It was great to have the opportunity to participate in Baringa’s Climate Change scenario analysis workshop last week with 40+ clients from across financial services (FS) and other sectors. It was impressive to see that firms are already deep in their planning cycle with regards to climate change, however, it seems that there is lots more work to do on executing these plans. When asked to state the phase of their climate change risk modelling journey, almost 60% of the participants stated that they are in the planning phase, with approximately 30% being in the pilot phase, and merely 10% going through an implementation of a climate change scenario analysis. This demonstrates that some steps in thinking have been taken around the impact of climate change, however, this is still only the beginning of what might be a long-journey and financial institutions need to act fast if they don’t want to get left behind. Climate change presents systemic risk to the FS sector, but also a great deal of opportunities, as long as they are seized in time.
Focusing on two areas in which risks arise; physical and transition. Physical risks arise from climate and weather-related events such as floods, wild fire and sea level rise which can cause physical damage to assets. Transition risk on the other hand arises from the process in which the world moves towards a low-carbon economy. This includes changes in policy and technology which can cause devaluation of assets and/or increased credit exposures for banks and lenders. This means that in addition to the existing complexity of deploying capital, an institution must now consider both transition and physical risks, and the potential systemic risks associated with climate change. For some institutions these can often be risks that don’t even exist in their current model framework, let alone the tools and knowledge to do a stress test on them. What if the company has a facility in a high-risk flood zone? What if part of its supply-chain is affected by potential sea-level rise? What if the company does not transition fast enough into low-carbon emission operations and gets penalised by policy makers and regulators? The potential of even one of these events occurring can have a material impact on the profit and loss (P&L) made across an investment portfolio. In a recent report by the Intergovernmental Panel on Climate Change (IPCC) it was found that to keep warming to 1.5⁰C the world needs to reach net-zero greenhouse emissions within 25 years, and that this will require a major reallocation of the investment portfolio.
How easy it is in practise though, to consider all of these together when evaluating your risk exposure, is another matter. Modelling both transition and physical risk together and understanding the impact of both on a company’s balance sheet and consequently on its equity is proving to be far more challenging than initially thought. Baringa’s extensive experience as number one consulting provider on energy transition, in combination with its strong financial services advisory practice, means it is uniquely placed to support this, and the diagram below summarises our model and approach in how to best achieve this.
In summary, there are three steps in climate change scenario analysis:
- Sector-level impact assessment – entails an analysis of how each sector can be affected by transition of its relevant technology or by the potential physical damage of its assets
- Company-level impact assessment – entails an understanding of how the sector in which a particular company conducts its business changes, and how these changes might affect its balance sheet and profit and loss
- Instrument-level impact assessment – entails modelling the impact on equity and bond valuation resulting from the affected balance sheet and P&L.
The implementation of such a modelling framework is definitely not easy, but certainly plausible and there are four key characteristics an institution needs to consider when designing their framework if they want to be successful:
- Dynamism - being able to capture the complex interconnectivity between the different sectors
- Transparency - providing visibility to individual parameters that make up the overall scenarios
- Configurability- allowing the institution to adapt their model as they further develop their climate change thinking
- “Zoomability” - allowing scenarios and impacts to be described in broad, global terms but at the same time being able to drill-down into regional characteristics.
Those firms that don’t move into their piloting and developing phase are running the risk of adverse selection contaminating their portfolios, which is far from ideal. It is, therefore, a matter of time before climate change risk and sustainability becomes a key consideration in an institution’s investment decision making, and it is up to each institution and their senior management to decide if they want to lead the way or simply follow the pack.
If you want to discuss more with how Baringa can support you in providing advisory services and the licencing of our model then please get in touch at firstname.lastname@example.org