasingly recognised that whilst climate-related risks may only materialise over the following decades, the actions they take today will determine the extent and impact of those future risks.

The risks from climate change that banks are analysing and integrating into their operations today, can broadly be split into two types: physical and transition risk.

 

Physical risk covers issues which the world may face in the future as a result of climate change causing melting glaciers, sea level rises and increasingly frequent extreme weather events, which in turn might cause catastrophic knock on events on the operations of various businesses.

In order to protect and mitigate against the future physical risks of climate change, governments around the world have been increasingly introducing new policies that are designed to encourage the move to an economy that will less severely impact global climates – a green economy. The application of these green policies represents transition risk.

 

Enhanced Disclosure

To protect against the future physical and current transition risks of climate change, banks must perform detailed analyses of their existing investment portfolios, to ascertain the degree to which each individual investee company is exposed to each of these risk types.

The critical first step in this process is better disclosure. Banks can only make well-informed decisions if the companies in which they invest are disclosing adequately.

The Task Force on Climate-related Financial Disclosures (TCFD) was launched almost immediately upon the signing of the global Paris Agreement in 2015. Its recommendations were published in 2017 and supported by global financial institutions, including the Bank of England.

Whilst the recommendations were extensive and applicable to all companies, a key issue was that they were only voluntary. Over the past five years the TCFD’s recommendations have been adopted by an increasing number of large businesses, albeit to a varying degree.

Fast forward to 2020 and the lessons learned from Covid appear to have rapidly intensified the urgency of ensuring financial systems are resilient to natural disasters.

In November 2020, we saw the UK Government announce that climate-related disclosures would become mandatory by 2025 for large companies and financial institutions, with some companies having to disclose from as early as 2021.

Other governments are expected to follow suit.

 

Climate Scenario Analysis

Even with increased disclosure from their investee companies, banks are faced with the problem of continuing uncertainty. The extent to which climate change will affect the economy depends on the temperature pathway, on a global scale as well as local.

Leaders around the world agreed in 2015 that to avert catastrophic events in the future, climate change must be restricted to no more than 2˚C above pre-industrial levels by 2100, and ideally kept below a 1.5˚C increase. Governments collectively agreed to commit to achieving these targets.

The problem is we are currently on a failure path ([2.6]˚C)1 and nobody quite knows which temperature pathway we will be on in the future.

One way in which banks can manage these uncertainties is to use climate scenario analysis and stress testing.

By incorporating multiple scenarios that cover a range of temperature pathways from a best case 1.5˚C to a worst case of >4˚C, banks can assess the resilience of their own operations, and that of their investment companies, across a wide range of possible future climate outcomes.

By analysing the sensitivity that companies are exhibiting across the whole range of likely futures, banks can determine today which companies are best prepared for the climate related storm that lies ahead, both physical and transition.

 

[1] https://climateactiontracker.org/global/temperatures/

 

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