We are just over one week until the UN Climate Change Conference of the Parties, COP26 convenes in Glasgow. As governments gather to push forward climate and renewable energy initiatives aligned with the Paris Agreement and the UN Framework Convention on Climate Change, financial institutions and asset managers will monitor the event with keen interest.
As I introduced in my first post on the topic, there is a strong intersection between climate and capital markets. The EU has defined a sustainable finance framework to provide guidance and oversight in the goal of becoming the first climate-neutral continent. As part of these efforts, disclosure requirements will mandate that firms provide “the impact of a company’s activities on the environment and society, as well as the business and financial risks faced by a company due to its sustainability exposures.” The Bank of England has taken a leadership position in publishing disclosures related to its own progress on climate-related initiatives. At the same time, regulators around the globe are moving towards increasingly stringent rules, including explicit public disclosures on climate initiatives.
Firms face critical questions related to these disclosures and how climate risk will affect their institutions. They need to understand;
- What are the key climate risk measurements and impacts?
- How do institutions protect and optimize their balance sheets and portfolios?
- How do institutions establish a baseline of where they are today?
These will be key questions for firms to better understand going forward related to climate change.
Understanding a firm’s exposure to climate risk begins with creating scenarios and gaining better visibility to the impact of a variety of variables on the book of business. Stress testing was heavily scrutinized in the post 2008 financial crisis. In a BIS advisory report, it was highlighted that the stress testing scenarios used by the banks were insufficient to capture the extreme risks and fluctuations that were realized. Since then, a further update has been made to the BIS stress testing principles that continues to emphasize the importance of scenarios in better understanding risk.
When it comes to measuring climate risk, generating scenarios will be a critical tactic for financial institutions and asset managers. Generating scenarios can help risk managers understand and assess the systemic risk across institutions, markets and geographies. Scenarios can be analyzed and pressure tested to understand the impact of an event, before it happens. Climate risk measurement has no precedent from which to learn and there are numerous variables to consider. Generating scenarios will help risk managers to quantify the impacts of different variables and enable better assessment of the actions to take.
The variables that affect the exposure to climate change can broadly be grouped into three categories of risk:
- Physical: the physical impacts, including upstream and downstream impacts (ex. rising temperature, sea level)
- Transition: the changes in asset values, business models, etc. (ex. cost of clean energy innovation)
- Alignment: the steps needed to adjust and determine next steps (ex. Changes in investment portfolios)
Quantifying and evaluating climate risk will require risk and finance teams to model behavior related to these risks and evolve new metrics. They must be able to address this dynamic and complex set of highly variable data and understand the correlating impact on capital requirements and regulatory reporting requirements. Mandated disclosures will create additional pressure on the accuracy and confidence of such models.
To measure and model climate risk, firms must have a robust platform with the agility to evolve. It is a complex and challenging problem that will require firms to iterate and adjust to learnings as part of a continual process.
A Partnership in Climate Risk Modelling
Cloudera has furthered its partnership with Simudyne in an effort to offer improved strategies for measuring and modelling climate risk. Simudyne is a simulation technology company, which has built an agent-based model (ABM) in partnership with Deloitte, to accurately measure climate risk. Simudyne runs on the Cloudera enterprise data platform and can use OpenShift containers from Red Hat. Deloitte provides extensive experience and consultation in the climate model inputs and analysis.
The climate risk model makes robust scenarios possible. These models yield useful and actionable insights for risk managers to baseline their current environment and assess the impact of the variables on an ongoing basis. It can help firms have greater confidence with the models and therefore quantify their disclosures with greater accuracy.
To learn more about measuring climate risk, join our upcoming session featuring Simudyne and Deloitte experts. You can join by registering here