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Will COP26 make ‘green finance’ a misnomer in banking?

Risk & Analytics|Financial, Executive and Professional Risks (FINEX)
Climate Risk and Resilience

By Nick Dunlop | January 10, 2022

That banks have a crucial role to play in climate transition was amplified loudly and clearly at COP26

COP26 strengthened the focus on investment objectives that support a pathway to Net Zero, not just carbon reduction

Indeed, many of my colleagues who’ve attended multiple Conferences of Parties (COP) over the years have said to me that the thing that really stood out about the Glasgow event to them was that it was the equivalent of the Paris COP in 2015 for business and finance.

Essentially, this was the conference that hammered home recognition of the systemic risk of global warming to the financial system. And the system in turn stood up to be counted as a key driver of the transition to net zero and beyond.

Among the headline evidence of that was that the Network for Greening of the Financial System (NGFS) announced it had surpassed 100 central bank and financial supervisor members during the conference. And as a mark of a step change in private sector commitments, the group of 450 banks and insurers that are part of The Glasgow Financial Alliance for Net Zero (Gfanz) committed $130 trillion towards ‘green finance’ between now and 2050.

An end to ‘green finance’ – please

But as I said in a pre-COP blog, my ambition for the banking sector and financial services in general is to see the redundancy of the term ‘green finance’. Instead, I think the focus and challenge for banks is to provide finance and services that inherently recognise that climate change, adaptation and resilience, and economic transition are synonymous not only with creating and supporting a net zero pathway but also with sound business practice and optimising returns for investors.

To this end, the biggest initial obstacle for banks (but not just banks) to surmount is likely to be the extra dimensions of the data and analytics challenge. That’s the challenge of not only assessing physical climate risks over shorter and longer timeframes, taking account of potential future adaptation and resilience measures, but also the pace and implications of transition, e.g. moving away from use of fossil fuels to a low carbon economy.

So, how does that translate into practical actions and areas of investigation and development that banks may need initiate over the next 12 months or so?

Evidence-based decision making

A major step that we, at WTW, would call out is the need to start carving out processes that support taking and demonstrating evidence-based decisions. In other words, there will be a need to develop or enhance the ability to represent to all stakeholders, such as regulators, rating agencies and customers, that there are clear and understood reasons for taking climate-based decisions.

The approach to data and models

A big, perhaps the biggest, element of that challenge will be data. Banks, like many other sectors, need to think through the data requirements that will sustain and serve them in a low carbon economy going forward. Currently, we see that banks are under pressure and want to invest in activities and companies that support net zero, but that many struggle to get comfortable due to lack of data.

On physical climate risks, let’s take the risk of future floods to a bank’s retail property portfolio as an example. Currently, models are typically calibrated against past storm and flood events at a macro level. There is a singular lack of credible physical risk data to look forward and understand the real level of ongoing risk to a bank’s individual portfolio. The challenge is not just to attempt to capture the climate signal (more storms, higher rainfall), but also the potential exposure – which will be influenced by factors such as land development and changes in the customer base.

On transition risks, banks will need to not only think through how their own business model might affect or be affected by steps to move to net zero but also how their customers can be supported to adapt. That’s the thinking behind Climate Transition Pathways, which WTW has incubated to ensure that high carbon industries transition effectively, in line with what the science indicates is needed to maintain a healthy climate trajectory, by giving them continued access to finance and insurance capacity. From an investment perspective, another transition analytics tool that WTW has developed is the Climate Transition Index, which uses a proprietary Climate Transition Value at Risk (CTVaR) measure to analyse the impact on company cash flows and performance of moves towards a net zero emission economy.

A key part of gaining and demonstrating broader insights on both physical and transition risks will be avoiding ‘black boxes’ and understanding the science behind models employed as much as possible. Otherwise, there is a danger of plugging in numbers that aren’t appropriate when, fundamentally, the need is for data to align with shifts in a bank’s risks caused by climate and knock-on factors – credit defaults for example.

Scenario development

Ultimately, all model projections of future climate risks are estimates. An intrinsic part of these estimates are future climate scenarios as produced by the likes of the Intergovernmental Panel on Climate Change (IPCC) and the NGFS. These represent science’s best efforts of a plausible view of the future and, from a bank’s point of view, are transparent and broadly validated.

Beyond these, however, banks will need to start thinking about how they integrate scenarios for hazard, specific geographies and socio-economics that include how the business might change and impacts on supply chains and client mix, and indeed, risk appetite. The longer-term goal is scenarios that reflect the reality of an organisation – albeit they, by definition, remain abstract and will need to use probabilities to account for inevitable uncertainties.

Governance and stewardship

Banks’ climate decision-making and governance structures are already commanding attention from regulators in many parts of the world, and COP26 will only have intensified and broadened that scrutiny. So, the organisational structures and governance that banks have in place to support evidence-based and transparent strategic and tactical decisions on climate are certainly worthy of review in the short term.

A key thing to remember is that banks have been and were in the COP26 spotlight for climate for good reason. There’s a real opportunity for banks to be stewards of a just transition, using their financial and economic influence for the general good and to generate reputational benefit.

Reflect on business culture

Linked to decision-making, governance and stewardship, a bank, like any other business or institution of course, constitutes a collection of people. ‘Green’ strategies are not enough if the culture does not support and motivate implementation, including potentially how people are rewarded.

COP26 provided the strongest signal to date of the need for the senior management of banks to ask hard questions of themselves and the organisation in relation to climate. Do the current culture and values support our view of climate obligations and opportunities? Are roles and responsibilities – including collective individual responsibility – clear? Do our people understand how climate risks are changing and will change our business? How do we communicate that transition to a low carbon economy will be good for business with the right tools, approach and, most of all, organisational cohesion?

Some final thoughts

We appreciate there is a lot to think about in these statements.

From our long-term experience in quantification of climate risks, we would recommend banks begin to ensure they have a credible sense of a means to quantify the current climate-related risks to the business and its credit and investment portfolios. Often, the temptation is jump ahead to focus on what may happen in the future. However, an inadequate baseline view of risk will make the more future gazing aspects of assessing and managing physical, transition – and not forgetting liability – climate risks all the more challenging.

In this respect, I pose a question. Could there be a bigger role for insurers and reinsurers to assist banks with quantifying those risks? In addition to capitalising on the insurance industry’s history of developing catastrophe models and using other scientific models to assess hazards such as flood, drought and wind in order to isolate risks to specific assets, it could also be a valuable step in bringing consistency of the data applied to what is a hugely complex analytical challenge for all involved.

Nick Dunlop is a managing director in WTW’s Risk and Broking business.

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