The financial sector is taking a multi-pronged approach to managing the risks relating to climate change: from the regulator’s proposed rules on disclosure to insurer innovations, Jeremy Hughes examines the response to the climate imperative

Typhoon Hagibis which struck Japan in mid-October was the worst on record for that country and just the latest in a growing list of incidents pointing to a rise in the frequency and severity of extreme weather events globally. Munich Re cites 2017–18 as the worst two-year period for natural catastrophes on record, with insured losses equivalent to £175bn, while its 12th annual Emerging Risks Survey cites climate change as the top risk this year, nudging terrorism, cyber threats and financial volatility down the rankings.

In a recent research note, Goldman Sachs listed the possible impacts, including “more frequent and more intense weather events, melting glaciers, rising sea levels, shifting agricultural patterns, pressure on food and drinking water, new threats to human health and harm to many natural ecosystems”. The phenomenon of climate change which drives this increase threatens to introduce a new era of progressively greater impacts to economies, infrastructure and human well-being across the planet.

In the UK, this year alone has seen record-breaking temperatures and floods. The Met Office on 25th July recorded a new UK temperature high of 38.7°C at Cambridge Botanic Garden. Meanwhile, Storm Hannah (26–27 April) was one of the most significant April storms in the last 50 years, with some parts of west Wales registered gusts of over 69mph; between 21st and 27th February, the UK experienced exceptionally high temperatures for the time of year with 21.2°C on 26th February at London’s Kew Gardens – the highest ever recorded temperature for a winter month.

While the rate and causes of climate change are still insufficiently understood, it has become more and more clear that to a large degree the changing climate is driven by rising temperatures, both atmospheric and oceanic, which in turn is correlated with the increase of carbon and other emissions into the atmosphere. Measuring the impact of these risks is companies and their balance sheets is similarly complex.

To this end, the UK’s Financial Conduct Authority recently launched a consultation with a view to introducing rules that will compel listed companies to disclose the risks to their business posed by climate change as well as the integration of climate change risk and opportunities into their decision-making.

As the issuers of securities, listed companies’ exposure to climate risk is an increasingly important factor in the valuation of their paper to investors. Without a clear view of issuers’ climate exposure, investors are unable to map their portfolios’ future performance.
The Bank of England agrees: “there is evidence to suggest the modelling of medium and long-term factors (beyond five years) by financial firms can be limited and that environmental factors are not fully integrated into financial and corporate decision-making”.

Not only will the FCA’s proposed disclosure standard require listed companies to disclose risks, the regulator also warned that it will ensure that companies’ green credentials are based on substantive ethical or sustainable criteria – a measure deployed with the aim of stamping out ‘greenwashing’; while listed companies have an obligation general obligation to treat consumers fairly, the regulator is concerned that many consumer and financial products are labelled ‘green’ with insufficient justification – a trend which could ultimately damage confidence in sustainable programmes.

A close look at the risks

For financial concerns and insurance companies the risks of climate change are twofold: physical risks resulting from extreme weather events which could drive higher claim values; and transition risk, where efforts to create a lower-carbon economy produce rapid reallocation of investments.

The Bank of England, as the guardian of financial stability in the UK, has declared its intention to ensure future risks do not compromise orderly markets or the UK’s position as a major global financial services hub. It states: “As part of a highly globalised financial centre, UK financial institutions are exposed to a wide range of sectors across the world, many of which may be affected.”

The BOE is taking a twofold approach to the issue. First, it is engaging with firms likely to encounter climate-related risks, in particular the insurance industry, to ensure that it continues to be able to respond to claims arising from climate-related incidents – countering fears that some risks may become uninsurable in the longer term. Second, it aims to bolster the UK financial sector’s resilience by supporting an orderly transition to a more risk-aware state. It conducted in July its annual insurance stress test which included a climate change scenario. “As with any form of global disruption, climate change creates risks – including natural disasters, liability risks associated with nondisclosure, directors’ responsibility and liability and reputational risks,” it stated.

Acknowledging the UK’s centrality in the global financial system, BoE governor Mark Carney has lent his backing to the Financial Stability Board’s global Task Force on Climate-related Financial Disclosures (TCFD), a project designed to encourage companies to analyse their climate risk exposure and disclose it to investors. A former FSB chairman himself, Carney said: “To bring climate risks and resilience into the heart of financial decision-making, climate disclosure must become comprehensive, climate risk management must be transformed, and investing for a two-degree world must go mainstream.”

Full and accurate disclosure of climate-related risks is critical for insurance companies which may be increasingly exposed to liabilities arising from organisations’ failure to disclose their exposure. Parties seeking compensation for damage or loss arising from climate events may take legal action against the parties they believe are responsible. In turn, insurers which have underwritten these responsible entities will see a rise in their payouts.

Building resilience will contribute to companies’ ability to cope with the changes brought about by ongoing global warming. The World Economic Forum sees resilience-building as comprising three pillars: the capability to adapt, to anticipate future events and to absorb disasters when they happen.

Insurers and reinsurers can contribute to resilience by tailoring their investments, such as helping finance more long-term infrastructure schemes. The Swiss Re Institute estimates global insurance and reinsurance assets are approximately £23 trillion. Just a portion of this could release significant amounts of capital for long-term resilience-related infrastructure projects.

While a significant protection gap still exists between climate disasters and coverage levels (the global all-catastrophe protection gap in the past two years combined was £218 billion), this presents an opportunity for the insurance industry.

This boom, coupled with growing demand for new products that address climate-related risks, is driving innovation. Goldman Sachs comments: “Insurers are looking at creating new policies with provisions that offer lower premiums to companies or local authorities demonstrating an active engagement in preemptive initiatives, such as building flood defences. In addition, markets for crop insurance, catastrophe bonds and resilience bonds could offer lower premiums for [customers] that take active steps to avert the worst effects of climate change.”

As climate change is a global phenomenon with no respect for national boundaries, it requires engagement by policymakers, businesses and institutions. By proactively engaging in financing resilience as well as providing new ways of writing cover for climate change-related events, the risk management industry is beginning to see ways of helping to build a more sustainable economy.

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