Climate change and Risk Management – what should actuaries do?

How should actuaries advise their companies on climate change? Increasingly all financial institutions need to consider the impact of the risks associated with climate change on their core businesses. Even if they aren’t exposed to the physical risks of climate change (as general insurers are), other risks are increasing and need to be managed.

The Actuaries Institute has recently put out an Information Note for Appointed Actuaries – how should they advise their companies on climate change? It’s a really good summary, even for non actuaries, so I thought I’d share what I learned from being part of the team that put it together.

Financial institutions are unavoidably exposed to climate risk in a number of ways.

Climate change is a material strategic risk and one of the major challenges facing financial institutions today. Investors in financial institutions acknowledged this in 2017 when the Taskforce for Climate Related Financial Disclosures (“TCFD”) released a voluntary disclosure basis. Regulators have recognised that the financial risks associated with climate change have the ability to undermine financial stability and are increasing their expectations around the measurement and management of climate change risks and opportunities.

Types of climate risks

Financial Institutions are exposed to climate impacts through three main mechanisms, as identified by the Bank of England’s Prudential Regulation Authority:

• Physical risks: The first-order risks arising from weather-related events. Impacts may arise directly through damage to property and business interruption, or indirectly through subsequent events such as disruption of global supply chains and the resulting effect on commercial businesses.
• Transition risks: The financial risks arising from a transition to a low-carbon economy. This includes the potential impact on asset values of carbon-intensive financial assets, and impact on insurance premiums from carbon-intensive sectors of the economy.
• Liability risks: Directors or trustees may be held responsible for failing to mitigate against climate change physical risks, or the risks arising from the transition to a low-carbon economy, as they relate to their organisation. These risks can manifest directly from an insurers’ own action/inaction, or through the activities of customers as risk is passed on to insurance firms under liability contracts such as professional indemnity and directors’ and officers’ insurance. Reputational risk arising from insurers’ broader management of climate change is a related risk which may amplify impacts on insurers.

Insurers, particularly general insurers spend a lot of time considering physical risks – hailstorms, bushfires and cyclones are all events which are more likely to occur in a world changed by climate change. As a community, those physical risks are how we think of climate change.

The insight for me from this piece of work was how important transition risks are if you have any financial investments. In that case, the transition risk may well be bigger than the physical risk. Even in the three months since we finalised our advice, this has become massively apparent.

• Investing in a coal mine with a valuation implicitly assuming income for the next 30 years? Could be very risky, if the rest of the world stops buying coal, no matter what you personally think of coal as a fuel source.
• Investing in debt backed by a port built to transport gas out of the country? If the gas industry loses its customer base as the world starts to move towards zero carbon emissions, the port will also lose its customer base.
• On the positive side – thinking of investing in a renewable energy project in regional Australia? The upside will be bigger the more the world values energy produced from low or zero carbon infrastructure.

It doesn’t matter what you think about the appropriate action the world should take about climate change; the world will take some form of action. And any financial instrument you have will be exposed to that action. So appropriate risk management of financial instruments increasingly involves understanding the economic landscape of carbon emissions; particularly if you are investing in a country like Australia which is highly exposed to high carbon energy production.

General insurers have long been concerned about climate change – the physical risks from the increases in cyclones, bushfires, hailstorms and many other events increase the costs of the risks they insure.

The impact on the financial services sector is about much more than the physical risks insured by general insurers. All financial services providers need to be concerned. No part of the economy will be untouched by actions that are taken to reduce carbon emissions, and anyone involved in risk management in a financial services company will have to understand the transition risk of moving to a low carbon economy. And that transition is accelerating – announcements of abandoned fossil fuel projects and reductions in lending and investment seem to happen every day.  Tim Buckley from The Institute for Energy Economics and Financial Analysis (IEEFA) explains in his round up of fossil fuel trends in 2020 here:

It is no coincidence that Exxon Mobil has destroyed US$150bn or more than 50% of its shareholder wealth just to-date in 2020. This marks an acceleration of the trend that has seen its market capitalisation shrink by a staggering US$350bn since 2000. One could fairly ask if the board needs to re-evaluate its generosity to, and patience with, current leadership?

Global capital is adopting the moral high ground on Environmental, Social & Governance (ESG), but mainly because it is the economically sensible thing to do. Their fiduciary duty is to manage risk, and there is no bigger risk than the financial risks of climate change.

Consideration of climate risk is increasingly part of the management of risk for any financial institution.