As Climate Risk Looms for the Financial Industry, Governments at all Levels Spring into Action

2018-10-03T15:36:22+00:00September 12th, 2018|Climate Risk|

September 12, 2018

True market transformation often requires parallel and, in a perfect world, coordinated efforts by both policy makers and industry.  The financial sector plays a key role in catalyzing these efforts.  More often than not, this effort requires true leadership, courage, and vision that cannot be taken for granted.

This week’s Global Climate Action Summit (GCAS) has kicked off with thousands of professionals landing in San Francisco to try to push forward ambitious action on climate change.  To kick it off, Jerry Brown, the Governor of California, signed an ambitious executive order requiring economy-wide carbon neutrality for the state by 2045, committing the 5th largest economy in the world to a net zero-carbon economy. This executive action builds upon Governor Brown’s signing of SB100, also signed yesterday, a new state-wide bill mandating 100 percent use of zero-carbon electricity by that year.  A difficult but highly worthy challenge given the state of our warming planet.

Setting in place the right policies or strategies around climate change and the risks it presents seems these days to require bold leadership, as does addressing the “tragedy of the horizon” that drives most investors – be they long-term or short-term – to underweight the threats of climate change that are perceived to be distant in the future. Such leadership is happening in many pockets of industry, the financial sector, and among policy makers at all levels.

Financial institutions such as pension funds and insurance companies play an important social function in providing financial security and stability for their clients. But what happens if these institutions themselves find their financial security under threat? Around the world, financial institutions providing security to millions of businesses and households are facing pressure to account for climate risks, as they often carry large investments in assets and businesses vulnerable to physical climate change impacts such as storms and sea-level rise, not to mention investments in fossil fuel assets. These assets may be at severe risk, and a sudden loss in their valuation could disrupt the stability and security of many pensioners’ retirement benefits.

Awareness of these climate risks in the finance sector is growing, but from a very low base. In its 2018 European Allocation Report, the consulting firm Mercer found that a mere 17% of European pension programs were now “thinking about the financial impact of climate change”. While investors and asset managers are increasingly promoting climate-smart investments, only in recent years has climate risk gained attention as a potential “financial” threat to their portfolios  This rise in awareness is in large measure thanks to the work of the Task Force on Climate-related Financial Disclosures (TCFD), which issued its disclosure recommendations around climate-related risks in 2017.

Also, this growing awareness is likely a response to the uptick in climate-related extreme weather events – such as storms, droughts, wildfires – that are increasing in intensity and having direct economic and financial consequences to assets in many parts of the world. With Florence bearing down on the East Coast this week, and millions of people fleeing their assets, its clear we are going to be facing a very large bill about this time next week.  Costs will be incurred by everyone in the path of Florence including businesses, their financiers and governments, and likely in the billions.  This of course is not unique any more: In 2017 Hurricane Harvey  cost the Houston area an estimated $125 billion, and the 2018 California wildfire season racked up a bill for damages projected at up to $180 billion.

While TCFD explicitly targets the issue of climate risk disclosure by corporations, such efforts have gained traction with corresponding efforts among policy makers to support climate change disclosure and risk management.

Governments are in some cases asking investors and insurers to not only disclose climate-related risks, but to also actively undertake climate-related risk management. Perhaps the earliest leadership came from France in 2015, which passed the landmark Energy Transition Law, with Article 173, pioneering mandatory, extensive reporting for asset managers on climate change-related risks. The European Union followed, passing a measure in November 2016 that requires retirement fund managers to consider the environmental, social, and governance (ESG) risks of their investments, along with liquidity, operational, or asset risks.

Following France’s lead, many governments are introducing similar climate risk oversight of the finance industry, focusing specifically on insurance and pensions. Brazil has pioneered support for the TCFD recommendations, as the world’s first insurance market to commit to transparency in climate risk. It is the largest insurance market in Latin America, and its most significant players have a proven commitment to sustainability. The country is one of few in the world where leading insurers, the national insurance association, and the industry’s regulatory agency have all signed the UN Environment’s Principles for Sustainable Insurance.

In the United States, where the outside observer could be mistaken in thinking progress on climate change has stalled in the last two years, some local and state governments have successfully passed laws requiring increased attention to climate risk in insurance and investment. Dave Jones, the California Insurance Commissioner, released a new report this week that made him the first U.S. financial regulator to conduct an assessment of the climate-related financial risk of insurers’ investments in fossil fuels. This ‘stress test’ was developed in response to the TCFD’s recommendations. It aimed to evaluate the exposure of insurers in the state to “transition risk” by comparing the current, business-as-usual production from physical assets like coal, which are held in an insurer’s portfolio, with the forecasted production in a scenario with a 2°C global warming.

In some cases, where governments run their own pension funds, political leaders are taking the management of climate risk into their own hands. Maryland’s Pension Risk Mitigation Act, signed into law on May 15, 2018, will require the Board of Trustees of the Maryland State Retirement and Pension System (SRPS) to implement policies relating to climate risk management in its investments, and also to conduct a climate risk assessment every 4 years. In 2017, New York City Comptroller Scott Stringer began an analysis of the carbon footprint of the city’s five pension funds and launched a process to help them revamp their asset allocation, manager selection, and risk management processes to adjust to the realities of climate change.

This leadership is hopefully a mark of a paradigm shift: not only investors and asset managers, but governments and the populace as a whole are demanding the incorporation of climate risk management into financial decision-making for both stewardship of public coffers and private investment. The paradigm shifts inherent to market transformation often happen incrementally at first, and they happen where pockets of leadership emerge – in companies, governments, or the financial sector. In many cases, the momentum created by multiple acts of leadership can itself be its own catalyst for change.  Here’s hoping for more acts of leadership, from the GCAS summit and beyond.