The world is changing. With regard to anthropogenic climate change, there are two possible future worlds:
- We manage to shift our economy so that it operates within the planetary boundaries.
- We fail to do so and face significant climate change, including all the extreme weather events that can be expected.
So either way, change is coming and change usually means risk if you are not prepared for it. In this case, we are talking about climate-related risks. Since the first recommendations of the Financial Stability Board in Basel through the Task Force on Climate-Related Financial Disclosures (TCFD), climate-related risks have come more and more into focus, although there is still a lot to do.
Why do climate risks need to be highlighted separately?
Financial markets and even the economy as such are characterised by short-termism. But looking at climate risks requires a long-term view. To describe this dilemma, Mark Carney, then Governor of the Bank of England, introduced the term “tragedy of the horizons” analogous to “tragedy of the commons”. Although the optimisation of short-term KPIs aims at the best possible economic result in the short term, it results in the opposite in the long-term. Therein lies the tragedy. And the tragedy extends not only to the individual market participant, but potentially to the entire market if climate risks are systematically underpriced.
How can climate risks be analysed?
Climate risks cannot be analysed on the basis of historical data. This is because there is no precedent for climate change or our response to it. It does not exist in historical data and therefore requires looking ahead: What can a climate-neutral economy look like? How many more floods will we face and how much worse will they be? Climate and energy scenarios from scientific sources answer these and other questions. The so-called scenario analysis takes companies, credit, equity and bond portfolios into these worlds and analyses the financial performance in the different scenarios, e.g. 1.5°C, <2°C and 3°C.
How can climate risks be integrated and taken into account in the long term?
Effective integration of the results from the scenario analysis requires clearly regulated governance and responsibilities within the company. Climate-related risks are not a risk category of their own, but rather translate into market, credit and operational risks. It should be clearly defined how and at what point climate-related risks are included and taken into account in the various risk models. Every financial decision-making process, whether it is lending or investing or underwriting, should take into account the financial perforamnce in climate- and energy scenarios.
What is the regulatory relevance of scenario analysis and climate-related risks?
The relevance of potentially underpriced climate risks has not escaped the attention of regulators. 108 supervisory authorities and central banks (as of February 2022) have therefore joined forces in the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) and are working together to integrate climate risks in supervision (keyword: climate stress test) and monetary policy. The relevant members in Germany are BaFin, Deutsche Bundesbank, ECB, EIOPA and EBA. All of them now require supervised companies to pay special attention to climate risks. In particular, the ECB climate stress test in spring 2022 should be highlighted.