Written by Peter-Jan Roose
Last summer, we all witnessed how climate change is starting to impact the operational and financial performance of organizations. The required changes to address climate change are complex, time-consuming, and investment intensive. This emphasizes the crucial role of the financial industry in the transition to net-zero.
Today, I am joined by Harold, a Financial Industry expert, to discuss how the risks of climate change are impacting his industry. Hello Harold, can you briefly introduce yourself?
Hello, my name is Harald Logt. I am a climate change & sustainable finance advisor, supporting both financial services and corporate clients in understanding the risk and opportunities of climate change.
Having worked across Europe in the financial services industry for nearly 25 years made me realize how much the support of financial institutions is needed to enable the transition to a sustainable and low carbon future.
In my advisory work, I aim to support both companies and banks to prepare for and have constructive dialogues on climate change risks and opportunities.
Recently, you have been involved in the latest ECB stress test, targeting the effects of climate risks on the financial industry. Would it be possible to share some information on this new type of stress test?
In September 2021, the European Central Bank published the outcomes of an economy-wide climate stress test focused on climate change. The main reason for this review is that the ECB realizes climate change is likely to impact our economies, businesses, and societies but the risks remain poorly understood.
With this stress test, the ECB wanted to assess the exposure and resilience of the non-financial corporates and banks in the Eurozone to climate risk. It is clear that the impact of climate change is different from previous financial crises: Where previous crises were caused by a short-term shock event (e.g., Lehman Brothers to start the financial crises) within one sector, the climate change crisis is a long-term problem prevention crisis, which requires a global, omni & inter-sector system change.
To better understand the climate-related vulnerabilities of the Eurobanking system, the ECB reviewed the resilience of the corporate business in the Eurozone.
Could you briefly explain how this concretely works?
Most climate change impact assessments use scenario models. The ECB has used the model from The Network of Central Banks and Supervisors for Greening the Financial System (NGFS), which contains three scenarios:
1. Orderly Transition: early and effective implementation of climate policies
2. Disorderly transition: delay in implementing climate policies
3. Hothouse world: no new policies implemented (business as usual)
Each scenario provides the projected development of economic factors for the next 30 years, including (non-limitative): real GDP, greenhouse gas emissions, energy price, and consumption.
Within these scenarios, the economic factors are combined with the exposure of individual companies due to the following risks:
Physical Climate Risk: disruptions due to extreme weather, storms, floods, drought, wildfires, sea-level rise, and temperature rise.
Transition Risk: disruptions due to changes in regulations, emission taxes, customer demand, or technology.
The geographical location of the operational activities of a company, its suppliers, and customers determine the exposure to physical and transition risk. Proximity to a river or coastal area will increase the physical climate change risk, while the unsynchronized adoption rate of climate policies between countries poses an increased transition risk.
Finally, to complete these scenarios, the composition and emission intensity of the products provided by companies are used as inputs. There are sub-sector-specific templates for these inputs. For this stress test, the ECB used a comprehensive dataset of combined climate and financial information from circa 4 million companies worldwide and mapped these companies to circa 2,400 banks in the EU based on their loan and security holding. This allows linking the climate impact of companies to the risk and impact on banks and insurance companies.
Sound like a very thorough exercise. Would it be possible to share some initial results?
Before sharing some outcomes, it is important to realize that the scenarios used are projections based on assumptions and not predictions of the future. In the real world, customers and companies will be confronted with other challenges than climate change. The current COVID-19 crisis is a clear example. Additionally, it is hard to include innovation and adaptation of companies and society 30 years into the future. Most companies do not plan more the 5 years ahead.
The results of the ECB’s economy-wide climate stress test show:
Clear benefits in acting early. The short-term costs of the transition are much lower than the cost to mitigate the consequences of climate change in the medium to long term.
Early adoption of policies to transition to a zero-carbon economy, accelerating the investment and roll-out of more efficient technologies.
The consequences and effects of climate change are concentrated in specific sectors and geographical areas where climate policies are not introduced.
Climate change represents a major source of systemic risk, particularly for companies and banks with businesses and portfolios concentrated in certain economic sectors and specific geographical areas.
The ECB stress test pointed out that sectors most exposed to climate change risk include Agriculture, Mining, Manufacturing, Oil and Gas, Electricity, Construction, Wholesale and Retail, Real Estate, Transport, ICT, Water Supply, and Waste.
Within the EU, the highest physical risk hazard is wildfires, followed by floods and sea-level rise. Spain and Italy are exposed to the highest risk, followed by Greece, France, Germany, Netherlands, Portugal, and Austria.
Mark Twain said: “Knowledge becomes wisdom, only after it has been put to good use.” How can business leaders use these results?
They can use these to familiarize themselves with climate change scenario analysis and the different kinds of existing climate risks within certain sectors and geographies. This will become increasingly important as banks will start asking companies for climate-related information when applying for a new loan or investment.
Most banks are developing new products like green loans, social loans, and green mortgages designed to help their customers finance the transition to a low-carbon and sustainable economy. A good understanding of the company’s emissions, climate risks, and transition plan will soon become essential when your company engages with banks on green products and services.
Understanding and resolving climate change is complex. While the sheer scale of the necessary transition is daunting, it is critical to start now. Could you share some final thoughts to encourage business leaders to act?
I recommend increasing your understanding of the shorter and longer-term impacts of climate change in your sector and your own company. This should be done step-by-step. Starting with getting a high-level overview, then diving into the details, and finally prioritizing the areas that have the largest impact on your company.
There is no one way to start a climate change analysis, as different sectors and geographies all have their specifics. That’s why external consultants, like BrightWolves and I, can help you determine your best starting point and next steps in your climate change analysis.
Interested to start now? Get in touch with Peter-Jan Roose