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15th September 2021
Financial Institutions are not equipped or structured to deal with the coming wave of sustainability regulation, period. This includes the many de-carbonisation and green taxonomies heading their way in the coming years. Globally, companies – from the smallest firms to the titans of industry – are about to be revalued upwards and downwards according to their climate risk valuation. This could mean decades of severe disruption like we’ve never seen before. Those organisations that fail to adapt will most likely cease to remain viable within as short a time as five years.
Many leaders of sustainability and other decision-makers are left scratching their heads. Where do they look to for advice on their climate risk exposure? How can they access open data to build decarbonisation models for their business?
In this post, I want to outline the challenge for financial institutions as they enter a more carbon-conscious regulatory era. I also want to highlight what they can do to turn the climate risk challenge into an opportunity.
Financial institutions face an avalanche of carbon-based rules, regulations, and standards in the coming years. These changes are moving faster than many anticipated as businesses, governments, stakeholders, and individuals worldwide move toward more sustainable practices.
National lawmakers worldwide are focussing more on climate risk disclosure in line with the Task Force on Climate-Related Financial Disclosures (TCFD) framework. Greenhouse gas (GHG) emissions are a particular area of focus. Also, lawmakers are looking at the capital adequacy of financial services companies to stress-test their exposure to global warming.
The catalyst for increased and accelerated carbon regulation will be the United Nations Climate Change Conference, (COP26), in November 2021. One of COP26’s stated goals is to mobilise finance to help deliver global net zero-carbon emissions. I also expect future financial regulation to put extra pressure on the financial sector by demanding rigorous climate risk reporting. This includes the Basel V accord, which I expect will be shaped fast during 2022 and 2023 with a long series of implementation milestones.
These new laws – and the speed in which they are arriving – means it will be a case of ‘adapt or die’ for many in the financial sector. Financial institutions can’t kick the carbon regulation can down the road. They must embrace climate risk management. In the same way that a business today has a “risk appetite”, it must modify this tomorrow to include a “climate risk appetite”.
The sheer volume of data required to report effectively and to remain compliant in a carbon regulated environment means we will need a huge element of machine learning and artificial intelligence (AI) built into our operating models to make sense of it all. It will then require smart humans to oversee the processes and interpret the results with added skill and judgement.
The financial sector simply does not have this talent yet; this is a physical science coming into a financial world. Financial institutions are going to have to change their thinking and make assessments based on the available data. Smaller firms are at particular risk due to a lack of resources.
There are three key building blocks needed to create a data-led financial institution that is fit for purpose in the era of sustainable finance:
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Data TaxonomyClassify data needed to create a structure for ingesting, normalising and taxonomising it. |
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Accurate ModellingTranslate out the incredibly complex raw data to simpler-to-understand risk-based output data metrics. |
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AnalyticsUse machines to analyse, then visualise information. This way, humans – with the support of AI support – can interpret what it means and make critical decisions. |
I see two very different camps emerging within financial services companies in their approach to climate risk. The first have appointed people in nominal sustainability roles that will have little meaningful impact on the business and contribute almost nothing to their future success. The second have taken the risk management approach of highly quantitative science-based methods that will have a positive, meaningful impact on their future success.
Even in the second camp, the challenge is that climate modelling is often done by meteorologists or academics who do not always understand finance. Likewise, finance does not always understand climate modelling specialists. So, the immediate business challenge is how to accelerate bridging this gap.
The financial sector is not great at looking outside its own industry for inspiration. Yet other industries are much further advanced and provide useful precedents. The insurance industry already has vast experience mapping climate change, to the point where some businesses in high-risk areas of the world are now uninsurable. In the aerospace industry, NASA unveiled its climate risk plan in 2014, and Airbus aims to develop the world’s first zero-emission commercial plane by 2035.
Within the financial services sector, we are seeing growing momentum around sustainability themes. These include green bonds, funding for clean energy projects, and climate risk tooling and services. For example, BlackRock, which manages almost $10 trillion in assets, announced in 2020 that climate change was a priority in its 2021 investment plans. BlackRock expects companies to reveal their plans to reduce emissions. So, the pressure is not just regulatory – it’s coming from within the industry too – insurers, investors, and lenders. In the UK, NatWest delivered £9.5 billion in sustainable funding in the first half of 2021. Across Europe, Glennmont runs its REBS (Renewable Backed Securities) credit fund for clean energy technologies. In fact, the trend is moving so fast, the list of projects and initiatives is driving an urgency for green taxonomies to address the risk of misleading sustainability projects, so called “green-washing”.
Risk management has been a key part of financial services companies’ competitive edge for a long time. Similarly, climate risk management could become a defining element in the credibility of a financial services institution. Its reputation and financial value, which are already inextricably entwined, are at stake.
Those that move first in this nascent market have most to gain, but they will need to prepare their organisation for the era of sustainable finance. This requires significant change from mindset to skillset. It will be key to partner with the right consultants and data experts to shape their future modelling. The challenge is that the financial sector does not have a stable framework to undertake what the regulators are asking them to do.
At First Derivative, we’re passionate about sustainability and believe we have our own role to play in creating a sustainable finance sector that works for the benefit of all. We serve as a catalyst for our clients’ business agility and solve their toughest operational data, risk, controls, and technology challenges. We can help our clients adjust their business model to take a data-led approach to climate risk management, so what looks like an insurmountable challenge can become a potential competitive advantage. The time to act is now.
I will be writing much more regularly on what you can do to prepare for the era of carbon regulation, so be sure to contact us. And if your organisation is struggling to understand what climate risk means for you in the coming years, do please get in touch.
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Johnny D Mattimore Managing Director, Global Head of Risk & Sustainable Finance |
