Climate Risk too is a Financial Risk
How does Climate Change threaten the Financial System?
On 14 December 2020, Bloomberg reported that in 18 high-risk sectors such as coal, oil, and gas rated by Moody’s, a combined US$7.2 trillion of debt has a “high inherent exposure to physical climate risks".1 This massive sum is larger than any other nation’s gross domestic product, save for the USA and China.
What are climate risks?
According to the Task Force on Climate-related Financial Disclosures (TCFD), climate risks, also known as climate-related risks, refer to the potential negative impacts of climate change on an organization.2 These include market, credit, operational, and legal risks that result from changes brought about by climate change, such as the financial losses arising from physical damage caused by natural disasters, or the depreciation of carbon-intensive assets like fossil fuels.
"Financial institutions are not only exposed to climate risks directly but also indirectly, through their investees’ or clients’ exposures to these risks."
Despite these potential risks, the Network for Greening the Financial System (NFGS) has noted that many financial institutions are still unprepared to assess the specific environmental risks associated with their assets.3 This could be due to a multitude of factors that result in difficulties measuring or pricing climate risks, such as the absence of standardised definitions of green assets or risk assessment guidelines, or the lack of accessible environmental data for financial institutions.
This lack of or uncertainty in assessing climate risk by financial institutions presents a real and costly problem. Financial institutions are not only exposed to climate risks directly - especially those with offices in areas vulnerable to extreme weather events or sea-level rise - but also indirectly, through their investees’ or clients’ exposures to these risks.
Climate risks may be physical in nature, with investments or assets being affected by the adverse weather or climatic effects of climate change. Acute events, such as a tsunami, are becoming more frequent and extreme with climate change. This could result in severe business disruption and property damage, impairing asset values and increasing underwriting risks for insurers. The chronic impacts - such as global warming and sea-level rise - from physical risks are more gradual, but could cause significant harm if left unmitigated, demanding a consequential degree of investment and adaptation from businesses and governments.
The implications of climate risk for Singapore
The implications of climate risk are particularly pertinent for Singapore: despite being shielded from natural hazards, we are still prone to inland flooding. In Singapore, heavy rainfall events are becoming more frequent and more severe - annual rainfall has increased by 9 mm per decade from 1980 to 2018 - greatly increasing the likelihood of inland flooding.4 Severe floods can disrupt the supply chains and business operations of clients, reducing their profit and introducing hefty repair costs that weaken their ability to repay bank loans. Insurers are also vulnerable - in just two months, inland flooding in 2010 resulted in a whopping S$23 million in insurance claims.5
"As the numbers continue to increase, regulators are heightening their expectations of financial institutions in assessing and managing climate risk."
As the world moves in the direction of a low-carbon economy, climate risks resulting from the transition may also materialise from pressures that cause investments and assets to lose their value. Transition risks can take the shape of policy changes, shifting public sentiment, or technological innovations that affect business operations and asset values. For instance, growing demand for cleaner renewable energy could result in vast fossil fuel deposits becoming stranded assets. This creates financial risks for lenders and investors, as well as broader impacts on workers and consumers.
While this transition is positive news, it poses significant transition risks for financial institutions that do not adapt to it. Considering the energy sector alone, the potential for losses have been estimated to be up to S$5.3 trillion dollars.6 If we expand that scale to the economy at-large, this figure skyrockets to a jaw-dropping S$26.6 trillion, more than 58 times of Singapore’s gross domestic product.
Will Public Sectors take the lead on climate risk?
As the numbers continue to increase, financial regulators are heightening their expectations of financial institutions in assessing and managing climate risk. In Asia, regulators in Hong Kong, Malaysia and Singapore - the Hong Kong Monetary Authority (HKMA), Bank Negara Malaysia (BNM), and the Monetary Authority of Singapore (MAS) - are already exploring ways to guide financial institutions on climate risk management7 and hold them accountable. MAS, in particular, has issued broad guidelines that set the highest expectations among Asian regulators, covering a wide range of financial institutions and risks.8
Evidently, climate risks have translated to severe financial risks, and it is vital for financial institutions to start adopting robust frameworks to assess and mitigate these risks.
“Climate change has become the defining challenge facing both present and future generations,” MAS declared in their Financial Stability Review 2020,9 “[f]rom shifting weather patterns to rising sea levels, the risks posed by climate change are both multi-faceted and pervasive in their manifestation… [A]ssessing them will require the necessary data, expertise, and models. It is thus imperative for the financial industry to build up these resources in a timely manner, in order to better assess, manage and mitigate climate risks.”
footnotes
1 Tim Quinson (2021), Environmental Debt Risk Is Bigger Than Japan’s GDP, Bloomberg Green, https://www.bloomberg.com/news/articles/2021-01-06/environmental-debt-risk-is-more-than-japan-s-gdp-green-insight
2 Task Force on Climate-related Financial Disclosures (2017), Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures, https://assets.bbhub.io/company/sites/60/2020/10/FINAL-2017-TCFD-Report-11052018.pdf
3 Network for Greening the Financial System, (2020), Overview of Environmental Risk Analysis by Financial Institutions, https://www.ngfs.net/sites/default/files/medias/documents/ngfs_status_report.pdf
4 Dhrubajyoti Samanta & Benjamin P Horton (2020), Commentary: Why that unusually high rainfall in Singapore during the last summer monsoon may be our new normal, Channel News Asia, https://www.channelnewsasia.com/news/commentary/rain-heavy-singapore-floods-2020-climate-change-monsoon-13472548
5 Derrick A Paulo & Ang Guangzheng (2019), Climate change, floods and drought: Here’s how badly Singapore could be affected, https://www.channelnewsasia.com/news/cnainsider/how-badly-climate-change-floods-drought-could-affect-singapore-12202206#
6 Network for Greening the Financial System (2020), Overview of Environmental Risk Analysis by Financial Institutions, https://www.ngfs.net/sites/default/files/medias/documents/ngfs_status_report.pdf
7 While we use the term ‘climate risk’ in this piece, MAS has used the broader term ‘environmental risk’ which encompasses climate risk in its risk management guidelines for Financial Institutions. In this respect, MAS has cited the reason that methodologies for the assessment, monitoring and reporting of environmental risk factors beyond climate change are less developed at this juncture, but banks’ risk management approaches are expected to encompass them in the future. See e.g.: MAS (2021), Response to the Proposed Guidelines on Environmental Risk Management (Banks), para 2.3 and para 4.16
8 Maxine Nelson (2020), The next risk challenge: Environmental Risk, Eco-Business, https://www.ngfs.net/sites/default/files/medias/documents/ngfs_status_report.pdf
9 Macroprudential Surveillance Department (2020), Financial Stability Review: December 2020, Monetary Authority of Singapore, https://www.mas.gov.sg/-/media/MAS/resource/publications/fsr/Financial-Stability-Review-2020.pdf