Ben Carr looks at the impact of climate-related risks on financial firms, and how their approaches are likely to evolve
The Paris Agreement came into force on 4 November 2016 and has been ratified by 185 countries to date. It aims to strengthen the global response to the threat of climate change by keeping global temperature rises well below 2°C above pre-industrial levels. The Financial Stability Board's Taskforce on Climate-related Financial Disclosures, chaired by Michael Bloomberg, published its recommendations on 29 June 2017. These voluntary disclosures cover how companies assess climate-related risks and opportunities in their governance, strategy and risk management, as well as the metrics and targets they use. The recommendations aim to make markets more efficient and economies more stable and resilient.
Regulators are increasingly scrutinising how financial firms are taking these risks into account. The Prudential Regulation Authority recently issued a Supervisory Statement, Enhancing banks' and insurers' approaches to managing the financial risks from climate change, and the Network for Greening the Financial System has published its first comprehensive report: A call for action - climate change as a source of financial risk. Despite this, many financial organisations are still failing to actively consider these risks.
Several initiatives have been kicked off by regulators, international agencies and industry associations to help firms get started. For example, the UN Environment Programme Finance Initiative (UNEP FI) investor pilot project recently published its Changing Course report. In this, it presented a climate value at risk (climate VaR) measure developed with environmental fintech company Carbon Delta. Climate VaR provides a holistic, forward-looking view of the impact of climate-related transition and physical risks and opportunities on investors' equity and corporate bond portfolios during the next 15 years.
Transition risks and opportunities include projected costs of policy action related to limiting greenhouse gas emissions (GHGs), as well as projected profits from green revenues arising from the development of new technologies and patents. The baseline for assessing the transition risk impact is that companies keep emitting GHGs at current levels. Physical risks cover the financial impact of climate change through extreme weather, rising sea levels and mean temperatures. For physical risk, the baseline is that current climate trends persist.
The VaR measure allows for four potential future scenarios with respect to climate change, developed by the Intergovernmental Panel on Climate Change (IPCC). Each describes a potential trajectory for future GHG and other air pollutant levels. They can be mapped to potential temperature rises - 1.5°C, 2°C, 3°C and 4°C - and the levels of mitigation required for each.
The four scenarios assume a gradual path in which temperatures rise slowly but climate policy is ramped up at varying speeds, with a fairly high degree of global coordination. They do not consider transition risk in a chaotic policy environment where there is lack of global coordination and where policy action is late and sudden. As a consequence, they may understate climate-related risks.
The IPCC Global warming of 1.5°C report, published in October 2018, demonstrates that dramatic action needs to be taken now if warming is to be kept below 1.5°C, and discusses the consequences of failing to achieve this. The scale of change needed to meet the 1.5°C target is unprecedented; industry will have to slash CO2 by 65%-90% by 2050. Investments in low-carbon and energy efficiency will need to increase fivefold by 2050 versus 2015 levels. Buildings and transport will also need to shift heavily towards green electricity, and tools that remove CO2 emissions from the atmosphere, such as carbon capture and storage, will be needed to store 100-1,000 gigatons of CO2 over the course of the century.
In the IPCC's 4°C scenario - in which emissions continue to rise at current rates - the transition risk is more limited, the potential physical risks are significant and the likelihood of tipping points being reached is much higher. In particular, increased precipitation, coastal and river flooding, periods of extreme heat and cold, wildfires and droughts can be expected. In addition, sea levels could rise significantly, resulting in major displacement of populations - as well as the spread of tropical diseases to more temperate areas.
Finally - and particularly in more extreme warming scenarios - it is important to consider whether climate change may trigger changes in social attitudes, leading to litigation against companies for failing to reduce emissions or disclose climate risks transparently.
Along with 19 other institutional investors from 11 countries, Aviva participated in the UNEP FI Investor pilot and has extended the climate VaR approach to the entire balance sheet. The analysis compares a plausible range of outcomes (5th to 95th percentile) from the different scenarios considered. The results show that exposure is greatest in relation to the business-as-usual 4°C scenario where physical risk dominates, negatively impacting long-term investment returns on equities, corporate bonds, real estate, real estate loans and sovereign exposures.
The aggressive mitigation 1.5°C scenario is the only scenario with potential upsides. Physical risk impacts are more limited but there is still downside risk on long-term investment returns from carbon intensive sectors (such as utilities) as a result of transition policy actions. This is offset partially by revenues on new technologies from some sectors (such as motor vehicles).
Aggregated together to estimate the overall impact of climate-related risks and opportunities across all scenarios, the plausible range is dominated by the results of the 3°C and 4°C scenarios, reflecting that neither existing or planned policy actions are sufficiently ambitious to meet the Paris Agreement goal.
The 1.5°C scenario is dominated by transition risk, even after applying mitigating measures. In the 2°C scenario, transition and physical risks are more evenly balanced, whereas in the 3°C and 4°C scenarios physical risk dominates.
Impact on liabilities
In all scenarios, the impact on insurance liabilities is more limited than on investment returns. However, changes in mortality rates in different scenarios could impact life and pensions businesses. These could arise either from physical effects, such as more extreme hot and cold days, or from transition effects related to changes in pollution levels. The impact on general insurance liabilities is relatively limited because of the short-term nature of the business, the ability to re-price annually and mitigation provided by our reinsurance programme. However, the physical effects of climate change will result in more risks and perils becoming either uninsurable or unaffordable over the longer term.
The development of tools such as climate VaR is just the beginning of our journey to increase understanding of the impact of climate-related risks and opportunities; approaches will undoubtably evolve and improve as new research and data becomes available.
Ben Carr is analytics and capital modelling director