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Table Of Contents
Quantifying The Effect Of Climate Change Starts With Good-Quality Data
Changing Attitudes Could Bring New Responsibilities
The Tangible Financial Impact May Initially Be Low, But Will Grow
Macroeconomic Changes May Hurt The Most
Despite Everything, Climate Change Also Offers Opportunities
Indicators For Measuring Exposure To Climate Change
This Emerging Risk Has Long-Term Implications
Appendix: How We Capture Climate Change Exposures In Our Rating
Analysis
Related Criteria And Research
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Climate Change, But Their View Could Be Restricted," published on Nov. 16, 2015, on RatingsDirect). At the same
time, we anticipate that reputational, regulatory, fiscal, and legal risks may present a greater threat in the
short-to-medium term. Those threats, rather than the direct costs, may provide a greater incentive for financial service
providers to better address climate change risks in their operations.
Given the financial sector's role as a key provider of funding to the public and private sector, societies and politicians
may increasingly consider that the sector has a duty to help economies deal with or prevent some of the consequences
of climate change. For example, financial services companies may be expected to provide the financing required for
shifting to a low-carbon economy and building a society that is more resilient to the consequences of global warming.
The financial sector also represents the biggest investors. By encouraging the companies they invest in to improve
their environmental sustainability, they could have a big impact. In particular, they could prompt a shift in attitudes in
those sectors that make the biggest contribution to carbon dioxide emissions and deforestation, such as energy
industries and some agricultural sectors.
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When financial service providers have failed to adequately account for climate change when managing customers'
investment funds, their customers could also choose to bring legal actions. In our view, the legal ramifications of being
indirectly responsible for causing climate issues are highly uncertain. Nevertheless, we expect boards and management
teams to try to avoid the unknown when it comes to legal risk.
The Tangible Financial Impact May Initially Be Low, But Will Grow
We expect banks, insurers, and asset managers to see tangible financial effects from climate change over time.
Restrictions on future carbon dioxide emissions, for example, could mean that the reserves currently allowed for in the
valuations of fossil fuel companies are unlikely to be realized. Once recognized as such, these "stranded" assets would
devalue investments and banks' loan books. Alternatively, new technologies may make traditional industries less
profitable, or even obsolete, hitting the value of companies operating in those industries. For example, the falling cost
of renewable energy technologies could erode the value of investments in fossil fuel facilities. Customers' preferences
could also shift toward more sustainable products, weighing on the valuation of some industries.
If, as many scientists believe, climate change increases the probability and severity of extreme weather events, insurers
may suffer higher-than-previously-expected claims. Insurers would have to allow for these increases in their pricing.
Property investments in high-risk areas could be materially affected in times of severe weather events, if not covered
by adequate insurance. The risk is more pronounced in coastal areas as the impact of coastal flooding will increase as
sea levels rise due to climate change. Banks that are heavily exposed to areas hit by extreme weather may be affected
through a reduction in the value of collateral in their loan portfolio. Borrowers' ability to repay loans may also
deteriorate significantly as a consequence of the event.
Climate patterns are expected to change as a result of global warming. Average temperatures and sea levels will rise,
while drier weather may become more common in some regions. The less favorable climate may harm such regions,
causing business prospects and prospective earnings to deteriorate. For example, if extreme weather is expected to
become a more regular event, the high risk of claims may make it uneconomic to cover a considerable proportion of
previously insured risks.
Business volumes and earnings could fall for banks that rely on the segments of the economy most affected by climate
change. It could also hurt the risk profile of banks that focus on a region where the economy has been damaged by
climate change.
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sectors, and the value of assets in those sectors could immediately see a material deterioration. The effect could
spread to the wider economy and the financial sector, triggering a crisis. The effect would be heightened if a lack of
transparency regarding each bank's exposure to the devalued assets caused a lack of confidence in the financial
system. Such a scenario would be similar to events during the subprime mortgage crisis.
Another scenario could occur if extreme drought led to food and water shortages that affected international stability
and trade. In turn, this could weaken economic prospects and subsequently the valuation of financial services assets,
leading to a financial crisis.
The complex nature of climate change risks means that we can easily create a long list of potential risks to financial
services companies caused by climate change. Inevitably, however, there will always be additional, unanticipated
effects. It is unclear how quickly those risks may emerge. Furthermore, even moderate climate change-related effects
have the power to destabilize vulnerable economies and financial systems.
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including:
The United Nations-sponsored Principles for Responsible Investment. The Principles for Responsible Investment
(PRI) is the leading global investor network promoting responsible investment, which is an approach to investing
that aims to incorporate environmental, social, and governance (ESG) factors into investment decisions to better
manage risk and generate sustainable, long-term returns.
The Montreal Carbon Pledge, supported by PRI. By signing the pledge, investors commit to measure and publicly
disclose the carbon footprint (the total greenhouse gas emissions they cause, directly and indirectly) of their
investment portfolios annually.
Portfolio decarbonization coalition (PDC). All PDC members commit to quantifying their carbon footprint and to
meeting concrete portfolio decarbonization targets (for example, by switching capital to carbon-efficient from
carbon-intensive companies, projects, and technologies within a sector).
The Banking Environment Initiative. Created to encourage the banking industry to act collectively to direct capital
toward environmentally and socially sustainable economic development.
The United Nations Environment Programme Finance Initiative Principles for Sustainable Insurance serve as a
global framework for the insurance industry to address ESG risks and opportunities.
The Geneva Association's Climate Risk Statement. This recognizes the substantial role insurance can play in global
efforts to tackle climate-related risks and aims to coordinate efforts to research and mitigate the effects.
That said, many of these initiatives are still at an early stage and many industry players have not signed them.
Metric
Risk Type
Transition risk
Company
exposure
Physical exposure
Country
exposure
Physical exposure
Company
exposure
Physical exposure
Company
exposure
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Table 1
Level Of
Exposure
Metric
Company
exposure
Regulatory/legal
Country
exposure
Regulatory/legal
Company
exposure
Litigation risk
Regulatory/legal
Country
exposure
Reputational damage
Reputational risk
Company
exposure
Reputational damage
Reputational risk
Company
exposure
Reputational risk
Company
exposure
Quality of disclosure
All risks
Company
exposure
We will increasingly review the following areas to look for evidence of a higher level of preparedness to deal with the
impact of climate change:
We recognize that these simple indicators may fail to capture the range and complexity of the ways climate risk may
affect various institutions. However, they can provide useful insights into our analysis of the potential longer-term
impact of climate change on the credit risk of specific companies. We will consider new information and metrics as
they emerge to assess how climate change may affect financial services companies.
We also recognize that future political decisions may determine the speed and method by which financial service
providers are affected by climate change, and which segments or regions will be more vulnerable. For example, if
measures to reduce carbon dioxide are introduced later, the effect on companies exposed to stranded assets will be
delayed and reduced. However, the increased level of carbon dioxide emissions may lead to more extreme weather
patterns, which could hurt other industries, such as agriculture. Financial service providers that have material exposure
to agriculture may suffer.
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medium-term effects. That said, we consider that climate change risk is only likely to grow in importance and its
potential impact is likely to increase.
The specific effects on each company will depend on the policies and measures taken by governments, combined with
the company's exposure to different risk factors. Depending on the paths the various participants choose to take,
different parts of the financial services sector will be most affected, but the environment in which they operate could
change dramatically.
In our view, providers that start to prepare early for the challenges presented by climate change are likely to be
best-positioned to take advantage of any opportunities that open up. For the others, there could be rating implications
if it is evident to us that a management team is not taking the right steps relative to its peers.
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Banks
The starting point for our ratings analysis of banks in a given country is the anchor we derive by applying our Banking
Industry Country Risk Assessment (BICRA) methodology (see "Banking Industry Country Risk Assessment
Methodology And Assumptions," published on Nov. 9, 2011). This macro analysis of the economic and industry risk in
a given market could be affected by material systemwide effects related to climate change.
To derive a rating on a specific bank, we then modify the anchor by incorporating our assessments of its business,
capital, and risk profiles (see "Banks: Rating Methodology And Assumptions," published on Nov. 9, 2011). For the
business profile, we analyze a bank's revenue stability and the diversification of its revenue stream. If a bank's business
activities are concentrated in an area or sector we consider could be marred by climate change, this could weaken its
business position and put its rating under pressure. Even if a bank reduces its exposure to climate-sensitive industries,
the pressure on its business position may not ease until it finds an adequate replacement for the lost revenue.
That said, if a bank develops expertise and becomes an industry leader in a climate change-related niche, it could
reinforce its business profile to some extent, by strengthening revenue stability and increasing market share.
We also consider the sustainability of management's strategy. Again, choices made around climate risk exposure could
affect our assessment.
If we anticipate that a bank will suffer losses due to the impact of climate change on its loan and investment portfolios,
we may revise down our risk position assessment. The risk position assessment may also weaken if, in our view, it is
exposed to significant legal risks.
Finally, a bank's capital ratios could also be affected. For example, losses on investments or reserves for loans could
rise significantly due to climate change exposure.
Asset managers
In rating an asset manager, we assess its business and financial risk profiles and combine the two assessments to
derive an anchor. Once the anchor is established, we assess five modifiers: liquidity, capital structure, financial policy,
management and governance, and comparable ratings analysis. These modifiers are applied to the anchor to derive
the stand-alone credit profile and, ultimately, the issuer credit rating (see "Corporate Methodology," published on Nov.
19, 2013 and "Key Credit Factors For Asset Managers," published on Dec. 9, 2014).
We consider that climate change could weigh most heavily on the business risk profiles of asset managers. Investors
are seeking to realize their environmental, social, and governance goals by seeking out new options, such as green
bonds. They are moving their portfolios away from what they deem to be high-risk industries (such as fossil fuel
companies) and toward sustainable and forward-thinking industries.
Asset managers are likely to continue to develop new funds and strategies to capture these investor preferences and
allocate investor money into climate-friendly investments such as wind, solar energy, and other renewable energy
sources. Their effectiveness at doing so could be a differentiating factor, enabling greener asset managers to expand
their asset bases faster than peers that have been less interested or successful in attracting green assets.
That said, we do not think that the impact would be material, unless the new strategy for asset accumulation increased
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Related Research
The Corporate Green Bond Market Fizzes As The Global Economy Decarbonizes, April 15, 2016
Insurers May Anticipate A Smooth Road Ahead On Climate Change, But Their View Could Be Restricted, Nov. 16,
2015
Additional Contacts:
Insurance Ratings Europe; InsuranceInteractive_Europe@standardandpoors.com
Financial Institutions Ratings Europe; FIG_Europe@standardandpoors.com
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