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Climate Risks - Beyond the Physical

Published

October 2022

The mention of ‘Climate Risk’ inevitably turns our thoughts to dramatic weather events such as floods, storms, hurricanes as well as drought and forest fires (“Physical Climate Risk”). These often-devastating Physical Climate Risk events grab the media’s attention and are widely reported.

However, there is another kind of Climate Risk which is much less discussed and not as widely covered in the mainstream media, despite the potential for it to impact every part of daily life: Climate Transition Risk.

Climate Transition Risk has significant implications for the global economy and financial sector, affecting every asset in investment portfolios and bank loan books worldwide.

Transition Risk

“Climate Transition Risk” is used to describe the disruption that is likely to be caused by a shift to a low-carbon economy to prevent the escalation of physical climate risks. This shift to a low-carbon economy is the “Climate Transition”, and the disruption caused by the Climate Transition, including the risks inherent in overhauling business models and/or adjusting reactions to policy changes, is the likely risk during Climate Transition.

From the Paris Agreement to the COP26 Climate Summit, governments globally are setting policy and implementing regulation in a bid to guide economies towards a more environmentally sustainable future.

Target Setting

One of the measures being adopted by governments globally is the introduction of targets for reducing greenhouse gases and limiting global temperature increases. Here, a common goal for companies and countries is to achieve “Net Zero” carbon emissions by the year 2050, a scientific target used to maintain alignment with the Paris Agreement, which aims to limit global warming to well below 2 °C, preferably to 1.5 °C.

While most carbon emissions reduction targets are set at country and economy wide levels, hitting these targets will require cutting emissions from high emitting industries across the world.

The energy and transport sectors for example, are often seen as the primary areas for transition and are certainly at the forefront of policy. The transition to electric vehicles is currently one of the most visible policy initiatives globally and is gaining the most exposure.

However, the financial sector has a pivotal role to play in Climate Transition, as it can act as both a catalyst and a transmission channel for change.

Finance Sector Pivotal to Climate Transition

Financial regulators are driving change through policy that encourages climate-related disclosures. These policies encompass asset owners, such as pension funds through to high street banks, and central banks globally that have started to introduce climate risk as a category (both physical and transition) in their stress testing frameworks.

The introduction of climate stress tests for banks suggest that financial regulators see climate risks as a potential source of financial instability. Banking stress tests are simulations to understand the robustness of individual banks and the banking system against various scenarios. The European Central Bank has been leading the way and other major G7 central banks are following.

Passing the Test

The wide adoption of mandatory climate-related disclosures by the financial industry has potentially massive implications for the economy and the global population.

While the financial sector’s role as a transmission channel of monetary policy to the broader economy is well known, the growing prominence of its role as a climate policy transmission channel is less widely acknowledged.

Regulators’ strategy of requiring banks to undertake stress tests and the resulting wider financial industry’s hopes to avoid having to report environmentally unfriendly investments is creating the primary catalysts for the change in behaviour that policy makers are looking for.

However, the pressure is not only coming from regulators.

Within the finance industry, investors are also driving the Climate Transition agenda, as evident in some high-profile examples of shareholders successfully holding companies to account regarding their climate disclosure policies.

The growing trend in activist and impact investing will expose companies that are lagging when it comes to Climate Transition, which will then open these companies to further harm, including reputational risks.

Climate Risk or Revolution?

The scale of change required globally for a successful Climate Transition has drawn comparisons to antecedent economic and technological revolutions, such as the industrial revolution and the introduction of the internet.

A significant difference with climate related transition changes from these previous economic and technological revolutions, which were propelled by technology and innovation, is that Climate Transition is currently driven by legislation and regulation, forcing change on businesses and the economy when the technology may not be in place to achieve those policy ambitions.

Indeed, while there are some examples of investor and consumer success in driving change, the current waves of Climate Transition legislation and regulation have technology and innovation scrambling to catch up.

While this gap between climate ambition and practical implementation exposes the economy to Climate Transition Risks, if/when technology catches up, Climate Transition Risks will quickly become climate-focused opportunities.

Not Just a Risk, But an Opportunity

During periods of significant change there is a tendency to focus on the negatives, especially when the change is forced upon us rather than organically resulting from technological change and innovation.

But there are reasons for optimism as investment in green technology and business is growing rapidly, fuelling innovation. Regulation in the financial sector will likely drive this trend further as banks are penalised for lending to old emissions-heavy industries and rewarded for green investments.

Climate Transition evolving from a policy-driven to a technology-driven revolution could prove to be more acceptable to the population. While a technology-driven transition could reduce the risks to transition (implementation risk), it might not necessarily reduce Climate Transition Risk if that transition takes too long as an extended delay to move to a technology-driven transition could intensify some of the transition risks, especially if complacency sets in.