The discussion about how climate risk affects the financial sector has gained significant momentum in recent years.
Financial regulators in the UK, France, Japan, Singapore, Hong Kong, Canada and beyond are looking seriously at the effects of climate change on financial stability, building on the work of the Financial Stability Board’s Taskforce on Climate Related Financial Disclosures (TCFD). In April 2019, the UK's Prudential Regulation Authority became the first regulator to issue a supervisory statement setting out its expectations concerning banks and insurers' approach to managing the financial risks associated with climate change. Shortly thereafter, the ACPR, France's financial regulator, announced its intention to include climate risks in its stress tests of banks and insurers and the European Central Bank is actively considering doing the same. Finally, in December 2019, the Bank of England published a discussion paper which sets out its proposals for stress testing the financial stability implications of climate change. The exercise – to be conducted in 2021 – will test the resilience of the UK's largest banks and insurers to the physical and transition risks associated with three distinct climate scenarios.
This steadily increasing regulatory focus highlights the need for financial institutions to have a robust climate change strategy which quantifies the potential impact of climate-related risks on assets and liabilities, while demonstrating how they will manage these risks. Given the uncertainty around the future path of emissions and their associated economic and financial impacts, scenarios – data-driven narratives about the future – can be used to drive better decisions today. They can help investors assess the potential range of impacts from physical and transition sources of risk to enhance strategic decision-making.
The case of real estate and infrastructure
While every asset class is exposed to climate risk to some degree, real assets, such as real estate and infrastructure, provide a vivid illustration of the hazards that lie ahead.
As the intensity of weather events continues to bring greater risk of even more damaging impacts, the risks to geographically vulnerable areas become particularly acute. Ratings agency S&P raised this issue in 2018 when it reported that the average impact of weather events on corporate earnings was 6% for companies that reported it (The Effects of Weather Events on Corporate Earnings are Gathering Force - 2018). To take one recent example, Hurricane Harvey alone damaged more than 200,000 homes and resulted in direct economic losses of $125 billion, forcing several real estate investment trusts to book hurricane-related charges. More broadly, a recent study (Disaster on the Horizon: The Price Effect of Sea Leval Rise - 2018) found that properties exposed to sea level rises are selling at an average discount of 7% relative to comparable but less-exposed properties in the United States, highlighting the longer-term impact of climate-related risks on asset prices.
Extreme weather events also pose both acute and chronic physical risks to infrastructure investments: in the worst case, an extreme weather event may cause damage that results in catastrophic failure and a dramatic reduction in the lifespan of infrastructure assets. In 2012, for example, Hurricane Sandy knocked out a large part of Verizon's power systems, contributing to a $4.2 billion quarterly loss despite adding customers over the period. Less perceptible, but equally important, is the impact of gradual climatic shifts. To take one example, reduced river flow impacts the operability and profitability of hydropower facilities and can lead to significant asset write-downs. Identifying and integrating these risks is a critical part of the risk management process.
Given the scale, scope and interrelatedness of the risks, it is incumbent on asset owners to assess and plan for climate change.
This is an extract from: Weather, Climate & Catastrophe Insight Report: 2019. To access the full report, please click here.
About the Authors
Tim Manuel is Aon’s UK Head of Responsible Investment, leading the development and implementation of Aon’s responsible investment policies and solutions. He is a senior member of the firm’s investment business practice and is responsible for advising several of Aon’s trustee and corporate clients. Tim is a fellow of the Institute and Faculty of Actuaries and holds a degree in Theoretical Physics from the University of Newcastle.
Ahmed Ali is an associate consultant in Aon’s Global Investment Practice and a member of the responsible investment team.He holds a master's degree in Mathematics and Statistics from Lancaster University and is a CFA charterholder.