10 minute read 22 Jun 2020
pier at sunset

What the COVID-19 pandemic teaches us about managing climate risk

Authors

Mike Zehetmayr

EY EMEIA Risk, Compliance and Regulatory Technology Leader

Leader in understanding the application of data in transition to a low carbon and sustainable economy. Fellow of the Royal Geographical Society.

Kanika Seth

EY EMEIA Financial Services Third-Party Risk Management Solution Leader

Experienced financial services professional, leading third-party management. Passionate about diversity and inclusivity across EY. Cricket enthusiast.

10 minute read 22 Jun 2020

Tackling the supply chain challenge of COVID-19 presents a unique opportunity for organizations to improve their climate risk management.

At first instance, the COVID-19 pandemic and climate change might appear to have little in common. However, both present real threats to life as we know it and business as usual. And responding to both threats involves developing a deep understanding of the ecosystems in which business operate – the extended supply chains in which they play a part.

To respond to both crises, we need to be able to measure and collect data to give insights to inform our response. To do this effectively, we need to look at old problems in new ways and learn the lessons of the past.

Sir John Cunliffe’s speech on 9 June 2020 outlined the fact that the changes made post the financial crisis have put the financial system in good stead to weather the shocks and tail effects of the COVID-19 pandemic. Without which we would certainly be facing a credit and financial crisis as well as a health crisis, an economic crisis and a social crisis. However, this has only been achieved by central banks stepping in.

It’s increasingly clear that financial services firms need to play their part in tackling climate change risk to support financial stability.
Mike Zehetmayr
EY EMEIA Risk, Compliance and Regulatory Technology Leader

The financial system does not understand climate risk, physical risk or transition risk. There is a need for consistent data, standards and methodology to help improve this understanding, so while stress testing and scenario modeling will help to move the understanding forward, what can we also learn from the COVID-19 situation to help inform the financial system more readily?

Across financial services, awareness of the risks and opportunities associated with climate change exists, but often at a limited level. It is perhaps strongest in the insurance and wealth and asset management sectors, but even here the skills and experience associated with fully understanding the risks associated with climate change are limited. Few organizations are capable of pricing climate change risk – presenting it in a financial perspective that enables organizations to forecast future risks and support complex decision-making about the allocation of assets. There are a small number of financial service organizations which are developing approaches for valuing carbon at risk and granular climate data sources to analyze temperature impact on portfolios.

The need to expand this work is becoming increasingly apparent. In 2017, the US suffered 16 weather and climate disasters with losses greater than $1 billion, costing the economy a total of $309 billion.Not all natural disasters can be attributed to climate change, what we can say is that there is sufficient evidence to support climate events will increase in frequency and severity. With global losses from natural disasters over the past decade totalled $3 trillion2 it’s therefore increasingly clear that financial services firms need to play their part in tackling climate change risk to support financial stability.

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Chapter 1

The global focus on climate risk

Discover recent key developments, the importance of reporting and of climate risk management.

In 2019 the former Governor of the Bank of England (BoE), Mark Carney, stated, “Now is the time for a steep change to bring the reporting, risk management and return optimization of sustainable finance into everyday mainstream, financial decision making.” The stark clarity of Mark Carney’s statement is aligned with The Bank for International Settlements (BIS) response in collaborating with the Central Bank community to improve understanding of the threat posed to financial stability by climate change risks. Its comprehensive January 2020 publication, “The green swan: central banking and financial stability in the age of climate change,” highlights that “traditional approaches to risk management consisting of extrapolating historical data and on assumptions of normal distributions are largely irrelevant to assess future climate-related risk.”4

We are on the edge of a fundamental reshaping of finance.
Larry Fink
Chairman and Chief Executive Officer, BlackRock

In his 2020 letter to CEOs, BlackRock Chief Executive Larry Fink wrote that “we are on the edge of a fundamental reshaping of finance” and that BlackRock’s clients are “seeking to understand both the physical risks associated with climate change as well as the ways that climate policy will impact prices, costs, and demand across the entire economy.”5 Fink anticipates “a significant reallocation of capital” in the near future. Members of the United Nations-convened Net-Zero Asset Owner Alliance, who have committed to transition their investment portfolios to net-zero greenhouse gas (GHG) emissions by 2050, already represent over $4.6 trillion in assets under management.6

The recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) now have over 1,000 supporters globally, including governments, national banks, regulators, stock exchanges and credit rating agencies. As of 12 February 2020, TCFD supporters included 473 financial firms responsible for assets of $138.8 trillion.7 UK regulator the Financial Conduct Authority (FCA) has proposed that all companies with their main listing in London will have to make climate-related disclosures as prescribed by the TCFD – or explain why they cannot. The FCA is also considering how best to enhance climate-related disclosures by regulated firms, including asset managers and life insurers, to ensure a coordinated approach.

The TCFD’s requirements cover governance, strategy and risk management, as well as metrics and targets. Organizations wishing to comply therefore need to disclose information on their processes for managing climate-related risks and how these are integrated into overall risk management. They are also required to disclose Scope 1 GHG emissions – their direct emissions from owned or controlled sources, as well as Scope 2 emissions – indirect emissions from the generation of purchased energy. If appropriate, they should also disclose Scope 3 emissions – all other indirect emissions that occur in the value chain of the reporting company, including both upstream and downstream emissions.

For some organizations, their Scope 3, supply-chain related emissions can be strikingly high. Kraft Foods, which road-tested the TCFD recommendations in 2010, found that value chain emissions comprise more than 90% of the company’s total emissions. Post-merger with Heinz, The Kraft Heinz Company is now reporting their Scope 3 emissions and calculation methodology through the Carbon Disclosure Project (CDP) every two years.

Value chain emissions

90%

of Kraft Foods’ total emission comprised of value chain emissions.[8]

The ability to compare Scope 3 emissions between different organizations can be very challenging as there is little consistency. As a consequence, consumers of this data like financial service firms will find the lack of consistency difficult to systematically use the data in pricing and risk models.

Organizations are working to try to encourage consistency in various areas of sustainability reporting. For example, the World Economic Forum International Business Council (IBC) has proposed a common, core set of metrics and recommended disclosures that its members could use to measure and disclose meaningful aspects of their performance on environment, social and governance matters. Big 4 firms including EY are supporting this initiative.

Mark Carney, as Finance Advisor for the 2021 United Nations Climate Change Conference (COP 26), highlighted the importance of reporting, emphasizing the need to improve the quantity and quality of climate-related disclosures by implementing a common framework built on TCFD.9 He also highlighted the importance of climate risk management – to ensure that firms and investors can measure and manage the risks in the transition to a net-zero carbon world, and the need for investing for a net-zero world to go mainstream. The BoE plans to introduce climate stress tests for the UK’s largest banks and insurers, based on three different environmental scenarios of rising severity. The tests will suggest how institutions would cope with more frequent severe weather events such as floods and what would happen if there were a sudden fire sale of “brown” assets considered detrimental to the environment.

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Chapter 2

Tackling the data challenge

Organizations are becoming more aware of the need for effective third-party risk management.

A key challenge in managing climate-related risk and meeting requirements such as those of the TCFD is the lack of relevant and reliable data. Businesses can’t manage what they can’t measure. Yet in relation to climate change risk, they are operating in a fragmented data landscape with missing or unreliable data points. Even where third parties produce emissions data, for example, this will be self-generated and may not be subject to any independent audit or assurance process. Organizations will need to have reliable information from suppliers along their supply chain. They will want to know about current GHG emissions, and plans for achieving future reductions. If suppliers are not aiming to become net-zero themselves, should alternative suppliers be sourced whose climate change goals are in closer alignment?

The messages from companies and investors is increasingly clear, better data is needed to inform strategy and business outcomes. As an example, Climate Action 100+ (CA100+) – an alliance of investors who manage more than US$40 trillion, coordinated by five global investor networks, including the Institutional Investors Group on Climate Change (IIGCC) – is asking for companies to curb emissions, enhance governance and improve climate-related disclosures. It is engaging with 100 “focus companies” in the Morgan Stanley Capital International All Country World Index (MSCI ACWI) global equity indexes with the highest direct and indirect emissions, and an additional 61 firms that present high levels of climate risk or opportunity.

Specifically, the CA 100+ initiative aims to fundamentally change corporate behavior, and can point to commitments secured from some of the world’s largest oil, gas and mining companies, which have agreed to enhance their climate change commitments in response to engagement campaigns by the initiative. CA100+ intends to provide enhanced corporate disclosure in line with the final recommendations of the TCFD and, when applicable, sector-specific Global Investor Coalition on Climate Change Investor Expectations on Climate Change to enable investors to assess the robustness of companies business plans against a range of climate scenarios, including well below 2 degrees Celsius, and improve investment decision-making.

To support this, CA100+ is engaged with companies to support them to improve the completeness of TCFD disclosure. This data will enable consumers of data, data distributors and providers to have access to data that they have increased confidence in to support investment decisions. The CA100+ initiative engaged with a number of key data providers through the “Technical Advisory Group,” including Transition Pathway Initiative (TPI), CDP, Coral Triangle Initiative (CTI), 2DII and InfluenceMap that provide various data points that help financial services companies form a view on climate action from companies.

The COVID-19 pandemic can be seen as a compressed version of a persistent climate-related event. Experiences gained now can be put to use in helping prepare for future climate change risks. For example, predicting how badly individual businesses will be affected by the COVID-19 pandemic involves understanding how suppliers down the line are affected – not just the first tier, but in the second and potentially the third tier too. Many organizations won’t have this information. Few, if any, will know all the constituents of their supply chain and the extent of their exposures. The reality of the knowledge gaps that currently exist was recently exposed by the 2019-2020 Australian wildfires. Some businesses were caught out by supply chain disruptions, unaware that they had connections to businesses operating in Australia.

As a result, organizations are becoming more aware of the need for effective third-party risk management (TPRM). Understanding the location of product and service suppliers is seen as increasingly important for enabling businesses to function as effectively as possible. Some geographies may be particularly vulnerable to climate change impacts. For example, research indicates that the southern US is entering a megadrought. Could businesses dependent on high water consumption be adversely affected? What impact might that have on the supply chain? Do businesses along that chain need to consider alternative supply options to protect themselves?

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Chapter 3

Time for deliberate action

Four concrete actions that organizations can take now to respond to future climate change risks.

The rapid onset of the COVID-19 pandemic and extent of business interruption globally indicates how suddenly risks can crystallize. The existential threat posed by the COVID-19 situation is clear. The threat posed by climate change is also real, but perhaps less tangible in this immediate moment.

Business leaders in financial services and other sectors are encouraged to consider how they see their response to the COVID-19 pandemic. Is this just a one-off event affecting the supply chain? Or is there a risk of other disruptive events – not only related to climate change (such as fires and floods), but also to disease, political uncertainty or economic downturns – that could require sophisticated and rapid supply chain management. If so, then it’s worth taking deliberate, strategic action now to find ways to use COVID-19 responses to enhance supply chain understanding and so strengthen resilience in the face of future business-interrupting events, such as climate change.

In tackling the COVID-19 pandemic, organizations will be asking suppliers for information on how they are responding to any business interruption, how and when employees will return to work, how they plan to operate safely, and how product and service delivery could be maintained if virus infections increase.

Some organizations may view this as a short-term activity only relevant to the COVID-19 pandemic. Alternatively, and preferably, they could take the opportunity to change the way they engage with the ecosystem in which they function as a business. They could gain greater understanding of relationships and dependencies within that ecosystem, reaching down through several tiers of suppliers. In this way they can help to improve decision making and protect the business from future disruptive events, including those linked to climate change. They can develop new skills and tools in the process.

A final lesson from the COVID-19 response is the importance of multidisciplinary teams. Organizations that have responded effectively have done so by rapidly bringing together people from a range of disciplines, with varied skills and experiences, who understand all the details of how their organization operates and what adjustments may be needed. Multidisciplinary teams are also vital for tackling climate change and establishing climate change risk management processes.

Business leaders therefore need to act deliberately to ensure they are developing the necessary resources and structures: institutionalizing a new way of operating so that the organization can respond effectively to future climate change risks. This again relies on developing a business strategy that understands the full implications of transitioning toward a net-zero future.

Concrete actions that organizations can take now include:

  1. Reviewing and assessing the impact of the COVID-19 pandemic on the business in terms of risk management capabilities and potential supply chain disruptions to inform their strategy on climate risk management. Consider taking time now to capture learnings and data from the COVID-19 pandemic which will inform your ESG strategy and response.
  2. Use insights from the COVID-19 pandemic to reassess and adapt ESG strategy and data required to incorporate climate change risk and sustainability considerations in alignment with regulatory requirements.
  3. Defining a data strategy to better assess their current state, track progress against the proposed sustainability strategy, and meet regulatory requirements. This involves:
    • Defining a data model to take account of the diverse data landscape and monitor risk in real-time
    • Defining the data points and potential sources of information
    • Defining required governance
    • Incorporating the regulatory requirements focused on climate risk, including the TCFD and the Central Bank environmental scenario stress testing (e.g. Bank of England Biannual Scenario Stress Testing).
  4. Enhancing climate risk management capabilities through the insights derived from the data model and real-time monitoring of risks and exposures arising from the COVID-19 pandemic. This will support with setting the right risk appetite, controls and assurance.

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Summary

The COVID-19 pandemic response provides a unique opportunity to improve climate change risk management.

Financial services organizations can choose to use the situation to increase understanding of supply chain relationships and dependencies, so informing and changing future behaviors. Capturing data and developing tools, as well as building knowledge, experience and capabilities, could be seen as a proactive way to improve risk management.

About this article

Authors

Mike Zehetmayr

EY EMEIA Risk, Compliance and Regulatory Technology Leader

Leader in understanding the application of data in transition to a low carbon and sustainable economy. Fellow of the Royal Geographical Society.

Kanika Seth

EY EMEIA Financial Services Third-Party Risk Management Solution Leader

Experienced financial services professional, leading third-party management. Passionate about diversity and inclusivity across EY. Cricket enthusiast.