Climate risk is forcing banks towards integrated risk management software | Part 1

In this article, we’ll cover what climate risk is and how does it affect today’s socioeconomic systems and banks in the upcoming decades. Besides that, we’ll try to map out what banks can do, in order to prepare for what’s coming.

See also our upcoming webinar: ESG – Climate Risk management in banks

What is climate risk in the first place?

For over 10 000 years – practically the whole existence of human civilization – the Earth’s climate has stayed rather stable but is now changing relatively fast.

Climate science has concluded that the rise in average temperatures will lead into more frequent and severe acute hazards, such as floods and heat waves, and the intensifying of chronic hazards, such as rising sea levels and drought.

This sets virtually every aspect of life under requirements of adaptation – financial life as an intertwined element most definitely included.

By definition, climate risk is a term referring to risk assessment based on formal analysis on the consequences, likelihoods and responses to the effects of climate change and how societal constraints shape adaptation options. But what does this mean for finance?

How does climate risk affect financial institutions?

The impact of climate change on finance is a double-edged sword, consisting of so called policy risk (a.k.a. transition risk) and physical impact risk, both of which are already a reality.

The first can be seen through a tightening of climate policies and regulations across the world. The aspiration to shift the economy away from fossil fuels, further accelerated by the Paris Agreement’s goal to limit global warming to 1.5 or 2 degrees Celsius, will undoubtedly guide future investment patterns and demand more from banks.

The second factor is a physical impact risk referring to the adverse effects of climate change itself, such as extreme weather, floods or droughts, and the rise of sea level. The growing frequency and severity of these kinds of events and conditions can lead to destabilizing losses for insurance companies, banks, etc. This in turn will certainly trickle down to different affected industries and assets.

In expert predictions the current worst-case scenario would by the year 2100 entail a rise of more than 4 degrees in the global average temperature compared to pre-industrial levels, rising emissions, forced migration of hundreds of millions of people, and a significant increase in extreme conditions. According to one estimate this scenario would cause a staggering $23 trillion in economic losses per year which in comparison would far outreach the financial crisis of 2007-2008.

In the best-case scenario warming above pre-industrial levels is limited to about 1.5°C and adequate as well as successful steps have been taken to enable steep declines in emissions. Weather extremes would still occur and cause damage but in much more manageable scale. Banks and other financial institution would have managed to adjust to the change and global economy would prevail.

How climate risk may change our socioeconomic system

No matter the severity of the outcome within the next 80 years, climate change keeps putting world in dire straits. If allowed to continue there is an acute risk of new areas developing to a state where the ability to work outdoors is hindered or in extreme cases it becomes life endangering. More areas of the Earth could even become uninhabitable. As temperatures rise, conditions also become more hospitable for diseases.

Climate risk is forcing banks towards integrated risk management software | Part 1

In close connection to livability and workability are the conditions of food systems. Every corner of the World has at some point experienced events that have led to difficulties in food production. This kind of situation developing in many areas simultaneously could however prove to be devastating.

Interconnected with this is the fate of the world’s natural capital. Climate change is already shifting ecosystems and as the phenomenon continues, more of them are lost to unfavorable conditions. On the other hand a change can mean that even if conditions worsen somewhere, they might become favorable in someplace else.

Extreme conditions also put under strain the manmade physical assets such as buildings and infrastructure. Damage and destruction in this area is prone to have knock-on effects, such as disruption of certain services or an increase in the costs of some others. This can create distrust that in turn further shakes the foundations of the whole socioeconomic structure.

Regulation-, competitive- and financial risks associated with climate risk

According to scientists’ humankind has already raised the global average temperature by 1 degree and the trend is prone to keep climbing for at least another decade. As a certain point of no return has already been passed, the only realistic option is to try to minimize the damage. As the scientific evidence has gradually put the legislators on the move, the financial sector faces challenges in adjusting to the change.

The operating conditions of different financial institutions and their success in competitive situation will be more and more dependent on their ability to adjust to the tightening regulations. This will hopefully lead into a positive spin wheel in which the fight against climate change as well as the climate risk management become even more desired policies.

Tightening the leash too much too fast however poses another risk which has to do with making sure the big institutions can in fact keep up with the restructuring. As the history of financial crisis has shown, systemically important institutions are able to and will transmit their peril throughout the financial system.

Climate risk management in banks

To succeed in comprehensive climate risk management, large-scale efforts are needed. As more and more institutions awake to the possible adverse outcomes, ways to build resilience are being integrated to their operations. Characteristic to this approach is its holistic nature aiming to understand the risks, anticipate their impacts, and promote ways to adapt to them. 

Instead of being reactive, the role of integrated risk management is more over proactive. Not about finding ways to avoid or minimize a certain risk but to turn it into a tool of growth.

As the heart of any bank’s operation is its software, a great way to promote risk management is to utilize an appropriate and reliable software solution. Climate risk management should not be viewed as a separate process but rather as an integral part of operations. In the same way the program design and implementation of a risk management software should become an integral part of the institution. Both its software and its execution of modern climate risk management.