Banks and insurers are currently investing significant funds in their climate risk programs. But successfully embedding climate risks in first- and second-line decision-making is challenging.
At RiskMinds 2021, together with our partners at BlackRock, we presented five key lessons from supporting several pioneers on their climate change journey.
A durable approach to climate risk and stress testing, Riskminds, 21 December
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Five key lessons from supporting financial services firms on their climate risk journey
1 – Set your target state for climate risk management – a “plan for a plan” will not survive
If you want to ensure you can stand behind the scope of your climate risk program – and therefore the funding and resource allocation – make sure you clearly articulate the target state for each risk type at each stage of the risk management lifecycle.
This clarity — which can be summed up in about 30 capability statements — is key to your ability to both maintain control of your program scope internally and demonstrate holistic thinking to your regulators and auditors.
2 – Risk and finance must work in partnership with business
Many CROs are responsible for the climate data and analyzes of their banks – and thus become the de facto “Climate Change Center of Excellence” in their organizations. However, finance also plays a critical role, such as embedding net-zero goals in business planning and the internal incentives needed to drive lending in line with those goals.
Working in partnership with companies to help them see climate change as a driver of growth opportunities rather than as a business constraint is also critical to the long-term success of your climate change program.
3 – Find out more specifically about the possibilities of financing the transition to engage companies
The first line must not be overwhelmed by risk management. Find ways to get them interested by combining the following:
- rich in content, industry-specific training how the transition may play out in different sectors and when and where the “tipping points” for funding the transition may occur
- Commitment of the counterparty This allows the company to identify new opportunities to finance the transition while gathering the information you need to assess counterparties’ transition plans. Recently, a Baringa client integrated its top 2,000 counterparties into its transition plans and significantly deepened its client relationships
- supply companies with Counterparty level scenario analysis Findings that enable them to have an informed conversation with their customers about climate change.
4 – Don’t rush to increase climate risk appetite
While you may feel the pressure to set appetites for climate risk, it will likely result in “tissue rejection” from companies if not based on metrics they:
- understand;
- de-register;
- can forecast;
- and control.
Instead, use your climate risk MI to develop a view of the metrics that meet these criteria over time, allowing you to manage concentrations of climate risk.
5 – Use climate scenario analysis to stimulate discussion about the relative winners and losers in your portfolio – bottom-up asset-level modeling is key
1. Through Aladdin Climate, BlackRock is on track to help the industry manage climate risk and transition to a net-zero economy
As a practitioner, BlackRock’s own way of embedding climate risk and net-zero considerations into our processes has provided invaluable insights on the issue. To meet the needs of our clients and our investment platform, we have developed modeling capabilities for transition risk, physical risk, temperature alignment/net zero and climate scenario extension.
We are making significant investments to maintain and develop Aladdin, our business and risk platform, and Aladdin Climate, our climate analysis toolkit.
- More than 5000 experts (from a total of >20,000 employees) are dedicated to the Aladdin platform
- More than 2000 FTE dedicated to R&D for Aladdin, including over 100 for the development and maintenance of Aladdin Climate
- More than 260 institutions worldwide use Aladdin, including around 40 Aladdin Climate
This means that the development of Aladdin Climate not only depends on BlackRock’s own IP (at 9.46 trillion
2. Why the need for centralized climate analysis and what are the key considerations?
Through our own journey and our experience in helping the industry along the way, some key lessons have emerged:
- A holistic platform that combines transition risk, physical risk and net zero views across functions enables more seamless integration
- A high degree of methodological flexibility and modularity to suit the unique use case of each function is key
- Detailed counterparty-level analysis and a portfolio view are required to generate actionable insights
- Comprehensive coverage of sector and asset class models incl. consistent data, methodology and coherent underlying assumptions are a key differentiator
- To be future-proof, a robust infrastructure is critical to improve usability, enable robust model and data management, and maintain the audit trail
3. Transition risk: Climate risks may already have an impact on some counterparties in the short to medium term
While climate change risk is likely to be a priority over the longer term, institutions need to be able to identify exposures that pose imminent risk now.
Based on an initial analysis of 120 global counterparties in the energy supply sector, it can be observed that almost half of these companies will have a Debt Service Coverage Ratio (DSCR) below 1.1 by 2025 in the NGFS Divergent Net Zero 2050 scenario, which may be the The case today requires further consideration in the banks’ risk management process.
4. Transition Risk: In order to identify vulnerabilities and opportunities, it is important to have detailed views of the counterparty
It is also not enough to look at climate risk on a sectoral basis, as the results can vary significantly within a sector. Take two European-based energy supply companies as an example; Despite being exposed to similar risk drivers in the same industry and region, Company A is proving more resilient than Company B.
Several idiosyncratic factors play a role, such as B. Company B’s higher exposure to coal and gas compared to Company A and higher Scope 1 emissions and costs.
Interestingly, although Company B has a more ambitious net-zero target, it shows a higher transition vulnerability as the expected emissions intensity is significantly higher. Counterparty-level modeling allows for a more holistic view of “greenness”, risks and opportunities and is also important when conducting stress tests.
5. Net Zero: The alignment of the portfolio often requires targeted efforts – example power utility portfolio
Net zero commitments require institutions to understand how their portfolio composition needs to evolve over time. For example, looking at the power portfolio for most institutions, key levers for alignment include managing exit from coal exposure and increasing exposure to renewables.
Zoom in to focus on the coal portfolio; Counterparty-level analysis is key to drill down into the portfolio view and identify key issuance drivers; It is not uncommon for financial institutions to focus their attention on 3-4 counterparties that cause the majority of issuance. A granular view also allows for the identification of opportunities to capitalize on the world’s transformational journey.
6. What should keep you up at night?
As financial institutions continue their journey to embedding climate risk, here are some key questions to consider:
- Is your view on climate risk and net zero consistent across the institution?
- Can you measure your climate risk in a way that you can embed in your first and second line business decisions?
- What are your biggest opportunities in the transition to low-carbon energy?
As of September 30, 2021
Source: BlackRock. Aladdin climate performance. As of October 31, 2021
Source: Black Rock. Aladdin climate performance. As of October 31, 2021
Learn more about Baringa’s Climate Risk Services and our partnership with BlackRock to develop their market-leading Aladdin Climate Analytics technology.
Originally published December 16, 2021
The content of this article is intended to provide a general guide to the topic. In relation to your specific circumstances, you should seek advice from a specialist.
