Climate change is the systemic risk no financial institution can afford to ignore

The environmental, financial and societal consequences of climate change places the systemic risk of climate change at the top of every financial institution’s agenda

“Firms should have fully embedded their approaches to managing climate-related financial risks by the end of 2021,” wrote the UK’s Bank of England in a ‘Dear CEO letter’ to all PRA regulated firms in July 2020. It was a clear warning that financial institutions can no longer afford to pay lip service to climate issues as the cost of climate change gathers pace.

With pressure building from regulators, government initiatives such as the drive to net zero on carbon emissions by 2050, as well as shareholders avoiding companies with high sustainability-related risks, building resilience to a systemic risk like climate change must now be a top boardroom issue.

Worst year ever

According to Aon’s latest Weather Climate and Catastrophe Insight 2020 Annual Report, direct economic losses and damage from natural disasters in 2020 were estimated at US$268 billion. Though not a record for the year, the figure was still 10% above the 21st Century average, while the insured loss of US$97 billion was 40% higher than the average. Perhaps more significantly, 2020 was the worst year ever for billion dollar insured loss events. Of the 28 recorded, the three most significant were in the US; Hurricane Laura at a total insured loss of US$10 billion, followed by a severe convective storm including Midwest Derecho (US$8.3 billion), and Hurricane Sally (US$3.5 billion).

Climate hit on assets and liabilities

In response, companies and markets are beginning to take action. At the end of last year, Lloyd’s announced that it would end its insurance of fossil fuel related activities such as coal-fired power plants, and oil sands exploration by 2030. It’s clear that insurers are pulling out of lines of business with negative environmental associations.

Shareholder action

While there is often a genuine desire amongst businesses to do better when it comes to environmental, social, and governance (ESG) factors, much of the pressure to act is coming from shareholders. Many investors will expect to see real evidence that firms don’t just have a climate policy in place but have quantified their exposures on all sides of their balance sheet. Take banks offering residential mortgages, for example. Climate change could increaset the probability of default on loans where asset valuations are negatively impacted in areas repeatedly hit by flooding or heat stress. Investors will expect a bank to mitigate these risks.

Regulatory response

The pressure is on from the regulators too and the bigger US and UK banks are looking to implement their first-generation catastrophe and climate risk models to comport with regulatory direction. They’ll all need to be able to model/quantify, disclose and start to risk manage the exposures in their loan and investment portfolios.

Aon is working to educate banks on the universe of models (our own and third-party models with whom we have licensing arrangements), interpret model output, adapt output in the context of default exposure to feed into bank credit models, provide insurance gap analysis and help with de-risking through tools like Insurance Linked Securities.

For insurers, the PRA expects an insurer’s board to understand and assess the financial risks from climate change and oversee these risks as part of the firm’s long-term strategy. This means there needs to be clear roles and allocation of responsibilities; evidence the board exercises effective oversight of risk management and controls; is deploying appropriate resources and skills/expertise to manage these financial risks; and the establishment of risk management frameworks to identify, measure, monitor, manage and report on exposure to these risks.

Better reporting

When it comes to reporting, the creation of the Task Force on Climate-related Financial Disclosures (TCFD) has developed recommendations for, “more effective climate-related disclosures that could promote more informed investment, credit, and insurance underwriting decisions and, in turn, enable stakeholders to better understand the concentrations of carbon-related assets in the financial sector and the financial system’s exposures to climate-related risks.”

The TCFD is rapidly becoming the dominant framework for companies to evaluate and quantify financial impacts from climate change-related risks across physical, transition, litigation and reputational related sources of loss. But while this regulatory framework has helped businesses respond to the climate challenge, it has also created a route for shareholders to bring claims against directors for their climate-related failures. Such claims could range from failure to mitigate emissions and comply with environmental regulations, through to a failure to adapt investment strategies.

Individual directors could also find themselves in the firing line and claims against them can already be brought through legislation like the UK’s 2006 Companies Act. And the tide of climate litigation is growing given evidence from the United Nations Environmental Programme’s Global Climate Litigation Report 2020, which shows that climate related litigation has doubled since 2017. We will see those actions continue to increase in numbers.

A three-phase approach to climate resilience

Building resilience to climate change is therefore of paramount importance to every business within the financial services sector. Thinking strategically about climate change is key. An approach developed by Aon, for example, follows three phases. Firstly, it’s about establishing a strategy and governance model that includes identifying material risks and opportunities; secondly, a risk and scenario analysis analyses those risks and opportunities in depth; and thirdly, a stakeholder management phase helps to define suitable actions to address financial risks and capture opportunities.

Such an approach informs a firm’s regulatory response as well as protecting its reputation and prompting an early dialogue on climate with key stakeholders like customers. In addition, a firm can take advantage of risk transfer solutions such as banks purchasing mortgage portfolio protection products geared towards protecting mortgage banking and other investors from the physical risk of climate change, or the use of innovative parametric solutions that can be implemented as part of evolving risk management frameworks that consider not just climate change but land use, population shifts and market cycles.

Employer of choice

Continually revisiting a climate response strategy will pay dividends from both a shareholder and a regulatory perspective. Customers will also demand that financial institutions get their house in order. But no firm should overlook the impact on its employees either. The financial services sector is, after all, a people business and it’s increasingly evident that current and future employees are looking at firms’ ESG position and determining whether that makes them an employer of choice. In the war for talent, it might just be a company’s ESG approach that tips the balance in their favour.

To find out more about the changing climate and ways to build resilience and transfer risk, download Aon’s Weather Climate and Catastrophe Insight 2020 Annual Report