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The impact of climate change is being felt more than ever across different sectors and regions. The financial implications arising from it have been acknowledged by regulatory bodies and governments across the globe and the need to mitigate it. In 2015, the Financial Stability Board (FSB) established the Task Force on Climate-related Financial Disclosures (TCFD) to develop recommendations for more effective climate-related disclosures to promote more informed decisions and exposures to climate-related risks and is applied by the Financial Conduct Authority (FCA) to UK regulated entities. US regulatory body, Securities and Exchange commission (SEC) has proposed rule changes that would require companies to include certain climate-related disclosures in their registration statements and periodic reports. Both initiatives aim to ensure transparency and help investors assess the financial implications of climate risks and opportunities. There are various other global policies and frameworks that help address and mitigate the impacts of climate change. Some of them include –
As part of Carbon Disclosure Project report 2018, 215 out of the 500 largest companies in the world could lose about one trillion dollars due to climate change. More than half of these risks were reported to materialize in the coming five years if not sooner. Meanwhile, 225 of these 500 companies reported climate-related opportunities, representing potential financial impacts totaling over US $2.1 trillion. The majority of this was driven by potential new revenue due to the growing demand for low emissions products and services, as well as the potential for a better competitive advantage with shifting consumer preferences. The report suggests that the potential negative impacts of climate change outweigh the costs to mitigate them, and that there are significant opportunities to be realized.
The different kind of climate risks include -
Climate Risk Impact
Climate risks can significantly impact various financial intermediaries as highlighted below -
Investors:
Both these risks (physical and transition) may impact the returns of the main asset classes – equities and bonds – at the broad market and individual security levels. As such, climate change may lead to reduced investment returns as physical and transition risks lead to higher costs and reduced revenues for many companies, although impact would differ based on the sector and geography of operation.
Companies:
Physical risks including flooding and extreme weather events which damage assets and disrupt business operations pose the greatest risk now and in the future. The level of disruption to business operations will depend, in part, on the resilience of local infrastructure including energy, transportation and telecoms. The knock-on impacts of severe weather include disruptions to supply chains and distribution channels, and impacts on staff, leading to lost business and reputational damage.
Regulators:
The unique characteristics of climate risks mean that their capture by capital frameworks requires a more forward-looking approach than used for many other risks. Scenario analysis and stress testing will play a key role in this. Regulators, including the Bank, need to focus on the development of these frameworks and how they can inform capital requirements.
Climate Value at Risk has emerged as a valuable new tool for assessing and managing climate related risks, providing quantitative insights that support informed decision making, risk mitigation, regulatory compliance and sustainable investing practices.
Climate Value at Risk (C-VaR): Overview
C-VaR is a concept that extends the traditional financial metric Value-at-Risk (VaR) to assess the potential financial losses associated with climate related risks i.e. a measure of possible financial implications of climate-related risks and opportunities, under a range of possible scenarios.
It considers factors such as physical risks and transition risks associated with climate change that helps investors, businesses, policymakers to understand the financial implications of climate relate events and take proactive measures to manage and mitigate these risks.
The C-VaR metric expressed as a percentage change from a portfolio’s current valuation, in general evaluates how an investment portfolio could be influenced by climate policy risk and climate physical risk(extreme weather) and benefit by a low-carbon technology transition although from a scenario point of view, it is beneficial to understand relative risks than absolute, as the absolute risk number alone would not communicate risk clearly, without the relative context.
C-VaR Calculation
C-VaR calculation is complex and evolving field and should involve below factors (among others)-
Estimated Value at Risk of Portfolio is 8.06% lower than the Benchmark -
*Above Sample values in % and not directly from climate data related vendor output. The above illustration shows the Climate VAR of a portfolio as compared to its relative benchmark, where the Climate VAR value shown is an aggregation of the Physical Risk and Transition Risk components, for the 1.5-degree Orderly Transition scenario. The Physical Risk and Transition Risk components are the functions of the individual holdings of the funds aggregated up to the portfolio level.
C-VaR Opportunities –
Opportunities related to climate risk arise from need to adapt to and mitigate the effects of climate change. These opportunities span multiple sectors and can offer significant benefits for Investors, companies, regulators, or society at large. Here are some of the key areas where opportunities exist
Asset Managers:
Conclusion
The C-VaR represents an important milestone for financial institutions in navigating the complex landscape of climate related risks and opportunities. A key pillar around the C-VaR framework is the availability of high-resolution, high-frequency and granular data and coverage. By integrating climate risk assessment into their financial models and risk management frameworks, institutions can proactively identify, measure, and mitigate potential impacts. This enhances resilience to climate-related shocks and positions them for long-term value creation and sustainability.
References-
This content is provided by an external author without editing by Finextra. It expresses the views and opinions of the author.
Ugne Buraciene Group CEO at payabl.
16 January
Ritesh Jain Founder at Infynit / Former COO HSBC
15 January
Bo Harald Chairman/Founding member, board member at Trust Infra for Real Time Economy Prgrm & MyData,
13 January
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