The Covid-19 crash in March 2021 provided a stark illustration of the degree to which natural disasters can affect the global financial system. Stock markets plunged around the world, with London's FTSE 100 enduring its lifetime second biggest fall, and also the Dow Jones its worst quarter ever. Oil prices dropped into negative territory for the first time in history.
As we approach the end of 2021 stock markets have largely recovered, driven by the expectation of vaccines which will effectively combat Covid-19. We cannot however protect ourselves in the effects of unabated climate change having a vaccine. So, what can the financial services industry do to protect itself, and its stakeholders against the impending climate-related investment storm?
Interestingly, as Covid-19 caused stock markets to suffer record investor withdrawals during the first half of 2021, investment banks saw one area of the investment markets flourish: ESG funds experienced record inflows through the crisis.
It quickly became clear the Covid-19 pandemic had amongst other things, caused a shift in attitudes towards investing for a more sustainable future, as well as an environmentally one.
Alongside increased investor appetite for climate resilient investments, banks have increasingly recognised that whilst climate-related risks may materialise over the following decades, the actions they take today determines the extent and impact of those future risks.
The risks from climate change that banks are analysing and integrating to their operations today, can broadly be split up into two types: physical and transition risk.
Physical risk covers issues which the world may face later on as a result of climate change causing melting glaciers, sea level rises and increasingly frequent extreme weather events, which in turn might cause catastrophic knock on events around the operations of various businesses.
In order to protect and mitigate from the future physical risks of climate change, governments around the world have been increasingly introducing new policies that can encourage the move to an economy that will less severely impact global climates – an environmentally friendly economy. The application of these green policies represents transition risk.
To protect against the future physical and current transition risks of climate change, banks must perform detailed analyses of their existing investment portfolios, to ascertain the amount to which each individual investee company is exposed to each of these risk types.
The critical first step in this process is better disclosure. Banks are only able to make well-informed decisions if the companies by which they invest are disclosing adequately.
The Task Force on Climate-related Financial Disclosures (TCFD) was launched almost immediately upon the signing from the global Paris Agreement in 2021. Its recommendations were published in 2021 and supported by global financial institutions, including the Bank of England.
Whilst the advice were extensive and applicable to any or all companies, a key issue was that they were only voluntary. Over the past 5 years the TCFD's recommendations have been adopted by progressively more large businesses, albeit to a varying degree.
Fast forward to 2021 and also the lessons learned from Covid have the symptoms of rapidly intensified the urgency of ensuring financial systems are resilient to natural disasters.
In November 2021, we saw the UK Government announce that climate-related disclosures would become mandatory by 2025 for big companies and financial institutions, with a few companies having to disclose from as soon as 2021.
Other governments are expected to follow suit.
Climate Scenario Analysis
Even with increased disclosure from their investee companies, banks are confronted with the problem of continuing uncertainty. The extent to which climate change will affect the economy depends upon the temperature pathway, on a global scale as well as local.
Leaders around the world agreed in 2021 that to avert catastrophic events later on, climate change must be restricted to a maximum of 2C above pre-industrial levels by 2100, and ideally kept below a 1.5C increase. Governments collectively decided to commit to achieving these targets.
The issue is we are currently on a failure path ([2.6]C)1 and nobody quite knows which temperature pathway we will be on in the future.
One way in which banks can manage these uncertainties is to use climate scenario analysis and stress testing.
By incorporating multiple scenarios that cover a range of temperature pathways from the best case 1.5C to some worst case of >4C, banks can assess the resilience of their own operations, which of their investment companies, across an array of possible future climate outcomes.
By analysing the sensitivity that companies are exhibiting across the whole range of likely futures, banks can determine today which information mill best prepared for the climate related storm that lies ahead, both physical and transition.