Climate change leads to considerable financial risks, many of which are still insufficiently priced in risk management processes. Governments, central banks, and regulators are therefore increasingly concerned with climate risks and green investments.
The Paris Climate Agreement prominently places the role of the financial sector in achieving climate goals. In line with the goals of limiting global temperature rise (Art. 1a) and promoting resilience to climate change (Art. 1b), the third step in Article 1c emphasizes the significant steering power of the financial sector for the transformation of the economy.
According to the latest scientific findings on climate change
Which were presented in the IPCC report of 2018, even global warming of 2 ° C has devastating effects on people and the environment. The report confirms the urgency to limit anthropogenic climate change to 1.5 ° C if possible. The IPCC estimates that we still have an economic cycle, around 12 years, to do this.
In order for the financial sector to be able to use the steering power of the inherent intermediary function in this sense, it is important to ensure a long-term and holistic orientation of the financial sector in the risk and opportunity considerations of investment decisions.
However, the financial sector not only has leeway, but it is also affected by climate change and is facing new and previously unpriced climate-related risks.
Climate change leads to consider climate risks
In 2019, environmental risks dominated for the third year in a row in the Global Risks Report of the World Economic Forum. The consequences of environmental degradation and climate change are therefore one of the greatest threats to the global economy. Although the risk experts’ judgment is clear, financial market players often do not understand them adequately and price them accordingly.
On the one hand, this is due to the fact that global financial markets are increasingly short-term, but that climate change is a long-term phenomenon. Mark Carney, governor of the Bank of England, calls this in his groundbreaking speech “The tragedy of the horizons”.
On the other hand, there is a lack of knowledge about climate risks and the necessary data, tools, and capacities to manage them. Ultimately, the support of the responsible management level in financial institutions is often lacking.
The Expert Commission Task Force on Climate-related Financial Disclosures (TCFD) of the G20 Financial Stability Board published its recommendations to companies and financial institutions for uniform climate reporting and dealing with climate-related risks. Among other things, the TCFD recommends the use of environmental scenario analyzes for the identification, measurement, and management of precisely these risks when dealing with climate risks.
Current risk management is based on retrospective approaches that use past data. However, as the global climate is currently changing with unprecedented intensity and frequency, dynamic and forward-looking approaches to risk management are recommended.
The environmental scenario analysis considers material climate and environmental risks and chances over short, medium and long-term time horizons in alternative plausible future conditions such as in a 2 ° C scenario, a 3 ° C and a 5 ° C Scenario.
Physical and transitory risks of climate change
The effects of climate change on the financial system are divided into physical and transitory risks. Physical risks include climate-related, geological and ecosystem risks such as extreme weather events, earthquakes or the extinction of insects. Transitional risks are the risks that arise from new laws, technological innovation and changes in mood.
Physical risks materialize above all in scenarios with strong global warming; transitional risks, especially in those scenarios in which climate change is successfully contained. Investing in green is worthwhile because both types of risk are reduced for the individual credit institution.
The question of sustainability in the financial sector, therefore, goes far beyond considering reputational risks and marketing strategies. Climate-related risks are financial risks. Equity rules could take this into account soon.