Why climate risk management is much more than a hygiene factor
The climate crisis has significant implications for financial institutions (FIs). These days, portfolio managers are asking: How does my portfolio impact climate and how do I drive effective climate action and achieve net-zero? We covered that here and here.
At the same time, we are managing climate effects already, many of which are irreversible. Furthermore, a shift to a carbon neutral economy will affect the viability of assets in a portfolio. So, portfolio managers must now ask: how do climate change and the associated climate risks impact the sustainability of my portfolio?
We talked to our clients about taking first steps in measuring climate risks, and the strategic question that climate risk brings to the table.
Taking first steps in climate risk management
Data availability and making sense of complex issues is the most common challenge in getting started. To overcome data hurdles, our clients start by using a top-down screening approach to identify the most prevalent and material climate risks in portfolio and the critical hotspots. With time, they complement this approach with asset-specific analysis.
In terms of processes, our clients have started incorporating climate risk analysis in ESG due diligence when making new investments, as well as disclosing in line with the recommendations from the Task Force on Climate-related Financial Disclosure (TCFD).
However, deciding how to address climate risks is becoming more and more a strategic decision, particularly raising implications for portfolios with a development focus.
More than a hygiene factor, a strategic question
Institutions with assets and investments in developing countries experience a high exposure to physical climate risks, as these regions will endure the most devastating effects of rising temperatures, such as droughts and heat waves.
While risks are something to steer away from, for portfolio with a development focus, this might prove detrimental to their mandate. In fact, avoiding physical climate risks would mean to steer away from investments in highly exposed regions and/or sectors that are highly sensitive to climate change, hence compromising development. Furthermore, it could deny countries and industries most in need with investments that have strong climate adaptation potential.
For FIs steering their portfolios towards development impact, establishing the right level of climate risk exposure will be key, or they risk shutting off vulnerable regions and countries in need of finance.
As so, FIs with portfolios in developing markets will need to accept and be prepared for a certain level of exposure to physical climate risks, to not shut off those countries that are most vulnerable to climate change. This can be done by developing sector-specific adaptation strategies at the FI-level and including adaptation and resilience action plans in investment deals. Take investments in agriculture in Africa, for example. These investments can include a climate risk insurance and a plan to raise awareness on climate risks for farmers and how to mitigate them.
In sum, our clients agree that managing climate risks is not only a measurement issue, but a strategic question. For FIs steering their portfolios towards development impact, establishing the right level of climate risk exposure will be key. Else, they risk shutting off vulnerable regions and countries in need of finance.
If you are interested in learning more about measuring climate risks in portfolio, you can reach out to silvia.binet@stewardredqueen.com, based in our Amsterdam office.
