In 2020 alone, the global losses from natural disasters amounted to a staggering US$210 billion! This is just short of the 2020 GDP of Portugal, or a little more than twice the market cap of HSBC, Europe’s
In 2020 alone, the global losses from natural disasters amounted to a staggering US$210 billion! This is just short of the 2020 GDP of Portugal, or a little more than twice the market cap of HSBC, Europe’s largest bank. The causes of these huge losses include drought-fuelled wildfires, severe floods and a record-breaking number of storms. How are natural disasters affecting your financial institution? And is climate change bringing other risks?
A multifaceted risk
When talking about the impact of climate risk on banks, most people consider only the physical impacts. Physical impacts can manifest themselves in the form of natural disasters, like floods, hurricanes or wildfires, or as permanent changes like rising sea levels and desertification. Such radical changes can shock firms and households alike, resulting in reduced asset values and even defaults.
Physical risks still have the largest impact on the banks’ lending portfolio but are far from the only ones. Transitional impacts come in more subtle forms through, for example, changed consumer behaviour, legislation and technological development. Greener and more sustainable products become increasingly more important amongst the average consumer, favouring certain players in the market while other industries are penalized. Alongside a more climate-conscious consumer base and society, supervisors and regulators are increasing their requirements for disclosure and creating climate-based taxation.
The challenges of climate
Working with a concept as wide and complex as climate change is difficult, and it is no surprise that data is key. Going into a new and unchartered area can be hard, as historical data is no longer a good predictor for the future. Not having sufficient current data poses a challenging barrier to meaningful scenarios and accurate, reliable predictions.
Another problem when trying to reach reliable predictions is modelling. How exactly do you relate a temperature increase to a default probability? And how do you identify the idiosyncratic risk as opposed to the systematic risk? There are many ways of trying to model climate change, which also makes it difficult to compare results once you have them. There are also potentially many model dimensions. Not only are the climate changes varying across geography, but the impacts are also varying across industries. This means that the causes and effects will vary over loan portfolios. This adds additional complexity to both the scenario creation and the applicability of the results.
A third challenge from trying to measure the impacts of climate changes is the uncertain time horizon paired with human behaviour. Climate-related financial risk analysis is long-term and often exceeds the time horizon of regular portfolio predictions. When performing long-term analysis, aspects like policies, technological development and human behaviour might alter the projections. These are just some of the challenges a financial institution is facing when trying to measure the financial impacts of climate change.
What do the regulators say?
Regulators are also reacting to this new risk arising from climate change by increasing their expectations of banks through more information disclosure and impact assessments. Additionally, regulators made it mandatory for banks to consider not only how th