Innovest Strategic Value Advisors, Inc.

Climate Change & the Financial Services Industry - Module 2 - A Blueprint for Action


Courtesy of Innovest Strategic Value Advisors, Inc.

Scientific and technical reports present compelling evidence that human-induced climate change is upon us, and that its consequences could be devastating. Worldwide economic losses due to natural disasters appear to be doubling every ten years, and have reached almost $1 trillion over the past 15 years. If current trends persist, the annual loss amounts will, within the next decade, come close to US$150 billion. At the same time, the greenhouse gas emissions regulations and emissions trading schemes that are close to becoming a reality in large parts of the world will have direct competitive consequences for large sections of the economy. That financial services companies will be faced with a range of threats and opportunities on account of climate change is, therefore, no longer a matter of conjecture.
What is undecided, however, is the manner in which companies should respond. As this report shows, there are radically differing opinions on the extent to which the industry could be affected by climate change, and what measures financial services companies could or should take now and in the future. With political momentum regaining pace, best practice in responding to climate change is likely to evolve rapidly in the near future.
Financial institutions perceive their role with respect to climate change to be more about the facilitation of transactions, market development and the pursuit of economic profitability than the attainment of particular political outcomes. With this in mind, universally applicable suggestions on how financial institutions can deliver market solutions to the climate change problem most effectively include:
  • Helping to structure and monitor an efficient market system by working with securities and exchange regulators, actuaries, accountants and other agents of the financial markets.
  • Engaging with other stakeholders (particularly along the business-to-business axis). 
  • Investing in and supporting the development of products and services that contribute towards adaptation and mitigation.

To date, progress has been slow and is concentrated in those organizations and entities with strategic interests in first mover advantages, i.e., those entities that see value in ‘sustainability’- oriented investing, or that are directly and obviously affected by climate change impacts or mitigation policies.
Beyond this, the view that climate change is of strategic importance is more prevalent within the insurance and reinsurance business than perhaps any other segment of the financial services industry. As yet, however, it has proved extremely difficult to explicitly factor climate change-related issues into underwriting costs due to problems in identifying and quantifying the incremental risks involved. Likewise, despite a growing awareness of the issue in commercial banking, the extent to which climate change and GHG mitigation regulations will affect lending decisions and the credit risk management policies that govern their behavior towards larger corporate clients remains largely unexplored. Both insurers and bankers appear to be more comfortable reacting to the manifestations of changing weather conditions than they are adopting proactive stances on the political issue of climate change per se.
With some exceptions, asset managers and the analysts that guide them appear to be largely ignorant of the extent to which climate change could affect their business. The potential of climate change and GHG regulations to destroy value in investment holdings, and impact July 2002 Innovest SVA equity prices, corporate earnings and relative sector risk has yet to be seriously examined.  Credit rating agencies are becoming better informed, in that analysts show greater understanding of the general issues, although the development of quantitative tools for factoring GHG risks into debt ratings is lacking.
At the project finance level, data from the World Bank’s Prototype Carbon Fund indicate that returns can be enhanced by several percentage points, although other practitioners have to date fared less well. Making full use of carbon finance opportunities plus other sustainability benefits (which can increasingly be monetized) can only become more important in future.
According to the G8 Renewable Energy Task Force, roughly $10-15 billion has been committed to renewables over the next 2-5 years by major companies, and up to $1.5 billion is being used to finance such projects in developing countries each year.
The emissions trading markets are clearly still under development. However, a clearer picture has emerged of the measures that need to be taken to stimulate greater trading activity, and the market will grow in the coming years, providing the political will to reduce emissions and assign carbon a value is there. Forecasts of the future GHG credit trading market project a rapid growth from $10 billion by 2005 to over $2 trillion per year by 2012.

Four factors prevent action on climate change issues in the financial services industry:

  • Cognitive barriers, which relate to the low level of awareness, understanding and attention afforded to the climate change issue;
  • Political barriers, associated with regulatory and policy issues, and governmental leadership;
  • Analytical barriers, relating to the quality of information for understanding the impacts of climate change and GHG regulations for financial services companies;
  • Market barriers, which surround the efficient functioning of transaction based markets for emissions credits, green certificates and such like.

Recommendations for overcoming these barriers, and for spurring greater involvement of financial institutions in climate change, are summarized in the table below. In recognition of the fact that implementation of these recommendations will take time, the following three action steps are offered as a means of stimulating immediate progress on the issue.

  1. The formation of an ‘awareness raising’ task force of senior finance sector executives to inspire individual financial institutions, industry associations, financial regulators and other industry umbrella associations to support education and engagement on climate change using this study’s reports as a blueprint for action.
  2. The formation of a team to develop a quantitative analytical methodology - the “Carbon Asset Pricing Model” -for capturing the asset pricing and valuation implications of climate change and carbon regulations.
  3. The formation of a parallel project team to examine methods for capturing, monetizing and optimizing the full range of environmental aspects within project finance settings.

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