INSTITUTE OF RISK MANAGEMENT TANZANIA

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CLIMATE - RELATED RISKS AND ITS IMPACT ON FINANCIAL STABILITY

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PRESENTER

DR. M. J. MKANDAWILE

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CLIMATE RELATED RISKS

• One of the most significant, and perhaps most misunderstood risks that organizations face today relates to climate change.
• Climate-Related Risk refers to the potential impacts of Climate Change on an organization.
• It includes the potential for adverse effects on lives, economy, social and cultural assets, services and infrastructure due to climate change.

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Justification

• The predicted impacts of climate change are becoming increasingly visible.
• Climate-related risks—including extreme weather events, water scarcity and the failure to adapt and mitigate climate change—are among the top risks the world faces.
• Policymakers, researchers and the public increasingly recognize the need to address climate-related risks through cooperation and dialogue.

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�Climate-Related Risk Drivers�

Climate risk drivers can be grouped into one of two categories:

Physical Risks

• Physical risks are those that are tied to weather and climatic changes that impact the economy.
• They can be subdivided further into acute risks and chronic risks
• Acute physical risks come about due to extreme weather events such as wildfires, floods, storms, hurricanes, typhoons, and cyclones.
• Chronic physical risks are associated with long-term progressive shifts in climate such as rising sea levels, ocean acidification, and rising temperatures.

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�Climate-Related Risk Drivers�

Transition Risks

• Transition risks refer to societal disruptions arising from adjustments towards a low-carbon economy.
• Migration to a low carbon economy (an economy based on energy sources that produce low levels of greenhouse gas (GHG) emissions) comes with a host of changes that impact not just working conditions but also the products manufactured.

Sources of transition risk include:

• Changes in public sector policies;
• Innovation and modifications in the affordability of existing technologies (e.g. that make renewable energies cheaper

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�Scope�

• If the world fails to step up climate action, continuing on the current climate change trajectory could force 100 million people into extreme poverty by 2030.
• Africa is the most-exposed region to the adverse effects of climate change despite contributing the least to global warming.
• Devastating cyclones affected 3 million people in Mozambique, Malawi, and Zimbabwe in the spring of 2018.
• GDP exposure in African nations vulnerable to extreme climate patterns is projected to grow from USD895 billion in 2018 to about USD1.4 trillion in 2023—nearly half of the continent’s GDP.

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Climate Change as a source of financial risk

• Climate change is therefore one of the major risks threatening the well-being of mankind.
• It has increased the frequency and magnitude of extreme weather events causing loss of lives, diminished livelihoods, reduced crop and livestock production, and damaged infrastructure, among other adverse impacts.
• Consequently, it is increasingly recognized as a source of financial risks for financial organizations and corporates.

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Specifics: Transition Risks

1. Policy and Legal Risks

Policy actions around climate change continue to evolve. Their objectives generally fall into two categories—policy actions that attempt to constrain actions that contribute to the adverse effects of climate change or policy actions that seek to promote adaptation to climate change.

Some examples include shifting energy use toward lower emission sources, adopting energy-efficiency solutions, encouraging greater water efficiency measures, and promoting more sustainable land-use practices.

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2. Technology Risk

• Technological improvements or innovations that support the transition to a lower-carbon, energy efficient economic system can have a significant impact on organizations.
• For example, the development and use of emerging technologies such as renewable energy, battery storage, energy efficiency, and carbon capture and storage will affect the competitiveness of certain organizations, their production and distribution costs, and ultimately the demand for their products and services from end users.

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3. Market Risk

• While the ways in which markets could be affected by climate change are varied and complex, one of the major ways is through shifts in supply and demand for certain commodities, products, and services as climate-related risks and opportunities are increasingly taken into account.

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3. Reputation Risk

• Climate change has been identified as a potential source of reputational risk tied to changing customer or community perceptions of an organization’s contribution to or detraction from the transition to a lower-carbon economy.

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Physical Risks

• Physical risks resulting from climate change can be event driven (acute) or longer-term shifts (chronic) in climate patterns.
• Physical risks may have financial implications for organizations, such as direct damage to assets and indirect impacts from supply chain disruption.
• Organizations’ financial performance may also be affected by changes in quality; food security; and extreme temperature changes affecting organizations’ premises, operations, supply chain, transport needs, and employee safety.

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�Financial Impacts�

• Fundamentally, the financial impacts of climate-related issues on an organization are driven by the specific climate-related risks and opportunities to which the organization is exposed and its strategic and risk management decisions on managing those risks
• The financial impacts of climate-related issues on organizations are not always clear or direct, and, for many organizations, identifying the issues, assessing potential impacts, and ensuring material issues are reflected in financial filings may be challenging.

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Financial Impacts�

Key reasons for this are likely because of

• (1) limited knowledge of climate-related issues within organizations;
• (2) the tendency to focus mainly on near-term risks without paying adequate attention to risks that may arise in the longer term; and
• (3) the difficulty in quantifying the financial effects of climate-related issues.

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Major Categories of Financial Impact

Revenues.

• Transition and physical risks may affect demand for products and services.
• In particular, given the emergence and likely growth of carbon pricing as a mechanism to regulate emissions, it is important for affected industries to consider the potential impacts of such pricing on business revenues

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���Expenditures��

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• An organization’s response to climate-related risks and opportunities may depend, in part, on the organization’s cost structure.
• Lower cost suppliers may be more resilient to changes in cost resulting from climate-related issues and more flexible in their ability to address such issues.
• By providing an indication of their cost structure and flexibility to adapt, organizations can better inform investors about their investment potential. It is also helpful for investors to understand capital expenditure plans and the level of debt or equity needed to fund these plans.
• The resilience of such plans should be considered bearing in mind organizations’ flexibility to shift capital and the willingness of capital markets to fund organizations exposed to significant levels of climate-related risks.
• Transparency of these plans may provide greater access to capital markets or improved financing terms

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Assets and Liabilities.

• Supply and demand changes from changes in policies, technology, and market dynamics related to climate change could affect the valuation of organizations’ assets and liabilities.
• Use of long-lived assets (assets that are expected to provide economic benefits over a future period of time, typically greater than one year) and, where relevant, reserves may be particularly affected by climate-related issues.
• It is important for organizations to provide an indication of the potential climate-related impact on their assets and liabilities, particularly long-lived assets.

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Examples of Climate-Related Risks and Potential Financial Impacts

Type: Transition risks

Example: Technology

Climate-Related Risks:

• Substitution of existing products and services with lower emissions options
• Unsuccessful investment in new technologies
• Costs to transition to lower emissions technology

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Potential Financial Impacts:

• Write-offs and early retirement of existing assets
• Reduced demand for products and services
• Research and development (R&D) expenditures in new and alternative technologies Capital investments in technology development
• Costs to adopt/deploy new practices and processes

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Examples of Climate-Related Risks and Potential Financial Impacts

Type: Transition risks

Example: Market

Climate-Related Risks:

• Changing customer behavior
• Uncertainty in market signals
• Increased cost of raw materials

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Potential Financial Impacts:

• Reduced demand for goods and services due to shift in consumer preferences
• Increased production costs due to changing input prices (e.g., energy, water) and output requirements (e.g., waste treatment)
• Abrupt and unexpected shifts in energy costs
• Change in revenue mix and sources, resulting in decreased revenues
• Re-pricing of assets (e.g., fossil fuel reserves, land valuations, securities valuations

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Examples of Climate-Related Risks and Potential Financial Impacts

Type: Transition risks

Example: Reputation

Climate-Related Risks:

• Shifts in consumer preferences
• Stigmatization of sector
• Increased stakeholder concern or negative stakeholder feedback

Potential Financial Impacts:

• Reduced revenue from decreased demand for goods/services
• Reduced revenue from decreased production capacity (e.g., delayed planning approvals, supply chain interruptions)
• Reduced revenue from negative impacts on workforce management and planning (e.g., employee attraction and retention)

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Examples of Climate-Related Risks and Potential Financial Impacts

Type: Physical risks

Example: Acute

Climate-Related Risks:

• Increased severity of extreme weather events such as cyclones and floods

Example: Chronic

Climate Related risks

• Changes in precipitation patterns and extreme variability in weather patterns
• Rising mean temperatures
• Rising sea levels

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���Potential Financial Impacts�� �

• Reduced revenue from decreased production capacity (e.g., transport difficulties, supply chain interruptions)
• Reduced revenue and higher costs from negative impacts on workforce (e.g., health, safety, absenteeism)
• Write-offs and early retirement of existing assets (e.g., damage to property and assets in “high-risk” locations)
• Increased operating costs (e.g., inadequate water supply for hydroelectric plants or to cool nuclear and fossil fuel plants)
• Increased capital costs (e.g., damage to facilities)
• Reduced revenues from lower sales/output
• Increased insurance premiums and potential for reduced availability of insurance on assets in “high-risk” locations

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Governance: management’s role in assessing and managing climate related risks

Responsibilities of the board and senior management:

• The board has the primary responsibility to oversee effective management of climate-related risks of an organization.
• To fulfil this responsibility, the board should consider climate-related risks when developing the organization’s overall business strategy, business objectives and risk management framework and to exercise effective oversight on their implementation

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The board and senior management should:

• Assess and quantify the organizan’s exposure to climate-related risks arising from its various lines of business.
• oversee development of a climate risk strategy.
• Define and formally allocate roles and responsibilities, as appropriate, within the organizational structure for implementation of the organization’s climate-related risk management framework and in line with its risk profile

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Senior management is responsible for:

• implementation of the organization’s climate risk strategy through regular updates and management information.
• The climate risk strategy should be incorporated into the organization’s risk management framework
• implementing strategies in a manner that limits climate related risks associated with each business strategy

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Implementation

• To ensure effective development and implementation of climate strategy, the board should play an active role in overseeing the development and implementation of the organization’s climate strategy, including:
• setting the organizations’ climate-related financial risk appetite and obtaining assurance that the risks are effectively managed and controlled.
• approving the climate strategy recommended by senior management, having regard to relevant local, regional and global developments (including economy-wide, nationwide and internationally agreed goals).
• ensuring that there are appropriate resources, processes, systems and controls to support the implementation of the strategy.
• cultivating a risk culture from the top that embeds climate-related considerations into the business activities and decision-making process.

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Strategy: Organization’s role in assessing and managing climate related risks

Organizations should provide the following information:

• a description of what they consider to be the relevant short-, medium-, and long-term time horizons, taking into consideration the useful life of the organization’s assets or infrastructure and the fact that climate-related issues often manifest themselves over the medium and longer terms,
• a description of the specific climate-related issues for each time horizon (short, medium, and long term) that could have a material financial impact on the organization, and
• a description of the process(es) used to determine which risks and opportunities could have a material financial impact on the organization.

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• organizations should also put forward how identified climate-related issues have affected their businesses, strategy, and financial planning.
• Organizations should consider including the impact on their businesses and strategy in the following areas:

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Risk Management: Organization's role in assessing and managing climate related risks

• Organizations should describe their risk management processes for identifying and assessing climate-related risks.
• Organizations should describe whether they consider existing and emerging regulatory requirements related to climate change (e.g., limits on emissions) as well as other relevant factors considered.
• Organizations should also consider disclosing the processes for assessing the potential size and scope of identified climate related risks

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Scenario Analysis and Climate-Related Issues

• Some organizations are affected by risks associated with climate change today.
• However, for many organizations, the most significant effects of climate change are likely to emerge over the medium to longer term and their timing and magnitude are uncertain.
• This uncertainty presents challenges for individual organizations in understanding the potential effects of climate change on their businesses, strategies, and financial performance.
• To appropriately incorporate the potential effects in their planning processes, organizations need to consider how their climate related risks and opportunities may evolve and the potential implications under different conditions.
• One way to do this is through scenario analysis.

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Scenario Analysis and Climate-Related Issues

• Scenario analysis is a process for identifying and assessing the potential implications of a range of plausible future states under conditions of uncertainty.
• Scenarios provide a way for organizations to consider how the future might look if certain trends continue or certain conditions are met.
• In the case of climate change, for example, scenarios allow an organization to explore and develop an understanding of how various combinations of climate-related risks, both transition and physical risks, may affect its businesses, strategies, and financial performance over time.

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Reasons to Consider Using Scenario Analysis for Climate Change

1. Scenario analysis can help organizations consider issues, like climate change, that have the following characteristics:

• Possible outcomes that are highly uncertain
• Outcomes that will play out over the medium to longer term (e.g., timing, distribution, and mechanisms of the transition to a lower-carbon economy)
• Potential disruptive effects that, due to uncertainty and complexity, are substantial

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Reasons to Consider Using Scenario Analysis for Climate Change

2. Scenario analysis can enhance organizations’ strategic conversations about the future by considering, in a more structured manner, what may unfold that is different from business-as-usual.

Importantly, it broadens decision makers’ thinking across a range of plausible scenarios, including scenarios where climate-related impacts can be significant

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Reasons to Consider Using Scenario Analysis for Climate Change 

3. Scenario analysis can help organizations frame and assess the potential range of plausible business, strategic, and financial impacts from climate change and the associated management actions that may need to be considered in strategic and financial plans.

4. Scenario analysis can help organizations identify indicators to monitor the external environment and better recognize when the environment is moving toward a different scenario state (or to a different stage along a scenario path).

This allows organizations the opportunity to reassess and adjust their strategies and financial plans accordingly

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Exposure to Climate-Related Risks

• The effects of climate change on specific sectors, industries, and individual organizations are highly variable.
• It is important, therefore, that all organizations consider applying a basic level of scenario analysis in their strategic planning and risk management processes.
• Organizations more significantly are affected by transition risk.

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Exposure to Transition Risks

• Transition risk scenarios are particularly relevant for resource-intensive organizations within their value chains, where policy actions, technology, or market changes aimed at emissions reductions, energy efficiency, subsidies or taxes, or other constraints or incentives may have a particularly direct effect.
• A key type of transition risk scenario is a so-called 2°C scenario, which lays out a pathway and an emissions trajectory consistent with holding the increase in the global average temperature to 2°C above pre-industrial levels

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Exposure to Physical Risks

• A wide range of organizations are exposed to climate-related physical risks.
• Physical climate related scenarios are particularly relevant for organizations exposed to acute or chronic climate change
• Physical risk scenarios generally identify extreme weather threats of moderate or higher risk before 2030 and a larger number a range of physical threats between 2030 and 2050.
• Although most climate models deliver scenario results for physical impacts beyond 2050, organizations typically focus on the consequences of physical risk scenarios over shorter time frames that reflect the lifetimes of their respective assets or liabilities, which vary across sectors and organizations

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Implementation

• organizations should develop appropriate key risk indicators and set appropriate limits for effectively managing climate-related risks in line with their regular monitoring and escalation arrangements.
• The risk appetite should be reviewed at least annually, considering the evolving physical and transition impacts arising from climate-related issues, as well as the circumstances of the organization such as data availability and capability in the assessment

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Implementation

• organizations could begin with identifying material climate-related risks at portfolio, counterparty (including clients), and where appropriate, transactional level, by assessing the relevant financial implications over both short and longer-term horizons.
• Such assessments could be carried out during credit initiation and underwriting, credit evaluation, credit review and investment decision process.

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Implementation

• At portfolio level, organizations could identify the high-risk asset portfolios based on sectoral/geographical exposures.
• This could be done by first performing high level identification of high-risk sectors/ geographical locations followed by more detailed analysis of client or transactional data.
• For physical risks, such analysis should focus on the physical location of a client’s business operations and assets, potential physical disruption to the client’s supply chain, as well as the potential implication on collateral valuations. For transition risks, risk criteria such as energy usage and sensitivity to climate policy may be applied to assess vulnerability of exposures to transition risk

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