By Partha Bose, Head of Capital Markets at Cervest
The financial sector is no stranger to risk. It’s founded on measuring, managing and correctly pricing it. But climate risk is presenting new challenges to doing just that. In a fast-changing regulatory and operational landscape, banks and lenders are for the first time ever, trying to simultaneously identify, quantify, disclose and act on the most significant form of risk to emerge this century – against the clock.
The sustainability landscape has rapidly evolved over the last decade, fueled by green-mindedness among investors and customers, and a growing realisation that climate change presents a serious risk to our global economies. Against this backdrop, it’s imperative that banks factor climate into their financial risk planning, including operational, credit and liquidity risks. Increasing the sector’s climate risk management capabilities at speed and scale is a key pillar in the foundation of socio-economic resilience.
But as the European Central Bank’s (ECB) recent Climate Risk Stress Test revealed, the sector is lagging behind. As regulatory pressures – and balance sheet losses – mount, effective climate risk management is critical. High-quality, climate science-based data holds the key to unlocking meaningful progress.
What kind of risks does climate change pose to the financial industry?
Regardless of how quickly we reach Net Zero, past emissions make further warming and extreme weather events inevitable in coming decades. The impacts of climate change – whether stresses like temperature shifts or rising sea levels, or shocks such as wildfires and floods – will create physical risks in every part of the world. “Global warming will undermine food systems, physical assets, infrastructure, and natural habitats,” warns McKinsey. By 2030, it finds that the risks of significantly reduced grain yields, and flood damage to capital stock, will double bringing with it other inevitable consequences such as forced economic migration and geo-political unrest.
Analysis puts Climate Value at Risk (CVaR) in the trillions. “If no mitigating action is taken, global temperatures could rise by more than 3°C and the world economy could shrink by 18% in the next 30 years,” says the Swiss Re Institute. The financial industry already knows that climate-related losses aren’t hypothetical: the global cost of climate damage in 2021 was almost £290 billion.
There are other drivers beyond protecting balance sheets. Effective reporting of climate risk is fast becoming imperative from regulatory, as well as reputational, perspectives. Many banks already disclose their climate risk as part of voluntary ESG reporting, which is largely non-standardised and often subjective and qualitative. This means it is not compatible with other risk metrics that are integrated into their existing decision workflows. But recognition of the need for “consistent and decision-useful information for market participants” and “high quality, comparable and reliable information on climate risks” has prompted a global shift towards mandatory, TCFD-aligned climate risk reporting.
Yet, as the results of the ECB Climate Stress Test show, managing and reporting climate risk is an emergent and unfamiliar challenge for all financial businesses. We’re breaking new ground, and that requires new ways of thinking, new methodologies, new metrics and data.
What the ECB’s Climate Stress Test reveals about the sector’s climate-related risk capabilities
The ECB’s Climate Stress Test was designed to find out how prepared European banks are for the economic impacts of climate change. It set out to identify potential weak links in EU regulation and support the establishment of best practices for the financial sector’s management of climate-related risk.
Around 65% of the banks scored ‘’poorly’’ and showed significant limitations in their stress test capabilities. There are some surprising revelations: despite facing at least €70 billion in losses, only 1 in 5 banks factors climate risk into their loan decisions, and most banks don’t consider climate risk in their credit risk pricing or in their risk management models at all. The findings also offer an explanation for this: lack of available data.
The data gap in managing climate risk
For a comprehensive picture of climate risk that supports adaptation planning and allows them to properly report, banks need high-resolution data and robust modelling methodologies.
They must be able to assess climate risk across different global emissions scenarios (including Business as usual, 2040 emissions peak, and Paris Agreement-aligned), and across multiple geographies and time horizons. They need decision-useful climate intelligence that scrutinises individual assets as well as entire portfolios. Having this granularity of analysis is the only way for institutions to accurately assess their exposure to climate-related physical risks.
Until now, this type of climate intelligence has been inaccessible to most financial institutions, and developing this specialised in-house capability – let alone applying it to organisational processes– is resource-intensive and cost-prohibitive. Technology leaps, fueled by advanced scientific methodologies and machine learning (ML) are making this type of intelligence accessible and cost-effective. Climate tech companies like Cervest harmonise climate data and present it in an intuitive UI with clear risk ratings, making it accessible and decision-useful for near- and long-term adaptation planning. It’s only a matter of time before climate ratings become standardised and financial institutions collectively use them to price financial risk into capital transactions.
What do banks need to do now?
Science-based and standardised risk ratings should drive climate risk preparedness in the financial sector, starting with asset screening and reporting. The key question every financial institution must answer is, “How will their organisation ensure that their risk models, analytics, stress testing and reported metrics use – and are based on – reliable climate data that accurately reflects exposures to climate risk?” says Bloomberg.
The first step towards resilience is to comprehensively quantify climate risk. Financial institutions should integrate asset-level climate intelligence, which includes spatial and multi-hazard correlations, into their existing suite of climate risk modelling and stress-testing solutions. Banks and other financial businesses should also ask their clients for more detailed asset-level climate risk disclosure, in the same way that they would expect them to disclose other potential risk sources to secure loans or access capital. This will lead to climate risk being incorporated in decision workflows at a transaction level, support internal and public reporting, and help banks develop robust climate stress-testing frameworks. This is essential for correctly baselining current risk levels, identifying future growth opportunities and stewarding their clients through an orderly transition from one to the other.
Once the financial sector has on-demand access to standardised, science-based climate intelligence, adopts best practices in its implementation, and consistently and comparably discloses climate risk, global financial resilience becomes attainable. Given the scale of the challenge, the moment for bridging the gap must be now.
About Partha Bose – Head of Capital Markets at Cervest
Partha is an experienced leader in finding strategic and commercial applications of complex data solutions, he has many years of technology and product leadership in companies including Winton Capital Management, HSBC, Lloyds, and eBay.
At Cervest, he synthesises his statistical knowledge with his knowledge of financial markets, climate change, and commercial data strategy.
Cervest is the climate intelligence (CI) company putting climate at the core of every decision. The company provides personalised, dynamic and science-backed climate intelligence on any asset, anywhere, anytime — giving enterprise and government decision-makers the most comprehensive view possible of climate risk at the asset level.
Founded in 2015, Cervest is a Certified B Corporation with executive offices in the U.K. and the U.S.