By Laura Canevari
Transitioning to a low carbon and climate-resilient future is a challenge of unprecedented scale. The financial sector has a fundamental role to play in this transition. However, to enable the sector to play this role, there is a need for a systemic shift in the way the financial system operates and in the way investment decisions are made.
Critical to a smooth transition is the effective management of climate risks and opportunities. The underestimation of climate risk poses a threat to the stability of the financial system, in particular, when capital is allocated without a full understanding of the potential climate implications on adjusted risk returns. Similarly, responding to climate change and transitioning to a low carbon economy offers huge investment opportunities, many of which remain largely untapped.
The role of the Task-Force on Climate-related Financial Disclosures (TCFD) Recommendations
Through the release of the TCFD Recommendations in 2017, financial institutions (FIs), along with corporates, have been given a robust compass with which to navigate climate disclosures. The TCFD recommendations encourage FIs and companies to incorporate climate-related considerations in their governance, strategy, risk management, metrics and targets, and to provide climate-related disclosures in their public financial fillings. The recommendations effectively require organisations to assess where they stand in their ability to understand and manage climate related risks. The TCFD knowledge hub has been established, which is an interactive portal that collates resources for organisations to aid their disclosure activities. Many FIs and corporates are still coming to grips with how best to analyse and disclose climate risks, though the direction of travel is clear – the TCFD recommendations has been a game changer in putting climate risks on their radar.
Investors clearly understand the value of this information and the demand for useful, climate related financial information continues to grow, according to the second TCFD status report, released in June 2019. Climate risk disclosures not only help investors to make more informed decisions, they also help reduce litigation risks.
Many organisations have started to disclose in alignment to the TCFD Recommendations (see the TCFD Knowledge Hub). Similarly, voluntary disclosure frameworks such as CDP, GRI and SASB have started to align their disclosure frameworks to the Recommendations of the TCFD. Others, such as PRI are making it mandatory for members to disclose certain types of climate related information.
Managing climate risks has become imperative for regulators, investors and the market
In early 2019, the Central Banks and Supervisors Network for Greening the Financial System (NGFS), 36 members in total, have joined forces to promote collective action to manage climate-related financial risks. Frank Elderson, Chair of the NGFS and board member of De Nederlandsche Bank, notes that climate-related risks are a source of financial risk. Elderson points out that climate-related risks are therefore within the mandates of central banks and supervisors, and it is up to them to ensure the financial system is resilient to these risks. In their most recent report, the NGFS published a set of recommendations around the distinctive elements of climate change-related financial risks and the need to ensure resilience in finance. These recommendations send a powerful signal to others within the finance sector that financial regulators are increasingly interested in robust climate disclosures.
Regulators have also independently started to tackle climate risks. In the UK, for example, The Prudential Regulatory Authority (PRA), has released a new supervisory statement setting out its expectations for banks and insurers on managing climate-related financial risks and established, together with the Financial Conduct Authority (FCA), a Climate Financial Risk Forum. In France, Article 173 made it mandatory for institutional investors to disclose climate-related information.
Rating agencies such as Moody’s and S&P Global have started to incorporate climate change considerations in their rating systems as well. Their assessments now illustrate how much climate factors can impact (negatively and positively) on the risk rating of companies and municipal bonds.
Similarly, investors have started to integrate climate change considerations as part of their due diligence processes and as part of their risk management and investment strategies. Early findings provided by BlackRock suggest that investor portfolios integrating climate change are already outperforming those that do not. Yet, BlackRock also suggests that most portfolios are still failing to fully account for climate related risks.
Growing action among banks and investors
The number of FIs that have started to align with the TCFD recommendations has steadily grown since the release of the final recommendations in 2017. Over 200 entities dedicated to banking, asset management or banking and insurance have become official supporters of the TCFD recommendations, and some have started to release their first climate-related risk disclosures.
Their activity is supported by a number of global initiatives with the mandate to help FIs understand and address climate related risks. For example, the TCFD pilot project established by the UNEP-FI with 16 commercial banks (with the support of Acclimatise, Oliver Wyman and Mercer) has led to the publication of a set of novel methodologies to help banks appraise and manage physical and transition credit risks.
Similar initiatives are proliferating across the world. In Mexico and South Africa, for example, the Cambridge Institute for Sustainable Leadership (CISL) and GIZ have established an initiative to help financial institutions incorporate environmental scenario analysis into routine financial-decision making. Similarly, in Mexico, the Inter-American Development Bank (IDB) and the Mexican Banking Association (ABM) have established a Climate Risk Capacity Building Program aimed at strengthening the institutional and operational capacity of Mexican banks to identify and manage climate, environmental and social risks. Within this program, a new stage started with the objective to analyse the gaps in governance systems and in the management of climate, environmental and social risks in Mexican banks in relation to the TCFD recommendations.
On the investor side, The Institutional Investors Group on Climate Change (IIGCC) has launched a new project to develop guidance for investors on how they integrate the risks and opportunities presented by the physical risks of climate change in their investment research and decision-making processes. This physical risk and opportunity guidance will be available in Summer 2019. This guidance will build on other guidance reports issued by the IIGCC, such as the 2018 practical guide on how to apply the principles of scenario analysis.
A proactive approach will likely pay off
It is clear that the way to do business is changing as the climate risk governance landscape is changing. The role of FIs is shifting in light of these broader changes. Similarly, the conversation around risk is also clearly shifting, from being centred on individual companies or investments, to a broader recognition of the environmental and societal risks that climate change is posing.
The financial sector has a privileged role to play in the coming years in steering economic development towards a more resilient future. Those who begin the journey early will help set the benchmark on best practice and start reaping the benefits that stem from making climate conscious decisions. Those that do not may be left behind.