Uncovering climate risks, financial risks and climate impacts

The mantra that “climate risk is financial risk” is becoming increasingly ubiquitous. Shareholder proposals, the need for companies to adopt transition plans (which we have previously discussed), asset managers' engagement with portfolio companies, and banks' fossil fuel financing, to name a few topics. is frequently cited in discussions.

The problem is that this mantra confuses climate impacts with financial risks, assuming that emissions represent financial risk and that managing climate-related financial risks will yield net zero results. It's often used. Although climate risks do exist, can Financial risks pose, but climate risks do not. everytime Additionally, managing financial risks from climate change is not the same as managing climate impacts. Even if the financial risk is low, the impact can be large.

Furthermore, characterizing the actual demand for emissions reductions as a demand for addressing fiscal risks is currently politicizing the debate about what needs to be done to build a net-zero world, and is now It could do more harm than good. Unless we disentangle the conflation between climate risk, financial risk and climate impacts, climate risk will continue to be politicized based on a misplaced reliance on the financial sector to drive the energy transition.

Consider the reaction to the withdrawal of BlackRock, JPMorgan Asset Management, and State Street Global Advisors from the Climate Action 100+. Angry cries claiming this was a rollback in climate policy were met with cheers that these investors were walking away from progressive “woke” policies. In reality, neither is true. The asset management company is the trustee. Their engagement with portfolio companies has always focused on risk-adjusted returns, consistent with the stated objectives of the investment strategies they manage. However, the cause of this controversy clearly has nothing to do with financial risk. The cause of this controversy is that both sides confuse asset managers' commitment to risk-adjusted returns with their commitment to climate impacts, and falsely believe that asset managers have the ability to accelerate the decarbonization of the economy. This is what we are assuming. Criticism from both sides reflects how far removed the story is from reality.

Another example is the rhetoric regarding bank lending to fossil fuel companies. Requests for banks to end fossil fuel lending are typically made to reduce the financial risk to banks when it is clear that the underlying objectives often have little to do with genuine concerns for the safety or soundness of the bank. It is framed as a demand for management. Moreover, the gesture that equates loan emissions with financial risk to banks conveniently ignores the short-term nature of most corporate loans. The bank gives him a one year loan and he doesn't have a 10 year credit risk. Also, no one thinks that “Big Oil” will go bankrupt in the near future. Unfortunately, bank lending for oil and gas is now effectively politicized, with Republicans concerned that banks will starve oil and gas companies of capital and undermine U.S. energy security. It's causing a backlash. Again, this controversy has nothing to do with actual financial risk. It rests on the premise that, on the one hand, banks can and should drive the transition through capital reallocation, and on the other hand, by putting pressure on banks to play the role of governments in actively shaping energy and industrial policy. This is based on concerns that the

At a system level, we see this happening with central banks. The focus on climate-related financial risks is tenuous, while deflecting calls to manage climate-related financial risks by using banking regulation to cut off fossil fuel financing. Their independence has been called into question as they have also faced accusations of policy. climate policy. ECB executives have been criticized for using banking regulation as leverage to push climate policy through banks, and the Fed says its efforts to address climate-related financial risks are focused solely on financial risks. I had to emphasize this many times.

But what do we actually mean when we talk about climate-related financial risk? Back to basics, when we talk about financial risk, what we're talking about is the risk of economic loss. is. So the next question is: Who is at risk of financial loss? What is the time horizon? And how significant is the risk of financial loss? These are important questions. Sometimes they are implicitly assumed, sometimes they are stated too vaguely, or they are not stated at all.

Let's take the example of a hypothetical oil and gas company we'll call Carboniferous, Inc. An oft-quoted saying is that oil and gas companies are at high transition risk. This succinctly illustrates the view that Carboniferous, Inc. will become less profitable over time and could go out of business as the transition progresses, leaving billions of dollars in stranded assets with no value at all. .

However, the transition risks that arise for Carboniferous' business over time do not necessarily translate neatly into material financial risks for Carboniferous' investors. Investors should be concerned if Carboniferous does not have a proper strategy that takes into account the impact of the energy transition on the company. At the same time, investors should be cognizant of the reality that demand for fossil fuels may persist longer than many would like, at least in part due to the lack of government policies such as carbon taxes. I strongly support it. However, the financial risk of investing in Carboniferous ultimately depends on the investor's time horizon, overall portfolio size and diversification, and hedging mechanisms in place. Investors may determine that the financial risk is low and the financial reward is high, given Carboniferous' current profitability.

Does Carboniferous' transition risk pose a financial risk to the banks that finance it? Depending on the financing instrument and its duration, the risk mitigation measures and hedging the bank has in place, and the diversification of the bank's overall portfolio. it's different. The bank's financial risk to Carboniferous is the risk that Carboniferous will not repay the loan. Many banks' loan books consist of loans with terms of one to five years. If Carboniferous is profitable with a strong balance sheet, the chances of default or impairment over that period may be very small. Additionally, banks factor the perceived risk of default into their loan costs. A further question is whether even if Carboniferous were to default, it would pose a material risk to banks. A regional bank with a significant oil and gas portfolio may have more risk than a large, global, diversified bank where oil and gas financing is a small portion of its overall business.

Notably, public discussions about transition risks have focused almost exclusively on the risk that companies are not transitioning fast enough, equating emissions with financial risk. Masu. As an example, a commonly cited transition risk is the risk that companies are not aligned with government commitments to net zero in the countries in which they operate, and when governments introduce new policies to meet net zero commitments. is the risk of being adversely affected.

However, the risks of moving too quickly are less discussed. For example, a car manufacturer that relies on a government's stated plan to phase out electric vehicles and invests in electric vehicle manufacturing plants could suffer if the government delays the plan due to voter pressure. , which may create financial risks for investors.

I can think of no other topic where we would argue that businesses are exposed to financial risk if they do not base important business decisions on the blind belief that they will achieve long-term policy goals set by the government. . It is also worth questioning whether governments can find the political support to impose policies that would bankrupt key sectors on which their economies remain highly dependent. It is clear that transition risks due to changes in government policy are not as straightforward as is often made out, and calls to manage transition risks can be used as a proxy for driving net-zero outcomes. I can not do it. Achieving net zero will be difficult and complex, with financial risks in all directions and avoiding those risks may not be fully consistent with net zero progress.

Somewhat puzzlingly, the 'climate risk is financial risk' argument has so far focused little on the risks of secondary effects of climate change. The massive economic downturn and decline in global GDP caused by climate change could pose far greater financial risks to asset prices than the climate itself. As an example, severe droughts that promote large-scale migration and destabilize economies in other regions can cause major global macroeconomic disruptions. As another example, a disorderly transition that causes large increases in energy and commodity prices could have significant macroeconomic implications for a broader range of businesses. In these cases, climate-related financial risks do not necessarily arise from exposure to high-emitting companies. A broader swath of the economy is being affected, and what matters is whether businesses and financial institutions are generally resilient to a major downturn.

In particular, it is perplexing that second-order effects are not discussed much by central banks. Failure to recognize this can lead to well-intentioned but ineffective policies, or to making matters worse. For example, increased capital requirements for banks lending to emissions-intensive sectors are sometimes advocated as a potential tool to reduce emissions and reduce financial risks from climate change. However, this means that (1) financial risks are reduced due to higher costs of capital in high-emitting sectors, and (2) central bankers are able to do so without creating further risks to the global economy (including erosion of central bank independence). It assumes that you have the ability to set energy policy. ).

Although central bankers cannot solve climate change, they are in a strong position to drive research on second-order effects and highlight the potential impact of broader macroeconomic disruptions due to climate change. It is located in There is no clear idea what this research should be or what can be done based on it, but for pure risk-minded people it should be scarier than the financial risks of investing in or lending to oil and gas companies. is.

Climate risks can certainly create financial risks. But details matter, and it's important to be clear about scale, potential, and timeframe. We need more knowledgeable people to recognize that climate impacts do not exactly equate to financial risks, and that asking companies and financial institutions to manage climate-related financial risks themselves will not effectively eliminate them. We need solid dialogue. Confusing climate impacts with financial risks undermines the intellectual credibility of the important research needed to understand how climate change spills over into financial risks for different actors in the economy. Become. Most importantly, framing climate-related financial risks as a tool for achieving net-zero outcomes not only politicizes efforts to manage financial risks, but also It also prevents honest conversations about what is actually needed.