Don’t Lose Sight of Climate Risk
While the COVID-19 pandemic is forcing governments and the private sector across the globe to take drastic measures, many commentators are pointing out the analogies with climate change. There is a key difference however: climate change won’t come as a surprise.
The 2020s are set to become the decade in which climate change ascends to the forefront of the political and regulatory agenda, and becomes a priority for investment firms. International co-operations, such as the UN’s 2030 Agenda for Sustainable Development or the Paris Agreement, together with popular social movements such as Greta Thunberg’s Fridays For Future or the Extinction Rebellion, suggest that momentum is building behind the carbon-free agenda.
Broadly speaking, climate change risk can be divided into two interrelated risks: physical risk to assets due to extreme weather conditions associated with climate change and transition risk associated with the transition to a low carbon economy (market and technological shifts and policy intervention). Whether firms will have to deal with higher physical risk or with higher transition risk will depend on the policy response.
Regulators are actively considering how to measure climate risk and how it would impact individual firms as well as financial stability. For example, in December 2019, the Bank of England published a consultation on its proposals for stress testing the resilience of banks and insurers to physical and transition risks. The test was based on three scenarios:
- Countries agree to net zero emissions by 2050 and start intervening now
- Simulated delays in policy-making followed by the introduction of harsh, punitive policies
- No real policy intervention and heightened physical risk
The message from regulators is clear. Banks and fund managers need to appreciate the seriousness of climate risk and start preparing for changes. Firms with large loan or mortgage portfolios, for example, should ask themselves what would happen in a four degree world, when rising sea levels, droughts, and other adverse conditions become the new normal. Firms with exposures to brown companies should evaluate their positions if more stringent regulation comes into force.
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