The shape of risks to come
Exploring sustainability finance risk analysis, its challenges and what lies ahead
The Taskforce on Climate-related Financing Disclosure (TCFD) defines risks as transitional or physical. Transitional risks come about due to a shift away from carbon-intense technologies intending to mitigate climate change, such as a firm owning stranded fossil fuel assets. Physical risks are a direct result of climate change itself, such as a flood, drought, mass famine and subsequent financial hardship, forced migration or immigration.
“It’s very difficult to assess risk around climate change because of the time scales between actions we take today and the impact of those actions are very long,” states Jonathan Drew, managing director, sustainable finance in real assets & structured finance group, HSBC, during a talk at the 14th Asia Bond Markets Summit in Singapore, organized by The Asset in association with the Asian Development Bank.
“The big potential climate impacts lie outside the boundaries of the models we have available to us today, hence producing robust and valid forecasts, and running reliable scenarios on which to base our risk assessment is very challenging,” he adds. “And there is a real data challenge.”
“We don’t even have particularly good data on the carbon footprint of each of the constituent parts of any portfolio today against scopes 1, 2 or 3 of greenhouse gas emissions [as defined globally by the Greenhouse Gas Protocol].”
If carbon pricing – a tax or cap-and-trade system on carbon emissions intended to discourage the use of fossil fuels - comes into effect, an investor will need to know how an asset will be affected, for example, its stock price, its owner’s ability to service its debt obligations, and, at another level, whether the asset is part of a high-carbon supply chain or whether other low-carbon alternatives are available. And, if investors are not dealing with these issues, they are at risk, Drew warns. “With such difficulties in assessing risks we have to acknowledge significant uncertainty associated with current valuations.”
New technologies – smart technology, fintech, IoT - could play a crucial part in solving the data collection problem by improving availability and the management of resources.
Satellites, especially for earth modelling, definitely will play an important role in the collection, transmission, and assessment of data when attempting to predict climate change events, such as where or when severe weather impacts might occur.
Earth modelling for risk factors would allow an increased level of granularity and result in a better level of risk assessment. This would involve incorporating a map of physical assets into the modelling process to get a better read of where you might foresee physical or financial loss from climate change.
However, we are not near having that capability today, Drew notes, though there has been discussions at various academic institutes, including some in Singapore, about modelling on that scale of granularity. This level of modelling would require a huge amount of data processing and the massive use of artificial intelligence in calculating the degree of risk assessment.
The next step in defining sustainability-associated risks would be to conduct scenario analysis. “I think where we are today is that we urgently need to put together analytical tools that integrate financial and earth system models to project the future financial performance of individual economic actors or portfolios under different scenarios,” Drew explains. “This is a crucial piece of work of phenomenal complexity.”
It is something no bank or individual institution could bring about alone. It has only been attempted by someone like Nobel prize-winning scholar William Nordhaus at Yale, Drew reveals. Nordhaus, over 30 or 40 years of work with his integrated assessment model, has attempted to assess the cost of failing to adapt or transition to low carbon by costing out the actual adaptation process, then creating a total cost curve, and modelling to find a carbon price.
“If we are to tackle this, we need to look at this line by line, look at how economic activity drives carbon emissions or pollution, feed that into the earth modelling system and ask what that means in terms of greenhouse gas concentration in the atmosphere, and how that drives temperature and how temperature change in turn feeds back into the financial system transmitted through physical and social impacts,” Drew elaborates.
As well, there is the hugely complex task of looking at how temperature impacts the physical world, such as causing storms or droughts, how they in turn drive social events, and how they, in reaction, have economic and financial impacts across areas of the world.
“Then, we need to start running scenarios using that model,” Drew explains, testing and stressing the model around baseline assumptions using different scenarios, such as 1°C, 2°C or 4°C temperature-rise pathways. A successful model would allow investors to analyze these different risks scenarios, shift between different sectors of economic activity, and, finally, develop positions for their assets and businesses around such scenarios to mitigate losses or optimize profit.
“And as financial institutions, we are increasingly being asked to run such scenarios by our friendly regulators. Asking the question is one thing. Answering it is another,” he points out. “This also aligns to TCFD recommendations, which many of us have signed up and committed to. And it will probably, in the near future, become mandatory for all of us to undertake exactly that type of scenario analysis.”
This is the type of analysis that lies ahead for banks, and its tenor is long-term – over 10, 20, 30 years - compared with the current short-term stress-testing of three to ten years they are used to, Drew shares. The Monetary Authority of Singapore has already asked banks “to look at scenarios with different carbon pricing, different transition mechanism, and different impacts on GDP”.
The huge challenge now, Drew sees, is to position our world and businesses around a sustainable future. And even though climate change-triggered economic and social consequences are phenomenally difficult to predict, the models to easily analyze them are beyond our current technical capability, and many structural and systemic risks are often related to factors beyond our decision-making abilities, he notes.
“We can imagine a successful transition [to a sustainable future]. Scenario analysis using robust models with appropriate assumptions will demonstrate that a successful transition is the high growth path. In fact, it is the only growth path.
Such analysis will guide that the solution to climate risks is to take risks and put capital to work to de-carbonize, de-pollute, deliver a successful transition, deliver strong returns and deliver opportunities for future generations.”
And why not, investors can’t lose. A 2019 research paper for the Morgan Stanley Institute for Sustainable Investing conducted on the performance of close to 11,000 mutual funds between 2004 and 2018 found that, across regions, asset classes, and time periods, sustainable funds provided returns in line with comparable traditional funds while demonstrating lower downside risk. Perhaps this explains the current high and increasing demand for sustainability-linked loans and bonds.