Svetlana Borovkova: Climate risk, a new investment fundamental?

November 9, 2021

By Svetlana Borovkova, Head of Quant Modelling at Probability & Partners

Climate risk is now firmly on the agenda of financial regulators. In September 2021, the ECB published the results of its wide-ranging climate stress test.

The most important conclusions were that the impact of climate risk can be quite severe, but also that this impact is unevenly distributed among geographical locations and sectors of the economy. On the other hand, this stress test also demonstrated that firms can clearly benefit from adopting climate risk mitigation policies.

Understanding risks and benefits of climate change

Climate risk is an important issue for asset owners and asset managers. Understanding how climate risk impacts a certain firm or a sector of the economy can help investors protect their portfolios against adverse effects of extreme climate events. At the same time, asset owners can choose to tilt their portfolios towards firms that will benefit from the transition to a greener, carbon-neutral economy.

Although climate risk awareness – of risks as well as potential benefits – is high in the financial sector, we see that the actual attempts to understand the impact of this risk on investments and other financial products can be quite sloppy due to one-sided reasoning, cause-and-effect confusion or simply a lack of critical thinking.

Furthermore, opportunities arising from climate risk mitigation are often not exploited.  Regulatory efforts in the area of climate risk are closely followed by banks, while asset managers, who are under less scrutiny from the regulators, are less alert to those developments, even though they too would benefit from paying more attention to them.

So, as an asset manager, you need to get informed and stay informed about the developments in climate risk, especially those coming from financial regulators and central banks.  This will require additional resources, in terms of both manpower and money. But failing to do so will result in lagging behind on these important developments and having to invest a lot more in a rush at a later stage.

Awareness instead of useless solutions

Climate risk measurement, management and stress testing are extremely complex issues, which currently have no definite or even approximate solutions, let alone standardized tools. However, there are quite a few commercial third parties that claim to have those tools or that promise to handle climate risk for you. So one needs to be alert regarding these strong (but often unfounded) claims of those who prey on poor climate risk awareness of financial institutions. This will help you avoid the high costs associated with purchasing such ready-made – but often useless – solutions.

It is also important to be honest to yourself and your clients about your current ability to deal with (measure and manage) climate risk of your investment portfolios. It is better to demonstrate your awareness regarding current developments and the fact that you are thinking about these issues, than to gain trust of your clients (and lull yourself into a false sense of security) by providing imaginary and unreliable numbers, such as monetary consequences of various climate scenarios – something which is currently practically impossible to estimate.

Solid narratives for a balanced toolkit

Finally, it is wise to start investing resources into developing a balanced toolkit for dealing with climate risk. This should start not with complex models or large (external) datasets, but with solid narratives (well-thought stories) about causes, effects, and transmission channels of climate risk for investments in your portfolios.

Starting from these narratives, think of necessary data, stress testing mechanists and finally the models for climate risk. The functional form of the models should be driven by your narrative and not the other way around. Be careful about climate risk-related models – internal and external – as there are currently no solid and viable models for these risks and it will take a while before such models get developed.

Wake up to a new investment fundamental factor

The investment industry will struggle with climate change issues in the foreseeable future. The tools, techniques and models for climate risk will evolve and more data will become available. But one thing is certain: once mainstream investors and market participants wake up to the climate risks and opportunities arising from our attempts to manage it, these will become common denominators in assessing the quality of investments, and will firmly establish climate risk as a new investment fundamental factor.

Probability & Partners is a Risk Advisory Firm offering integrated risk management and quantitative modelling solutions to the financial sector and data-driven enterprises.

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