Greater scope and depth needed to keep pace with demand for more holistic approaches to climate risk management by banks and investors.
Climate risk tools available to financial institutions suffer from shortcomings in data inputs and scope, despite recent consolidation and technology innovation, according to a new report by the UN Environment Programme Finance Initiative (UNEP FI).
The report said there was “room for improvement” in the relevance, coverage and use of proxies by tools across physical risk, transition risk and emissions data. It also said tools increasingly needed to capture impacts from “a wide range of climate-related phenomena”, including physical, policy-driven transition and litigation risks, as well as interaction between risks and financial system contagion.
The report is based on the practical user experience of almost 50 banks and investors using available climate risk management tools and includes 15 case studies. The institutions were all participants in the UNEP FI’s TCFD (Task Force on Climate-related Financial Disclosures) programme, and the report’s recommendations are an output from a module reviewing climate risk assessment methodologies.
It follows the UNEP FI’s publication of The Climate Risk Landscape in 2021, which mapped climate-related financial risk assessment methodologies and summarised recent developments across 40 third-party climate risk assessment providers.
The market for climate risk management tools has evolved rapidly in recent years, due to the growing need of financial institutions to increase the scope of their physical and transition risk analyses across geographies and asset classes, partly under pressure from regulators and other stakeholders.
“Climate tools have gone from being used for exploratory analyses to now being really central, not only in climate disclosures under TCFD, but also in regulatorily mandated stress tests,” said David Carlin, TCFD Programme Lead, UNEP FI, speaking at a webinar to launch the report.
“In addition, they’ve been required by those interested in understanding how to update their strategies, both to take advantage of changing markets and sectors, but also to effectively set targets.”
The new UNEP FI report said suppliers had responded to fast-evolving demand through mergers and partnerships between tool developers and data providers in order to broaden coverage. Consolidation has also helped providers to support the need of financial institutions to take a more integrated approach to climate risk management by combining transition and physical risk methodologies.
The report said a more holistic assessment of financial institutions’ climate strategies and risks was being driven by the “physical-transition risk-combined reference scenarios” of the Network for Greening the Financial System.
The capabilities of climate risk management tools are being significantly enhanced by greater use of technology innovation, the report said, notably use of machine learning, artificial intelligence and the use of data sources derived from remote sensors. “As computing power has grown and new statistical techniques have developed, climate risk tools providers are also looking to leverage advanced data collection and analysis techniques,” it said.
Remote sensing technologies are increasingly providing early warnings or more detailed pictures of physical hazards in previously data-scarce regions, the report said, as well as identifying transition risks, with space agency data being used to pinpoint methane leaks and other sources of emissions to refine estimates of financed emissions.
Although the report highlighted a number of initiatives aimed at increasing the granularity of data to better capture financial relevance, it made a number of recommendations to address input data shortfalls.
Pilot participants with holdings in Africa, Southeast Asia, and South America all raised concerns about the degree of granularity offered by climate risk tools flagging data gaps across physical hazards, transition risks, and emissions data. The report also said third-party tool providers should consider how new information from mandatory TCFD reporting regimes such as the UK can be effectively incorporated into company assessments.
UNEP FI pilot participants recommended that tools should account for a wide range of risks, but also improve categorisation of related risks, including by sector or geography. With regard to flood risk, the report said that “nuance is welcomed” between different types of risks across regions, such as coastal inundation, river overflow or rainfall.
Pilot participants expressed a need for a better understanding of the implications of government policies on their portfolios, including net-zero commitments and carbon pricing, regarded as “one of the clearest ways” to evaluate the performance of portfolios and counterparties across a transition scenario.
“Tools that allow users to change the carbon price or compare different carbon prices and their effects were particularly desirable to participants,” the report said.