How climate intelligence can bridge the banking sector’s knowledge gap on climate risks

By Partha Bose, Head of Capital Markets at Cervest

The financial sector is no stranger to risk. It is based on its measurement, management and fair pricing. But climate risk presents new challenges to getting there. In a rapidly changing regulatory and operational landscape, banks and lenders are trying for the first time to identify, quantify, disclose and act simultaneously on the most significant form of risk emerging in this century – against the watch.

The sustainability landscape has evolved rapidly over the past decade, fueled by the green spirit of investors and customers, and a growing awareness that climate change poses a serious risk to our global economies. In this context, it is imperative that banks take the climate into account in their financial risk planning, including operational, credit and liquidity risks. Rapidly and at scale increasing the sector’s climate risk management capabilities is a critical pillar in building the foundation for socio-economic resilience.

But as the recent European Central Bank (ECB) climate risk stress test revealed, the sector is lagging behind. As regulatory pressures – and balance sheet losses – increase, effective climate risk management is essential. High-quality data grounded in climate science is the key to unlocking meaningful progress.

What kinds of risks does climate change pose to the financial sector?

However quickly we reach Net Zero, past emissions make further warming and extreme weather events inevitable in the coming decades. The impacts of climate change – whether stresses such as temperature changes or sea level rise, or shocks such as wildfires and floods – will create physical risks in all regions of the world. “Global warming will undermine food systems, physical assets, infrastructure and natural habitats,” McKinsey warns. By 2030, it finds that the risks of significantly reduced grain yields and flood damage to capital stock will double, leading to other unavoidable consequences such as forced economic migration and geopolitical unrest.

The analysis places the climate value at risk (CVaR) in the trillions. “If no mitigation measures are taken, global temperatures could rise by more than 3°C and the global economy could contract by 18% over the next 30 years,” says the Swiss Re Institute. The financial industry already knows that climate-related losses are not hypothetical: the global cost of climate damage in 2021 was almost £290 billion.

There are other drivers beyond balance sheet protection. Effective climate risk reporting is quickly becoming imperative from a regulatory perspective, as well as a reputational one. Many banks already disclose their climate risk as part of voluntary ESG reporting, which is largely non-standardized and often subjective and qualitative. This means that it is not compatible with other risk metrics that are integrated into their existing decision-making workflows. But recognition of the need for “consistent and decision-useful information for market participants” and “high-quality, comparable and reliable information on climate risks” has led to a global shift towards mandatory reporting on climate risks aligned with TCFD.

Yet, as the results of the ECB’s climate stress test show, climate risk management and reporting is an emerging and unrecognized challenge for all financial firms. We innovate, and that requires new ways of thinking, new methodologies, new metrics and data.

What the ECB’s Climate Stress Test reveals about the sector’s climate risk capacities

The ECB’s Climate Stress Test was designed to determine how prepared European banks are for the economic impacts of climate change. It aimed to identify potential weak links in EU regulation and support the establishment of best practices for the management of climate-related risks by the financial sector.

About 65% of banks scored “bad” and showed significant limitations in their stress testing capabilities. There are startling revelations: despite facing at least 70 billion euros in losses, only 1 in 5 banks take climate risk into account in their lending decisions, and most banks do not take this into account. climate risk in their credit risk pricing or whole-level risk management models. The results also offer an explanation for this: the lack of available data.

The lack of data in climate risk management

To get a complete picture of climate risk that supports adaptation planning and enables them to produce appropriate reports, banks need high-resolution data and robust modeling methodologies.

They must be able to assess climate risk under different global emissions scenarios (including business as usual, peak 2040 emissions, and alignment with the Paris Agreement), and across multiple geographies and regions. time horizons. They need decision-useful climate intelligence that looks at individual assets as well as entire portfolios. This granularity of analysis is the only way for institutions to accurately assess their exposure to climate-related physical risks.

Until now, this kind of climate intelligence has been inaccessible to most financial institutions, and developing this specialized internal capability – let alone applying it to organizational processes – is resource-intensive and cost-prohibitive. Advances in technology, fueled by advanced scientific methodologies and machine learning (ML), are making this kind of intelligence accessible and profitable. Climate tech companies like Cervest harmonize climate data and present it in an intuitive user interface with clear risk assessments, making it accessible and useful for short- and long-term adaptation planning. It is only a matter of time before climate ratings become standardized and financial institutions use them collectively to assess financial risk in capital transactions.

What should banks do now?

Science-based and standardized risk ratings should guide climate risk preparedness in the financial sector, starting with asset selection and reporting. The key question that every financial institution must answer is: “How will their organization ensure that its risk models, analyses, stress tests and reported measures use – and are based on – reliable climate data that accurately reflects climate risk exposures? says Bloomberg.

The first step towards resilience is to comprehensively quantify climate risk. Financial institutions should integrate asset-level climate intelligence, which includes spatial and multi-risk correlations, into their existing suite of climate risk modeling and stress testing solutions. Banks and other financial firms should also ask their customers for more detailed disclosure of climate risks at the asset level, in the same way that they would expect them to disclose other potential sources of risk to obtain loans. or access capital. This will lead to the integration of climate risk into transaction-level decision-making processes, support internal and public reporting, and help banks develop robust climate stress testing frameworks. This is essential to properly establish current risk levels, identify future growth opportunities, and support their clients through an orderly transition from one to the other.

Once the financial sector has on-demand access to standardized, science-based climate information, adopts best practices in its implementation, and consistently and comparably discloses climate risks, global financial resilience becomes achievable. Given the magnitude of the challenge, the time to close the gap must be now.

About Partha Bose – Head of Capital Markets at Cervest

Partha is an experienced leader in finding strategic and business applications of complex data solutions. He has many years of technology and product leadership at companies including Winton Capital Management, HSBC, Lloyds and eBay.

At Cervest, he synthesizes his statistical knowledge with his knowledge of financial markets, climate change and business data strategy.

About Cervest

Cervest is the climate intelligence (CI) company that puts climate at the heart of every decision. The company provides personalized, dynamic and science-based climate information on any asset, anywhere, anytime, giving business and government decision makers the most comprehensive view of climate risk at the asset level. ‘asset.

Founded in 2015, Cervest is a Certified B Corporation with executive offices in the UK and USA

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