A rapid transition to a low carbon economy is critical to mitigating the impacts of climate change caused by human activity.
Where we will end up on the spectrum between rapid de-carbonisation of our economy (with associated transition risks, such as stranded assets) and significant climate change (with associated physical risks) is unclear.
The nature of climate risk and opportunity – physical, transition and liability risks
The transition will be challenging but brings significant opportunities for financial services firms. This is well recognised at the policy level with many global, EU and UK initiatives underway as policymakers strive to align financial system goals with broader societal objectives around sustainable development.
This month, the Department of Work & Pensions (DWP) launches a consultation into government policy and regulations on trustees' legal duties to consider environmental, social and governance (ESG) risks1. The consultation confirms the broad expectation that the DWP will confirm the Law Commission recommendations around the definition of fiduciary duty and the need to take account of climate change as a material financial risk2. Other UK regulators are also moving on this topic, with updated guidance from the Pensions Regulator and the Bank of England increasing its supervisory activity as well as the significant policy activity.
How can you prepare?
In order to position well for this change, firms must first understand both the risks and significant opportunities and develop a climate strategy that is informed by robust financial analysis. Some firms are now building increasingly sophisticated risk models, incorporating climate into their overall strategy, preparing to enhance disclosures to meet the requirements of the ‘Task Force on Climate-related Financial Disclosures' (TCFD) and bringing a range of products to market.
Those who underestimate the magnitude of this change or are slow to adapt, risk far more than their reputation3 .
Three practical steps
1 Understand
Build an understanding of climate change and the transition to a low carbon economy, as this is a new topic for many in management positions.
We are now operating businesses in an era of climate change, with the three hottest years on record being 2015, 2016 and 2017. Decision makers need to understand how this impacts their business model. Increasingly there is an expectation that this understanding is communicated to the market.
To make informed progress, it is necessary to build an understanding of the risks and opportunities, the policy and regulatory environment, where you sit against peers and how all of this impacts your business model. For firms who are yet to begin, actions could include:
- Training sessions with key stakeholders – what are physical and transition risks, how they impact customers and clients and what opportunities exist. An update on relevant policy and initiatives including direction of travel and emerging regulatory expectations.
- Workshops with business unit owners to articulate potential impacts on portfolio – start to think through ‘what if’ scenarios
- Independent review of climate risk strategy and plans, including preparation for enhanced corporate disclosures to understand positions relative to peers
2 Assess
Appoint an appropriate owner for climate risk and undertake an assessment to quantify the potential impacts for the business, taking into account both physical and transition risks, over the medium and long term.
Identify risks and opportunities and develop an implementation plan. This might cover customer proposition, policy, strategy, risk management and disclosures. Actions include:
- Assessment of climate risks and opportunities across different business units and geographies.
- Assessing exposure of own operations and key suppliers to physical risk.
- Aggregation of exposure and reporting of results.
- Board paper to communicate findings, next steps and recommendations.
3 Act
Following steps 1 and 2 will allow action to be taken, informed by robust financial analyses, to integrate climate appropriately into the overall strategy of the firm. Actions include:
- Implementing any changes to portfolios required as a result of risks and opportunities identified through analysis.
- Drafting policy and accompanying risk tools and metrics.
- Developing detailed implementation plan
Firms who have not begun preparing for climate risk are now behind the curve – this should move onto the management agenda as a priority.
References
- Consultation on clarifying and strengthening trustees’ investment duties
- Pension funds and social investment: the government’s interim response
- Greening finance: embedding sustainability in financial decision making
