How is climate analysis going to impact future finance?

Maybe you feel it too, but this summer, I am somehow even more concerned about what is happening to our planet. The burning fires and global floods make it all too clear that action is needed urgently. On the positive side, there is also a lot of great progress being made in the world of finance. One of the things that can help at scale is including climate-related risks into how our money is allocated.

Until now, investors, lenders, and insurers did not have a very clear view of how companies may fare as environmental changes evolve. This is about to change. As climate risks become the focus of central banks and supervisory authorities, 'climate stress testing' is about to become a huge part of how we allocate our money. In this issue of Money's Impact, I want to provide a bit of background into what this all means, and what we can expect to come out of it.

The link between climate and economy

Just last week, the Intergovernmental Panel on Climate Change (IPCC) released their 'Climate Change 2021' report, which addressed our current understanding of climate change and risk assessments of potential future scenarios. Immediately, public reaction showed just how terrifying these findings were...

This report, as I'm sure many of you have read, detailed how 'human influence has warmed the climate at a rate that is unprecedented in at least the last 2000 years'. Most of this damage, it adds, 'is irreversible for centuries to millennia', especially when it comes to the global sea level.

The level of human tragedy that natural disasters bring with them is hard to comprehend, and on top of the enormous losses that those on the frontlines often face, there is also an economic impact, which further challenges future recovery.

After flooding in Germany, Finance Minister Olaf Scholz announced that approximately ￡353.1 million of emergency aid would be provided, and billions more was pledged as part of a 'reconstruction programme' towards the destroyed infrastructure.

Climate risks will have a huge impact on the economy. Carbon-intensive companies, for example, could lose up to 67% of enterprise value under a 1.5°C warming scenario, if regulations were to change. To better understand these potential risks and opportunities, we have what is known as climate analysis.

The trend: climate analysis and climate stress testing

Climate analysis helps us to better understand the earth's past and present climate, in order to help us prepare sufficient and proactive responses to future climate risks and crises. This is especially important in the world of investing, through what is known as 'climate stress testing'.

What is stress testing?

When we think about investments, one of the first words that comes to most people's minds is 'risk'. Regardless of where you stand, whether it be at the very beginning, or with decades of experience, it's important to understand your attitude to risk. The way that banks and investment companies calculate 'risk' is through stress testing. Here, a computer simulation analyses how different portfolios might fare in 'drastic economic scenarios'.

What is climate stress testing?

Climate stress testing means that the economic scenarios run by the simulation are all associated with the climate crises. For example, it might take into account the economic damage caused by natural disasters, or the emerging trend of people divesting from the fossil fuel industry.

Earlier this year, the Bank of England announced that it would be launching climate stress testing, and since then, similar announcements have been made in Australia and Singapore. With many more countries following suit, this is quickly becoming an emerging trend amongst central banks.

It would have been far more difficult to perform accurate climate stress tests before the last few years, because of how few companies were releasing their climate data. Without access to points such as the average carbon footprint of an industry, these tests would not be able to predict any real long-term results.

What has climate stress testing shown?

Results from the European Central Bank have unequivocally shown that climate change is a source of systemic risk to the entire economy. It breaks this risk into two forms:

1. Physical risk: the economic impact of natural disasters, such as the destruction of infrastructure
2. Transition risk: the economic impact that new climate policies will have on carbon-intensive industries

For example, the long-term predictions for the oil industry show 'transition risk' in action, the plunging profit margin a direct antithesis to that of sustainable industries. The introduction of climate policies will almost certainly cause transition risk to increase, with companies forced to spend a huge amount of both time and money removing carbon-practices and reaching net-zero emissions. Many will also face an increased cost of raw materials, as well as a decreased profit margin.

How can you use climate stress testing?

Climate analysis is still very much exploratory, since most models remain in their early stages of development. As UBS puts it, 'there is a risk that different policy makers create a cacophony of differing standards, data taxonomies, and scenarios - let alone different environmental policies - that will be tough for investors to interpret'.

The chart below from UBS shows how climate risk is now moving to the centre of attention for central banks and supervisory authorities.

Despite these early stages, as climate analysis evolves, it can lead to new requirements for banks, insurers, and financial institutions. These changes might include a requirement to disclose appropriate data when lending capital to companies, which would make lending more expensive for high-carbon companies.

What can we do?

As normal investors, how can these global changes impact our day-to-day decisions? Here are some suggestions:

1. Watch the space: these trends exist, and will continue to influence regulations and investment practices. You must stay informed about how they impact financial institutions, but also more personal aspects, such as your pension fund manager.
2. Make use of new data: stress testing helps you to understand and make informed decisions with your money - why not use these tests to see which industries you might want to invest in, and how these results change your long-term decisions.
3. Advocate for change: we are well past the time for asking nicely. It's time to make your voice heard, and demand that climate-related risks are considered in all investment decisions. This can be as simple as asking your financial providers what they are doing to help.

What's your view? Will climate stress testing impact the future of finance?

In our next issue, I'll be discussing what all of this means for your money, and how you can measure your impact when investing sustainably (and I'll have some great guests to help!). See you then!

• Article: GreenBiz, 'Central banks can prevent the next climate-sparked financial crisis'.
• Podcast: The Climate Question, 'What do we tell the kids?'
• Report: IPCC, 'AR6 Climate Change 2021: The Physical Science Basis'.