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Climate Risk Data and Models: Why They’re Important and How Banks and Vendors are Handling Them

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Financial institutions are using increasingly sophisticated data and analytical tools to identify and measure the risks that climate change poses to their investments and operations.

Data providers including Institutional Shareholder Services (ISS), Baringa and Bloomberg, as well as risk-management and controls specialist Acin, are offering their financial clients solutions that can help them track and mitigate the exposures they face. At the same time, those clients are using the products to meet regulatory and investor demands for transparency into their own decarbonisation and climate performance.

The mushrooming of the climate risk space has led observers to predict climate risk data will soon become as important as credit, liquidity and other conventional financial risk analyses.

“We think, increasingly, that companies being able to provide this data is going to be a prerequisite to accessing affordable finance,” James Belmont, Partner for Financial Services at Baringa told ESG Insight.

As the effects of climate change become ever more apparent in the form of frequent violent storms, rising sea levels and forest fires, so too are the risks they pose to companies. The World Economic Forum list five environmental challenges among its top 10 list of global risks, with climate action failure topping the grisly assessment.

That’s led investors to clamour for information from and about their investee companies on how they are addressing the issue as well as analyses on how those actions are progressing. A survey by Robeco entitled “Global Climate Survey” of 300 institutional and wholesale investors with more than US$23 trillion of assets under management found that 75 per cent said climate change is now “central to or a significant factor in their investment policy”. That’s up from 34 per cent last year.

Climate risks were identified early in the development of the ESG space. The Financial Stability Board created the Task Force on Climate-related Financial Disclosures (TCFD) in 2015 to improve and increase reporting of climate-related financial information. The body recommends disclosures based on four thematic elements: Governance, strategy, risk management, and metrics and targets.

Understanding the risks a company faces is vital to lenders and investors, who need to decide if it is safe to provide them with loans, back their bonds or buy their assets.

Clients “are using this data to help them tell the likely winners from the likely losers under climate change and that then changes their appetite to lend to different companies in the real economy, or if they’re investors, to invest in them”, said Belmont. “If you know the relative winners and losers within a sector and you can create that separation, then you can tilt your portfolio in the direction of probable winners.”

Hidden Risks

The risks associated with climate change come in many forms. Physical risks to companies located in areas prone to flooding or wildfire, for instance, are obvious. Reputational risk is a real concern for companies reliant on mass consumption, especially in the retail, fashion and telecom sectors.

Less obvious, however, are the risks that come with seeking to address corporate carbon footprints and emissions. That’s where accurate data is essential. Such transition risks include stranded assets, credit exposures, investing in the wrong sectors and missing emissions targets.

These are now occupying data and analytics companies who have to gauge net-zero pledges against progress towards meeting them. Doing so is not an easy task given that many organisations that have made such promises have only done so in the past year or so; there just isn’t yet the data to make effective judgements. Consequently, many companies don’t have a good enough understanding of the risks they face.

“The transition from where they are today, which is quite a wide range of preparedness, to where they should be to be truly zero … they’re the risks that even if they know that they exist, companies are not yet acting upon,” explained Acin Innovation Consultant Damian Hoskins.

New Products Emerging

Underlining the growing importance of climate risk tools to financial institutions and the depth of concern over the impact of of global warming, ISS ESG released two new climate-related data products in the past week alone.

The ESG unit of Institutional Shareholder Services (ISS) upgraded its Net Zero Solutions last week to help financial institutions with carbon transition alignment processes, including a tool for regulatory reporting. That was followed this week with the unveiling of the company’s Water Risk Rating, which is designed to make it easier for investors to identify freshwater-related risks to their portfolios.

“Our solution aims to support asset managers and asset owners in giving them the type of metrics that help them to set their own net zero targets according to the various initiatives that are out there and it empowers them by providing them specific set of data points that really digs deep into how they judge companies’ action on net zero,” ISS ESG Head of Climate Solutions Viola Lutz told ESG Insight.

Identifying and quantifying risk is the challenge that faces data providers and many have come up with novel solutions.

Baringa’s award-winning Climate Change Scenario Model uses disclosed and sourced data to build a picture of the likely outcomes of companies’ activities in terms of climate risks. The model, which was created by Baringa and acquired by BlackRock in 2021, incorporates macro-economic data as well as company-specific information to forecast scenarios out as far as 30 years.

Baringa’s Belmont said the model is being used by the company’s traditional customers – large banks and asset managers – and, increasingly, smaller businesses. For the latter, having access to data on their activities is important because they want insights into their own activities and to gauge how they can improve them.

Data Gaps

Data behemoth Bloomberg offers a range of climate-related services including a transition risk solution that is helping investors keep tabs on the progress companies are making towards keeping their net-zero pledges.

Despite holding among the world’s largest financial databases, the New York-based giant is no less prone to a problem that has long dogged the ESG space: holes in the data record. Like other data providers, it’s forced to fill those gaps with estimates.

Zane Van Dusen, Head of Risk & Investment Analytics products at Bloomberg said the growing importance of climate risk data means greater focus has to put on making sure those estimates were as accurate as possible. For that reason, the company has eschewed making sector-based extrapolations; Van Dusen describes them as “not reliable” because they eliminate nuances that could be having an impact on a corporate’s carbon footprint.

Instead, Bloomberg focuses on harnessing its huge data resources to build “quantitative models” that are based on a broader range of factors. Some are less obvious than others. Company head count, for instance, is one indicator of a company’s likely emissions. Back tests of this approach suggest Bloomberg is on the right track, Van Dusen said.

“Once you move to a risk space, coverage becomes really important – if you have great risk metrics for only 50% of your portfolio, it means that your overall risk assessment is not super useful,” he said.

The novelty of tracking corporate performance on climate-risk mitigation means that many data companies are in effect testing new hypothesise with their solutions. ISS ESG, for instance, makes capital expenditure a key part of its Net Zero Solutions, reckoning that financial commitments to such efforts provide strong indicators on how their transitions ate likely to progress.

Using the Data

As data providers offer tools to help financial institutions, their clients are also learning how to use the information and incorporate it into risk-analysis and management workflows as well as portfolio building processes. Impact-focused Triodos Investment Management, for instance, has a three-step process that balances potential investments’ good and bad sustainability attributes with their fundamental financial positions. First Triodos identifies only companies that do good and then eliminates those that fail its own “minimum standards” test. At this level all fossil fuel-linked companies are excluded, for example.

Then, financial data is considered alongside an ESG materiality overlay, where climate risk is an important input that could affect the valuation of a company.

As Investment Strategist Roeland Tso explains, the granular data matters in this process.

“It could be the case that a particular company that produces renewable energy uses wind turbines that contain conflict minerals, for instance, which are being produced in the Democratic Republic of Congo and have a very high likelihood of child labour being involved,” said Tso. “It’s great that you build a wind turbine and produce renewable energy but if you make use of such processes in the supply chain, it does not fit our ethics, our values and our ethical standards.”

Observers are agreed that the days when climate risk was a passing consideration have long gone. Unlike other measures of corporate risk, climate risk is expected to attain more prominence in financial institutions’ calculations as the impact of climate change becomes ever more apparent and appetite to do something about it grows.

“At the end of the day, your transition risk and your physical risk are essentially telling you the impact on a firm’s viability given what the future state will be from a climate perspective, both due to policy changes and weather events over time,” said Bloomberg’s Van Dusen. “There will be impacts on other things, like liquidity risk, but it won’t be as significant and as perfect of a fit as it is to credit risk, where I think it really will just become another aspect of credit risk analysis.”

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