In addition to its unprecedented impact on society, it’s understood that climate change will affect multiple sectors. This will pose significant risks to the global economy and will result in intensifying threats to business continuity and resilience.
These risks include physical climate disruption, such as resource depletion and direct damage from extreme weather events and rising sea levels. The resultant knock-on effects include volatility in commodity prices, additional capital costs, financial losses and potential reputational damage.
Unsurprisingly, these threats are steering leaders towards rethinking their business models. Coupled with transition-related policies from governments and regulators, these interconnected risks could significantly erode the value of existing investments and assets.
On the flip side, the growing number of innovative technologies developed to address climate change will present multiple opportunities as the market transitions from high-carbon to low-carbon products and services.
Chasing net-zero targets
A clear risk comes from regulation in response to climate change, especially the rising pressure on businesses to reduce greenhouse gas emissions and set net-zero targets by 2050. This is because those companies that fail to respond may face legal and reputational consequences.
While there is no single solution that could get us to net-zero, it will be imperative that business and policymakers cross-collaborate, alongside innovative climate finance. As such, lenders and banks will play a central role in driving the transition to a lower-carbon economy.
Financing this green agenda will require considered assessment of climate-related credit risk exposure and direct investment in climate adaptation and mitigation solutions. Yet, this process poses significant challenges in a fast-changing world, coupled with regulatory uncertainty.
The vital role of policy certainty
Real challenges exist in aligning differing climate-related policy regimes, which is evident from the varied approaches adopted by governments and regulators around the globe.
The interconnectedness of economic, environmental and social systems exaggerates these challenges and requires careful consideration. As such, policy formulation should centre around a collective discussion between economic and social players to achieve a collective climate response.
Until we achieve consensus, all stakeholders, including banks, will continue operating in a vacuum of policy around the journey we need to take.
One of the key policy drivers related to climate change is concern over the economic impact of both global warming and the cost of mitigation and adaptation.
While stakeholders are trying to find solutions, there’s a lack of clarity around the fundamental route we should take to achieve net-zero carbon emissions and the timing of these targets. This poses significant risks – ultimately, we cannot afford to go down multiple paths.
Unfortunately, central banks and regulators are struggling to find viable climate stress-test scenarios and integrate them into financial stability monitoring and supervision.
We need to supplement current regulatory stress-testing 30 years in advance of the 2050 target with risk-based, shorter-dated scenarios that factor in potential and known regulatory changes. This approach will make stress-testing more relevant for shorter-dated financing arrangements.
Furthermore, politicians remain uncertain about viable climate funding, while many nations, particularly developing countries, lack the financial means to implement radical solutions.
A prudent response should include increased development assistance and climate finance, alongside global investment for a green and sustainable future. Developed and developing countries should come together to design and implement viable solutions.
Without a clear idea of which direction climate policies are heading, businesses lack the certainty to make key investment decisions. Banks will also face challenges when trying to help their clients to transition their business models to remain relevant.
Capitalising on opportunities
However, like any form of industry disruption, responding to the challenges posed by climate disruption can open up a range of opportunities.
Responding proactively to these climate challenges will increase the resilience of organisations while improving their capacity to capture growth opportunities. We have already seen various innovative companies shift their strategies to remain relevant and tap into the opportunities that climate change presents as traditional business models change.
Banks can help identify emerging market gaps and opportunities and support entrepreneurs with relevant innovative business solutions as they scale up and create bankable businesses. The massive capital flows that renewable energy projects attract today offer a prime example.
Banks also need to help clients understand how they should adapt, particularly smaller businesses that lack the internal resources to conduct the research needed to successfully transition or pivot their business models.
However, it is extremely challenging to make strategic decisions about investments that potentially have lifespans of five, 10 or even 30 years without any historical data as a guide.
A new risk-rating approach needed
Traditionally, assessing credit risk was predominantly a short-term concern for banks. However, climate risk requires a longer-term focus.
Banks will need to move away from the traditional predictive foresight approach. This approach identifies forces that can shape the future based on historical data – it then uses these insights to predict likely eventualities, while considering regulation and policy changes that could change the risk of the asset or business being financed.
Moving forward, banks will need to apply new insights to existing systems with a greater reliance on climate science. They must take every uncertainty into account to guide decision-making in the risk assessment process while leveraging creative foresight to envision the future, the unintended consequences and the interconnected ripple effects associated with climate change.
Relevance and longevity are key considerations in climate financing, and banks will need to consider the speed of technological advancement when extending funding to these innovations. Furthermore, banks need to ensure that they are not funding unsustainable assets that lose their relevance within a few years.
Similarly, banks must avoid the risk of stranded assets, such as coal-fired power stations, or energy suppliers that cannot operate as a going concern due to tightly regulated markets that prevent charging cost-reflective tariffs.
Creating ESG and financial value
To ensure a just transition, banks will need to fund some forms of ‘transition energy solutions’ in the short to medium term, particularly for developing countries that still rely heavily on fossil fuels, despite growing pressure from shareholders and investors to end support for these projects.
We feel increasing pressure from our investors, clients and other stakeholders who want to understand our environmental, social and governance (ESG) approach. Investec has a group-wide environmental policy and climate change statement that guides our decision-making processes to help us understand and evaluate the consequences of our investment and lending decisions.
However, the financial sector, like all other sectors, is only beginning to understand the relationship between natural and economic capital and how ‘non-financial’ ESG issues can impact value.
The current market system judges the fundamental performance of a business on its previous ability to generate a financial return on the capital invested. Consequently, the performance of other forms of environmental and social capital, while well understood and relevant to economic success, are treated as ‘externalities’ which we cannot account for unless there are demonstrable financial consequences.
Specifically, investors are interested in the longer-term impact of climate change on a company’s profitability and the strategies around appropriately managing and mitigating these risks. As such, the need is there to provide transparent and comparable disclosures so that investors can incorporate this information into investment valuations.
Making tangible investment decisions
Unfortunately, there isn’t a unified set of comparable disclosures, although the Task Force on Climate-Related Financial Disclosures (TCFD) has developed a framework to help public companies and other organisations disclose climate-related risks and opportunities.
In addition, it remains unclear how rating agencies and regulators will measure banks and the underlying companies to which they lend. Without clear, common standards, banks need to constantly assess and review their governance processes to future-proof their business.
This is a difficult space in which to operate as it requires the agility to pivot strategies as the market changes and new policies emerge.
Ultimately, policies and regulations will determine how banks need to adapt and change, but the understanding of the holistic impact of climate and ESG remains a challenge for regulators. This consequently puts pressure on banks to find solutions to achieve positive change without clear regulatory guidance.
Until the world gets more clarity on policies from global leaders, banks will need to play a leading role in providing businesses with the guidance they need to navigate the risks posed by climate change and combine different perspectives to make responsible investment decisions.
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