Introduction
Many regulatory bodies and organisations have expressed their concerns about climate change risk. The Institute and Faculty of Actuaries (“IFoA”), the Central Bank of Ireland (“CBI”), European Insurance and Occupational Pensions Authority (“EIOPA”), Financial Conduct Authority (“FCA”), Prudential Regulations Authority (“PRA”) and the Financial Stability Board Task Force on Climate-related Financial Disclosures (“Task Force” or “TCFD”) have all recently published papers and opinions on the issue. This article summarises the key implications, recommendations and challenges that have been addressed in these papers.
All parties agree that climate change risk is a real threat. It is important not to think of it in a narrow-minded way; climate risk encompasses a range of different areas; from the data and assumptions that feed into models, to change in population and demographic profiles. There is increasing demand from investors for meaningful and decision-useful environmental disclosures. Regulatory bodies have already issued recommendations on climate-related financial disclosures. The companies who fail to satisfy the market demand for such information will be at a competitive disadvantage.
Categories of Climate Change Risk
All publications discuss two main categories of climate risk. The first category relates to the physical risks arising from the damage caused by the climate change itself. The increased risk of severe weather events could lead, for example, to a higher number of insurance claims due to property damage as a result of flooding. House prices, asset prices, cost and coverage of insurance contracts and macroeconomic outcomes are all areas that could be impacted by the increased frequency of severe weather events. Physical risks also include the global warming of the physical environment in different regions (CBI, 2019).
The second category relates to the transitional risks stemming from the efforts to mitigate the impact of climate change, transition to a lower-carbon economy and reduction in greenhouse gas emissions. These include, for example, the introduction of carbon taxes into the economy and the increase in the level of these taxes or investments that companies will need to make in order to be more sustainable. Reputational risk, changes to government policies, as well as consumer demand are also possible sources of uncertainty (IFoA, 2019). As highlighted by the CBI, if the transition is delayed by insufficient action, a sharp adjustment would be required. This would pose additional financial stability and macroeconomic risks, and could potentially trigger a general recession. It is also possible that the measures could outpace the capacity of the economy to switch to low-carbon techniques. For example, this could happen if an overly ambitious schedule for the increase in carbon taxes is implemented.
The IFoA (2017, 2019) lists one more category which actuaries should consider: liability risks. These are risks of third parties seeking compensation as a result of damages or losses caused by the effect of climate change. Some latent liability claims related to climate change could emerge in the future. There have already been many cases of legal proceedings due to climate change (IFoA, 2019).
EIOPA (2019) have recently published a consultation paper on sustainability considerations within Solvency II. They found that, in many instances, companies have narrowly interpreted climate risk as a natural catastrophe risk. EIOPA reiterated that climate risk actually encompasses all risks that arise from trends or events caused by climate change. This does include the rising risk of natural catastrophes, but also includes other areas such as rising sea levels, rising temperatures and the risk relating to the mitigating actions that companies might be forced to implement.
Key Implications
The climate change working party of the IFoA (2019) has summarised the key implications of climate change to the insurance industry. Below are the points they highlighted:
- The uncertainty around the nature, scale and frequency of climate risks will drive up the price of certain types of insurance. The property and agriculture sectors will be impacted, as well as the home insurance sector. As a result, fewer customers and businesses will be able to afford insurance, widening the gap between those who can and cannot afford protection. Moreover, insurers and reinsurers will be exposed to a greater accumulation of risks. This will be especially true for areas susceptible to such risks (e.g. coastal regions). The correlation between usually uncorrelated risks may change. This will be difficult to quantify and manage. The future pricing, reserving and capital modelling will need to take these issues into account.
- There is a risk that actuarial models may not adequately represent the real world in light of climate change. Premiums, reserves and capital requirements may be impacted. The sensitivity of the models to assumptions and data that could be impacted by climate change may also have to be reconsidered. Failure to address the issues discussed may leave insurers and reinsurers exposed to adverse selection.
- The market for certain products may shrink. Exposed coastal properties might become uninsurable. Some insurers and reinsurers refuse to underwrite new coal projects or have already divested from coal companies. This is done as part of the Paris Agreement commitment to keep the change in temperature well below 2°C above pre-industrial levels, with the aim to limit the increase to 1.5°C.
- Climate change may result in changing mortality and morbidity patterns. On one hand, the number of deaths due to extreme weather may increase, for example deaths due to wild fires, heat waves or drought/famine. On the other hand, the mortality and morbidity of some populations may fall because the relationship between climate change and disease is complex. Some areas could see a decrease in the number of cold-related deaths. Overall, it is expected that the impact of climate change on human health and mortality will be detrimental (IFoA, 2019).
- Climate change may also lead to changes in population, due to changes in migration patterns as well as changes in demographic profile.
- A growing number of jurisdictions have introduced climate-related reporting requirements for insurance companies. Credit rating agencies have also stated that ratings will need to reflect climate risk. Climate risk may also impact the value of assets. As a result, the capital requirements for insurance and reinsurance companies could increase (IFoA, 2019).
Financial Disclosure Recommendations
The TCFD (2017) and PRA (2019) have both published opinions on similar sets of recommendations for climate-related disclosures, which apply to companies in the financial sector. The TCFD has developed a voluntary framework that is aimed broadly at all companies. Their intention is to include the disclosures in the financial returns, which would also mean that they are likely to be reviewed by the senior management. The aim of the disclosures are to be meaningful, forward-looking and focused on the risks and opportunities arising from the transition to a low-carbon economy. The following areas were the focus of the climate-related disclosure recommendations by the PRA and the TCFD:
- The governance framework of the company should consider the financial risks and opportunities from climate change.
- These should be addressed via the existing risk management framework.
- It is important to explore different climate-related scenarios in order to understand any potential implications for the organisation. The output of this analysis should be used to shape the business strategy.
- A set of metrics and targets should be developed and maintained by companies in order to assess and manage the climate-related risks and opportunities. These metrics and targets should be disclosed.
In the recent paper “Climate Change and the Irish financial system”, the CBI (2019) wrote that since carbon transition can give rise to financial stability risk, they plan to incorporate the carbon transition into the macroeconomic and financial stability assessments. The carbon-related systemic risk factors will need to be incorporated into the current models. The CBI acknowledges that the regulators and supervisors will have to establish clear expectations for the regulated firms. Also, sufficient information is required to adequately assess the risks related to climate change. TCFD has highlighted that each firm above a certain threshold should calculate and disclose its carbon related exposures. For comparability purposes, some standardisation of the disclosures will be required (CBI, 2019).
Impact on Pensions
The FCA (2018) has also highlighted that, due to the long-term nature of pensions, climate change could play a material role in the pension fund’s financial performance. They are considering different solutions, with the FCA focusing on the following areas in the short term:
- Boosting innovation in specialist green products;
- Greater encouragement for disclosure of appropriate information to the markets; and
- Potentially introducing requirements to publicly report actions taken to tackle climate change.
The FCA (2018) acknowledges that climate change is a practical consideration for the UK pension market and is not merely an ethical concern. The future value of investments could be reduced by climate change and, as a regulator, the FCA will need to address this.
Challenges
The CBI (2019), IFoA (2019) and EIOPA (2019) have all stated that climate change poses a challenge because it is a long-term risk and the companies’ typical planning horizon is short and medium term. This makes it difficult to incorporate into strategy and take action. The IFoA (2019) suggests that systems thinking could be used to tackle this challenge, where the environment could be modelled as a complex adaptive system. The components are interacting with and are impacted by each other. The system is treated as one whole rather than separate parts. EIOPA (2019) suggests that scenario analysis, stress testing and other complementary tools should be used to appropriately capture the climate change impact. According to EIOPA, the most immediate need for companies is to implement such tools into their governance, risk management and ORSA frameworks. It is important for climate-related analysis to be done in a forward-looking manner and to be subsequently reflected into business planning and strategy.
Recent Developments and Next Steps
TCFD has recently issued ”2019 Status Report”, which follows up and offers updates on their previous 2017 report “Recommendations of the Task Force on Climate-related Financial Disclosures”. They found out that many companies incorrectly thought that climate change risk was only relevant in the long term and that it was not necessary to respond now. However, based on a recent report by the United Nations, urgent and unprecedented action is needed. In order to limit the increase in global temperature to no more than 1.5⁰C, the greenhouse gas emissions have to peak by 2020 and decline rapidly after that. Based on the current trend, it is estimated that greenhouse gas emissions will not yet have peaked by 2030 (TCFD, 2019). TCFD also mentions that companies may experience lower financial returns and be more exposed to climate related risks in the future, unless they take action. Investors are demanding more decision-useful information on how companies are responding to the transition to a low-carbon economy and climate-related issues. Companies who are better placed to provide this information may therefore have a competitive advantage over rivals.
TCFD (2019) also explored how climate-related financial disclosures have evolved over the last number of years. They found that while there has been an increase in disclosures, the information was still insufficient for investors. The potential financial impact on the companies of climate related risks also remains unclear. Moreover, the majority of the companies who consider climate related risk to be material, and do use scenario analysis, do not disclose information on the resilience of their strategies. TCFD (2019) also believes that more functions need to be involved in the process of main-streaming climate related issues, including risk management and financial functions. The overall results of the 2019 TCFD report shows that companies need more support for implementing the disclosures. As a result, the Task Force is planning to issue guidance on how to introduce and conduct climate-related scenario analysis, as well as to identify some scenarios that would be relevant to the business.
Conclusion/Summary
In conclusion, it is evident that action on climate change is required now. There has been an increase in the number of papers issued by regulatory bodies and organisations on climate risk in recent times. It is very positive that investors and the market are demanding more information and companies are increasingly paying attention to the issue. Moreover, it is our ethical duty to be conscious of the impact of climate change and try to limit it as much as possible.
References:
IFoA (May 2017) Risk Alert: Climate Related Risks
https://www.actuaries.org.uk/documents/risk-alert-climate-related-risks
IFoA (March 2019) Climate Change working Group, “Climate Change for Actuaries: An Introduction”
https://www.actuaries.org.uk/documents/climate-change-actuaries-introduction
Philip R. Lane, CBI (2019) “Climate Change and the Irish Financial System”
https://www.centralbank.ie/docs/default-source/publications/economic-letters/vol-2019-no-1-climate-change-and-the-irish-financial-system-(lane).pdf?sfvrsn=2
TCFD (2017) Final Report: Recommendations of the Task Force on Climate-related Financial Disclosures (June 2017)
https://www.fsb-tcfd.org/wp-content/uploads/2017/06/FINAL-2017-TCFD-Report-11052018.pdf
TCFD: 2019 Status Report (June 2019)
https://www.fsb-tcfd.org/wp-content/uploads/2019/06/2019-TCFD-Status-Report-FINAL-053119.pdf
PRA (April 2019) “PS11/19: Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change”
https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/policy-statement/2019/ps1119.pdf?la=en&hash=CD95D958ECD437140A4C7CF94337DAFD8AD962DE
EIOPA (June 2019) “Consultation Paper on an opinion on sustainability in Solvency II”
https://eiopa.europa.eu/Publications/Consultations/EIOPA-BoS-19-241_Consultation_Paper_on_an_opinion_%20on_sustainability_in_Solvency_II.pdf
FCA (October 2018) “DP18/8: Climate Change and Green Finance”
https://www.fca.org.uk/publication/discussion/dp18-08.pdf
Svilena Dimitrova works with RGA International Reinsurance Company dac and is a member of the Society of Actuaries in Ireland.
The views of this article do not necessarily reflect the views of the Society of Actuaries in Ireland, the Enterprise Risk Management Committee, or the author’s employer.