Posted on: June 15, 2023
The risk that is posed by the climate and its changing patterns, is the financial impact resulting from adverse climatic events that are occurring on a more frequent basis. These impacts are, and will be seen, through losses, more risky exposures, greater capital requirements and lower asset values.
In our opinion, the risk presented by climate change is not something that any business can choose to ignore. All businesses and their customers are likely to be affected by this new global challenge. For banks and building societies, the risk presents itself through incidents including:
- Subsidence and flooding of property acting as collateral
- Coastal erosion impacting properties, their values and the infrastructure
- Drought and fires that will affect the agricultural sector, in particular and all those to which it is connected
Given the implications of climate risk and the expectations of the Prudential Regulation Authority (in its Supervisory Statement 3-19), it is our opinion that all Financial Services firms will be taking the risk presented by climate change, seriously.
Besides the obvious effects of climate risk, firms need to consider other factors. A firm’s asset profile and business model will need to undergo change. For example, lending and investment policies will probably need to have a greater focus on sector type, locations and counterparties so that those more susceptible to climate risk, are clearly identified and priced accordingly. In the short term, perhaps before there is more sophistication, it may be difficult to identify that susceptibility with a high degree of confidence. There may also be an increased need for a trade-off between profit and lending that encourages green initiatives.
Asset valuations could be adversely affected as a result of investments being deemed to be more exposed to climate risk. Such an adverse movement would obviously affect the losses to be absorbed by a firm, but could also have implications for meeting liquidity regulatory targets (e.g. Coverage Ratio).
There are also possible effects on critical third party providers to a firm and their abilities to deliver in the face of infrastructure damage.
Whistlebrook understands that firms may well have created appropriate committees to manage climate risk, but it is also important to have education throughout the business. For example, lending processes, product marketing and HR communication are areas worthy of consideration. It is essential that the education looks both externally and internally e.g. encouragement of energy saving throughout the organisation.
Climate risk is obviously a major threat to the Financial Services sector, but it is also an opportunity. Measuring and sharing progress towards a ‘net zero’ position, will have reputational implications, making some firms shine, whilst others are in the shadows.
In summary, the Financial Services sector is faced with yet another challenge in an uncertain global environment. The challenge presented by climate risk is one that firms cannot categorise as a low priority, especially given the PRA’s expectations and the real risk of financial loss.
Software systems that enable comprehensive scenario analysis and stress testing are likely to become ever more important, as climate risk demands increased attention.