Aon  |  Financial Institutions Practice
Building a sustainable future: how can financial institutions navigate climate risk?

Ecosystems and economies increasingly are exposed to climate change risks, creating unpredictable business and operational environments for financial institutions.

To ensure a functioning global economy, financial institutions must continue to provide liquidity while also successfully managing a host of risks, including:

• Physical risks
• Operational risks
• Financial risks
• Reputational risks

From the outside in and the inside out – pressures driving climate action

Before the outbreak of COVID-19, regulatory and investor pressure was primarily focused on reducing the environmental impact of commercial operations. With the onset of the COVID-19 pandemic, the focus on tail risk has accelerated and expectations from investors, regulators, clients and other stakeholders has increased. Financial institutions are now expected to be able to quantify, disclose, manage risk and adapt corporate strategy in contemplation of climate risk.

1. Regulatory pressures

Although European regulatory and disclosure regimes are more established, regulatory pressures across North America are gaining momentum under the new administration. Financial institutions face a host of regimes, including the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), the Carbon Disclosure Programme (CDP), and the Taskforce for Climate-Related Financial Disclosure (TCFD), among others.

TCFD is rapidly becoming the dominant global framework, enabling firms to structure their approach to climate risk around four primary pillars: governance; strategy; risk management; and metrics and targets.

Read the full paper to find out which steps firms need to take to prepare for changing regulation

2. Stakeholder pressures – investors and employees

In most cases, a generic climate policy is no longer sufficient for most investors. The long-term viability of investments is a core concern and driving investor focus on resiliency and sustainability. Moving forward, financial institutions will need to quantify their exposures at corporate and commercial levels and make specific disclosures about climate change risk to investors.

Alongside external stakeholder pressures, shifting demographics and sociocultural values are directly impacting workforce behaviours. Millennials, which are now the dominant portion of the workforce, are particularly aligned to environmental, social and governance issues, so the firms that embrace sustainability and respond to employee demand for action and disclosure are more likely to attract and retain talent and boost employee engagement.

The journey: risk quantification

Although many quantification tools and models are in nascent stages of development and sophistication, the market for climate models is expanding rapidly.

Current quantification models fall largely into two categories – catastrophe models and global climate models.

• 1. Catastrophe models are the traditional modelling frameworks which harness historical data, alongside current surface and atmospheric observation data to simulate hundreds of thousands of events against a portfolio. Since catastrophe models rely almost exclusively on historical data to predict losses from catastrophe risk, they are reliable predictors of near-term acute physical risk, but are less equipped to provide meaningful insights into longer-term risks.
• 2. Global climate models are designed to provide large-scale simulation and identify links between global mean temperature change, individual events and hazard characteristics to gauge longer-term climate risk. While global climate models offer a valuable tool to inform decisions for the long term, the data can introduce uncertainty into climate risk strategies.

Read the full paper to find out how firms can navigate a fragmented market of quantitative tools to robust frameworks for climate change modelling

The journey: integration

A centralized team focused primarily on sourcing data, modelling and implementing the analytics across the firm, can work more efficiently and effectively to respond to demands and provide objective insights which can be leveraged in a meaningful way across multiple risk categories.

Credit risk

Climate change has the potential to directly impact market and credit risks in several ways, including:

• reductions in the value of financial assets;
• uncertainty concerning financial assets’ future payoffs;
• credit losses due to reductions in the borrower profitability, and;
• reductions in the value of collateral.

At the asset level, catastrophe models may be used to try and uncover the latent physical risk that is carried within loan portfolios to build a more robust due diligence process and enable firms to make informed investment decisions. Meanwhile, financial institutions should also incorporate financial, litigation and other models to identify the industries most likely to be impacted by the transition to a low carbon economy, and over what timeframe. With these insights, firms can take active measures to prepare for credit risk exposures by either reducing lending or managing the impact over time.

Operational risk

From an operational risk perspective, it is imperative that banks and other financial institutions assess and address their own carbon footprint. Despite increasing digitalization and the transition to remote working environments reducing the need for physical space, financial institutions’ offices and branches are likely to maintain a substantial footprint, at least for the foreseeable future. Firms which focus on building these considerations into their operational risk taxonomies will be well positioned to make strategic decisions about sustainable and future-ready operating models that maximize business continuity.

Read the full paper to find out why firms should work strategically with data, rather than striving for complete coverage initially and work on a longer-term sustainable approach to risk

In the accompanying podcast to this paper, experts discuss the immediate and longer-term challenges faced by financial institutions, and how firms can mobilise risk quantification and credit strategies to build a sustainable operating model.