As the costs of climate change mount and a business-as-usual approach becomes untenable, financial firms still have a lot of uncertainty when it comes to how climate change will affect their businesses.
A recent survey by the GARP Risk Institute found that just 6% of firms think that climate risk is fully priced in, though “quite a lot of them do think that it's partially priced,” Jo Paisley, president of GARP Risk Institute, told Yahoo Finance (video above). “And I think what we're seeing across the risk profession and the finance profession, is just a growing awareness, a growing understanding of the risks.”
The survey, in its third year running, polled 78 financial firms worldwide, encompassing 47 banks, 20 asset managers, and 11 other firms in insurance and financial market infrastructure.
The firms ranked the availability of reliable models and data and regulatory uncertainty as the top challenges to building out their climate risk strategies.
Two types of risks
Financial risks brought on by climate change generally fall into two buckets: physical risks and transition risks.
The GARP survey found that financial firms prioritized transition risks over physical risks or portfolio alignment. They're also more confident about managing climate risks over the short term than over the long term: Three-fourths of the firms said they were more confident about the resilience of their climate strategies in the next one to five years than in the next 10-15 years.
Transition risks will likely exert a greater influence on asset values in the short term, whereas physical risks are projected to have a stronger effect on economic performance in the medium to long term, according to a CRO Forum report. GARP has also noted that insufficient voluntary corporate action in the short term increases the likelihood of more aggressive government policy down the road.
The extent of transition risks depends largely on how effectively governments and corporations can coordinate carbon emission reductions across disparate sectors. A slower transition could be more expensive — by trillions of dollars — than a rapid one, an Oxford Institute for New Economic Thinking working paper found.
By the same token, physical risks — such as damage to property brought about by weather events — depend on how quickly these transitions happen, as the physical risks will only increase in severity with each incremental degree of warming. Worse still is the risk of overshooting dangerous tipping points that could lead to cascading irreversible changes to the global climate system.
Climate risk is also becoming a focus for the U.S. government, as with other governments worldwide.
In April, Sen. Elizabeth Warren (D-MA) and Rep. Sean Casten (D-IL) introduced legislation that would require companies to increase the information they disclose about climate-related risks.
The SEC and Treasury Department are also looking into climate risk disclosures. Treasury Secretary Janet Yellen, who recently reiterated that climate change is an "existential threat that must be addressed," will lead regulators in reviewing whether financial firms are appropriately addressing climate risk.
This year, the Bank of England (the UK's central bank) initiated a stress test of UK banks and insurers to explore their resilience against various climate change pathways. San Francisco Federal Reserve President has also said that the Fed has a job to “anticipate the changes before us and understand their implications,” though for now the central bank's role "is to listen, study, and adjust to whatever comes our way."
'A growing level of sophistication' for assessing climate risk
Compared to previous years, the GARP survey found that financial firms honed their climate risk assessment models. This was particularly the case for those that adopted scenario analysis, in which companies look at a variety of transition pathways.
Scenario analysis as it relates to climate change differs from other methods banks use in a couple of key ways. Climate change scenarios typically play out over longer time horizons. The most common horizon firms reported using in this year's survey was 10-30 years.
Scenario analysis also involves extrapolating the financial impacts from the physical variables that scientists measure. For instance, scenario analysis could be used to quantify the macroeconomic implications of sea levels rising by 1-2 feet.
“Also, you need good quality data," Paisley said. "You need to be able to model this. And those things take time to develop. So, we're seeing the emergence of new professional level of expertise. The firms are also learning from one another as well. I think you'll see over time a growing level of sophistication. I'm certainly hoping so.”
One positive trend that Paisley noted was that firms aren't just using scenario analysis, “they're actually taking action on the back of it.”
For instance, many firms made changes to risk management, portfolio composition, product offerings, and disclosure. Additionally, financial firms are increasingly aligning their carbon emission reduction targets with the Paris Agreement's target of limiting global heating to 1.5°C.
Furthermore, “we see a huge amount of product innovation," Paisley said. "So new products coming in or existing products being changed. We also see firms increasing their staffing levels to kind of try and get more equipped. And I think the other thing of note is that we see a lot more interest from supervisors, which is probably really focusing the minds of those financial firms.”
Grace is an assistant editor for Yahoo Finance and a UX writer for Yahoo products.