Current disclosure frameworks provide a solid basis for financial institutions to assess climate risks. However, the climate resilience goals recently outlined at the Climate Adaptation Summit 2021 require these frameworks to also integrate real world resilience.
Even in the best-case scenario, if we do manage to limit global temperature rise by 2100 to +1.5°C, we can expect an 8% loss in global GDP (Carbon Brief, 2018). Climate adaptation is not a choice: our ability to adapt to both acute and chronic hazards will define how resilient our societies are to present and future climatic change. There may even be clear benefits: The Global Commission on Adaptation estimates investing $1.8tn in climate adaptation in the decade up to 2030 could yield up to $7.1tn in public and private benefits (GCA, 2019).
How is the financial sector responding to climate risks?
Financial institutions are increasingly encouraged to assess and disclose the climate risks they face, to quantify the impacts of climate change on portfolios, and to improve climate risk management. The recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) provide the most mainstream of these reporting guidelines and other reporting frameworks, namely SASB, CDSB, CDP, GRI and IIRC, have committed to working together to develop comprehensive corporate reporting, including climate risk (CDSB, 2020).
While the TCFD includes both transition and physical risks into its framework, the focus of many financial institutions has so far been on transition risks. Leading financial institutions are even moving beyond risk management and are proactively setting targets to align their portfolios with the Paris Agreement.
Does disclosure lead to real-world resilience?
These frameworks are not explicitly designed to build resilience in the wider economy and society, other than as a ‘potential co-benefit’ of portfolio risk management. Few investors are actively embedding adaptation in their investment decision-making processes. For example, only 22% of pension funds in the Netherlands currently engage with investees about climate-related physical impacts (VBDO, 2019; p.19). Even then, the focus is on direct risks at the asset level, as opposed to socio-economic adaptation impacts of the asset.
Even more than with transition risks, addressing climate-related physical risks is hugely complex. Effective adaptation will require financial institutions to also manage these risks and impacts by engaging with public institutions, civil society and other economic actors, in order to reduce the negative and increase the positive real-world impact of their business at both global and local levels.
Could disclosure at scale encourage greater engagement on adaptation?
The Network for Greening the Financial System (NGFS), a coalition of central banks and supervisors founded in 2017, stresses that climate risk disclosure can build financial sector resilience and lead to better risk management, while enabling market players to better identify opportunities ‘thereby contributing to the growth of the green finance ecosystem’ (NGFS, 2020, p.32). This will only be possible if the currently low level of physical risk disclosure is scaled up by financial institutions, leading to:
- More accurate and consistent data if a majority of financial institutions require ESG disclosure from their investees and clients. This may also encourage companies to confront climate risks and develop robust adaptation strategies (Goldstein et al., 2019);
- Greater innovation in methodology development and data analysis;
- More rapid identification of at-risk sectors and geographies. Moreover, risk pricing by banks and investors in collaboration with insurers can create new resilience-related opportunities by reorienting and scaling up finance for projects that take into account future climatic changes (CCRI, 2020).
While greater adoption of disclosure frameworks is essential for the finance sector, we cannot solely rely on this to accelerate adaptation in the real economy.
How can disclosure be improved to drive real-world resilience?
Society can only manage risks that are translated into government policies and verifiably measured and disclosed in the private sector. For the financial sector, the key is to translate those disclosures into risk management strategies that can achieve both portfolio resilience and climate resilience in the real-world. This will require disclosure frameworks that go beyond portfolio risk and include a range of indicators related to the real-world impact of investments. From a government perspective, it makes sense for financial disclosure requirements to be aligned with real-world resilience targets, enabling financial institutions to become part of the solution. The TCFD are exploring ways to align their recommendations more readily with net-zero emissions targets through, for example, Implied Temperature Rise (ITR) metrics. We believe there should also be scope for linking physical risk and impact metrics to adaptation finance (TCFD, 2020).
How can financial institutions drive greater adaptation?
Financial institutions can use existing frameworks to encourage climate risk disclosures from investees and use the information in investment decisionmaking and for their own disclosures. Building real-world resilience, however, will require the financial sector to go further. The following recommendations provide avenues for greater progress:
1. Scale up disclosure
Given the portfolio focus of disclosures, transparency on climate risks at the macro-level will only be possible if a critical mass of financial institutions commits to disclosure. UNEP FI and a leading group of financial institutions have called for mandatory disclosure as current voluntary frameworks are not delivering adequate disclosures across financial markets (UNEP FI, 2021).
2. Standardise disclosure frameworks
To facilitate more widespread disclosure, regulatory authorities should adopt more standardised approaches, including clear guidelines and best practices. This process has been catalysed by some of the leading ESG reporting frameworks (CDSB, 2020), while UNEP FI has called on governance bodies to standardise climate-related reporting on physical risks, to ensure access to climate data, and to standardise climate scenario sets (UNEP FI, 2021).
3. Enhance the level of ambition of disclosure frameworks
For financial institutions to become part of the solution, they should measure, disclose, and manage their impact on climate change resilience. This will require financial disclosure frameworks to include a range of adaptation-linked indicators.
4. Move beyond disclosure
- Shareholder engagement on climate resilience: Financial institutions should place greater emphasis on the opportunities and investor benefits from client and investee solutions for real-world resilience. There is a wide range of adaptation needs for which banks and investors can develop strategies and engage portfolio companies, project developers, and governments (VBDO, 2019).
- Public sector engagement on climate resilience: Assets cannot be made resilient in isolation. Financial institutions must therefore make sure that financial flows for adaptation are in line with local community development and national adaptation strategies. It will become imperative to collaborate with the public sector to coordinate effective adaptation.
This article was previously made available in Financial Investigator’s magazine 2021 nr 1. It is written by Jacqueline Duiker, Senior Manager, VBDO, and Paul Smith, Consultant Climate Change, United Nations Environment Programme Finance Initiative (UNEP FI).