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According to the European Environment Agency (EEA) report, Europeans have suffered losses exceeding 650 billion euros due to climate disasters between 1980 and 2022. As the frequency and intensity of such events increase, financial actors, driven by regulation, are questioning the effective consideration of the numerous climate hazards weighing on their assets.
WeeFin presents an analysis of climate risks: from their definition to their materialization, via the associated regulations and the level of maturity of financial players on these issues. To illustrate our study, Manuel Coeslier takes a look at the subject, drawing on his experience as Lead Expert, Climate & Environment at Mirova.
“As a responsible investor, Mirova aims to measure its climate risks. To fulfill its mission of contributing to the achievement of the Sustainable Development Goals (SDGs), and specifically in terms of climate, to contribute to global carbon neutrality, we must understand the risks we face.”
Manuel Coeslier
In November 2020, the European Central Bank, in its Guide to Climate and Environmental Risksdefines climate risks, which are commonly divided into physical and transitional risks. The European Central Bank subsequently established the link between these climate risks and traditional financial risks.
This week'sNovethic article illustrates the impact of these environmental factors on economic activities, using the physical risk of flooding as an example. Indeed, Porsche's share price lost 5% due to flooding, which led to aluminum shortages at the heart of its supply chain. Companies now need to guard against these physical risks, which reduce deliveries, production and sales.
For example, a transitional risk that a carmaker like Porsche could face would be restrictions on combustion-powered cars in a given geographical area by law.
Supply chain management, mastering the transition to a low-carbon economy and, more broadly, reducing exposure to climate risks are all crucial to ensuring the resilience of any business.
But how has understanding these risks become a strategic issue for financial players?
"Depending on the type of player, the stakes are not the same, but the risks must be taken into consideration in the same way. Asset managers need to fully understand climate risks in order to mitigate them as best they can, rather than reselling highly exposed assets and transferring the risk to other players, which will have no influence on the real economy."
 Manuel Coeslier
On the one hand, banks and insurance companies need to manage their own capital to remain solvent. As the solvency of these financial players is intrinsically linked to risk, the climatic hazards weighing on their assets will increase the need for capital. For another structuring reason, as areas become uninsurable, the insurers' business model is being challenged. Â
On the other hand, management companies need to ensure their attractiveness to institutional investors. The latter take into account the risk management of their clients, and in particular that dedicated to climatic hazards. Furthermore, when a management company is a client of insurers, it must calculate the SCR (Solvency Capital Requirement) cost of the funds, and in future, this cost should include climate risks.
So, if climate risk management is a highly strategic issue for all financial players, how are they encouraged by regulations to take these hazards into account?
The first structuring regulation on the subject of climate risks is French! Indeed, the Energy-Climate Law (LEC), from which the Article 29 report was drawn up , provides a comprehensive framework on climate and, more broadly, emphasizes the need to take ESG risks into account. While Part 6 of the report sets out the elements of the strategy for alignment with the Paris Agreements, Section 8 of the report is dedicated to ESG risks. This section requests a quantitative estimate of the financial impact of sustainability risks. This exhaustive and ambitious requirement encourages financial players to examine the subject of risks and to back up this analysis with a quantification that requires a model.
Solvency II, the regulation governing European insurance and reinsurance, has been amended in its 3 pillars to take sustainability into account. Insurers must now integrate climate risk factors when assessing risks and determining the levels of technical reserves needed to guarantee their solvency and long-term financial stability. They must also measure the exposure of their assets to transitional and physical risks, and include this in their QRT (Quantitative Reporting Template).
In addition, the issue of financial risks is increasingly being discussed on a global scale. By way of example, in order to provide a global baseline for sustainability-related disclosures in reporting, two IFRS sustainable accounting standards came into force in January 2024, and will become mandatory in jurisdictions that choose to adopt them. IFRS S1 incorporates general requirements for sustainability-related financial disclosures, while IFRS S2 underpins climate change-related disclosures. The expectations of IFRS S2 are consistent with the recommendations published by the TCFD (Task Force on Climate-related Financial Disclosures) aimed at providing information on climate-related risks and opportunities to assist investment decisions. Â
“The drafting of an Article 29 report prompts many actors to address climate risks, but this only applies in France, which is a drop in the ocean. Regulation still has a long way to go.”
Manuel Coeslier
To further structure the consideration of climate issues, many financial players are relying on the recommendations of regulators. For example, in August 2022, EIOPA published an Opinion specifying the supervisory authorities' expectations regarding the integration of climate change scenarios by insurance companies in the ORSA (Own Risk and Solvency Assessment) model.
Have financial players succeeded in developing appropriate models?
WeeFin has published an analysis based on a study of some fifty Article 29 reports, designed to measure the maturity of French financial players with regard to sustainability issues, and in particular climate change. To identify risks, the players studied highlighted ESG rating monitoring, due diligence, risk mapping and controversy tracking. 54% of players specified measures implemented to mitigate risks, with exclusions and engagement the most commonly used.
This analysis also revealed that only 26% of the players surveyed quantitatively estimate the financial impact of their risks. Of these, over 60% use MSCI's Climate VaR. However, only half of the players measuring their risks provide descriptions of the impacts and details of the conclusions to be drawn. This is an obvious first limitation to measurement, as Manuel Coeslier points out:
"The question of measurement matters, but once the impact is assessed and consistent, it doesn't say much about the impact, the real question is: how to deal with the measurement?"
Manuel Coeslier
In addition, other limitations of this measure and of risk models are explained by many players, such as the cost and uncertainty of modeling. Manuel Coeslier explains the difficulty of modeling:
“There are two major issues hindering climate risk models. Firstly, few actors have databases offering the geolocation of the assets they invest in. Secondly, value chain mapping to obtain exposure to companies’ indirect risks is not yet integrated. Vulnerability analysis is a complex exercise that should be customized. For example, measuring the vulnerability of an infrastructure project is impossible without examining the project itself and speaking to developers.”
Manuel Coeslier
These balances reflect a modeling exercise that remains complex in terms of implementation and integration of long-term risks into a traditional model.
In short, while regulations and the relevant authorities seem to be leaning more towards taking climate risks into account and mitigating them, the state of maturity of financial players on these subjects remains shaky. Unfortunately, exposure to climate risks is not yet considered a major issue, which calls into question the risk modeling exercise, as our interviewee observes:
"We're still evolving in a world where the players who are performing well today won't be the ones making the biggest contribution to the Paris Agreements. In the long term, we'll be the losers in a +3/4°C world."
Manuel Coeslier
Today, we need to rethink the guidelines addressed to financial players and push back the limits of regulations. Manuel Coeslier shares his vision of future developments in climate risk exposure:
"NZIF 2.0 (Net Zero Investment Framework 2.0) has been redesigned to separate the economy into macro-sectors and value solution providers. A financial player can be exposed to issuers with growing carbon footprints if they are contributors to the future. As an example, it is desirable today for a wind turbine producer to have a growing carbon footprint."
Manuel Coeslier
To be continued ...
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