Earlier this year, the Bank of England completed its inaugural “climate stress test,” involving the largest U.K. banks and insurers. In its report, it stated that if no action is taken to address climate change, the resulting financial risks could, in the most severe scenario, result in losses of over £300 billion, with banks and insurers likely to pass a portion of these costs on to their customers. Banks projected that the sectors likely to be impacted the most by inaction on climate change were mining, manufacturing, transportation and wholesale and retail trade, with predicted cumulative impairment rates across these sectors of 35%. Similarly, insurers expected that losses would be particularly concentrated in carbon-intensive industries, with the greatest exposure for the forestry, fishing and food manufacturing sectors.
A climate stress test conducted by the European Central Bank (ECB) also found that losses across banks, insurers and investment funds were significantly concentrated in selected economic sectors. For banks, these consist of loan exposures to electricity and real estate. For insurers, the most sensitive assets appear to be equity holdings related to the production of oil, gas and vehicles and, for investment funds, holdings of assets related to energy sectors and basic materials.
Although the U.S. Federal Reserve has not completed similar tests, preliminary findings from the New York Federal Reserve indicated that the effect of climate stress in 2020 was “economically substantial.”
Many governments around the world have committed to meeting net zero targets and making a green energy transition in order to address climate change. This will require billions of dollars of public and private sector investment and significant policy reform. As regulators grapple with how to measure, classify and monitor climate-related financial risks and issue new mandates, companies and boards are facing expanded legal and compliance obligations.
The Regulatory Burden
Companies are already seeing new climate- and ESG-related regulations, and in some cases mandatory obligations on directors to consider a wider range of stakeholders in their decision making, and for more businesses to make climate-related financial risk disclosures. Complicating the issue is the fact that agreement on the application of green taxonomies that underpin the climate-related disclosures and define that economic activities that are “environmentally sustainable” are still unclear in many countries. There are also inconsistencies between the taxonomies applied in different countries, which creates further uncertainty for companies operating cross-border or internationally. Because of this, companies face challenges in measuring the impact that their businesses operations, supply chain and investment activity has on the climate. They also need to make sure their climate-related regulatory disclosures and market statements are accurate and will stand up to scrutiny in order to avoid accusations of “greenwashing,” which are actions or statements that convey a false impression or provide misleading information about a company’s green credentials.
The risk landscape for company boards, especially around nonfinancial or conduct-related risks is getting more complex. These conduct-related risks may not be financially material (at least initially), but they can have an outsized reputational and business impact. Pressure on management to meet climate-related targets, while also continuing to meet financial targets, could result in some committing fraud by manipulating and misstating financial information or misreporting on climate-related disclosures. This creates risks of both regulatory sanction and civil claims.
Regulators are re-energizing enforcement efforts in this area and many have stated their intention to take action where companies breach their ESG-related legal and regulatory obligations. In the United States, the SEC has proposed amendments to rules and reporting forms to promote consistent and comparable information for investors when investment funds use terms such as “ESG,” “sustainable’ and “low-carbon.” The U.S. securities regulator has also stated that it intends to crack down on exaggerated or misleading ESG-related credentials in investment products. This follows the SEC’s announcement last year that it was establishing an enforcement taskforce focused on climate and ESG issues. The European Securities and Market Authority (ESMA) has stated that tackling greenwashing is a key priority and the UK’s Financial Conduct Authority (FCA) has made similar statements. Further, the European Commission has started to implement the Sustainable Finance Disclosure Regulation (SFDR), which will set out the exact content, methodology and presentation of sustainability-related disclosures. When the regulations are fully applied, they will help with the assessment of the sustainability performance of financial products.
On the civil side, countries are implementing more stringent ESG disclosure requirements, supported by new laws which confer new or expanded legal duties on directors. Companies, their directors and, in some cases, third party advisors (such as auditors) can find themselves vulnerable to civil claims from investors and other stakeholders where their disclosures or marketing material are inaccurate or misleading, or where their business operations are alleged to have caused environmental harm.
Navigating the Risks
In order to navigate this new legal, regulatory and reputational risk landscape and manage climate-related risks in their businesses, risk professionals should take the following actions:
- Understand the threats: Given the range of risks, it may be prudent to revisit prior baseline annual risk assessment data to ensure assumptions are still valid and the climate change-related risks caused by or affecting business operations are fully understood and included. Involve legal and compliance colleagues, as well as product and business function owners. Climate change-related regulation and law is changing rapidly and duties on companies and its directors are becoming more onerous. In some jurisdictions and sectors, voluntary guidelines are now being codified into law and made mandatory. For example, the EU intends to adopt a directive requiring businesses above a certain size that are operating from or trading into the EU to conduct supply chain due diligence, to identify and address any environmental and human rights risks in their operations and supply chain.
- Measure and assess the risks: Data collection, whether it is internal operational information, data held on risk registers or interviews with staff, is key. Businesses should carry out a comprehensive review of their supply chain, any distribution channels and all products, services and other economic activity to identify relevant external data sources, such as information drawn from an analysis of the market, sector or jurisdiction the business operates in, or by analyzing prior risk events that have impacted competitors. It may also be appropriate to conduct economic, legal and geopolitical analysis to help identify medium- to long-term risks, or other emerging trends that could have a bearing on the business.
- Conduct a review of all policies, procedures, marketing material and contracts: Ensure policies and procedures are up to date and do not expose the business to risks where they are inconsistent with climate change related regulation. Policies and procedures may also need to be adapted to cover new climate change-related risks identified during the risk assessment process (such as those resulting from changes to regulation or the development of new products, services or economic activities, for example) or because of events in the sector or market.
Review terms of business, and supplier, procurement and employment contracts, as well as any partnership or joint venture agreements to ensure these are consistent with the businesses’ climate change-related policies. In some cases, it may be prudent to assess whether key suppliers’ climate change related policies adhere to the businesses’ own policies.
Recognize that black swan events do happen, and with increasing frequency: Black swans are low-probability, high-impact events. In recent times, we have seen examples of these, including the impact that the pandemic and Russia’s invasion of Ukraine have had on labor markets, global supply chains, energy prices and entire economies. At a corporate level, these types of risks should be as closely scrutinized as those more predictable, high-probability, lower-impact risks. The transition, physical and financial risks of climate change are likely to rapidly evolve, and companies should continue to monitor and assess their businesses’ exposure to the worst-case climate change related threats. Companies should have well-rehearsed crisis response plans in place that set out what actions should be taken and by whom in the event that these black swan events become a reality.
Gareth Eklund and Karyshma Gill contributed to this article.