The 2016 Low Carbon Economy Index shows that climate risks are here to stay, so managing the credit implications is simply common (financial) sense

31 October 2016

By George Stylianides and Jon Williams

Climate change presents risks that are being felt today, and as this year’s Low Carbon Economy Index shows, will continue to generate both physical impact risks and low carbon transition risks that could impact companies’ financial performance. Climate policy such as a carbon tax could drive up costs of production, whilst physical climate impacts could disrupt supply chains. Technological responses to combat climate change could shift demand curves for established markets, and energy policies that favour renewables could leave the value of carbon emitting assets impaired.

As the providers of financial services and capital to companies exposed to such climate risks, financial institutions including banks, asset managers, and insurers are increasingly trying to come to terms with how such risks could transfer to them. This necessitates a broadening of the traditional scope of risk management to adapt to the fundamental changes to markets and business models wrought by climate change.

The challenge for the financial sector is that climate-related reporting has historically evolved around environmental metrics such as greenhouse gas emissions or water use. These are useful measures in some instances, such as working out the direct implications of a carbon tax, but may be of limited use in others, for example in trying to understand the implications of changes to the demand for conventional cars and electric vehicles.

The Financial Stability Board (FSB) recognises that without the right disclosures, the financial sector will not have access to the information necessary to make well-informed lending, investing, and underwriting decisions. And if climate risks aren’t well understood and correctly priced in, the financial system may be prone to abrupt market corrections. In other words, pricing in climate risk necessitates a broadening of the traditional scope of risk management and enables risk functions to move from gate keepers to strategic business partners.

As a result, Mark Carney, as Chair of the FSB, established the Task Force on Climate-related Financial Disclosures which is set to consult on its recommendations for improved reporting next month. There are high hopes for its outputs and we are supportive of recommendations which encourage companies, including financial companies, to consider the mid to long term implications of climate risks on their business, strategies and financial performance, for example through the use of scenario analysis.

Widespread uptake of the recommendations will mean that financial institutions will have access to consistent, comparable data which will aid risk management and disclosure at the financial institution level.  A key challenge for financial institutions will be to assess current processes and systems for collecting and analysing such data, and consider how such enhanced information can be best incorporated into existing risk management and financial reporting frameworks. Appropriate pricing of risk should mean that capital is deployed in ways that make financial sense for businesses, including in the capturing of climate-related opportunities. Is this perhaps a situation where the planet and profits do not have to be at odds?

For more information, please see the 2016 Low Carbon Economy Index or please get in touch with us directly.

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