Climate change presents financial risks as a number of challenges converge: the rise in natural catastrophes, chronic environmental shifts, and the impacts associated with a transition to a low carbon economy. To assess, manage and disclose climate risks, the Taskforce on Climate-related Financial Disclosures (TCFD), provides guidance across four aspects or ‘pillars’: governance, strategy, risk management, and metrics and targets. There are also 11 recommended disclosures that seek to provide investors and stakeholders with decision-useful information.
With so many businesses engaging with the TCFD to guide their management and disclosure of climate risks, Energetics has a podcast series stepping through and discussing each of the four pillars. In previous podcasts, we have covered governance and strategy. For the third in our series, we examine risk management and how an organisation identifies, assesses and manages climate related risks.
This article captures the discussion led by Joel Hextall who heads Energetics’ team in Western Australia. Joining Joel was John Evans, formerly the Head of Enterprise Risk Advisory at the Commonwealth Bank and now director of JE Advisory. John is an expert in risk management for the financial sector specialising in climate risk and a regular contributor to the climate risk projects that Energetics delivers. Sally Cook, Energetics’ Head of Strategy who has advised boards and executive teams across the finance and banking, mining, retail and infrastructure sectors, also shared her insights.
Listen to our podcast.
The following is based on the transcript of the podcast episode.
What are climate related risks?
(Sally Cook) In its simplest form, a risk is an uncertain future event. Generally, climate related risks are grouped into three areas. The first are physical risks, which occur due to changes in the earth’s system such as increasing temperatures and extreme rainfall events. The second group covers transition risks arising because of policy and market changes as an economy decarbonises. The third are reputational risks through investor or customer pressure and the associated liability risks can that come from stakeholder litigation and regulatory enforcement.
Business also needs to be alert to the many climate related opportunities, which include your ability to differentiate your product or service in the market, potentially move into new markets, build reputational capital and enhance the value of your business in a low carbon economy.
From a practical point of view, how are risks traditionally identified, assessed and managed?
(Sally Cook) Risk management processes are well embedded in most large companies. A lot of companies adopt the ‘three lines of defence’ model. The first is at the operational level and involves the systems, controls and the culture that are in place to recognise and then manage risk. The second line of defence relates to compliance in which the operational level is supported by systems and insights. The third line of defence is provided by the internal audit function for which there is independent assurance that risk management and internal controls are fulfilling their purpose.
Risks are rated for their potential impact, according to the consequences and their likelihood. They can be rated on an inherent basis, which is before controls that a company might impose to reduce the likelihood of a risk or the possible consequences. Or a risk could be rated as a residual risk after the application of the controls. Organisations might also identify treatment actions, for example where controls don't exist, or where they're ineffective. Those risks, their ratings, controls and treatments will commonly be documented in a risk register, which is used as the basis for internal and external reporting.
Are climate risks new and unique risks, or do they potentially exacerbate known risks and require additional control measures?
(Sally Cook) That's a really good question. They can be both. Examples of new risks include emerging markets, changes in technology, disruption to existing markets, or they can be risks where the existing risk identified has changed or deepened. For example, an increase in health and safety risks associated with increasing heat days is possible.
It's also interesting to think about climate related risks as being dynamic. If you look at the last 10 years of Australian climate policy, you can reflect on how dynamic it's been and consider how dynamic it will become in the future for the country to achieve net zero. These risks are ongoing, and we also need to consider them a current problem, not necessarily only a future problem. This is particularly the case for physical risks. We're finding more and more that physical changes are starting to impact in the short term.
Do climate related risks affect financial institutions? If so, how?
(John Evans) The various forms of climate related risks that Sally's already mentioned, the physical and transition risks, will impact every organisation across the economy in some way. Financial institutions provide services to large sections of the economy and the broader population and are therefore subjected to the aggregate impacts of climate risk. Similarly, insurers provide insurance coverage to a range of businesses and individuals. So, the transition to a low carbon economy and the physical risks to the assets that are either insured or financed will have a material impact on the future financial results of financial institutions.
But there's another aspect that's perhaps less appreciated by those outside the finance sector. These institutions need to borrow money or raise capital to continue to operate and grow their businesses. Their response to their climate related risks will be a key factor in deciding whether investors are willing to fund them in the future. If they decide that they'd rather invest elsewhere, the costs of these funds will increase and thereby reduce a bank’s or insurer’s profitability, or even challenge their viability going forward. This is pretty serious and presents major strategic risks for financial institutions. Remember, neither financial or non-financial companies are able to control the changes in the physical climate and the structural changes to the global economy as it transitions to low carbon future. What they can do or what they need to do, is to structure their businesses to make them more resilient to these changes, thereby limiting the likelihood and size of any damage and maximizing the opportunities as these changes occur.
What would you suggest are the key challenges that organisations face in identifying, assessing, and managing climate related risks?
(John Evans) I'd highlight three key challenges. The first is an appreciation of the breadth of the potential climate related impacts. For many organisations, and I'm thinking of banks in particular where my experience lies, most parts of the balance sheet are going to be impacted by climate risk in one way or another.
Secondly, climate risk is a major strategic risk. It's something that could cause a business strategy to fail to deliver its objectives by some significant margin. Strategic risk itself is actually a relatively new category in many risk frameworks and primarily comes from external sources that we're not able to control such as regulatory changes, technology advancements, shifts in the competitive landscape, or what our customers or society more broadly expects or wants. So strategic risk is, in some cases, not that well understood and in many cases is immature in the way it's being implemented and embedded into business processes.
Climate risk management is being built on a less than robust foundation. In the worst cases, this could lead to boards signing off on strategies that have no clearly articulated approach to what are major challenges to the success of the strategy; particularly less familiar challenges such as the impact of climate change.
The third major challenge is that climate risk impacts most or all risk classes, yet it's rarely explicitly and comprehensively included in risk frameworks. For example, credit decision making and portfolio management tools probably have insufficient explicit consideration of climate risk and wider ESG risks at the current time, although I think that is getting better. This is partly due to the fact that climate risk is different to the risks that most frameworks are used to considering. There are longer timeframes than traditional business and strategic planning horizons would use. There's also the fact that climate change is happening and it's irreversible. It's not cyclical like lots of other risks. Climate risk is also dependent on characteristics such as geography, location, and topography. Such aspects probably haven't previously been incorporated into some decision-making processes. We also face the large uncertainty of both the impact and timing of these risks, which is difficult to deal with. Finally, there's no relevant history here making traditional risk modelling methods largely redundant. In many cases, climate risk factors aren't yet fully included in risk measurement models and all relevant climate risk data is not yet being collected.
If you could summarise, what are the most important actions for organisations when it comes to managing climate related risks?
(John Evans) Fundamentally organisations need to embed the consideration of climate related risks into all business decisions. Now that sounds easy, but it won't happen by osmosis. People don't really know how to take account of climate related factors and, as we've already mentioned, understanding the breadth of potential climate related impacts is immature. The nature of the risks is very different with little or no precedent to draw on.
I also think corporate memory can fall short. Businesses forget or are unaware of the assumptions that underpin current methodologies. They don't always recognise when those assumptions may be compromised by climate related factors. For example, there might be the assumption that the behaviours of the past will continue. On top of that, the uncertainty and complexity of climate related impacts can be overwhelming. To help decision-makers, risk management frameworks need to provide the structure and tools for comprehensive consideration of all relevant climate related factors. Although, even for existing risk types, the full integration of risk consideration into business decisions is quite immature as was evidenced in the finance industry by the findings of the Banking Royal Commission.
Two particularly high priority actions for financial institutions really need to be, firstly, portfolio management decisions need to reflect future climate related risks and opportunities, reducing exposure to traditional industries and sectors, and increasing exposure to sectors aligning with the transition to a low carbon economy.
I think the other issue is product pricing. We hear that climate risk isn't being priced by markets. Pricing needs to reflect climate related risks over the terms of the products or loans that are being offered. Banks need to move away from lending and pricing on the basis of the risk that existed historically and take a more forward looking view of the risks that could lead to potential losses. They may need greater risk-based pricing where they actually charge customers with high climate risk exposure more than they do for loans to businesses which have low climate related risks.
How are climate risks affecting our clients’ strategies to not only mitigate risk, but potentially grow from the transition to a lower carbon economy?
(Sally Cook) There are many clients working through a risk assessment and finding that a net zero economy will be very beneficial to them. That could be around new business opportunities and, as John mentioned, being able to capture some of the green capital that's starting to flow into the market from the banks. It could also be from attracting and retaining talented staff within their businesses.
We see opportunity both in existing core business practices and in the decisions around growth, mergers and acquisitions. A new frontier lies in embedding a better understanding of climate related risk and opportunity into those decisions and conducting appropriate due diligence. That's picking up on a lot of John’s comments, not just on the cost of capital and the flip side of that, the availability of capital.
What are the biggest barriers to progress to managing climate related risks and the opportunities that may present?
(John Evans) I think that is a very interesting question. I recently ran a survey to try and tease out the key drivers. The survey suggested 14 barriers to meaningful progress, ranging from non-belief in global warming, to technical issues such as lack of relevant data, and a lack of awareness and understanding of climate drivers. Two factors came out on top. The first was a misalignment of long-term climate impacts and short-term management, tenure and incentives. The second was scepticism over the usefulness of climate scenario analysis results for decision-making.
It would be great to get some further input. Should anyone wish to participate in the survey, please follow this link. Please feel free to give me your thoughts.
On the point of misalignment, I think this highlights the fundamental issue of timeframes. Climate related risks extend longer than traditional business planning and risk assessment horizons. The scepticism point highlights the general issue of uncertainty which I believe is the major issue for many organisations when it comes to acting on climate change. Uncertainty is something that people aren't used to. You can't measure it. You can only investigate uncertainty via scenario analysis and, as we know, scenarios are full of assumptions that need to change over time according to circumstances. In addition, assumptions can be challenged. We also see a wide range of potential impacts when we look at different scenarios;.a broad set of bookends makes decision-making harder because we don't know where in that spectrum we're going to land. I think building the confidence to act when outcomes are uncertain, is something that will need to improve rapidly.
Organisations can’t stand still while the world changes around them. Leaders need to understand that you can take decisions today that will help steer you on a pathway and enable short-term risks to be managed. But they also need to know when a further decision is required and the point at which the assumptions used become invalid or less likely to play out in the way you previously thought.
We also need to recognise that decisions made today will impact future outcomes, especially when entering into long-term contracts. An example is home loans where historically banks have made loans for 30 years on the assumption that people will refinance every four or five years.
However, into the future, that might not be the case. If other lenders have stopped lending to high climate risk locations, there is no market for refinancing in that location, and if we don't recognise this, we're going to be burned when those loans are still on our books in 20 years when the changing climate is really impacting us.
Lastly, I think we need to take appropriate and measured actions when new information on climate related risk exposures becomes available from our assessment activities. Although lots of scenarios may have been explored, action in response has been relatively slow. There are a number of concerns: currently profitable business may have to be foregone and associated relationships with customers might be damaged; there’s the impact on staff and the conversations that are going to be needed with customers; and we also don't know what the ‘final’ position will look like, making people reluctant to take action today that may turn out to be suboptimal in the long term and maybe unnecessary in retrospect.
John, what are the three main points or recommendations for addressing the risk management pillar of the TCFD?
(John Evans) It's all about understanding the risks and factoring these into your decision-making to ensure a sustainable future for your organisation.
First, I would make climate risk a material risk type in its own right in the risk management framework. This will help ensure the transparency, governance, focus, and the resourcing needed to develop and embed climate related risk tools into all relevant parts of the business and its processes. This may feel counter-intuitive when we're thinking about integrating climate risk into the existing risk management framework, which is what the TCFD asks us to do, but like many issues that need integrating, a distinct focus is needed first. Treating climate risk separately is probably needed in the short term to direct, drive and oversee the integration of climate risk into those wider frameworks.
The second recommendation is to identify the biggest barriers to progress and focus on addressing these as a priority. That might mean developing education and training programs for employees to expand their understanding, awareness and capability in climate risk.
Thirdly, it's vital that we start taking incremental actions. We can't afford ‘analysis paralysis’. It's easy to be overwhelmed, but I think inaction is the worst outcome. Start collecting the missing data that will allow improved understanding of the climate related risk exposures. Ensure that the focus is on the risks to the organisation from climate change rather than the risks to the climate from the organisation, which is where a lot of disclosures have been focused so far. It is these risks to the organisation and its business model from climate change, that are going to damage you.
I would also highlight pricing for increased climate related risks and incentivising customers to take climate risk mitigation actions that are going to protect both us and them.
Sally, what are your three recommendations?
(Sally Cook) I agree with John's points. Looking at the communication aspects that John highlighted, I think capacity building and following your risk assessment process are priorities.
On capability, there's a need to upskill people throughout an organisation to understand how to interpret and manage climate related risks, which is not necessarily being addressed. Climate risks are often novel. They have historically originated from environment functions but may need to be identified and managed by other business functions, for example those with strategy, risk management and financial responsibilities. This makes capability development across the business particularly important.
A business also needs to understand that external stakeholders will make their own assessments of the company’s climate risk exposure, and the adequacy of their management of those risks. Understanding this potential scrutiny should impact not only the way disclosures are made to the market, but how you frame your risks. Transparency and responsiveness to stakeholders is vital.
Finally, understanding your internal audience and what will drive them in terms of stakeholder and external pressures to manage climate risks, will help you frame those risks and obtain traction to address some of the barriers that John mentioned.