Financial risk, climate change and ground hazards

16th November 2020

Part One - A Changing Climate

A top-down approach

In his speech, announcing the June 2021 launch of the Climate Biennial Exploratory Scenarios (BES), Governor of the Bank of England, Andrew Bailey, acknowledged the Covid-19 pandemic as a stark reminder of the shockwaves a crisis can send through the economy and acknowledged that the risks from climate change are far greater. This difference, he hopefully offers, is that unlike Covid-19 we know climate change is coming and have a window of opportunity to identify, manage and resolve the financial risks ahead.

It’s a sentiment mirrored by Sarah Breeden in her speech earlier this year, where the Bank of England’s sponsor on climate change signalled their intention to move beyond the rhetoric on climate change and into action. The 2021 Climate BES, confirmed this week, represents the first step towards that action and will test the UK’s biggest banks, building societies and insurers resilience to climate-related financial risks.

Whichever path we take climate change creates financial risks

Returning to the rhetoric is important to understand the nature of these risks. According to the Bank of England’s (SS319) Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change published in April 2019, they present as physical and transitional risks. Physical risks arise through weather events and longer-term shifts in climate, while transition risks are those that arise out of the process of adjusting towards a low-carbon economy. Adopting new climate action policies and adapting society to these changes all create significant risks, such as stranding assets and impacting pricing, demand, and supply chains.

Climate change presents a complex challenge, for example, our models can only project scenarios of what may come, they cannot predict for certain the climate of the future. These uncertainties pose a huge problem for financial institutions and policy makers as they try and wrestle with likelihood vs impact. What does appear clear is that our governments are committed to taking action. Last year, the UK government made a commitment to a net zero economy by 2050 and in November 2020, Boris Johnson set out a new ten point plan on climate action. This plan included several measures to reduce the impact of climate-related physical risks, however, inevitably increasing the number of transitional risks that financial firms will now need to identify and manage. Much like climate change itself, the future of financial risk is a finely poised balancing act.

Physical risks are even more complex

Physical risks can arise through acute specific weather events like floods, droughts or storms or chronic longer-term shifts in climate like rising temperatures and sea level rise, and could be more or less severe, dependent on the emissions path we take in the future.

The best guide available for projecting how weather and climate will change in the UK relating to this path is the UK Climate Projections (UKCP18) from the Met Office. Under all scenarios the number of severe weather events and the long-term trend of average temperatures and sea-levels are expected to rise, inevitably increasing both macro- and micro-scale physical, financial and legal liabilities for our society.

Banks, building societies and insurers, who are responsible for generating wealth and creating economic stability by understanding financial risks, now need to identify and manage a wide variety of new physical risks that threaten the future of our economy and society. Physical risks associated with climate change will manifest in a number of ways and will require a step change in financial firms understanding of risk, with knowledge of a number of different disciplines across climatology, meteorology, geology, soil science, hydrology and more. These complex and niche scientific disciplines will need to be translated into real-world impact and become embedded in the way financial institutions and policy makers come to decisions in the years ahead.

The concept of financial risk is being redefined by these ever-more complex physical and transitional risks. Financial firms will now look beyond traditional risk horizons of product policies to understand how their balance sheets will respond to our changing climate and following Andrew Baileys speech this week, they will need to do it in 2021.

Stay tuned for part two of this six-part series of short-reads later this week, to learn more about the challenges and the importance of managing climate change, how uncertainties in emissions scenarios and physical risks can be resolved and why it isn’t just the financial firms that need to be aware of the changes inevitably coming around the corner.

To find out more about the National Ground Risk Model (NGRM): Climate™, please get in touch.

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Image: Drone photograph of marshland in Wales.

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Blog written by Tom Backhouse

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