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Centro LAW Guest Series: Climate risk. An emerging financial risk category

Climate change is top of mind for almost the entire world, and climate risk is, in turn, accelerating as a topic for policy-makers, investors, lenders, and companies. Today, Stephanie Gnissios, a climate risk advisor to financial markets, shares her insights on climate as an emerging financial risk category. This post explores climate risk and how it can affect investment performance or investment strategies. Stephanie highlights why wealth owners and asset managers should incorporate climate into governance, strategy, and decision-making.

Thank you, Stephanie, for taking the time to have a chat with Centro LAW. Tell us a bit more about your field of expertise.

My background is mechanical engineering and professional project management in the gold mining sector. As I moved from technical aspects into strategic decision-making and risk management, I started to wonder how companies could make better decisions. In exploring how companies could bring more holistic and long-term factors into investment decisions and risk management, I found a focus on climate risk. Now, I help investors, lenders, and companies identify, understand, and embed climate risk into governance, strategy, risk management, and decision-making.

I bridge the gap between the technical side of climate science and data and the financial sector by turning climate data into fit-for-purpose information for companies and financial market players. My objective is to support stable growth and long-term profit generation in a sustainable way. 

Can you give us a brief explanation of what you mean by climate risks?

Climate risks are categorized as either physical risk or transition risk.

Physical Risks resulting from climate change can be event-driven (acute) or longer-term shifts (chronic) in climate patterns. Categories of physical risk include pluvial (rainfall) flooding, fluvial (coastal) flooding, heat/cold stress, water stress, wildfire, and extreme weather events (storms). Acute physical risks may have financial implications such as direct damage to assets and indirect impacts through supply chain disruption. Financial performance may also be affected by chronic changes such as changing temperatures reducing productivity, impacting employee safety; or, changing precipitation patterns impacting water supply and management.

Transition Risks arise as the global economy shifts towards a green and low-carbon economy. The risks arising from these changes can be categorized into policy and regulatory, technology, market, and reputational. Transition Risks can also be event-driven such as policy shocks or carbon pricing shocks, or longer-term shifts such as increasing regulatory requirements for climate-related disclosures. The most tangible and easily quantifiable transition risk is carbon price, with direct financial implications. Recently, especially in the EU, significant policy and regulatory changes are accelerating, particularly around disclosures of climate-related risks.

Both categories of risk channels can have near-term and material impacts on investments and investee companies and are important in longer-term strategic planning and business model management. 

You mentioned policy and regulatory shifts. Can you highlight what the main ones are and how they might be relevant for investors?

The European Union has accelerated efforts towards the EU Green Deal through policies, regulations, and guidelines that are likely to become regulatory requirements. Some of these include the European Central Bank's Guide on Climate-Related and Environmental Risks (ECB Guide), the EU Sustainable Finance Taxonomy, the Sustainable Finance Disclosures Regulation (SFDR), and the Non-Financial Reporting Directive (NFDR, now the Corporate Sustainability Reporting Directive).

The ECB Guide sets out a very comprehensive set of guidelines for significant financial institutions in the EU around governance, management, and disclosures of climate-related risks. These guidelines entered into the supervisory dialog in January of this year. These expectations range from incorporating climate risks into capital adequacy ratios to climate stress testing. This will require corporate clients of these institutions to boost their own disclosures to enable financial institutions to meet their supervisory requirements. It's also likely to affect loan pricing through incorporation into credit risk models. The ECB Guide is viewed as a best practice manual, with regulators in other regions and jurisdictions looking to it to shape their own regulations and guidelines. Within the EU, other national regulators have already integrated the ECB Guide expectations into their own dialog.  

The EU Taxonomy applies to both companies and financial market players. It will require disclosure of 'green' versus 'brown,' with very specific and often quantitative definitions, currently focused on climate change mitigation and adaptation. It will also expand to cover water resources, circular economy, pollution, and biodiversity soon. This will mean that companies and financial institutions need to decide their tolerance level for brown economic activity and work to develop and disclose transition pathways.

Sustainable Finance Disclosures Regulation (SFDR) Level 1 Principles came into force in March 2021 alongside planned amendments to asset management regulation and MiFID. It applies to financial market participants and financial advisors. SFDR requires disclosures at product level and firm level in the documentation for the financial products and on their website. They will need to cover information on policies on the integration of sustainability risks into investment decision-making, and principal adverse impacts of investment decisions on sustainability factors; due diligence policies; how remuneration policies are consistent with integration of sustainability risks.

Finally, and most recently, the Non-Financial Reporting Directive (NFRD) was overhauled in April of this year when the European Commission adopted the Corporate Sustainability Reporting Directive (CSRD). This extended the reach of the previous NFRD to large companies in terms of employees, turnover, and assets, and all listed companies within the EU; it also requires assurance of reported information and more detailed reporting, which must be digitally tagged.

The main takeaway is that the EU is taking accelerated and concrete actions to embed climate and sustainability into financial markets. Investors should prepare to understand, assess, and disclose the climate risk profile of their portfolios and demonstrate active management of climate as a risk driver. This requirement may come directly from regulators (such as SFDR and CSRD) as a compliance requirement, indirectly through financial institutions impacting access to capital or cost of capital, or through asset owners and other stakeholders through requests for improved disclosures on the topic. Different regions and regulators are also following suit.

Wealth owners increasingly focus on sustainable investments, which means more appetite for investing in climate mitigation such as renewable energy. However, investment performance remains essential. How can we best combine these aspects?

As you said, sustainable investment tends to minimize harm to the climate and positively impact global climate mitigation efforts. Increasingly, this also includes investments into climate adaptation or building resilience of cities and communities. However, a holistic view of sustainable investment must also adequately compensate the risk of the investment to protect performance; this means you must also consider the effects of climate on the investment's financial return. The two are also integrated: if carbon pricing presents a material risk, then stepping towards a lower carbon portfolio contributes to climate mitigation and protects against the financial risk of carbon pricing policy shocks.

But, climate risk is a systemic risk. You can avoid some climate-related risks through exclusion lists or divestment of fossil fuel sectors. Ultimately, though, what we want is resilient investment portfolios and a resilient financial system. This means we also need investments that are managing their own climate risks while actively contributing to transition pathways for the financial sector as a whole.  

In general, what advice do you have for wealth owners who want to understand how climate risk could affect their investment portfolios?

It's a big topic which is evolving fast. Don't strive for the right answer or expect to solve the challenge in the near term. Instead, take a step-wise approach and learn and evolve as you go.

Start with understanding which climate risk channels could be material to your investments. This means understanding exposure to climate hazards (both physical and transition), then assessing if and how they would impact your performance target and risk profile. Then, you can focus on building out a framework to assess and manage the most material risk channels. If you want to identify red flags, you can look to do a top-down analysis, which will draw general conclusions about the exposure of a portfolio or company to climate risk hazards. Looking to understand how to manage climate risks at an entity level or transaction level? Then you'll need to do a bottom-up analysis on the climate risks for the unique context of the asset or company and its value chain. Perhaps start with a selection of the portfolio or even a few particular investments as case studies.

Secondly, understand your objectives. What is the question you are trying to answer? What constitutes an acceptable answer? What would make the answer actionable? Suppose you are trying to identify climate risks with the view to updating internal policies and investment mandates. In that case, that may require a different approach than solely seeking to meet regulatory requirements for disclosures.

Finally, don't rely solely on the quantification of risks. It's tempting to look for solutions or tools that will tell you that the 2030 EBITDA might see a 7.2% reduction. This is precise but not accurate. It's also not helpful in establishing policies or management strategies. Look to understand how climate risks are material, then proceed with a focus on meaningful and insightful analysis rather than just number crunching. The high levels of uncertainty associated with climate and the climate transition mean it is more beneficial to identify a range of possible futures and develop an adaptive management approach to ensure agility and focus on building holistic resilience.

About Stephanie Gnissios

Stephanie Gnissios is the co-founder and COO of a climate risk advisory firm in Bussum, Netherlands, supporting the financial sector, real estate investment, and heavy industry in identifying, assessing, and managing climate-related risks. Her background is mechanical engineering and professional project management in the gold mining sector, and she holds an Executive MBA from Oxford University. Stephanie is an active mentor for women in STEM (science, technology, engineering, and mathematics) and impact-focused entrepreneurs. She also holds board and advisory board roles for early-stage ventures in the UK, South Africa, and Zimbabwe. 

19-05-2021

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