What is Climate Risk?
Organizations and firms understand that they must modify their behaviour and business practices, to reduce the magnitude of anthropogenic climate change.
Global natural disasters, of which almost 60% were meteorological and climatological, resulted in losses of around $5.2 trillion between 1980 and 2018, and these loss numbers are trending upwards (Munich Re (2020)).
Equity and debt investor awareness and expectations with respect to climate change are increasing. A growing number of investors are incorporating climate risk considerations into their investment decisions, potentially reflecting growing pressure from non-governmental associations and environmental groups.
This can be seen in the asset management business, where some of the world’s largest asset managers who provide these investment services have signalled that they are either incorporating, or intending to incorporate, climate change into their investment approach and decision-making. The risk profile and valuation of debt and equity investments of corporates exposed to climate change will be impacted as investors undertake a reassessment of their investment decisions.
According to the Basel Committee, Climate is defined as the average weather, or more rigorously, as the statistical description in terms of the mean and variability of relevant quantities over a period of time ranging from months to thousands or millions of years.
The classical period for averaging these variables is 30 years, as defined by the World Meteorological Organization.
The relevant quantities are most often surface variables such as temperature, precipitation and wind. Climate in a wider sense is the state, including a statistical description, of the climate system.
A climate projection is the simulated response of the climate system to a scenario of future emission or concentration of greenhouse gases (GHGs) and aerosols, generally derived using climate models. Climate projections are distinguished from climate predictions by their dependence on the emission/concentration/radiative forcing scenario used, which is in turn based on assumptions concerning, for example, future socioeconomic and technological developments that may or may not be realised.
Climate-related financial risks are the potential risks that may arise from climate change, or from efforts to mitigate climate change, their related impacts and their economic and financial consequences.
Environmental Social and Governance (ESG) is a set of criteria that play a role in the investment decision-making process or in a company’s operations. Environmental factors consider how an investment or a company contributes to environmental issues such as climate change and sustainability. Social factors examine the social impacts of an investment or a company on communities. Governance relates to transparency and legal compliance of an investment or a company’s operations, for instance in terms of accounting and shareholders’ rights.
Global warming is the estimated increase in global mean surface temperature averaged over a 30-year period, or the 30-year period centred on a particular year or decade, expressed relative to preindustrial levels unless otherwise specified. For 30-year periods that span past and future years, the current multi-decadal warming trend is assumed to continue.
Anthropogenic emissions are emissions of greenhouse gases (GHGs), precursors of GHGs and aerosols caused by human activities. These activities include the burning of fossil fuels, deforestation, land use and land use changes, livestock production, fertilisation, waste management and industrial processes.
Carbon taxation (carbon tax) is a tax levied on the carbon content of some goods and services, typically in the transport and/or energy sectors. The purpose is to reduce CO2 emissions by increasing the price of these goods and services. It is one of the main types of tools used in climate change policies around the world.
Basel Committee, Climate-related risk drivers and their transmission channels
Banks and the banking system are exposed to climate change through macro- and microeconomic transmission channels that arise from two distinct types of climate risk drivers.
First, they may suffer from the economic costs and financial losses resulting from the increasing severity and frequency of physical climate risk drivers.
Second, as economies seek to reduce carbon dioxide emissions, which make up the vast majority of greenhouse gas (GHG) emissions, these efforts generate transition risk drivers.
These arise through changes in government policies, technological developments, or investor and consumer sentiment. They may also generate significant costs and losses for banks and the banking system.
Evidence suggests that the impacts of these risk drivers on banks can be observed through traditional risk categories:
1. Credit risk - Credit risk increases if climate risk drivers reduce borrowers’ ability to repay and service debt (income effect) or banks’ ability to fully recover the value of a loan in the event of default (wealth effect).
2. Market risk - Reduction in financial asset values, including the potential to trigger large, sudden and negative price adjustments where climate risk is not yet incorporated into prices. Climate risk could also lead to a breakdown in correlations between assets or a change in market liquidity for particular assets, undermining risk management assumptions.
3. Liquidity risk - Banks’ access to stable sources of funding could be reduced as market conditions change. Climate risk drivers may cause banks’ counterparties to draw down deposits and credit lines.
4. Operational risk - Increasing legal and regulatory compliance risk associated with climate-sensitive investments and businesses.
5. Reputational risk - Increasing reputational risk to banks based on changing market or consumer sentiment.
Existing literature largely focuses on the impacts of climate risk drivers on those aspects of the economy relevant to banks’ credit risk, and to a lesser extent on market risk. There is little work that takes climate risk drivers all the way through to the impact on banks. So far, empirical analysis of realised impacts is largely focused on the wider economic impacts of observed physical risks. Given its forward-looking nature, analysis of transition risks is focused on scenario analysis. To better understand transmission channels going forward, analysis on the realised impact of transition risks on banks across various jurisdictions would be valuable.
Climate-related events and risks are uncertain, and may be subject to non-linearities. Physical risks have been categorised into acute and chronic events, and while some aspects of those risks can be predictable, there is increasing uncertainty as to the location, frequency and severity of these events. For transition risks, there is uncertainty as to the future pathways that changes in policies, technology innovation and shifts in consumer sentiment contribute to shaping.
To size climate-related financial risks, banks and regulators require plausible ranges of scenarios to assess the potential impacts of both physical and transition risk drivers on their exposures. These scenarios need to be combined with sufficiently granular data that capture the climate sensitivity of their exposures and are subject to an appropriate methodology as discussed in the companion report Climate-related financial risks – measurement methodologies.
There is a limited amount of research and accompanying data that explore how climate risk drivers feed into transmission channels and the financial risks faced by banks. Existing analysis does not generally translate changes in climate-related variables into changes in banks’ credit, market, liquidity or operational risk exposures or bank balance sheet losses. Instead, the focus is on how specific climate risk drivers can impact narrowly defined sectors of particular economies, individual markets, or top-down assessments of the macro economy as a whole.
Learning from the Annual Reports
Emerging Risks, important parts from the 2021 Annual Report, Barclays Bank UK PLC
The impact on Financial and Operational Risks arising from climate change through physical risks, risks associated with transitioning to a low-carbon economy and connected risks arising as a result of second order impacts on portfolios of these two drivers.
The Barclays Bank UK Group assesses and manages its climate risk across its businesses and functions in line with its net zero ambition by monitoring exposure to elevated risk sectors, conducting scenario analysis and risk assessments for key portfolios. Climate risk controls are embedded across the Financial and Operational Principal Risk types through the Barclays Group’s Frameworks, Policies and Standards (which apply to the Barclays Bank UK Group).
Material existing and emerging risks impacting individual principal risks
The risks associated with climate change are subject to rapidly increasing societal, regulatory and political focus, both in the UK and internationally. Embedding climate risk into the Barclays Bank UK Group’s risk framework in line with regulatory expectations and requirements, and adapting the Barclays Bank UK Group’s operations and strategy to address the financial risks resulting from both:
(i) the physical risk of climate change; and
(ii) the risk from the transition to a low-carbon economy,could have a significant impact on the Barclays Bank UK Group’s business, results of operations, financial condition and prospects, the Barclays Bank UK Group’s customers and clients and the creditworthiness of the Barclays Bank UK Group’s counterparties.
Physical risks from climate change arise from a number of factors and relate to specific weather events and longer-term shifts in the climate. The nature and timing of extreme weather events are uncertain but they are increasing in frequency and their impact on the economy is predicted to be more acute in the future.
The potential impact on the economy includes, but is not limited to, lower GDP growth, higher unemployment and significant changes in asset prices and profitability of industries. Damage to properties and operations of borrowers could impair asset values and the creditworthiness of customers leading to increased default rates, delinquencies, write-offs and impairment charges in the Barclays Bank UK Group’s portfolios. In addition, the Barclays Bank UK Group’s premises and resilience may also suffer physical damage due to weather events leading to increased costs for the Barclays Bank UK Group.
As the economy transitions to a low-carbon economy, financial institutions such as the Barclays Bank UK Group may face significant and rapid developments in stakeholder expectations, policy, law and regulation which could impact the lending activities the Barclays Bank UK Group undertakes, as well as the risks associated with its lending portfolios and the value of the Barclays Bank UK Group’s assets.
As sentiment towards climate change shifts and societal preferences change, the Barclays Bank UK Group may face greater scrutiny of the type of business it conducts, adverse media coverage and reputational damage, which may in turn impact customer demand for the Barclays Bank UK Group's products, returns on certain business activities and the value of certain assets resulting in impairment charges.
In addition, the impacts of physical and transition climate risks can lead to second order connected risks, which have the potential to affect the Barclays Bank UK Group’s retail and wholesale portfolios. The impacts of climate change may increase losses for those sectors sensitive to the effects of physical and transition risks. For example, the Barclays Bank UK Group’s UK mortgage and agriculture portfolios are particularly exposed to both the physical and transition risks of climate change.
The mortgage portfolio is affected by the risks of flooding, subsidence and energy efficiency performance requirements, all of which may impact property valuations, whilst the agriculture portfolio is exposed to flooding and drought, as well as the potential for legislative changes and changes in consumer behaviour. Furthermore, any subsequent increase in defaults and rising unemployment could create recessionary pressures, which may lead to wider deterioration in the creditworthiness of the Barclays Bank UK Group’s clients, higher ECLs, and increased charge-offs and defaults among retail customers.
With effect from 1 January 2022, climate risk became one of the principal risks within the Barclays Bank UK Group’s Enterprise Risk Management Framework. Failure to adequately embed risks associated with climate change into its risk framework to appropriately measure, manage and disclose the various financial and operational risks it faces as a result of climate change or failure to adapt the Barclays Bank UK Group’s strategy and business model to the changing regulatory requirements and market expectations on a timely basis, may have a material and adverse impact on the Barclays Bank UK Group’s level of business growth, competitiveness, profitability, capital requirements, cost of funding, and financial condition.
In March 2020, the Barclays Group announced its ambition to become a net zero bank by 2050 and its commitment to align all of its financing activities with the goals and timelines of the Paris Agreement. In order to reach these ambitions and targets or any other climate related ambitions or targets the Barclays Group may commit to in future, the Barclays Bank UK Group will need to incorporate climate considerations into its strategy, business model, the products and services it provides to customers and its financial and non-financial risk management processes (including processes to measure and manage the various financial and non-financial risks the Barclays Bank UK Group faces as a result of climate change). The Barclays Bank UK Group also needs to ensure that its strategy and business model adapt to changing standards, industry and scientific practices, regulatory requirements and market expectations regarding climate change, which remain under continuous development and are subject to different interpretations.
There can be no assurance that these standards, practices, requirements and expectations will not be interpreted differently than what was the Barclays Group’s understanding when defining its climate-related ambitions and targets, or change in a manner that substantially increases the cost or effort for the Barclays Bank UK Group to achieve such ambitions and targets.
In addition, the Barclays Group’s ambitions and targets may prove to be considerably more difficult or even impossible to achieve under such changing circumstances. This may be exacerbated if the Barclays Group chooses or is required to accelerate its climate-related ambitions or targets as a result of (among other things) regulatory developments or stakeholder expectations.
Achieving the Barclays Group’s climate-related ambitions and targets will also depend on a number of factors outside the Barclays Bank UK Group’s control, including (among other things) availability of data to measure and assess the climate impact of the Barclays Bank UK Group’s customers, advancements of low-carbon technologies and supportive public policies in the markets where the Barclays Bank UK Group operates. If these external factors and other changes do not occur, or do not occur on a timely basis, the Barclays Group may fail to achieve its climate-related ambitions and targets and this could have a material adverse effect on the Barclays Bank UK Group’s business, results of operations, financial condition, prospects and reputation.
Climate risk management
The impact on Financial and Operational Risks arising from climate change through, physical risks, risks associated with transitioning to a lower carbon economy and connected risks arising as a result of second order impacts on portfolios of these two drivers. Overview Given the increasing risks associated with climate change, and to support the Barclays Group’s ambition to be a net zero bank by 2050, it was agreed that climate risk would become a Principal Risk from 2022.
To support this decision, in 2021 the Barclays Group delivered a Climate Risk Integration Plan with three overarching objectives:
1. Governance Framework: Develop a Principal Risk Framework and Risk Appetite Statement and integrate climate drivers into limit setting
2. Scenario Analysis: Refine methodologies used for the 2020 scenario analysis to support the Bank of England Biennial Exploratory Scenario on climate change, with specific focus on wholesale credit and physical risk modelling
3. Carbon Modelling: Enhance the BlueTrackTM model to further develop the approach for the Energy sector, expand coverage to Cement and Metals and consider the overall net zero ambition of the Barclays Group
A Climate Risk Appetite at Barclays Group level was introduced in line with the Barclays Group’s risk appetite approach. It establishes a direct link between strategic plans and risk appetite, supporting the Barclays Group’s ambition to be a net zero bank by 2050. The Barclays Bank UK Group has introduced a climate risk appetite and constraint, in line with the Barclays Group approach. Work is ongoing to define quantitative targets against which the strategic plan will be tested.
Climate Risk, important parts from the 2020 Annual Report, Airbus
Climate change may have a major impact on both the Company’s industrial operations and its upstream and downstream value chain, including aircraft direct operations and the wider air transport ecosystem along with a strong influence on regulations and stakeholders expectations. Accordingly, climate-related risks can potentially affect the Company’s business and competitiveness, its customers and other actors from the aviation industry.
The Company categorises its climate-related risks and opportunities according to the Task Force on Climate-related Financial Disclosures (“TCFD”) recommendations. In particular, risks are sorted into two categories: transition and physical.
Technology: The Company has identified the risk of a reduction in the Company’s business, results of operations and financial condition if a competitor brings a lower emission product to the market before it does.
Delivering on commitments and potential future requirements to mitigate climate impacts will require significant technological developments for the commercial aircraft sector.
In the event that a competitor or new market participant has access to technological developments unavailable to the Company and is able to place on the market a large passenger aircraft with significantly lower emissions before the Company, climate mitigation requirements may temporarily push the market towards competing products until the Company can develop a competing alternative, which could lead to a temporary loss of market competitiveness and reduced revenue.
Market: Changes in societal expectations and growing concerns about climate change may impact market demand for air transport. In particular, a change in certain passengers’ behaviour or their transition to other transport modes could decrease the demand for the Company’s current and future generation of products, causing a loss of revenues.
The development of future products based on the ZEROe concepts will require significant investments in both products and supporting infrastructure, which could directly impact the operating costs of such a product.
The competitiveness of this next generation product will also strongly depend, among other factors, on the evolution of the price of carbon. It is therefore crucial for the Company to account at each step of development for market expectations, while staying affordable for its customers and competitive with regards to competitors’ portfolios. The failure to do so could result in the Company losing market share to competitors, as well as affecting the Company’s return on investment with regards to future commercial aircraft products.
Policy and Legal: Aviation is a complex industry, with long product development cycles and where change takes a long time to be implemented.
A rapid evolution of climaterelated policies (such as carbon pricing policies and sustainable aviation fuel policies) and regulatory frameworks (CO2 standards, sustainable finance, emissions trading systems, aircraft operation restrictions among others) could generate fast-changing requirements and could obstruct new product development pathways.
As aviation is a global industry, policies and regulatory frameworks implemented at regional level rather than international level, or evolving at a different speed depending on the region, would unbalance a competitive level playing field for manufacturers and operators possibly creating market distortion. This could result in a loss of competitiveness for the Company.
Reputation: Reputational risks could be divided in several categories.
Firstly, there is a risk that misperceptions about the Company’s environmental performance is used as a key decision-making criteria for consumers, investors, or even new talents.
Secondly, there is a risk that the Company’s reputation is damaged by growing societal concerns about the climate change impact of aviation or by the lack of transparency on progress made to address climate-related issues.
As an example, the Company was the first manufacturer to disclose its ambition to bring a zero-emission aircraft to the market.
If the ambition is perceived as unattainable or if the Company is not able to deliver on its ambition it could result in reputational damage leading to reduced investment, loss of revenues and reduced attractiveness. A similar situation could occur if the Company’s environmental performance is not on par with its expressed ambition.
Physical Risks: The foreseen consequences of climate change include harsher average weather conditions and more frequent extreme weather events, such as hurricanes, hail storms, heat waves or extreme cold spells.
To cope with degraded operational conditions, costly, time-consuming and more frequent redesigns may be required by the Company to improve its products to meet more stringent regulation and certification criteria or standards.
The effects of climate change on weather conditions may impact operating conditions of the Company’s industrial activities (including the activities of its supply chain) with higher occurrence and severity of, for instance, hurricanes, hail storms or floods.
As a consequence, industrial activities may be disrupted or interrupted if a part of the Company’s industrial system or its supply chain is affected or impaired by such events.
The Company’s future installations may require more stringent requirements and planning to withstand more intense weather events.
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