Physical and transition risks being incorporated into a more holistic approach by financial institutions, says UNEP FI report, as regulators increase scrutiny.
Climate risk management tools are reflecting an increasingly integrated approach by financial institutions (FIs), according to a new report United Nations Environment Programme Finance Initiative (UNEP FI), but the practice is still in its early stages.
Greater integration of physical and transition risk management tools and practices are needed to effectively tackle climate change, said David Carlin, UNEP FI’s Head of Climate Risk, noting that “urgent gaps” still persist.
By taking advantage of the growing availability of integrated risk tools, FIs could develop a “more comprehensive approach to managing climate risks”, he told ESG Investor.
“Best practice in this area is evolving,” he added.
Released this week, UNEP FI’s 2023 Climate Risk Landscape report found that tool providers have recognised the need for FIs to understand the full range of climate risks faced by portfolio counterparties. The range of tools integrating physical and transition risks has expanded as a result, as has coverage of specific hazards. But these solutions and approaches are still being developed, meaning many risk interaction effects and tipping points not necessarily being captured.
The report said that FIs are realising the importance of integrating climate-related risks, with the risks being divided primarily into physical and transition risks. Physical risks encompass those resulting from extreme weather events such as floods, wildfires, and landslides, while transition risks are associated with policies, technologies, laws and similar actions designed to shift the economy toward lower fossil fuel consumption.
Previously the two categories of climate risk have tended to be tackled separately, with the former receiving more attention than the latter. UNEP FI suggests that this approach must be overhauled to better manage climate risks, with integration of physical and transition risk tools an essential part of addressing this issue.
Climate risk integration
According to Carlin, FIs must take an integrated approach to physical and transition risk management, developing a “holistic understanding of how physical and transition risks interact” rather than approaching them as separate issues.
In recent years, tool providers faced rising demand to offer integrated solutions, with feedback from a recent UNEP FI piloting exercise showcasing a “growing desire” from banks to see physical and transition risks covered in the same platform as an integrated solution.
This rise in demand has driven consolidation among providers of risk management tools, resulting in a concentrated market comprised of established firms and newly merged entities. This trend has led to an increase in both partnerships and M&A activity within the sector.
Carlin underlined the use of scenario analysis as a tool to examine physical and transition risks combined impact on the portfolios of FIs, stressing the importance of considering both sets of risks and incorporating interaction effects between them.
The incorporation of physical and transition risks offers an “all-in” picture of climate risk, said Carlin. This picture is cross-cutting and will interact with other financial risks including credit, market, and operational risks, he said.
“FIs should not just consider climate risks, but how they may amplify and create tipping points in other financial drivers.”
Carlin recommended FIs consider a range of time horizons when evaluating physical and transition risks and incorporate this into their risk management frameworks. He additionally underlined the importance of “close coordination” between FIs and clients in identifying potential areas of weakness and supporting resiliency around climate risks.
“Physical and transition risks are complex issues that require a deep understanding of particular vulnerabilities,” he said.
The UNEP FI report noted that climate risk tools can provide tailored analytics for FIs to understand where and to what extent their investments, operations, and downstream supply chains are likely to be exposed to climate impacts, with the improved integration of physical and transition risks boosting the usefulness of these analytics.
Mind the gap
UNEP FI’s report flagged the conclusions of the European Central Bank’s thematic review on climate risks, which said that the current integration of climate risks into risk management frameworks is “inadequate” and that greater levels of integration are needed. This is one of the “urgent gaps” in FI climate risk management noted by Carlin.
He also highlighted that significant data availability and quality gaps still present an issue, particularly for assets in developing countries.
“Addressing these data gaps will require greater investment in data collection and analysis, as well as better collaboration between financial institutions, clients, and data,” he said.
The lack of standardisation and harmonisation in metrics and outputs also presents a challenge for stakeholders, with variation in input and output metrics with different calculations making it more challenging for them to compare institutions approaches to climate risk management.
Carlin also warned of the lack of integration at many institutions between climate risk, alignment, and green financing, with each of these responsibilities being interrelated.
“Managing risk well is necessary to growing green financing,” he said. “A green financing strategy should be supportive of alignment commitments, and alignment goals need to take sector risks into account.”
Regulatory developments are playing an increasingly important role in accelerating the development of financial institutions’ climate risk capabilities, according to Carlin, with regulatory mandates promoting greater transparency and disclosure of climate risks requiring FIs to develop their climate risk assessment capabilities more fully.
The US Securities and Exchange Commission will finalise its climate risk disclosure requirements this year, while the Corporate Sustainability Reporting Directive is expected to raise reporting standards in Europe.
The release of the sustainability and climate disclosure guidance by the International Sustainability Standards Board in June will “help improve interoperability across jurisdictions”, he added. These mandates are expected to benefit climate risk management by improving the quality of disclosures, enhancing standardisation and comparability, and providing stakeholders with greater transparency on risks.