Three reasons why financial institutions need to speed up for climate risk readiness
“You may delay, but time will not”, Benjamin Franklin said. This can definitely be said about humanity’s hesitation to seriously start battling climate change. And, as we argued before, it also applies to financial institutions, which are not ready for assessing and managing climate risk. That might be a bigger problem than people think. We see at least three reasons why financial institutions had better step up their efforts to get climate risk ready: 1) It is a real and significant risk that will affect pricing and portfolio risk; 2) It will be mandatory; and 3) It involves first mover advantages.
- Climate risks are significant and will affect pricing
Regulators such as the ECB continuously warn banks and other financial institutions that climate risk is increasingly causing financial risks. And they encourage to deal with them accordingly. So far, the response has been muted. Sure, financial institutions make vague statements about such risks, announce all kinds of green products, and are engaged in a serious greenwashing arms race. But they do not integrate it in their core risk assessment. Current bank credit models and asset pricing models typically do not include climate risk — as it does not (yet) fit their backward looking statistics on PDs, LGDs, Sharpe ratios, etc. That means that they systematically underestimate and underprice risk for a significant part of the portfolios under consideration. On the flip side, it also means that they overestimate and overprice risk for those assets that are better prepared for climate risks.
Such risks are already materializing. They are visible not just in the extreme weather conditions we’ve seen lately (49 degrees Celsius in Canada..), but also in financial markets that rely less on models and more on fundamental analysis by individual investors - such as real estate or primary issues in the bond market. For example, in Florida real estate prices in the physical climate risk of flooding with discounts, as beach front houses in risky areas now often sell at lower prices than those a few miles inland. And Australia coal projects find that investors are increasingly wary of the transition risks involved. Climate risks are coming to your financial markets too, and likely sooner than expected.
2. It will be mandatory
So far, regulators’ calls for reporting on climate risks are mostly without obligations. But that will change. In a recent Reuters article, US bank regulators stated that climate risk will in time be included in regulatory capital requirements. The ‘in time’ reflects the fact that regulators too, still have a lot of homework to do, and financial institutions are given some time to adapt their models. How much time remains unclear. It is also unclear what and how exactly will have to be reported. It is a gradual learning process since both financial institutions and supervisors lack the data and the people to do this right in one go. They will need to build capacity, and that might result in a scramble for resources. What if all 6.000 banks in Europe all of a sudden need a climate expert?
3. First mover advantage
There are serious first mover advantages involved. First, if you can price risks that others cannot, then you will have a competitive edge in pricing. You can offer better prices for low risk projects, which allows you to take substantial market share. Conversely, if you are not able to price those risks while others can, then you will be stuck with the high risk projects at too low prices and your own survival will be at risk. Second, if you do build the inhouse knowledge on climate risks, you will spot more opportunities, might discover new business models, and won’t be scrambling to obtain climate risk experts when everyone else is trying to hire them as well. If you don’t build those resources, then yet another Benjamin Franklin quote applies: “By failing to prepare, you are preparing to fail”.
