Moving ahead on climate change: Tackling climate risks in financial services

  • By Penny Pryor

Climate change is an immediate risk that bankers and insurers now recognise as they move to embrace net-zero emissions. RFi Group and CoreLogic brought together representatives from banking and insurance to discuss how the industry is responding to the challenge.

If nothing else, the past 12 to 18 months have shown the wide-reaching effects of climate change on almost every single aspect of financial services. Bushfires, floods and a global pandemic have all touched the banking and finance industry in a myriad of ways.

At the CoreLogic Moving ahead on climate change: Tackling climate risks in financial services panel, six eminent climate change and finance specialists discussed some of the biggest climate change problems facing the sector and what needs to be done about them.

Lecturer in accounting at Sydney University and researcher at the Sydney Environment Institute, Dr. Tanya Fiedler, moderated the session and was joined (virtually) by head of consulting and risk management at CoreLogic Asia Pacific Dr. Pierre Wiart, chief climate and geo scientist at Munich Re Ernst Rauch, co-chair of the Australian Sustainable Finance Initiative Jacki Johnson, chief executive officer at the Insurance Council of New Zealand Tim Grafton, and executive director at Pollination Zoe Whitton.

Insurance lessons

Dialling into the panel from Germany, Rauch started the discussion off by highlighting the many ways the insurance industry has been able to embed climate change as part of their risk assessment process. “As a reinsurance company and risk management company, indeed, our aim is on understanding, measuring and managing risks. And one of our core areas of expertise [for] more than 100 years is on the natural hazards,” he said.

“And in order to deliver on this business model, we have started collecting detailed data and running analysis of data of natural catastrophe losses worldwide since the 1970s.”

To improve the incorporation of scientific knowledge into their methodologies, Munich Re started working together with the United Nations Intergovernmental Panel on Climate Change. 

To help other financial institutions incorporate climate change fully into their risk modelling, Munich Re is also now making these tools available to its clients. 

“We are now offering this to our clients in the banking industry, perhaps to managers and others, and that helps these clients in the financial service industries to really ultimately understand the risks, for instance, in mortgage portfolios or real estate portfolios’ forward-looking risks for the next 10, 20, 30 years. And we do this analysis now until the end of this century.”

Compound climate risk

CoreLogic Asia Pacific’s Wiart, noted that the insurance sector also has lessons to teach the rest of the industry about how climate change risks can compound.

“What we've learned so far from the insurance industry, when they've been facing natural disasters, is that we know that it affects obviously properties, homes and businesses, but it also affects communities,” he said.

“When a disaster occurs, it results in very large insurance bills, which are often supported by the local and international capital markets. But for the community, it is translated into a drop in vacancy rates, an increase in delinquencies and often an increased demand for resources,” Wiart added.

Therefore, climate change risk isn’t just a static risk to be assessed by a financial institution. A bank can also take a proactive role in reducing that risk, and its exposure to it, by ensuring properties and new builds are constructed with climate change in mind. Wiart used the example of cyclones and helping communities in cyclone-prone areas to have better housing with better roofing and anchoring in order to reduce the risk of destruction to those buildings.

It means institutions in the banking and finance sector need to take a macro approach and move beyond assessing one risk at a time, particularly when it comes to climate change. The Australian Sustainable Finance Initiative’s Johnson warned the velocity of climate change risk accelerates when it comes together with a different risk.

“Traditionally, we've looked at past events by looking at the physical science. But we need to combine physical and behavioural science,” she said. A good example of this is how many people have responded to the Covid-19 crisis and working from home opportunities by moving to coastal or country areas – areas which may be more exposed to climate change risks such as flooding or bushfire.

“[That] means that aggregation of risk shifts. So it might alter the trajectory of increased rainfall, fire, and flooding. And we need to consider those in our models,” Johnson said. The banking and finance sector needs to look past the physical science at the behavioural things happening in society that may impact the likelihood of a climate event.

Leading by example

Johnson stressed that in such a changing environment, leaders need to make sure they keep their thinking and learning current and not anchored in past beliefs. Using the example of the Christchurch earthquake 10 years ago, she said that even if a business had really good risk management and business continuity planning, they only did well if they taught their leaders how to make decisions.

“You also need leadership at the most senior level to know about the trajectory of five to 10 years ahead to recover from that risk,” she said. As co-chair of the Australian Sustainable Finance Initiative, Johnson oversaw the group’s revised Roadmap late last year.

“Ultimately, when I think about the Australian Sustainable Finance Initiative, the top eight of our recommendations are actually about leadership in practice for sustainability, and we have to take accountability ourselves on that,” she told the panel.

The Roadmap makes a total of 37 recommendations, which are designed to help the financial system transition to a net-zero carbon emissions economy.

The first eight recommendations come under the banner of “Embedding sustainability into leadership” and include the following:

• Accountability for sustainability led from top;

• Establish a First Peoples Financial Services Office; and 

• Align remuneration structures with sustainable long-term value creation and consider embedding sustainability targets.

Lost in translation

As executive director at specialist climate change advisory and investment firm Pollination, Whitton assists financial services firms with their strategies around climate change and understanding the science of climate change. “The distance between CSIRO and an investment bank is actually a very big distance - human capital wise, language wise, expertise wise - and what we're trying to do when we do the translation work is actually bridge that distance,” she says.

Moderator Fiedler then asked the panel who might be best placed to do the translation work between climate scientists and the finance and banking industry? 

 “The answers are collaborative efforts, but it's not just scientists. It's not just the financial sector. It also requires a number of entities to be part of this mix,” Insurance Council of New Zealand’s Grafton said.

Grafton used the example of the Representative Users Group of the Deep South Science Challenge, which he chaired for three years. The New Zealand group focussed on research to adapt to climate change and included insurers, the agricultural sector and government. 

“And our role solely was to talk to the scientists to say this is what we want. We don't understand the science, but we'd like to know this so that we can assess our risk,” he said. “The critical issue is how do you translate this through so that you get the right price? Because if you misprice climate change, then you affect investment everywhere. And if we're looking for a smooth transition to a low carbon, sustainable global economy, then those investment signals have to be as precise as possible, albeit recognising those huge uncertainties that we've already covered off,” Grafton added.

Scenario analysis and stress testing

CoreLogic’s Wiart suggested that perhaps the best place for a financial institution to start when considering how to measure climate change risk was a scenario analysis of their physical risk. That could then lead to an understanding of other related risks they would be exposed to.

“The first step is to assess through a scenario what it means, what do we learn and what do we need to do next? Does it affect my portfolio? Should I change my strategy? Should I communicate differently to my customers?” he said. “And then, as you're involved in your understanding of the risks and your relationship with your customers, you might want to be more and more sophisticated.”

Another tool available to institutions to understand their climate change risks is stress testing. Where scenario analysis is considering how future events might affect a portfolio, stress-testing is more about trying to understand the circumstances under which an investment you hold might fail, according to Pollination’s Whitton. 

“Now, more and more people are using this kind of stress testing approach. It works quite well on transition risk because you can move energy prices around, you can move water prices around in the system and see what the model kicks out. But it’s still difficult on physical risk, because you still need a lot more information,” Whitton said.

She suggested that a combination of both might be the most helpful in understanding overall risk. “What we did with transition analysis is we said, look, I can't calculate every single exposure of every utility asset in Europe, but what I can say is on average utility assets are exposed by this much… And then I'll do deep analysis where I see really high-risk areas.” 

Click here to listen to the RFi Group/CoreLogic webinar