Improving Climate Risk Forecasting

Covid, the war in Ukraine and inflation have created an unprecedented, uncertain and volatile environment that firms now need to navigate. However, one of the biggest challenges has yet to fully materialise, but already requires their focused attention today – Climate Change.

A growing threat

With the arrival of the latest IPCC reports, it is clear that the extent and speed of Climate Change is worse than expected.

The back-to-back storms that struck the UK earlier this year and the floods in Australia are the latest extreme weather events we’ve experienced, and these will continue to have implications for insurers in particular. The cost of damage caused by Storm Eunice alone was estimated to be more than £360million.

According to Munich Re, in 2021 the extreme events caused globally a total damage of $280 billion, a significant increase from previous years (>30% vs 2020 and >70% vs 2019). For financial institutions it is becoming increasingly important to better understand the impact of changing climate and of the corresponding governmental mitigating actions on their activities, investments and customers. One such area of mitigation action is the drive for net zero.

Following the COP26 summit, the Glasgow Financial Alliance for Net Zero (GFANZ) now represents more than 450 financial firms across 45 countries with total assets over $130 trillion. These institutions have committed to decarbonise their loan and investment portfolios to reach net-zero portfolio carbon emissions by 2050 – with the added goal of achieving significant decreases by 2025 and 2030.

Climate change is a multi-faceted and fast-moving development, which can make it very difficult to predict outcomes of future climate developments but also of portfolio actions needed for the net-zero activities. Some institutions underestimating and ignoring these developments could find their business model significantly exposed to these new risks.

On the other hand businesses investing in new capabilities to better understand these new trends, and address the above, will become better positioned to make the right choices when navigating the volatile waters of uncertainty now and in the future. Because whether it is a pandemic, geo-politic, energy or climate crisis the key to tackling it is the same - to better understand it and its impact on my business.

Understanding the risks

First there are the physical risks mentioned earlier – storms, floods, droughts and wildfires that can cause devastation and a surge in insurance claims. These are specific to geographic location, industry segment and specific to the business model of each firm.

It’s not just about the severe weather though. The slow rise in temperature may be imperceptible but the effects are being felt in a number of industries, from agriculture through manufacturing to tourism.

Then there’s transition risk. As we move towards a low-carbon economy, firms will need to mitigate the impact of government policies, such as carbon pricing. Banks offering 10-year loans to automotive manufacturers must ensure the company has a robust plan in place for when the UK’s ban on the sale of petrol and diesel cars comes into force in 2030.

Lastly there is stringent regulation around climate risk management and reporting, that businesses must comply with. For example net zero is now enshrined in UK law and the country’s largest businesses are required to disclose their net zero transition plans alongside their ‘climate-related risks and opportunities’ identified along the way.

Of course, every strategy and decision around climate risk must stand up to the scrutiny of regulators, investors and the public, who take a dim view of ‘greenwashing’ – which is the practice of companies claiming to be doing something environmentally sound when this isn’t really the case or it’s only having a superficial impact. It’s no longer about putting solar panels on buildings; companies need to understand the carbon footprint of their investment and customer portfolios – what are they enabling and what are they preventing?

And for exactly that reason the recent disclosure requirements will require that results of the above activities will have to get a stamp from the external audit.

New stress tests & forward looking analysis

With both the European Central Bank (ECB) and Bank of England stress testing the industry, financial institutions will need to satisfy the regulators that they can survive the impact of climate change and prove they have robust processes in place to thoroughly assess that.

And technology can play an important role in this, according to the Bank for International Settlements which says that a company’s ability to ‘identify, assess and manage’ climate risk largely depends on the ‘maturity of its underlying infrastructure’ – and that means having the capability to deal with large amounts of data.

As mentioned previously, every decision carries the risk of unintended consequences on the environment but also on capital, growth, risks, profitability and reputation. Pulling investment from one sector may bring environmental benefits yet expose the company to risk elsewhere, which is why data is so important in helping choose the optimal path.

Advanced analytical capabilities can allow firms to manage and process more data and run more simulations and ‘what-if’ scenarios to better understand the impact of climate risk and net zero decarbonisation on their KPIs, and ultimately identify the optimal portfolio and strategy decisions going forward.

Saying ‘we don’t have the data’ won’t cut it

Lack of data is a big challenge – but regulators are clear that while building models based on insufficient data is a risk, the risk to businesses of taking no action is even higher.

Although historical data is often lacking, we can expect vast amounts of new data to become available in the coming years with the new sustainability & climate disclosure regimes being adopted across the globe. The new disclosures corporations are preparing to release will contain a lot of new valuable insights and financial institutions should start preparing how to collect and process in the most efficient and timely manner.

To fill in the data gap, some banks are sending qualitative surveys to their corporate customers, collecting missing information manually. In the meantime, their analytical models will need to rely on expert-judgement, which creates exposure to Model Risk that will have to be properly managed.

At the same time there are emerging climate data providers offering for example carbon footprint data, and analytical models that simulate the impact of a company’s carbon footprint if there is a lack of data. To integrate all the above with existing customer and credit risk data will not be trivial, especially for large institutions.

According to a recent study data integration is the biggest challenge to climate risk analysis.

Making sense of the data

Financial Institutions need to think now about what technologies they need to process all this data, in particular the unstructured information. Advanced text analytics is increasingly being deployed to help find the information needed within data coming from various sources, formats and reports.

Advanced location analytics will help to map risk based on where businesses are located and how different industries perform there. Even if a company headquartered in a highly-regulated country like the UK might have a low carbon footprint, and therefore be deemed a low-risk investment option, its suppliers and subsidiaries in other countries may not share the same credentials.

Banks can nowadays deploy such advanced capabilities quicker than ever before as these are becoming increasingly available directly via the cloud where also large amounts of data and calculations can be executed much faster compared to the traditional on-site infrastructures.

Linked to all the above are the risks around the models themselves, which are new, lacking the input data, often highly complex and thus should require strict governance and supervision. Firms must continually evaluate the accuracy of these models and whether they’re over-reliant on them.

Along with the technical advances, we’re also seeing greater collaboration in the industry through organisations such as the Global Data Consortium, which is sharing data and benchmarking models. Climate change risk is complex, and the more firms are able to pool knowledge and share the learnings of others, the better.

Parting thoughts

Climate risk and net zero represent additional use cases and are a logical extension of existing analytical capabilities already in use by financial institutions around the world.

However, the challenges that come with these new developments will put extra pressure on existing processes and infrastructure. Accordingly, institutions with legacy systems and/or fragmented application landscapes will face greater difficulty responding to these challenges in an efficient and effective manner.
And the good news? Financial institutions can leverage today’s climate risk and net zero imperatives to modernise and automate their processes and analytic capabilities, and deploy and leverage them also for other business-as-usual activities.

Ultimately, institutions that can better analyse the impact of various alternative future scenarios and management actions on their customers and portfolios will be best positioned to make smarter, impact-aware decisions. And, in that, they’ll be better prepared to navigate the inevitable uncertainty ahead irrespective whether it is caused by macro-economic, pandemic, geo-political or climate crises.