The pressure is on for financial institutions (FIs) to adopt climate risk models as regulators and shareholders zero in on environmental, social and governance (ESG) factors.
“[Climate risk assessment] is absolutely going to be required to be done, but we’re seeing the banks moving faster and more proactively because they believe in the commercial case as well, and they’re getting pressure from their shareholders,” says Colin Preston, head of financial services and climate change lead, Baringa Partners.
A heightened focus on climate risk in financial services follows a guide published in June by the UK’s Climate Financial Risk Forum (CFRF), an industry body established by the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) in 2019. The Bank of England (BoE) is also consulting on its climate change stress test, while the European Central Bank (ECB) is considering holding climate reserve funds.
According to Preston, pressure from regulators and central banks will speed up work on climate risk modelling. But shareholders are also pushing climate risk considerations onto firms.
“The duty of care to shareholders has always been to maximise profits effectively and to a greater or lesser extent do no harm at the same time. Now you’ve got the shareholders going against the banks or the asset managers voting against the company’s resolutions, saying you need to take more action. Shareholders in the main aren’t prepared to just take the short term commercial returns without worrying about the long term impact,” he says.
Nick Stewart, climate change and chief financial officer (CFO) lead at Baringa points to several large banks currently increasing resources towards the monitoring of ESG factors. In July, Citi announced a $250bn sustainable finance strategy and HSBC launched its first ESG solutions team.
“You can see those changes don’t happen unless [banks] think there is a new product, new money – and we shouldn’t shy away from it. Often people think it has to be just for the good, but we’re pragmatists as well. We’re doing it because it’s the right thing, but we’re also doing it because we’re helping our clients mitigate risks to also generate returns,” says Stewart.
Climate change will have far-reaching implications across financial services, from asset managers to insurers.
“Climate risk solutions are definitely emerging as a key contributing factor for financial firms when they consider their future priorities,” said Sachin Kapila, chief policy officer at climate risk management firm Cervest in an email.
“As one of the key verticals within this space, insurance companies are taking note of climate risk solutions, including the volatility and enormous payouts they have to make to those organisations who suffer at the hands of climatic events. They are looking for guidance from industry bodies such as the PRA and the Climate Standards Board on how to better disclose climatic exposure,” he said.
“Like most organisations, central banks are trying to figure this process out as they go, and naturally there is little historic reference for climate related risk for them to base their strategy off.”
Following a growing trend in adopting ESG principles, more and more firms are beginning to recognise the business case for incorporating climate risk models.
“Banks and asset managers haven’t really ever needed to understand, manage, measure and monetise climate,” says Stewart.
Preston agrees, adding that climate risk models should be integrated into existing models. While FIs typically rely on shorter term risk models, climate models assess 30 to 50 year horizons – this divergence makes integration into existing models imperative, he says.
“In aggregate, we’re talking about being able to measure the financial risk in the financial system as a whole and drive decision that are congruent with that. That will take money away from certain companies and towards certain companies, and it will make companies change their behaviours as they see that happen,” says Preston.