Climate Change and the Financial Sector

Welcome to the first edition in Zizzo Strategy’s blog series exploring the implications of climate change for various economic sectors and the organizations and individuals within them. Climate change is recognized as a global and wide-reaching challenge and “threat multiplier” to other existing challenges. In this aspect, it can be an overwhelming topic especially if all you want to know is what the next steps should be for your organization or your specific role. Throughout this series, we will dive into the key impacts for particular sectors, discussing both the financial and non-financial impacts, but translating them into decision-useful considerations to provide clarity and help propel internal discussions and management. Each post will finish with suggestions on next steps and tools you can use to prepare your organization for the climate change challenge.

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Awareness and calls to action on climate change in the financial sector have gained significant momentum in the last few years, especially since the 2015 Paris Agreement and surrounding private-sector initiatives. Increasing pressure is being placed on investors, including asset owners, asset managers and banks, due to the influence they have on the companies they own and the amount of assets they control.

Financial organizations have seen increased calls for transparency in the identification of their exposure to climate-related risk and their role in mitigating climate change risk overall. They are being asked how their organization will transition to a lower-carbon economy, adapt to a changing climate and seize opportunities related to the transition and need to adapt. These calls for increased transparency and action show no sign of abating. Forthcoming standardization, developing reporting standards and legislative requirements will all likely keep the pressure coming.

We suggest that while transparency through reporting is a key part of a climate change strategy, it should not drive the management of climate change impacts in your organization. For any financial player, climate change impacts from the physical and economic transition changes will have business impacts on your investments. Ultimately, prioritizing business for your organization will depend on your relationship with your clients, members and other stakeholders as well as your investment strategy and portfolio specifics. We suggest three top areas of business impacts related to climate change that all financial organizations should consider:

1. Transparency and disclosure

The FSB’s Task Force on Climate-related Financial Disclosure (TCFD)’s recommendation on climate change reporting is directed at all financial players as well as non-financial public companies. Recent momentum, such as the UNEP FI pilot projects, French legislation and early reporting efforts by significant industry players, has shown that reporting on these issues will be an accepted “norm” in the industry in the next few years. However, investors must decide when to disclose, how much to disclose and how to get that information to clients without disclosing trade-secrets or losing competitive advantage. The disclosure does not (and arguably should not) drive decisions on the investment operations, but it does need to be genuine and disclose how climate considerations are being integrated into business strategy. A good place to start is with existing processes, such as governance and risk management that you may already have in your organization.

2. Accounting for volatility and quicker than expected change

Having an investment strategy to account for known risks is nothing new to financial players. However, climate change impacts have been shown to change the historical patterns in the physical world (global temperature has risen about 1 Degree Celcius since pre-industrial times, extreme storms are occurring more frequently) and are seeing economic responses (energy transitions driven by policy and market demands). Cognitive biases such as anchoring to the past and conforming with perceived consensus, will lead to risk underestimation and may not best serve organization goals and objectives over time. For example, they may lead to gaps in scenario analyses with overly conservative scenarios of the energy future. Additionally, there are many energy system modeling issues that make predictions uncertain. Without more complete views of the future, asset owners may not be adequately prepared for change. We have historically seen the industry-standard IEA World Energy Outlook consistently underestimate clean energy uptake significantly. For an investment or corporate strategy to be truly resilient, it needs to push the boundaries of the scenarios we have today. This could mean thinking more broadly using tools such as scenario analysis that looks beyond business-as-usual time frames as well as considering what would be normally “extreme” cases.

3. Focus on opportunity

Risk is often the easiest way to introduce climate change to an organization, and is a role commonly tasked with considering climate change issues. Most of what is written about climate change focusses on the risk related to a transition towards a lower-carbon economy, such as stranded assets, loss of value or cash flow associated with a price on carbon or reduced demand. However, climate change undoubtably presents asset owners with opportunities whether measured as relative to the broader market or value add with exposure to new sub-sectors. For example, investments in the renewable energy market grew from $47 billion USD in 2004 to over $240 billion USD in 2016. While risk management for climate change impacts is certainly needed, opportunity should not be considered as just the “other side of the risk coin”, but more broadly encompass what investments will be needed to support and thrive from a transition to a lower-carbon and more resilient economy.

Note for Asset Owners
Certain institutional investors, particularly pension plans, have been targetted as the ultimate owners of the investments and influencers over other financial actors such as asset managers and others. With generally higher profiles and closer ties to the end beneficiaries, an asset owner’s transparency on their climate change approach is also a factor in their credibility and can be used to enhance an asset owners’ profile. Asset owners are being asked to prove they have appropriately thought about, incorporated and planned for climate change impacts. For those that do not do this, some form of public naming and shaming is entirely likely. Asset owners have a unique opportunity to set the tone for the financial sector response to climate change while reporting and standards are in their infancy. These considerations should be included when designing an organization’s climate change response.

Once you’ve determined the risks and opportunities most salient for your organization to consider there are a variety of strategies and tools available to assist in their identification and management. Our suggestions for immediate and medium-term steps are:

A. Find out what strengths you already have in your organization. There are likely ways to build upon existing systems, roles and management. You may already be undertaking actions that, although not earmarked as such, identify and manage climate-related issues. These existing strengths, roles and actions may need to be further developed or systemized, but will provide a basis for a strategy that will work for your teams.
B. Learn from existing progress by identifying and expanding on best practices. As many leading organizations and pioneering individuals are tacking these issues, it’s smart practice to build on existing knowledge and not “reinvent the wheel”. A thorough review of existing best practices, strategies and tools applicable to your needs will help to determine what’s needed to address priority concerns and whether existing tools have a place in your toolkit.
C. Think broadly. Climate change is a broad and complex issue and fairly new to the financial sector. It doesn’t fit neatly into the usual analytical tools and is particularly prone to cognitive biases. Scenario analysis can be tailored to your organization’s capacity and needs and is an excellent way to introduce “outside-the-box” thinking and integrate a longer-term perspective.

Contact Zizzo Strategy to understand how we can help you and your organization manage these climate-related business impacts. We can guide you in considering what to disclose and when and how to disclose it, how to overcome the cognitive and modeling biases and how to bring opportunities as well as risk into focus. Our services encompass the spectrum of climate change management processes from education to scenario analysis.

Click on “Climate Series” from the categories menu to read more blog entries from this series.

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