Ch06_SCR 2022 Sustainability and Climate Risk Exam.pdf

Climate Risk Measurement and Management Mf Learning Objectives After completing this reading you should be able to: @ Identify approaches to measuring climate-related risks and the available metrics and tools. @ Explain how climate risk can be incorporated into existing Enterprise Risk Management (ERM) frameworks. @ Understand both why and how climate risks are different from other risk types. © Describe the basic risk types: operational, credit, @ Explain how climate change could be incorporated into the different aspects of risk management, such as risk identification, measurement, and monitoring. liquidity, insurance underwriting, market and sover- eign risk. © Describe how climate risk can be incorporated into risk governance frameworks, risk appetite statements, @ Identify the standard tools and techniques for measur- ing, modeling, and managing the basic risk types. and risk culture. © Describe the Climate Value at Risk (CVaR) framework. Understand the climate risk implications for corporate culture and governance. @ Understand how existing tools and techniques can be applied, adapted, or amended to incorporate climate Evaluate the rationale for the different types of cli- risk. mate models and explain the justification for the models’ varying levels of certainty. 109 * This chapter describes how climate risk is measured and managed, covering both types of climate risk, physical and transition (as described in Chapter 3). After an introduction, this chapter covers in detail how climate risk transmits into more traditional risk categories at the company level, including operational risk, credit risk, liquidity risk, and underwriting risk. It then covers how climate risk can be a systemic risk with potential threat to financial stability, transmitting either through one of the previously mentioned chan- © Corporate scope. The emissions), and Scope * tion risks, building on material from Chapter 3. Finally, Understanding transition risks requires data beyond current emissions, notably on emission trajectories, as well as data on a number of drivers ranging from policy and technological changes to consumer preferences and effects on countries (sovereign risk). analytical tools for measuring both physical and transi- greenhouse gas emissions are classified by classifications are as follows: Scope 1 (direct Scope 2 (emissions from energy inputted) 3 (indirect emissions from supply chains and products). nels or through market dislocations (market risk) or The chapter goes on to describe available data and Climate risk can also constitute a systemic risk and a potential threat to financial stability through its impacts ‘on entire sectors and swathes of the economy. market sentiment. © Physical risks can be analyzed at the asset level, or, for ease of use, through company-level scores. Asset-level analysis is more thorough but also more difficult; scores this chapter examines how climate risk can be, and is are easier to use and integrate but can sometimes suffer being, integrated into existing enterprise risk man- from methodological opacity or lack of cross-comparability agement (ERM) processes, ranging from governance structures and strategy setting to risk evaluation and disclosure. The material in this chapter sets the stage for Chapter 7, which builds on these topics by looking specifically at the application of scenario analysis to climate risk management. Chapter Outline 6.1 Introduction to Climate Risk Measurement and Management 6.2 Introducing Climate Risk Transmission: Micro and Macro Level 6.3 Company-level Climate Risks: Transmission Mechanisms 6.4 Climate as Systemic Risk and Financial Stability Risk 6.5 Climate Risk Measurement: Data and Analysis 6.6 Climate Risk within Enterprise Risk Management (ERM) Key Learning Points © Measuring and defining climate risk is a prerequisite for being able to manage it—even more acutely so than for many other kinds of risks. © Climate risk affects many company-level risks, including operational, credit, liquidity, and underwriting risks. 110 ™ Sustainability and Climate Risk Exam between providers. © Climate risk can be integrated into enterprise risk management in all its facets. This includes risk governance, strategy, risk assessment, review, and disclosure. CLIMATE RISK MEASUREMENT AND MANAGEMENT 6.1 Introduction to Climate Risk Measurement and Management Risk management is a structured approach to monitoring, measuring, and managing exposures to reduce the potential impacts of uncertain occurrences, and it has long been practiced by non-financial corporations and financial institutions alike. Climate risk affects corporations and port- folios in various ways. As with other kinds of risks, climate risk management, when practiced proactively, can help to mitigate the impacts of climate change, both from physical impacts and transition impacts, on a financial institution's portfolio or corporation's operations. To understand and manage climate risk, it is helpful to examine how climate risk affects various types of financial risk, such as operational, market, insurance, liquidity, and credit risk. This is not only because risk managers are more familiar with these “traditional” categories of risk, but rather it is because climate change transmits through these various types of risk, so understanding these transmissions channels greater variety of data is often required. Understanding transition risk not only requires solid data on the amount of greenhouse gas emissions attributable to a particular com- is helpful. For analytical clarity, this chapter starts by looking pany or asset but also an understanding of the evolving cli- at company-level “micro” climate risk transmission (Section mate policy landscape, technological changes, and evolving 6.2) and then goes on to discuss climate change as a macro phenomenon, with the potential to be a source of systemic risk and pose a threat to financial stability (Section 6.3). consumer and broader societal preferences, as well as mar- The old cliché that “You can only manage what you can as information on physical geography, adaptive infrastructure, market responses, cross-correlations, and distributions measure” is just as true for climate risk as it is for other types of risk, though compared to other types of risk, a ket sentiment. Understanding physical risk requires forward- looking climate models and historical weather data, as well (see schematic for an example, and Section 6.4 for details). EXAMPLE: DATA FOR UNDERSTANDING PHYSICAL RISK TRANSMISSION INTO FINANCIAL PORTFOLIOS This example, a generalized version of the transmission In jurisdictions where mortgages tend to be retained chain of physical risk into financial assets, as presented on bank balance sheets, banks need access to this for the US mortgage market in Chapter 3, highlights the different types of data and information needed to account for climate risk in a financial context, to information to track their risk exposure and conduct risk management. In jurisdictions such as the United States, where mortgages tend to be securitized and sold measure it, and then manage it. Weather and climate onwards in financial markets, this adds an additional hazards; topographical maps and geolocation data to layer of complexity. Ultimately, end investors need access to climate risk exposure data to be able to data and models are needed to understand the physical understand exposure; and data on flood defenses and adequately gauge the riskiness of their holdings. other adaptive measures to understand vulnerability. Source: Author. = Weather data "Climate models/projections "Empirical data on price effects of sea level exposure Geographic in portfolio Duration of variation ‘COASTAL PROPERTIES Greater risk of current, future flooding Topographical maps ™ Data on flood defenses Chapter 6 Climate Risk Measurement and Management M 111 6.2 Introducing Climate Risk Transmission: Micro and Macro Level households can be impacted by property damage, business interruption, loss of income, changes in demand, and falls in Climate risk drivers can transmit to financial risk through can be affected by shifts in prices, changes in productivity, socioeconomic changes, or labor-market frictions. These asset valuation through asset stranding. The macroeconomy a number of risk types, ranging from operational risk and credit risk to market risk. This section contextualizes the classification of these risks before the transmission channels are covered in much more detail in Section 6.3 and Section 6.4. can then cause financial risks to manifest. However, the micro- and macroeconomic split, with financial risk relegated to a separate category, de-emphasizes the Many classification schemes of climate risk transmission channels come from central banks (and umbrella organizations made up of them, such as the Basel Committee for Banking Supervision or the Network for Greening the Financial System). Given these institutions’ focus on the health of the macroeconomy, including maintaining price stability and employment, their schemes distinguish between micro- economic, macroeconomic, and financial consequences and drivers (see graphic). The NGFS schematic clearly shows how both transition and physical climate risks can cause microeconomic and macroeconomic effects. At the micro level, individual firms and effects on the broader financial system, notably to financial stability, as well as any feedback effects between the economy and the financial system. Due to this chapter's focus on corporations, both non- financial and financial, with less emphasis on households or ‘on the macroeconomy, Section 6.3 focuses on companyspecific risks, whereas 6.4 combines macroeconomic risks with systemic risks and those that potentially threaten finan- cial stability. The following section focuses on six main risk categories, some primarily at the company level, some primarily affecting markets, and some at the macro level. The summary table below highlights these risks, which are then analyzed in greater detail in the following sections. Environment- and climate-related risks Transition risks Micro 'e Policy and regulation Affecting individual businesses and households '* Consumer preferences Households ‘* Property damage and business + Loss of income (from weather disruption from severe weather disruption and health impacts, ‘* Stranded assets and new capital labour market frictions) expenditure due to transition ‘* Property damage (from severe weather) or restrictions (from ‘© Changing demand and costs low-carbon policies) increasing + Legal liability (from failure to mitigate or adapt) costs and affecting valuations Physical risks © Chronic Macro Aggregate impacts on the macroeconomy ae ee aan Sais) 4 ee ee Rote eines and wildfires) «© Capital depreciation and increased investment «© Shifts in prices (from structural changes, supply shocks) ‘© Productivity changes (from severe heat, diversion of investment to mitigation and adaptation, higher risk aversion) «Labour market frictions (from physical and transition risks) * Socioeconomic changes (from changing consumption patterns, migration, conflict) ‘* Other impactson international trade, government revenues, fiscal space, output, interest rates and exchange rates. Environment & climate and economy feedback effects Economyand financial system feedback effects Reprinted with permission of the Network for Greening the Financial System. 112 M@ Sustaina ility and Climate Risk Exam Financial sytem contagion Businesses * Technology development Risk Type Operational risk ro-level: How do climate risk drivers cause company-specific climate to cause systemic / Risk Metrics risks? financial stability risk? * Physical risk leading to more frequent, LIMITED—Only under a spe- more severe extreme weather can cific set of circumstances, such Proportion of facilities in risky areas © Level of company preparedness Macro-level: Potential for as where a sector has high geographic concentration cause property damage and business interruption, both to a business’ own. facilities and to supply chains. Heat can also affect worker productivity. Transition risk can transmit to operational risk in case of abrupt policy changes leading to facility shutdowns. Credit risk © Probability of default (PD) ; * Loss given default (LGD) © Exposure at default (EAD) | Physical risk causing property dam- | SIGNIFICANT—Sector-wide age and business interruption can asset stranding or changes lead to loss of revenues and lower _| profits, worsening a firm’s financial __| position and increasing probability of. | default. Transition risk causing asset strand. | ing can worsen a firm’s financial in demand can impact sector revenues and increase sector-level PD, posing financial stability risks in the case ofexposed important sectors and for financial institutions. position, increasing its probability of default, and increasing the loss given default for a lender given the lower asset valuations. Liquidity risk * Loan to deposit ratio _| Abrupt physical and transition (banks) * Liquidity ratios © Bid-ask spread (markets) risk-related events such as natural disasters or abrupt policy changes can prompt sharp repricing and sudden market re-evaluation of firms’ viability, leading to liquidity shocks. SIGNIFICANT—A “climate Minsky moment” could cause abrupt and wide enough repricing and dislocation to constitute a market liquidity shock. This can lead to widening of bid-ask spreads. Abrupt climate events can prompt large demand for deposit withdrawals at banks, raising their loan-to-deposit ratios. insurance risk * [Change in] insurance premiums * Availability of insurance Physical risk can lead to higher insur- SIGNIFICANT—If a number ance premiums for corporations, of insurers withdraw or refuse coverage, this might leave firms completely without cov- or, in more severe cases, for certain facilities in extremely vulnerable areas to become uninsurable, with no erage, potentially amplifying insurance available. risks to financial stability. Transition risk can lead to less insurance availability, as some insurers refuse to underwrite certain kinds of activities and facilities, such as ther- mal coal power plants. (continued) Chapter 6 Climate Risk Measurement and Management ® 113 Risk Type Market risk Risk Metrics * [Weighted average] carbon intensity © [Climate] Value at Risk ° Portfolio risk scores Micro-level: How do climate risk drivers cause company-specific risks? Physical and transition risk can become more widely incorporated in asset prices, both through abrupt repricing as well as more gradually. Large-scale shifts in input and product markets affect non-financial corporations. Shifts in asset prices Macro-level: Potential for climate to cause systemic / financial stability risk SIGNIFICANT—Climate risk is expected to produce sector- and market-wide repricing of many if not most assets and commodities, causing dislocation and potential systemic risk. increase the risk of financial institu- Sovereign risk * * tions’ portfolios. Physical risk can cause countries MIXED—Many countries revenues from fossil fuels that are particularly vulnerable, such as Bangladesh, to have higher costs of damage and lower GDP growth, have diversified economies Vulnerability to physical and geographies, but some countries are heavily exposed hampering long-term ability to repay. to physical or transition risk climate risks Transition risk can heavily affect countries reliant on fossil-fuel produc- Proportion of budget and are likely to be severely affected. tion for a substantial proportion of GDP and of government tax revenue. 6.3 Micro (Company-Level) Climate Risks An important way in which climate risk manifests as financial risk is through its effects on microeconomic company-level risks such as operational, credit, liquidity, and insurance risk, each of which are examined in turn in this section. (some of these channels can also pose a systemic risk, which is discussed in Section 6.3 alongside other non-company-specific transmission channels). facilities in vulnerable locations (for external risk) and various measures of company preparedness. One of the strongest effects of climate risk on operational risk is through its effect on external risk. Acute climate change hazards, such as wildfires, storms, or floods, or chronic climate hazards, such as sea level rise, can damage or destroy the factories, supply lines, or warehouses needed by a corporation or the offices, data centers, or bank branches of a financial institution. However, unlike some definitions of external risk that consider events such as natural disasters to be ones that have negative impacts that 6.3.1 Operational Risk are beyond a given company’s control, climate models com- Operational risk is the risk inherent in doing business, and bined with detailed data can allow at least some degree of anticipation on what physical facilities will be affected by it reflects potential losses from inadequate or failed internal processes, systems, human error, or outside events such as these external risks. extreme weather or terrorist attacks. These various causes To the extent that climate risk transmits into operational of operational risk tend to be regarded as subcategories, systems risk, it does so in ways similar to external risk. Physi- and they include external risk (from outside events); systems cal climate hazards such as floods or fires can affect data risk; people risk (from human error); internal process risk; centers and other system infrastructure, thus causing sys- and legal, strategic, and reputational risks. ‘tems risk to a corporation or financial institution. Operational risk, being multifaceted, can be somewhat Climate risk can manifest through people risk in a few dif- harderto measure. But metrics include the proportion of ferent ways. Inadequate staff training or management ility and Climate Risk Exam attention toward physical and transition climate effects can category is strategic risk, where poor business decisions lead to these issues being ignored or underplayed within around failing to align business practices with the netzero transition or adapt to the physical impacts of climate an institution's operations, potentially leading to losses. Another way climate risk can become people risk is more direct—through the harmful effects of excess heat on worker productivity and acuity (see ILO research mentioned in Chapter 3). Transmission of climate risk into internal process risk is similar to that for people risk—if a bank's or other corporation's internal processes and procedures do not take sufficient account of climate risk, it can end up affecting portfolios and facilities more deeply than anticipated. Three other categories of operational risk are particularly important when analyzing climate risk. One of these cat- egories is legal risk. As described in much greater detail in Chapter 3, legal and liability risk can end up significantly affecting financial institutions and non-financial corporations if they are held liable for a) neglecting to manage climate risks, b) failing to adequately disclose their exposures to such risks, or c) contributing to climate change. Another VISUALIZATION OF CLIMATE SUBCOMPONENTS change can cause significant risks compared to competitors that do mitigate and adapt. And the third category is reputational risk, which can severely affect institutions working with “dirty” industries that come to be seen as having lost their social license to operate (see the example on Goldman Sachs in Chapter 3). 6.3.2 Credit Risk Credit risk measures the creditworthiness, or ability a borrower has to pay back, a loan. Key metrics for gauging credit risk, especially for banks, include the probability of default (PD) and the loss given default (LGD) (i.e., the proportion of value recovered after a default). The third key metric used under the Basel supervisory framework for banks is exposure at default (EAD). We focus primarily on PD, as this is the most general measure of credit risk and it is applicable beyond banks (e.g., to AFFECTING OPERATIONAL RISK AND ITS Increased temperature and heatwaves More frequent floods, storms, hurricanes Abrupt policy shifts Chapter 6 Climate Risk Measurement and Management ® 115 Impact of climate transition risk Distribution of asset value of a borrower L, Original PD Reprinted with permission of the United Nations Environment Programme. bond markets). LGD is expected to be highly sector-specific and it requires high degrees of customization (UNEP funding. The asset stranding can be due to physical risk, Finance Initiative, 2018). In general, climate risk is expected to shift the entire PD risk distribution of a borrower (see resale value, or due to transition risk, if a company’s highemissions factory is hit with a regulatory shutdown mandate graphic, labeled for transition risk but applicable for all or a higher carbon tax. types of climate risk). such as a warehouse in a floodprone area with a much lower The oil & gas sector is a good example of a sector that has One important transmission channel from climate to credit been hit by the stranded asset transmission channel. His- risk runs through operational risk. A company whose factories, warehouses, or supply chains are particularly vulnerable to extreme weather impacts (physical risk), or indeed torically, much of the value of such firms has been in their to abrupt policy changes (abrupt transition risk), will have greater business interruption, resulting in a loss of revenues and profits. This weakens the company’s ability to repay loans compared to a similar company that is not exposed, thus translating into increased PD and increased credit risk reserves and the expectation of their consistent or growing revenues. The fact that many of these firms’ assets may become stranded and that oil demand is expected to fall means that these firms may become less creditworthy than they would in the absence of climate change. (Of course, there are still differences within the sector—for instance, oil for a lender. Project finance tied to a specifically vulner- companies with very low extraction costs on their reserves will tend to have a smaller proportion of stranded assets than able asset, such as a warehouse at risk of flooding, would companies with assets that are more expensive to extract.) be subject to even higher PD and LGD than the exposure of an entire company owning a mix of vulnerable and non- A final, related channel is that of pricing effects—both vulnerable assets. through markets for inputs (raw materials) and outputs (products). If climate risk causes a company’s raw materials Another important channel operates through valuation effects, that is, asset stranding (as covered in Chapter 3). If to become more expensive, or makes its products less valuable, this, too, can increase its credit risk. Pricing effects can a company’s core assets fall in value or even become worth- also work the other way and, in fact, reduce a company’s credit risk. Companies in the mining sector that extract minerals important for mass electrification, such as copper less, this significantly affects the financial health of the firm. With less valuable assets, a company’s liabilities suddenly weigh a lot heavier on its balance sheets and make it more likely that the company will default on future debts and that losses given default will be greater—not to mention that the company also has less collateral to use to secure ility and Climate Risk Exam for wiring or lithium for lithium-ion batteries, can benefit from the higher prices of these commodities, make greater revenues and profits, and be more creditworthy than they would have been without climate change. Policy considerations regarding the rise of credit risk due on Banking Supervision, 2021). This phenomenon could to climate risk are being increasingly incorporated by major credit ratings agencies, which serve as important arbiters of potentially affect other types of financial firms as well. For instance, if abrupt climate-related drivers prompt end inves- credit risk for financial markets. In January 2021, S&P, one of the three major rating agencies, revised its entire outlook on the oil & gas industry due to “[s]ignificant challenges and tors to want to liquidate their fund holdings at the same time as climate drivers are causing market dislocations, this could cause some asset managers to suffer liquidity risk. uncertainties engendered by the energy transition, includ- (Market dislocations are a more meaningful source of risk ing market declines due to growth of renewables,” and shortly afterward downgraded oil & gas firms ExxonMobil, Chevron, and ConocoPhillips by one step to “AA-" (S&P Global Ratings, 2021). through their macro effects and their effects on financial stability and the potential for “Minsky moments,” all of which are discussed in Section 6.4). The rise of sustainability-linked bonds and loans, as dis- For an individual non-financial company, liquidity risk only manifests as a consequence of climate risk under specific cussed in Chapter 5, can also be seen as an example of the circumstances. An acute climate-related event, such as a financial industry internalizing the linkage between credit risk and sustainability performance. Offering a lower rate major hurricane devastating a firm's operations and under- on a loan or lowering the coupon on a bond that an issuer must pay in return for meeting sustainability targets, as these instruments do, implicitly recognizes the corollary, which is that that performing worse in this respect raises credit risk. lining its lack of preparedness, or a fine imposed by authorities for non-compliance with carbon emissions regulations, leads investors and lenders to reassess their view of a firm’s viability so suddenly and abruptly that the firm has trouble accessing liquidity. However, under most circumstances and given the gradual pace of climate change, it is more likely that climate risk filters through to companies more gradually through increased credit risk rather than abruptly 6.3.3 Firm-Specific Liquidity Risk through liquidity risk. Increased investor awareness of risks, Liquidity risk is about losing access to liquidity—the ability to quickly and easily convert assets into cash. For banks, liquidity risk means something very specific, as banks’ business models are based on liquidity transformation: Banks take on short-term deposits and underwrite long-term loans. Key metrics for liquidity risk include loan-to-deposit ratios (specifically for banks) and bid-ask spreads (specifically for markets; also see Section 6.4.3). Because liquidity is of such paramount importance to banks, banks are also particularly affected by climate risk impacts on liquidity. Climate risk drivers can prompt depositors to draw down deposits and debtors to draw down credit lines at the same time, dramatically increasing (worsening) loanto-deposit ratios. Some empirical evidence suggests that this does occur due to physical climate risks, specifically in the wake of natural disasters, as households and corporations withdraw deposits and draw on credit lines to finance cash-flow needs for recovery. This combination puts pressure on banks’ liquidity and can lead to crystallized liquidity risks (Basel Committee and increasing manifestation of climate risk, leads to higher credit risk and thus higher cost of capital for a firm. 6.3.4 Underwriting Risk Although underwriting risk only directly affects the insurance sector, it is still important to single out as a type of risk affected by climate risk, especially physical climate risk, as many other corporations and financial institutions rely on insurance coverage as a crucial part of their risk-mitigation strategies. Key metrics to gauge underwriting risk from a corporation's perspective are changes in insurance premiums and the availability of insurance. The insurance industry itself uses a variety of metrics and models to arrive at estimates of the riskiness of the entities it insures, many of which are proprietary not the focus here. Insurance works best when a large pool of participants (motorists, corporations, homeowners, etc.) all have a small, and close-to-equal, chance of being struck by misfortune, and when these accidents or other losses follow Chapter 6 Climate Risk Measurement and Management M 117 predictable patterns discernible from historical data. The problem with climate risk, especially some types of physical available to individuals or corporations are on one-year renewal cycles, so insurers can pull coverage with relatively climate risk, is that the risks become so concentrated that short notice. the risk of underwriting affected facilities and properties in those areas can grow too high to be economical. Examples Climate transition risk, too, can affect underwriting risk. The include buildings in low-lying coastal areas subject to sea level rise and coastal flooding or buildings in wooded areas that are becoming drier and hotter due to climate change and thus more prone to wildfire, such as in California and parts of Australia. In areas such as these, climate risk is very concentrated geographically, and it is intensified as climate change progresses, with events that were previously rare, such as 1-in-100 year events, becoming much more com- policy, operational, and technological changes required for a transition to a net-zero economy could cause litigation against fossil-fuel companies or other emissions-intensive industries, which could then transmit into insurance through general liability or “directors and officers” (D&O) policies through which insurance takes on (at least part of) the finan- cial risks of a firm being sued. Underwriting-risk increases can also affect other types of mon. To provide just one example, the severe heatwave risk. For example, if a company can no longer obtain insur- in France and the Netherlands in 2019 was estimated as a ance coverage for physical damage, business interruption, 1-in-50 year event in the current climate, but it would be a or directors’ liability, it cannot use insurance as one of its 1-in-1000 year event (or even less frequent) in the absence resilience and buffer mechanisms, which further increases of climate change (Vautard, 2019). With further warming, the return period—the period during which such events operational risk. This, in turn, increases its credit risk from are expected to recur (50 years in the above example)—for these sorts of events will continue to decrease. For shorter return periods, for the insurer to break even the perspective of a lender. Indeed, it is unsurprising that in many cases, such as home or commercial property mort- gages, lending banks require insurance coverage as a condition of issuing a mortgage. would require very high premiums; for instance, a ten-year return period (i.e., a 10% chance of annual occurrence) of a total destruction event in a specific location would require an insurance premium of at least 10% of the value of the insured property. This level of occurrence is not outland- 6.4 Macro Climate Risk: Systemic Risk and Financial Stability ish for many physical risks. One study found that for an Because climate change, both through its physical impacts and policy and societal effects to mitigate emissions and extreme rain event in Texas equivalent in size to Hurricane achieve a zero-carbon transition, is such a broad phenome- Harvey (which flooded Houston in 2017), the annual proba- non, it can be a source of systemic risk and potentially pose a risk to financial stability. Generally, the risk types covered in Section 6.3 can have systemic effects if they occur bility of occurrence was 1% from 1981 to 2000; 6% by 2017, when Harvey occurred; and 18% by 2081 to 2100 under a worst-case climate scenario (Emanuel, 2017). An 18% probability of annual occurrence is the same as a return period economy—each of these is covered briefly in turn (Sections of just 5.5 years. 6.4.1-6.4.4). But there are also other categories of risk that Of course, larger insurers with diversified exposures can operate primarily at the systemic and/or macroeconomic and do cross-subsidize to an extent, but smaller, regional insurers without geographical diversity do not have that widely enough, and affect entire sectors or swathes of the level, such as market risk and sovereign risk. luxury. (Insurers can sometimes offload a portion of their 6.4.1 Operational Risk risk to reinsurers, but these firms are also becoming warier If physical climate impacts cause operational risk to manifest of taking on climate risk.) There are already some anec- across a range of companies, this can have ripple effects across supply chains and through to markets, customers, and financial counterparties. For operational risk to have this wide of an effect typically requires a particular set of dotal examples of smaller insurers, such as in California in areas hard-hit by climate-exacerbated wildfires, that have gauged the underwriting risk to be too high and have refused renewals to homeowners—most types of insurance 118 M Sustainal ility and Climate Risk Exam circumstances, such as geographic concentration and pinch points in supply chains. The climate change-exacerbated Thai floods of 2011, which significantly affected global semiconductor production and had ripple effects across supply chains, are a good example of the macro effects of operational risk. But they only had a macro effect because so many intermediate components for the global semicon- ductor manufacturers specifically came from Thailand. the maximum daily liquidity during the 2007-2009 financial crisis (Basel Committee on Banking Supervision, 2021). Another potential concerning source of systemic liquidity risk would be a “climate Minsky moment”. A Minsky moment, in general, is a sudden, major collapse of asset values. In 2016, Mark Carney, then Governor of the Bank of England, warned of the potential for a climate Minsky moment in the case of a wholesale, abrupt and broad-based re-evaluation of climate 6.4.2 Credit Risk risks by markets, causing massive repricing of assets and a pro-cyclical crystallization of losses (Carney, 2016). If severe enough, such a climate Minsky moment could provoke a Increased counterparty credit risk that results from climate change can directly transmit into the financial sector and pose a potential threat to financial stability if it occurs market-wide liquidity crunch not unlike the shock of the broadly enough. A lot of the climate risk drivers that can lead global financial crisis of 2008, perhaps even greater. to increased credit risk at an individual firm can affect entire sectors. In sectors such as utilities (for those still reliant on However, it is worth noting that large-scale dislocations and fossil power plants) or oil & gas, sector-wide asset stranding is expected to occur or has already occurred, which increases problem even if they do not occur suddenly enough to con- credit risk. Changing demand and cost structures resulting repricings resulting from climate risk are expected to be a stitute a Minsky moment and a liquidity shock. These kinds of market changes are classified under market risk rather from climate-related pressures can impact companies’ revenues and profits, as can physical climate impacts leading to business interruption, both of which can lead to widespread increases in credit risk. For financial institutions heavily than liquidity risk (see Section 6.4.5). exposed to these sectors, this can pose a risk to the financial institution’s soundness. If exposures run across the financial sector, increased credit risk at the company level can become Insurance risks, particularly the specter of uninsurability, in cases where the insurers deem climate risks to be too great 6.4.4 Insurance Risk a threat to financial stability. to underwrite, can have systemic effects. Even if insurers are acting individually to reduce their exposure to climaterelated risks, these actions, taken collectively, could have 6.4.3 Liquidity Risk negative consequences for the financial system as a whole. ‘As examined above, banks are also particularly affected by climate risk impacts on liquidity. Given the wide reach and potential severity of climate impacts, it is possible for liquidity risk to be a source of systemic risk to the banking sector and to therefore threaten financial stability. If enough households, corporations, and financial firms sharply increase their demand for precautionary liquidity after a severe natural disaster, this can be at a systemic enough scale to necessitate intervention by the central bank. A good example of the potential for this kind of course of If large numbers of insurers significantly increase premiums or completely withdraw their coverage of certain climate- related risks, this might leave households and firms without coverage, potentially amplifying the resulting risks to financial stability (FSB, 2020). 6.4.5 Market Risk At the systemic level, climate risk translates into market risk through repricing and dislocation effects as well as through events comes from the aftermath of the large Japanese earthquake in March 2011—admittedly not a climate- asset stranding. The repricing effect is an important channel through which physical or transition risks that are anticipated but not yet realized can more quickly and tangibly have an related natural disaster, but comparable to one. After the impact on asset prices, whether they are physical assets such shock, the Bank of Japan (BoJ) had to offer record amounts as housing or financial assets such as shares and bonds. The of liquidity to Japanese banks to ensure stability in the markets: On the first business day after the earthquake, the research by Bernstein and co-authors cited in Chapter 3 shows how sea level rise and coastal flooding risk transmits BoJ offered funds totaling 21.8 trillion yen, nearly three times into, and is reflected in, US coastal property prices today, Chapter 6 Climate Risk Measurement and Management M 119 with discounts ranging from 14.7% for properties exposed at or the climate version thereof, climate VaR (see box). Other 1 ft (0.3m) of sea level rise to 4% for properties exposed at metrics are useful for individual institutions to gauge their own exposure to climate-related market risk, such as the 6 ft (1.8m) (Bernstein et al., 2019). Of more concern to most market actors, however, are quicker, more abrupt pricing shocks and increased volatility. These are reflected in key metrics such as Value at Risk (VaR), CLIMATE VALUE weighted average carbon intensity of a portfolio, which is a proxy for transition risk exposure, or portfolio-level physical risk scores (see also next section, Section 6.5). AT RISK (CVaR) Standard Value at Risk is a metric for quantifying the adapted by at least one data provider to look specifically level of financial risk in a firm, a portfolio, or a given at climate risk. investment, and it is meant to give an estimate of a bad outcome. A standard way of calculating VaR is to take an estimated profit-and-loss probability density curve of an investment or portfolio and then look at the lowest MSCI, a data provider, sells a commercial tool called 5% of the distribution to estimate tail risk. VaR is useful for its cross-comparability across different types of investments, although it is sensitive to the data used to construct it—for example, if constructed using data from a period of low volatility, the probability distribution can be unrealistically “optimistic” and even the 5% cutoff does not show a particularly significant loss. Because of its relation to market volatility, however, VaR is one of the best metrics of market risk and has therefore been 8 a 3 a “Climate Value at Risk,” which, like standard VaR, is meant to capture a rough estimate of climate-related financial losses. While the MSCI methodology is proprietary, the firm does disclose that it includes both transition and physical risk as well as economic data and company-level data. Climate risk, on both the transition and physical side, is calculated as a combination of hazards, vulnerability, and exposure that is converted into monetary amounts using a financial valuation model. Aggregated at the sector level, CVaR shows that construction, coal, and electrical utilities are the most exposed to a combination of physical and transition risks. Climate VaR spread by primary sectors of activity Construction Materials | ___l@ | | _, eu Coal Electricity Utilities -——-e44 Gas Distribution ° Other Services e Health Care Services ———e} Oil and Gas —_e—_—_——— Travel and Leisure ie ‘Consumer Services © Pulp and Paper —e——— 100 -75 50 -25 0 25 50 75 100 Aggregated Climate VaR [%] © 2020 MSCI ESG Research LLC and reproduced by permission of MSCI ESG Research LLC; all rights reserved. The MSCI ESG data contained herein is the property of MSCI ESG Research LLC, its affiliates and/or information providers (“MSCI ESG”). MSCI ESG make no warranties with respect to any such data. The ESG data contained herein is used under license and may not be further used, distributed, or disseminated without the express written consent of MSCI ESG. 120 © Sustainability and Climate Risk Exam Climate risk drivers, both physical and transition risk, can reveal new information about future conditions, precipitat- composition of their economies; capacity to create adaptive ing downward price shocks and increases in market volatil- policies and responses to climate change; debt accessibility and affordability; and specific policy decisions. Moody's, the ity in traded assets. It is also possible that climate risk could credit ratings agency, came up with a physical risk method- lead to a (partial) breakdown of typical correlation pattern ology for sovereigns as early as 2016 and found that India, between assets, reducing the effectiveness of hedges and challenging banks’ abilities to actively manage their risks. Pakistan, Vietnam, Cambodia, and much of Central America The empirical evidence, while mixed, suggests that climate risk is not yet priced into many asset classes (Basel Committee on Banking Supervision, 2021). As and when climate risk drivers become priced in, it is likely that there will be less potential for unexpected price movements or volatility. Climate risk incorporation into asset prices might also reduce risks to financial stability. That said, it may also end up serving to illustrate that risks are concentrated in certain parts of the financial system, and sub-Saharan Africa was most vulnerable. Academic research from Buhr et al. (2018) has demonstrated empirically that countries with higher exposure to physical climate vulnerability do face a higher cost of capital, by up to 1.17 percentage points (Buhr, 2018). As for transition risk effects on sovereigns, discussions are mostly still centered on countries’ reliance on fossil fuel and other carbon-intensive exports. For instance, as tighter climate policies, new technologies and preference changes which could in fact increase the threat to financial stability, reduce the demand for fossil fuels, this may turn states heavily reliant on fossil fuel exports into “stranded nations” particularly if it triggers amplifying behaviors among finan- (by analogy to stranded assets). If this occurs, fossil-fuel cial institutions (FSB, 2020). reserves become commercially unattractive to extract and It is also important to note that even if abrupt repricing has been relatively infrequent so far, this is partly due to the insufficiency of both governments’ and companies’ actions for reaching commitments such as the Paris 2°C target. Many experts expect much more severe repricing and market risk in the years ahead as climate policy tightens. For instance, the Principles for Responsible Investment has a project called the “Inevitable Policy Response,” which assumes that as the realities of climate change become increasingly apparent and urgent, governments, firms, and others will be forced to act more decisively, potentially in quite a rapid, abrupt, and disorderly way. This, in turn, could have important implications for financial markets and trigger repricing on much larger scales. (Note that deeper analysis of different outcomes necessitates scenario-based analysis, which will be covered in Chapter 7.) a substantial share of national wealth may permanently lose its value, leading to a massive drop in sovereign creditworthiness and a corresponding increase in sovereign risk (Manley, 2017). A scenario-based study using modeling to look at the medium-term impact of climate on countries’ GDP per capita, GDP growth, and debt ratios, and thereby their sovereign credit ratings, predicted that 63 nations will experience a drop in credit rating by 2030 without emis- sions reductions (Klusak, 2021). 6.5 Climate Risk Measurement: Data and Analysis Accurately gauging transition and physical risks requires multiple types of data as well as appropriate analytical tools to understand their application to the user's needs (see also Section 6.5 and Chapter 7). Transition risk requires, first and foremost, accurate asset-level and company-level data 6.4.6 Sovereign Risk The transmission of climate risk into sovereign risk is examined here separately due to the unique considerations involved. On physical risk, evaluating a country starts, as with a company, with geographical exposures, such as the on greenhouse gas emissions but also data on policy landscapes, technological changes, and consumer preferences to capture the various drivers of transition risk as laid out in Chapter 3. Physical risk requires data on current and future physical hazards, derived from a combination of historical presence or proportion of low-lying coastal areas vulnerable data and climate models; topographical data and locational to sea level rise and coastal flooding. But understanding data of assets; and information on vulnerability and adap- entire countries also means examining the size and sectoral tive capacity. Chapter 6 Climate Risk Measurement and Management M 121 through mechanisms such as an annual questionnaire by CDP, an NGO formerly known as the Carbon Disclosure 6.5.1 Company-Level Transition Risk Data Measuring transition risk starts with measuring greenhouse- Project. These voluntary disclosures are not only typically gas emissions, which need to be nearly eliminated to reach unaudited but also vary in their breadth and detail. Beyond anet-zero economy. The Greenhouse Gas (GHG) Protocol provides a widely accepted way of categorizing emissions. It defines Scope 1 as those emissions resulting directly from a the many companies that do not disclose at all, others dis- close only Scope 1 and/or Scope 2 emissions. Few firms disclose all of the Scope 1, 2, and 3 emissions. To get around company's operations; Scope 2 includes upstream emissions from purchased electricity, heating and cooling; and Scope 3 includes all other upstream emissions from supply chains the limitations of data availability, some data providers model the predicted emissions of non- or partial-disclosing companies on sectoral data. At the portfolio level, issues of as well as downstream emissions resulting from the use, or double-counting also need to be considered; for example, an industrial firm's Scope 2 emissions (from purchased electricity) disposal, of products and services sold by the company. Sectors vary widely in the proportion of these different kinds of would be counted as part of the electricity utility’s Scope 1. emissions. For instance, almost all banks’ emissions are categorized as downstream Scope 3, as are the majority of oil But transition risk is not only about current emissions but & gas firms’ emissions (from the combustion of vehicles or also about whether companies have solid and credible in the power plants of the oil and gas they sell). Meanwhile, plans to reduce emissions in the future and to ultimately align their corporate emissions trajectories with national and international goals, such as alignment with the Paris Agreement 2°C target or the target of net-zero emissions utilities have a lot of Scope 1 emissions (see graph below). These carbon emissions data, or corporate carbon footprints, as they are also called, have some shortcomings. Most data by 2050. Various approaches seek to measure the degree currently come from self-reporting by companies themselves, BREAKDOWN Wo OF CARBON EMISSIONS WITHIN 0 O0K00O00O0000000000000 80 90 Percentage of emissions SECTORS: 80 70 60 50 @ eo @ Scope 2 and 3 Upstream (Supply Chain) ee? o 8 @Scope 1 eeege 8b? e @ Scope 3 downstream (Product Use) Adapted from Chart 5 Scope 3 of the publication Investor Guide to Carbon Footprinting, published on the 23 of November 2015 (Kepler Cheuvreux). 122 Sustainability and Climate Risk Exam of corporate inment. At the corporate level, there are both opt-in initiatives, such as the Science-Based Targets that companies can sign up to as well as external parties, such as the Transition Pathway Initiative, that seek to gauge firms’ plans. Various methodologies have been developed for temperature scores that give a shorthand way of climate scenario a company’s strategy is aligned with, and thus are covered in greater detail in Chapter 7. Combined with new approaches to more accurately measure carbon footprints without relying on self-disclosure, the use of asset-level data on specific factories or power understanding what level of warming a company’s plans plants ultimately provides a lot more granular information are aligned with. Most of these, however, examine which matic graphic below). SCHEMATIC: DISCLOSURE FOOTPRINTS on which to base investment or lending decisions (see sche- VS ASSET-LEVEL Old Model DATA ON CARBON New Model Power plant A (Coal) Power plant C (Wind farm) Satellite and data firms, OPTION 1: Corporate-level disclosure of emissions OPTION 2: Corporate-level estimate of emissions Corporate-level disclosure of ee eer climate alignment an phyical/transition risk plans INVESTMENT / LENDING © Plant-level emissions Plantlevel © dataPlantlevel INVESTMENT / LENDING Jat® DECISION DECISION This schematic shows how much more granular the new model of data collection and decision-making is than the old one for an example firm, ABC Electric Power Inc. Historically, ABC’s shareholders, bondholders, and from open source datasets. Meanwhile, corporations are increasingly expected to disclose not just emissions but also on alignment and plans for addressing both transition and physical climate risk. Thus, investors and bank lenders would have had to rely either on ABC’s lenders can start to make more granular decisions, such own disclosures of emissions or on estimates from as relating to project finance of specific plants or at the corporate level, based on much more sophisticated data firms. Increasingly, however, asset-level data is becoming available at the facility level (in this case at the power plant level) through data firms, including through earth observation and satellite data as well as Chapter 6 datasets. Source: Author. Climate Risk Measurement and Management ® 123 More sophisticated transition risk analysis typically requires the use of climate scenarios, covered in Chapter 7. But for the purpose of this chapter, the last important point to mention regarding transition risk is that even data on both emissions and emissions trajectories are not enough without an understanding of the drivers of transition risk such as poli- cies, changing technologies, shifts in consumer preferences, and market sentiment (as discussed in Chapter 3). There are international agencies, such as the International Energy Agency (IEA) or International Renewable Energy Agency (IRENA); specialist consultancies, such as Bloomberg New Energy Finance or Rystad Energy; and large data firms, such as S&P Global, that offer quantitative and qualitative data terparties have the ability and desire to bring the specialist knowledge in-house to make direct use of these models. Moreover, for them to be relevant and usable for firms or investors, the output of the different models must be rec- onciled, downscaled to give regional or local estimates, and then it needs to be combined with exposure and vulnerabilto run different scenarios is covered in Chapter 7 as part of or lithium-ion batteries. Some types of data are quite difficult to come by and valuable to market participants, which means purchasing access can be quite expensive. PHYSICAL scenario analysis. Some physical climate risk tools that are one notch above simple raw data—for example, combining climate hazard RISK ESTIMATES Source: NASA. Source: Htonl. REACHING The basic data for gauging physical hazards is provided by global climate models developed by climate scientists for the periodic reports of the IPCC; an example is the Coupled Model intercomparison Project, versions 5 or 6 (CMIPS and CMIP6), Only some corporations and financial coun- ity data (see schematic below). The use of climate models on policies and new technologies, such as by providing data on the learning curves and pricing of solar modules SCHEMATIC: 6.5.2 Company-Level Physical Risk Data Data on hazards © Downscaled models Information on vulnerability and resilience To reach an understanding of physical risks, global climate models must be downscaled, both in spatial and temporal resolution, as they are usually designed for global use on multi-decadal timescales; then, exposures 124 ® Sustainability and Climate Risk Exam must be mapped geographically and combined with information on vulnerability and resilience to arrive at an estimate of physical risks. data with topographical or vegetation data—are available for free from governmental or non-profit organizations. Examples include the dataset from Climate Central on projected sea level rise, combining sea level estimates with methodologies of downscaling and normalizing climate model data with detailed facility-level location information of firms, mainly those that are publicly listed. By combining data on water stress; and the Max Planck Institute's index on ‘on climate hazards with the location of companies’ factories and warehouses and an estimate of vulnerability, the physical climate risk scores can tell investors about the relative physi- wildfire vulnerability, combining drought and precipitation cal risk of investing in, say, Volkswagen as compared to Ford estimates with vegetation cover. or Microsoft without needing to, themselves, delve deeply into the climate models or into figuring out exactly where local topography; the World Resources Institute's (WRI) data That being said, many physical risk indicators have been developed by, and are sold by, specialist for-profit consultancies. One survey, recent at the time of publication, identified eight firms or organizations that provide investors with physical climate risk analysis tools of some kind: Acclimatise, Moody's, WRI, Four Twenty Seven (since acquired WW or Ford have their factories, or Microsoft its data centers. The scores are normalized on a 0-100 scale, and they are available both by hazard type, and as an overall score. These “heavily digested” scores do have their downsides, however. The proprietary methods and datasets that they by Moody’s, the credit rating agency), Carbone 4, Carbon derive from remain a “black box” to the investors who pur- Delta (since acquired by MSCI, a data firm), Mercer, and chase the scores, which is why some investors have opted a collaboration between Ecolab, Trucost, and Microsoft to work with “raw” data themselves or construct in-house (ClimINVEST, 2019). Since the survey, Trucost, a division of S&P Global, the ratings and data firm, has also started scores. Many of these scores also attempt to capture several hazards in one score, meaning that the weighting and selling physical risk data on firms; and McKinsey & Co, the global management consultancy, acquired Vivid Econom- averaging methodology can matter as much to the end result as the underlying raw climate data. Due to the inclu- ics and Planetrics, two other firms that have also worked sion of different hazards, different ways of measuring, and different methodologies, scores from competing providers, or compiled internally by different financial firms, are not necessarily comparable. with investors on physical risks. Other consultancies beyond these, such as XDI or South Pole Group, have been hired by investors on an ad hoc customized basis on issues of physical climate risk, but they do not provide scores or analysis for broad use. Company or asset-level physical risk data and scores are arguably the most easily interpretable approach to physical risk analysis in a way that is accessible to lenders, investors, and other stakeholders. Although some of the free datasets offer a high level of geographic precision, the output is fairly “raw” (e.g., whether a given location is above or below the 2050 coastal flooding line). A real estate tool such as Four Twenty Seven’s, by contrast, allows real estate investors to easily gain a sense of the exposure of their assets by overlaying the location of buildings with the tool, which uses normalized numerical scales to give a sense the relative severity of extreme precipitation, hurricane-force winds, sea level rise, water stress, and heat stress for a given geographical location or address. Company-level scores, as sold by Four Twenty Seven, Carbone 4, and Trucost, take this approach a step further. The competing offerings all combine the proprietary 6.5.3 Portfolio-Level Analysis (Transition and Physical) Portfolio-level analysis, as opposed to asset: or firm-level analysis, is the type of analysis of most relevance to a financial counterparty, such as a lender or an investor. Understanding both transition and physical risk at the portfolio level can be somewhat different than just understanding the impact of these risks on a particular firm. On transition risks, many portfolio-level approaches start with numbers that are proportional to an amount, either of an invested amount or of corporate revenues, rather than simply total absolute emissions. Two common metrics are carbon intensity, or greenhouse gas emissions normalized by portfolio market value (for example, tons of CO2 equivalent/million USD invested), and weighted average carbon intensity (tCO2e/million USD of revenues). Other methodologies pin a temperature or “warming potential” on an entire portfolio. More risk-based approaches to transition Chapter 6 Climate Risk Measurement and Management M 125 whole fairly easily, looking at which assets are exposed to which hazards using free and commercial tools. But sensibly aggregating and evaluating portfolio-level physical risk is difficult for equity or bond portfolios, where exposure is to entire companies (and all their facilities as well as all of their supply chains). Some tools do give (rough) estimates of physical hazards in monetary terms: For example, a risk include stress testing (for example, modeling how a portfolio reacts to a transition shock such as a sudden rise in carbon tax). However, most stress testing on climate risks, especially transition risks, is heavily scenario-based and thus will be covered more deeply in Chapter 7. (On physical risks, portfolios made up of individual physical assets such as buildings or factories can be evaluated as a EXAMPLE: ANALYSIS A SIMPLE APPROACH TO PORTFOLIO-LEVEL PHYSICAL wildfires, as well as a view of market and supply chain risk based on a company’s industry. One relatively simple way of examining physical risk at portfolio level is to look at the best- and worst- in class of an index, which the below figure from Moody's However, in a space that has changed and matured ESG Solutions demonstrates. It shows the physical quickly, most physical climate risk analyses currently climate risk, based on the physical risk exposure of the use and compare different climate outcomes and scenarios. companies’ underlying assets to floods,heat stress, hurricanes & typhoons, sea level rise, water stress and Credit Agricole aya Capgemini BNP Paribas \\ Qo Publicis Groupe ‘bei S me: Société Générale Unibail-Rodamco © Orange Carrefour Michelin Renault Airbus TechnipFMC © Nokia Ore Schneider Electric OS Essilor International Pernod Ricard s ° ‘ay ArcelorMittal fe) Air Liquide Vaeo O Danone LatargeHolcim Py Lesrand O ; Cee) OoQ xus O 4% Oo 6% O « O om © Bouygues vinct Sanofi — Veolia Environnement Ratin d © Best ° © Above average ENGIE © Average © Below average @ Worst Solvay ° Market & Supply Chain Risk Score Best and worst-in class in France's CAC40 [PTE] Source: Reprinted with permission of Moody's ESG Solutions. 126 Accor © (O Saint-Gobain Peugeot a S é ° ; 8 z g Soden° Wo vans Er rocrO--O RISK Sustainability and Climate Risk Exam framework called “climate Value at Risk (VAR)" from a and within an organization, such as a large corporation. company called Carbon Delta, now part of MSCI, gives a One of the most widely used frameworks for ERM was quantitative estimate of the expected financial losses or developed by the Committee of Sponsoring Organizations gains from climate risks and opportunities. In this way, it of the Treadway Commission (COSO), originally released in 2004 and periodically updated. The latest version, from seeks to mimic traditional VAR, a measure used heavily by financial institutions (especially before the 2008 global 2017, includes actions and responsibilities across five broad financial crisis). areas, from governance and strategy to performance, review, and communication, with subcategories under each 6.6 Climate Risk wit! Risk Management (see graphic). Importantly, ERM is not considered to simply Enterprise be a function or a department, but it consists of “culture, capabilities and practices that organizations integrate with strategy-setting.” Neither is ERM simply about compiling a list of risks, having internal controls, or using checklists, In recent years, the notion of climate risk as an analogous risk to other types of financial risk, and indeed one that affects most “traditional” categories of risk, has led to an interest in managing climate risks proactively. rather, COSO argues, it is a holistic modus operandi across an entire firm (COSO, 2017). This section is generally structured in line with the COSO categories, as they are well suited to examining climate risk. However, other important frameworks are also This has notably been the case with regard to including climate risk drivers in enterprise risk management (ERM), that is, comprehensive approaches to managing risk across Figure 2: COSO’s Enterprise Risk Management Framework " MISSION, VISION ‘& CORE VALUES. BUSINESS. OBJECTIVE FORMULATION STRATEGY DEVELOPMENT a i) GOVERNANCE & CULTURE 1. Exercises Board Risk Oversight 2 Establishes Operating structures) 3.Defines Desired Culture AR Jemonstrates ‘Commitmentto Core Gas 5. Attracts, Develops and Retains Capable Individuals Reprinted with permission of IMPLEMENTATION ‘& PERFORMANCE ENHANCED VALUE 24 © STRATEGY & 2) OBJECTIVE-SETTING PERFORMANCE i) REVIEW & REVISION @ INFORMATION, COMMUNICATION & REPORTING 6. Analyzes Business 10. Identifies Risk 15. Assesses Substantial | 18. Leverages Context ni. Acscuser Sevaeny Change Information 7. Defines Risk Appetite of Risk 16. Reviews Risk eu 8. Evaluates Alternative | 12. Prioritizes Risks and Performance Ls ateiceal Strategies 13. Implements Risk | 17+ Pursues Improvement capremene in Enterprise Risk 20. Reports on Risk, 9. Formulates Business Responses te ‘Objectives Menegement cidtare aid) 14. Develops Performance Portfolio View Committee of Sponsoring Organizations of the Treadway Commission (COSO). Chapter 6 Climate Risk Measurement and Management ® 127 incorporated, notably regulatory ones. The TCFD, in particular, has been a key initiator of framing climate change influence the decisions of management and personnel and as a source of risk (as described in Chapter 3), of promoting reflect the mission, vision and core values of the organiza- disclosure to investors and other stakeholders, and of push- tion” (COSO and WBCSD, 2018). For climate change and sustainability to be reflected in a company’s culture, its mis- ing scenario analysis as a methodological tool (see Chapter 7). Another prominent example of a regulatory initiative tak- “attitudes, behaviors and understanding about risk [...] that sion and core values should address climate risk drivers; the ing action is the Network for Greening the Financial System, tone from senior leadership should convey expectations on a consortium of central banks and supervisors. At a country climate; and employee behaviors and initiatives that are in level, some countries have national-level bodies, such as line with strategic corporate priorities should be welcomed and encouraged (COSO and WBCSD, 2018). the Climate Financial Risk Forum (CFRF) in the UK, where the country’s two main financial regulators bring together industry representatives. The CFRF has helped categorize and frame the management of climate risk, and this section also partly draws on its CFRF categorizations. 6.6.1 Risk Governance and Culture Managing climate risk properly within an institution, as with managing any other sort of risk, starts with having structures and staff in place to monitor these risks. Successful risk governance starts at the highest level, with the board and senior executives. Effective risk governance can ensure understanding and diffusion of knowledge as well as genuine accountability at all levels of an institution, and it can help increase the resilience of a firm. Best practice governance arrangements tend to involve multiple layers of employees and internal processes. For instance, client-facing staff, responsible for new transac- tions, or portfolio managers, who make allocation decisions, can be tasked with making initial judgments on the environmental and climate risks of the transactions they are con- sidering (see ING case study). Climate risk can also be built into legal and compliance processes. This kind of integration can supplement and complement formalized internal risk management procedures and oversight. The TCFD recommendations on governance have helped prompt many companies to institute climate risk-governance structures and to allocate responsibility to specified senior execu- tives. Firms often disclose these arrangements and, indeed, promote them as differentiating factors of their respective firms. 6.6.2 Strategy and Setting Objectives, Goals, and Targets Corporate strategy, that is, high-level decisions on an organizations priorities and mission, is an important component of a holistic ERM approach in general, as well as of any enterprise’s response to climate risk drivers in particular. An important prerequisite for strategic decisions is strategic landscape evaluation; this is especially the case in regard to climate issues. Understanding the full business context on climate risk requires understanding the external environment and megatrends, such as the expected physical, societal. and macroeconomic impacts of climate change. But it also requires understanding how the inputs, business activities, and outputs of that particular company are affected by climate change. COSO and the World Business Council for Sustainable Development (WBCSD) have recommended starting with megatrend analysis and then delving deeper through the use of tools such as SWOT analysis, impact mapping, and materiality assessment. A SWOT analysis (strengths, weaknesses, opportunities, threats) uses a two-by-two matrix to compare the (internal) strengths and weaknesses, (external) opportunities, and threats an organization is facing, and it is commonly used for strategic planning (see example). In impact and dependency mapping, impacts and dependencies are described in terms of stock and flow in relation to various types of capital, not only financial capital but also natural, human, and physical capital, among others. Because all organizations face a unique set of challenges based on their circumstances, materiality assessment Culture can seem more difficult to pin down; nevertheless, it is just as important to risk management and climate risk management, as are specific governance arrangements. allows companies to assess the relative importance of vari‘ous climate risk and other sustainability risk drivers. A common tool is the SASB materiality assessment framework A corporation's culture has been defined by COSO as the (covered in Chapter 2). ility and Climate Risk Exam CASE STUDY: INTEGRATING CLIMATE RISK GOVERNANCE—ING (GCTP) and its Global Credit Committee—Transaction Approval (GCC-TA), both of which include the CRO, CFO, and Head of Wholesale Banking. The large Dutch bank ING has been one of the forerunners in holistically and deeply integrating climate change risk into its risk-governance structures. The current level of integration is described in detail in its annual report and its Climate Risk Report. Like many Seen horizontally, the bank describes its risk and control structure as a “three lines of defense” model. Here, front continental European banks, the bank has a two-tiered office staff, including relationship managers and deal board structure. At the supervisory board level, the principals who actually negotiate transactions, form the risk committee is tasked with oversight of climate risks, “first line of defense” and are tasked with identifying whereas at management board level, the Chief Risk Officer has this responsibility. potential environmental risks. Local and regional risk From a credit risk angle, climate risk is within the remit constitute the “second line of defense,” and regular committees at the bank, as well as regional risk managers, internal audits provide the “third line” (see graphic). SB Level Supervisory board Risk committee Executive Management board Level CRO 2-tier board structure of the bank’s Global Credit & Trading Policy Committee Risk committees GcTP GCC-TA ALCO bank Non-financial risk committee MoRMC. Regional and BU level BU line management, regional and local managers Internal audit Local and regional risk committee Regional and BU risk managers 1st line of defence 2nd line of defence 3rd line of defence Reprinted with permission of Internationale Nederlanden Groep. Two other key components of strategy with regards to climate change, and emphasized by the TCFD, are time horizons and outcome variance by scenario, which can be addressed through scenario analysis. Climate-related Chapter 6 risks and opportunities vary significantly over the short-, medium-, and long-term, and organizational strategy- setting and ERM processes to address climate change need to examine different time horizons separately. Climate Climate Risk Measurement and Management ® 129 EXAMPLE: SWOT analysis table for climate Internal origin risk drivers Helpful Harmful Strengths: How can a company apply its existing strengths to the physical and transi- Weaknesses: Do any peers face similar weaknesses or risks from climate change? Opportunities: Can the company create new solutions to climate-related challenges? Is there a gap that can be addressed? Threats: Where are climate-related (physical or transition) challenges creating threats to tion challenges of climate change? External origin Source: Adapted from (COSO and WBCSD, future business value? 2018). outcomes also significantly vary based on emissions trajec- identifiable risks and assess the impact and severity on the tories, for which scenario analysis can help corporate preparedness (see Chapter 7). organization in question. Beyond simply “listing” pertinent Finally, strategy is also about setting goals and targets. On climate change, a lot of corporate goal setting revolves risks, risk identification involves articulating the potential impact on business operations and strategy. k assessment involves gathering data on the actual scope of these risks. Investors and banks can use companylevel data, including scores on physical and transition risk exposure, and they can also conduct portfolio-level analysis around climate change mitigation and emissions commitments, including alignment with net zero emissions (for example, as the members of the Net Zero Asset Owners Coalition have done), or even commitments to being to determine whether they have excess overall risk at the carbon negative (e.g., Microsoft has pledged to remove portfolio level—or if they would have such a level in an all carbon dioxide attributable to its historical operations unfavorable climate scenario (as described in Section 6.5, as from the atmosphere by 2050). These goals may be driven well as in Chapter 3 and in Chapter 7 on scenario analysis). by a range of motivations, and they seek various different risk objectives, such as corporate social responsibility and A financial institution will tend to do this sort of analysis at a keeping up with peers and societal norms (avoidance of reputational risk) or protection from asset valuation through pre-emptive corporate transition (avoidance of stranded asset and market risk). But, once these targets are in place, they also then help to shape future decisions. 6.6.3 Performance: Tracking and Measuring Risks According to the COSO ERM framework, tracking performance for ESG and climate risks consists of three sub-components: risk identification, risk assessment and prioritization, and the implementation of risk responses. Risk identification starts with examining the transmission counterparty level (see McKinsey case study on banking). Non-financial companies looking inward at their own operations will be able to source some data from external providers or from publicly available sources, such as maps of projected sea level rise that can be compared against facility and asset locations. But internal risk assessment for a company will also require assessing the vulnerability and adaptive capacity of these facilities. isk prioritization is especially important in an ERM con‘text, as any large enterprise will be exposed to a multitude of risks, and it is important to rank these in order of impor- tance. Ranking methods include ranking by likelihood of occurrence, adaptability and complexity, or severity. One channels of climate risk drivers into financial risk (Sections way of ranking by severity is to examine what outcomes the risks affect, where risks affecting the fundamentals of 6.2-6.4) and then identifying which of these are the most business—profits, revenues, and asset values—are ranked relevant for a particular organization. Not all climate risks present an enterprise-level risk to all companies, and it is part of risk managers’ remit to translate external trends into as more severe than risks that only affect more ancillary out- ility and Climate Risk Exam comes such as employee morale or land use. Another way of prioritizing risks is to filter by the risks that the company can CASE STUDY: MCKINSEY & CO ON ASSESSMENT IN BANKING McKinsey gives the example of a (real life, unnamed) COUNTERPARTY international banking group that has embedded climate risk into its counterparty risk evaluation process. The process allows the bank to assess climate risk for 2,500 counterparties on an annual basis. For the sake of straightforwardness, the bank opted for a scorecard system that starts with the counterparty’s industry and geographical footprint, with adjustments for the firm's CLIMATE RISK emissions intensity and reliance on fossil fuels on the transition risk side and exposure to physical hazards on the physical risk side. The model was especially helpful for differentiating climate risk exposure between counterparties within the same sector. As an example, within the utilities portfolio, electricity providers and multi-utilities scored more poorly than did regulated networks. An international banking group embedded climate risk into counterparty ratings. Risk level Assessment for an integrated utility Anchor score Physical risk RS Low IRIN High Transition risk A. Idiosyncratic adjustment Inherent risk score B. Mitigation AIS © SGSCS SK SSTe © and adaptation capability Residual-risk score McKinsey & Company Exhibit from “Banking imperatives for managing climate risk”, June 2020, McKinsey & Company, www.mckinsey. com. Copyright (c) 2021 McKinsey & Company. All rights reserved. Reprinted by permission. impact and on level of control, focusing on those risks with risk responses. The standard COSO ERM framework counts five possibi ies: acceptance, avoidance, pursuit, reduction, and sharing. Accepting a risk means accepting it will have an the severest impact but over which it has the most control to actually improve outcomes (COSO and WBCSD, 2018). impact, but not taking action. Avoidance refers to removing the risk completely, and anything related to it: A transition actually control. As an example of such an approach, Solvay, a French chemicals firm, has, in the past, rated risks both on For all risks that are identified and assessed, firm management and risk managers can take a limited number of Chapter 6 risk-related example is the refusal by some asset managers to invest in, and some insurers to insure, any businesses that Climate Risk Measurement and Management ® 131 derive above a certain percent of revenues from thermal coal, making thermal coal “too noxious to touch.” Pursuit refers to converting risks into opportunities. Reduction of risk through improvements in processes, systems, or strategies. Sharing refers to collaboration as a risk-mitigation strategy, whether with suppliers, regulators, professional associations, or even competing firms (COSO and WBCSD, 2018). 6.6.4 Review and Revision 6.6.5 Communication, Reporting, and Disclosure Communication to stakeholders, internal and external, is considered an integral part of successful ERM. Obviously, the larger a company, the less straightforward even internal com- munication can be, which is why organizations need processes in place to ensure that the board and senior management get timely information about climate and sustainability risk exposure and the risk management operations undertaken. Commurnicating to external stakeholders, including investors The review and revision portion of the COSO framework and lenders but also credit rating agencies, employees, suppli- mainly refers to additional checks and balances on the ERM ers, regulators, and the public at large, is likewise an important framework. This portion of ERM starts with re-assessing outcome of successful ERM. Of course, individual risk manage- risks in light of any substantial changes to the business context of a firm. But more importantly, it is about being self-critical and responsive with regard to the effectiveness of ERM processes themselves. Any substantial changes in ment decisions, particularly around sensitive issues like contro- the external environment should ideally be flagged speedily and trigger modified ERM responses (see Infosys example). But even in the absence of large external changes, compre- hensive ERM involves having processes in place to monitor the implementation of ERM and provide additional checks and balances. This kind of function can be performed, for example, through a periodic internal audit in addition to normal, continuous risk management (as at ING—see case study in Section 6.6.1). versial transactions and avoidance of reputational risk, can be made in private. However, risk management that is practiced fully in private is not successful risk management. It is important for shareholders and lenders to know that a company has solid ERM in place to ensure continued value creation in the face of the crystallization of risks such as climate risk. But public disclosure of best practices in risk management can itself have a systemic effect, helping even competing firms, and thus entire sectors, to transition toward a more climate-ready and a zero-emissions future. This is why the entire TCFD framework is predicated on disclosure. (Many of the case studies highlighted in this book, especially in this chapter and in Chapters EXAMPLE: INFOSYS—PROACTIVE MONITORING FOR CHANGES IN RISK EXPOSURE Infosys is a large, India-based information technology Although water is not always scarce and company that does a lot of outsourcing work and employs close to 260,000 people (as of 2021), a large majority of whom are based in India. India is a country that periodically suffers water stress, and Infosys relies on water to ensure employees’ well-being (cooking, cleaning, drinking, and bathrooms) and for landscaping and cooling at its office campuses. Infosys considers water scarcity a significant operational risk to its activities in India, due to the deleterious effects of water scarcity on employee's well-being and ability to work. 132 © this risk is not always considered severe, Infosys has set up a monitoring system to proactively monitor water availability and allow it to quickly update its risk severity assessment. The monitoring tracks, in particular, the 1) water tables in each geographic area, 2) storage capacity of rainwater on each office campus, and 3) availability and cost of water for delivery via water tankers. Each of these criteria have specific thresholds that, if crossed, alert management to allow for follow-up measures. Source: WBCSD. Sustainability and Climate Risk Exam 3 and 7, are drawn specifically from companies’ TCFD reports, which would not exist without this push for disclosure, which helps to spread knowledge and expertise.) level. Thus, any holistic approach to risk management must consider climate risk at nearly every stage, from the different drivers of physical and transition risks to the transmission 6.7 Conclusions This chapter shows “traditional” categories of risk in some way at the companyspecific level, and it also poses a potential threat to financial stability, constituting a source of systemic risk at the macro that climate risk measurement and man- channels through various types of risks into financial risk. Ulti- agement is possible and can be integrated into standard enterprise risk management frameworks. However, importantly, climate is a transversal risk, which affects nearly all mately, however, many of the best risk-assessment methods rely quite heavily on scenario analysis, which will be examined and explored in the next chapter (see Chapter 7). REFERENCES FSB. (2020). The Implications of Climate Change for Finan- cial Stability. https://www.fsb.org/wp-content/uploads/ Basel Committee on Banking Supervision. (2021). Climate- related risk drivers and their transmission channels. https:// www.bis.org/bebs/publ/d517.pdf Bernstein, A., Gustafson, M. T., & Lewis, R. (2019, 2019/11/01/). Disaster on the horizon: The price effect of sea level rise. Journal of Financial Economics, 134(2), 253-272. https://doi.org/https://doi.org/10.1016/j. jfineco.2019.03.013 Buhr, B. D., C.; Kling, G.; Lo, ¥.; Murinde, V,; Pullin, N.; Volz, U. (2018). Climate Change and the Cost of Capital in Developing Countries. Carney, M. (2016). Resolving the climate paradox (Arthur Burns Memorial Lecture, Issue). https://www.bis.org/review/ 1160926h.pdf ClimINVEST. (2019). Physical climate risk: Investor needs and information gaps (CICERO Report, Issue). http://hdl. handle.net/11250/2589503 COSO. (2017). Enterprise Risk Management: Integrating with Strategy and Performance https://www.coso.org/ Documents/2017-COSO-ERM-Integrating-with-Strategyand-Performance-Executive-Summary.pdf COSO and WBCSD. (2018). Enterprise Risk Management: Applying enterprise risk management to environmental, social and governance-related risks. https://www.coso.org/ Documents/COSO-WBCSD-ESGERM-Guidance-Full.pdf P231120.pdf Klusak, P. A., Matthew; Burke, Matt; Kraemer, Moritz; Mohaddes, Kamiar. (2021). Rising Temperatures, Falling Ratings: The Effect of Climate Change on Sovereign Creditworthiness (Bennet Institute Working Papers, Issue. Manley, D. C., James; Cecchinato, Giorgia. (2017). Stranded Nations? The Climate Policy Implications for Fossil Fuel-Rich Developing Countries (OxCarre Policy Papers, Issue). S&P Global Ratings. (2021, Jan 26 2021). S&P Global Rat- ings Takes Multiple Rating Actions On Major Oil And Gas Companies To Factor In Greater Industry Risks http:// press.spglobal.com/2021-01-26-S-P-Global-Ratings-TakesMultiple-Rating-Actions-On-Major-Oil-And-Gas-CompaniesTo-Factor-In-Greater-Industry-Risks UNEP Finance Initiative. (2018). Extending Our Horizons: Assessing credit risk and opportunity in a changing climate. Outputs of a working group of 16 banks piloting the TCFD Recommendations. PART 1: Transition-related risks & opportunities. https://www.oliverwyman.com/content/dam/ oliver-wyman/v2/publications/2018/april/EXTENDING-OURHORIZONS-AW.pdf Vautard, R. B., O.; van Oldenborgh, G. J.; Otto, F;; Haus- tein, K.; Vogel, M. M.; Seneviratne, S..; Soubeyroux, J-M.; Schneider, M.; Drouin, A.; Ribes, A.; Kreienkamp, F; Stott, P,; van Aalst, M. (2019). Human contribution to the record- breaking July 2019 heat wave in Western Europe. World Emanuel, K. (2017). Assessing the present and future probability of Hurricane Harvey's rainfall. Proceedings of the Weather Attribution. Retrieved 30 Apr 2021, from https:// www.worldweatherattribution.org/wp-content/uploads/ National Academy of Sciences, 114(48), 12681. https://doi. July2019heatwave.pdf org/10.1073/pnas.17 16222114 Chapter 6 Climate Risk Measurement and Management ® 133

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