Until recently, business leaders could assume the most costly effects of the climate crisis wouldn’t occur for decades. People entrusted with guarding their organizations from financial risks could put off worries about the impact of extreme weather patterns, mega fires, and policy shifts toward a low-carbon economy. That conventional wisdom has crumbled.
The hottest decade in history came to a dire end in 2020 with the Atlantic hurricane season producing the most named storms ever, and California and much of the West choked by record-setting wildfires.
“California is steadily marching toward an uninsurable future regarding insurance coverage for wildfires,” Dave Jones, The Nature Conservancy’s Senior Director for Environmental Risk, warned in congressional testimony.
Financial Regulators Warn of Shocks and ‘an Existential Threat’
Meanwhile, financial regulators are rushing to catch up with climate change, and business leaders can expect policy changes to confront its impact.
Janet Yellen calls climate change “an existential threat.” She plans to create a new government unit to focus on its financial consequences, including stranded assets, volatile asset prices, and credit risks.
Similarly, the Federal Reserve for the first time included climate risk as part of its biannual financial stability report. In November, the Fed warned that climate-driven events could cause significant financial shocks and disruptions to the financial sector and other industries.
“As inundations or storm surges become more frequent,” the Fed warned, “the expected value of exposed real estate may decrease,” creating risks for non-financial firms that own or use the exposed properties.
For CFOs, treasurers, and other financial decision-makers, risks from rapid global warming have surged into view at a time when their own roles have been changing. Many, particularly in light of the pandemic, have taken on added strategic leadership responsibilities, and as a result, they are collaborating more with IT, sales, legal, and other functions to guide their businesses.
“There’s growing and broad consensus that climate change poses systemic risk to the US financial system. ”
Those alliances forged in this pandemic may prove to be even more important as companies confront the climate emergency. Now is the time for finance leaders to guide their organizations through new financial risks born from the climate crisis. Anticipating risks to present-day financial transactions will be vital, but also risks to future revenue streams, the cost of capital, supply chains, and regulatory disclosures. The Fed and others have already zeroed in on several imminent risks to business and the financial system.
“There’s growing and broad consensus that climate change poses systemic risk to the US financial system,” says Jones, who was California’s insurance commissioner prior to joining The Nature Conservancy.
Here is a rundown of the financial risks and suggestions for how companies can build resilience against them in 2021 and beyond.
Business Leaders Are Focusing More on Transition Risks
Only in the past several years have we managed to quantify the private sector financial impact of the climate crisis. This is important to understanding the system-wide effects of climate change rather than assuming incorrectly that risks are only concentrated in regions prone to wildfires or extreme weather events.
The root issue is the difference between physical and transition risks.
- Physical risks arise from damage to property, infrastructure, and land as a result of climate change. Think of the 3 million homes in California (25 percent of the state’s 12 million units) that CalFire says are at high risk from wildfires. Or the estimated $24 billion in claims insurers faced from California’s 2017 and 2018 wildfire seasons.
- Transition risk, a relatively new area of focus, refers to the economic and financial impact of the global shift to a low- or zero-carbon economy. “This transition can be driven by technology, market forces, or policy. But as it occurs—gradually or abruptly—it can have an impact on the valuation of assets that are related to the greenhouse gas-emitting sectors,” Jones says.
More than 200 of the world’s biggest companies, representing around $17 trillion in market capitalization, valued the climate risks to their businesses at nearly $1 trillion, according to a seminal 2019 report from CDP, a non-profit that runs a global environmental disclosure system.
In addition to reporting potential losses of $250 billion on stranded assets tied to fossil fuels, the companies surveyed said that within the next five years more than half of the climate risks they face are likely, very likely, or virtually certain to materialize. Most of the companies indicated they consider addressing transition risks a priority.
Of course, both transition and physical risks can have a financial impact on corporate operations and business—they can be sources of financial risks.
Carbon Footprint Can Push Up Cost of Credit
The energy transition will have an impact on the value of assets in the extractive industries. That much is known. But recent research explores other exposures to climate change via securities markets and financial counterparties, such as banks.
A 2020 paper from the EDHEC-Risk Institute, a think tank in France, found credit risk for companies rose in tandem with their emissions. Put another way, the larger a company’s carbon footprint, the bigger the risk of default.
The authors of the study looked at a decade of data from 458 issuers of US investment-grade debt. They found a strong correlation between the least-polluting companies as measured by emissions and carbon intensity and the lowest default risk—and vice versa. The results held firm even when excluding companies in the energy and extractive industries.
Capital markets penalize corporate borrowers with bigger carbon footprints, factoring in expectations for higher carbon prices and tougher regulations, especially following the Paris Agreement. “This finding supports the view that financial markets are increasingly pricing climate change exposure of listed companies, and such exposure affects the overall creditworthiness of companies,” the paper says.
One of the implications is that companies, particularly those from polluting industries, may find capital markets increasingly more expensive to access. The authors of the study recommended that ratings agencies and lenders consider the carbon footprint metrics of would-be borrowers when assessing creditworthiness.
Moody’s actually did an in-depth analysis in 2020 and found 13 global sectors with a combined $3.4 trillion in debt have very high or high environmental credit risk. Total debt held by sectors with heightened environmental credit risk rose 49 percent since 2018, the ratings agency said.
Banks themselves already may have more transition risk exposure than previously understood. In fact, the 2019 survey of large companies by CDP found the “vast majority of risks” concentrated in the financial services industry.
Loan Portfolios Reflect Elevated Transition Risk in Banks
CFOs should explore to what extent their banking partners are sources of climate-related financial risks. The largest US banks have multiple layers of transition risk, according to a 2020 report from the sustainability non-profit Ceres.
- Lending to the fossil fuel industry directly exposes many banks to falling asset valuations in transitioning economies.
- Banks also lend to industries that depend heavily on fossil fuels, such as manufacturing, utilities, and airlines. This comprises a second layer of risk seldom included in regulatory disclosures.
- A third and final layer is formed by the interdependence within the financial sector itself.
To understand the scope of risk exposure, Ceres performed an analysis of syndicated loan portfolios. More than two-thirds of the average loan portfolio, or $553 billion, is exposed to transition risk, according to the report. The researchers stress-tested the portfolios by estimating the impact of an adverse scenario, which in this case was a policy shock causing a disorderly transition to a lower-carbon economy. Loan losses, not including the indirect exposure to the financial sector, amounted to anywhere between 3 percent to as much as 18 percent.
The loss estimate, moreover, doesn’t take into account how differing amounts of leverage at banks could amplify the impact. The research raises the need for finance to take a leading role on behalf of their organizations in engaging with banking partners and asking them about efforts to mitigate transition risk exposure.
Supply Chains Pose Event-Driven Financial Risks
Another area where finance can take on a leadership role is with supply chains and the financial implications of climate-driven disruptions. It’s clear that rising sea levels and climate-related disasters have already threatened ports and broken global supply chains. Hurricane Harvey in 2017 disrupted crude oil deliveries to refineries and caused gasoline prices to spike as much as 16 percent in some parts of the US. And the frequency of climate-related events has been increasing.
In 2020, there were 22 extreme weather events in the US with losses exceeding $1 billion, shattering the previous annual record of 16 events in 2011 and 2017. In fact, 2020 was the sixth consecutive year (2015–2020) in which 10 or more billion-dollar weather and climate disaster events occurred in the country.
Of course, many supply chains today wrap around the world. More than half (55 percent) of global trade passes through seaports that have a high risk of at least one climate-related event. About 8 percent of trade is vulnerable to three or more events.
A focus over the past several decades on creating efficient supply chains and reaping the benefits of higher productivity may have tipped the balance away from resiliency.
The implications of a higher frequency of supply chain disruptions are uncertain. Financial decision-makers can lead by asking incisive questions like, “How would more frequent disruptions impact the availability of working capital or the status of payments?” Some have suggested that companies should extend the typical time horizon for risk mitigation plans from five to 20 years. But financial planning over the next five years is challenging at the best of times. With climate-driven supply chain disruptions increasing, forecasting out 20 years might be a tall order.
What Can Be Done Now to Mitigate Risks?
Mitigating climate-related financial risks calls for a different way of identifying vulnerabilities. Banks, finance executives, and investors often make decisions based on benchmarks. However, historical information on economic and financial performance is much less relevant to assessing climate risk because the risk depends on future changes in the climate and operating environment.
A scenario-based approach is more effective. When analyzing bank loan portfolios, Ceres used a series of scenarios: one in which transition risks dominate, another where physical risks are more present, and a third in which both transition and physical risks are potent.
“From a risk-management perspective, we’ve learned that our worst nightmares can come true, and sometimes, our imaginations are not big enough. ”
“From a risk-management perspective, we’ve learned that our worst nightmares can come true, and sometimes, our imaginations are not big enough,” says Emilie Mazzacurati, Founder and CEO of Four Twenty Seven, a market intelligence firm focused on climate-related and environmental risks. “The pandemic shows that a worst-case scenario can happen, and it’s pretty painful if you’re not prepared. We need to stretch our imaginations for stress tests.”
Here are some suggestions on how to address financial risks of climate change.
A good starting point for managing climate risks is transparency about carbon footprint. Companies should expect increasing regulatory requirements on disclosures. For now, the Task Force on Climate-related Financial Disclosures (TCFD) has developed voluntary climate-related financial risk disclosures. Climate credit analysis is a new field of study. A few consultancies, such as Moody’s, S&P, and Oliver Wyman, have developed specialized expertise. Finally, CFOs and other financial decision-makers can consider forming multifunction task forces (including operations, sales, compliance and legal, and others) to perform climate stress tests and scenario analysis to expose vulnerabilities.
Corporate customers should be willing to ask their banks about financing policies for extractive industries and how lenders plan to facilitate the transition to a low- or zero-carbon economy. How restrictive are their finance policies? What are they planning for banking clients from energy-intensive industries that don’t have their own transition plans? These are just a couple of questions worth posing.
Supply Chain Risk
This is an area where finance leaders can work closely with business partners to conduct risk diagnostics. Many of the lessons learned during the pandemic will guide this work related to climate change. Supply chain managers will first need to identify which of their suppliers are essential for business continuity and map them to potential physical and transition hazards. Does insurance protect against disruptions? What time horizon is being used for risk mitigation plans? There is a high level of complexity involved, particularly because of the global nature of modern supply chains. That is why finance departments may want to consider enhanced capabilities to counteract risks, including real-time monitoring of payments and treasury centralization.