Uncovering Climate Risk: The dangers of overlooking the severity of climate-related risks

What are some key strategies that businesses and financial institutions can implement to effectively mitigate and manage transition risks associated with the shift to a low-carbon economy? Join Ravi Chidambaram and Dr. Géraldine Bouveret as they discuss how climate risk extends beyond physical risks and encompasses the often-underestimated transition risks, which can have far-reaching consequences for the financial stability of our world. Gain insights into the CR360 solution, a tool that assesses the resilience of business units in transitioning to a low-carbon economy, helping them identify vulnerabilities and opportunities. Tune in now!

Discussion Topics: Uncovering Climate Risk

• What is climate risk?
• Is climate risk a threat to financial stability?
• What is the carbon bubble?
• What can banks do in this situation?
• How does one assess transition risk?
• What is TCFD?
• Low transition risk implies high physical risk
• What does CR360 offer?
• Closing

Transcript: Uncovering Climate Risk

Ravi Chidambaram: Hi, everyone. Welcome to Debunking ESG Myths, a podcast where we debunk, demystify, and deconstruct some key ESG preconceptions with unfiltered knowledge and data from key experts in the field. I’m Ravi Chidambaram, CEO and founder of RIMM Sustainability, an impact driven SaaS company that advocates for making sustainability accessible and actionable to all.

In this episode, we’re very excited to welcome Dr. Géraldine Bouveret. Who is an established academic and researcher in the finance, mathematics and climate fields? Specialising in the areas of climate scenario-based financial modelling and data driven insights. She’s also RIMM’s CRO and the brain behind our proprietary climate risk 360 solution, which we will touch upon later. Geraldine, good to have you here today. Thanks for coming on.

Dr. Géraldine Bouveret: Thank you, Ravi, for having me here.

Ravi Chidambaram: Excellent. Let’s get started then. Climate risks. What does it mean to you? What is it all about? And how would you go about defining climate risks?

What is climate risk?

Dr. Géraldine Bouveret: Yes, the G20 Sustainable Green Finance Study Group has identified Two types of climate-related financial risks. The first one is physical risk. And the second one is transition risk. And both are affecting firms, business models, as well as their credit worthiness. So what is physical risk? Physical risk refers to the potential financial and economic losses that are caused by climate related hazards, and we distinguish two types of climate hazards.

The first one is acute hazards, which arise from extreme climate events like drought, flood, storm, etc. And the second one relates to chronic hazards which arise from a progressive shift in climate pattern, that is an increase in temperature, sea level rise, a change in precipitation, et cetera. And now, what is transition risk?

Transition risk refers to the potential financial and economic losses that arise from transitioning towards a low carbon economy. And what is important to grasp today is the fact that there are three main drivers to a transition. The first one is a change in consumer preferences with preferences directed towards greener products.

The second one is a change in technological deployment with the deployment of competitive low carbon technology.

The third one is a change in regulations, policies, with the implementation of a carbon tax, for example, or with the implementation of carbon emission reduction.

And what is extremely important to understand is the fact that there are several economic transmission channels. This is an avenue through which climate risk drivers will affect both macro and micro economic factors. And through those channels, the climate risk factors will actually impact the level of financial risk to which an entity is being exposed. So this is, in a nutshell, how I would define climate risk.

Ravi Chidambaram: Thank you very much. you talked about how transition risk models quantify potential financial impacts on a company, such as the cost of credit and so on. Why is climate risk in your view, a threat to financial stability going forward?

Is climate risk a threat to financial stability?

Dr. Géraldine Bouveret: So I think one of the big myths to debunk here is and here I will quote a report that has been released by Deloitte in 2021 is the fact that over the short term, The costs associated with physical risk are expected to be greater than the cost related to transition risk.

In 2020, for example, storms will cause over 200 billion USD in economic damages. However, Over the medium to long-term run, the story is a bit different. The costs associated with transition risk, potentially originating from a decrease in revenue, an increase in operating costs, and an increase in the regulatory burden, are expected to reach trillions of dollars over the decades to come, which would cause great instability within the financial system.

To highlight a bit more why this risk is a risk threat is a threat for the financial system, we need to bear in mind that transition risk is not something that will affect only one sector. This is something that will affect many sectors and all those sectors are highly interconnected is a very complex interconnection.

This means that one disruption may send reports to the entire financial system. And there is a study that was released in 2018, which is very interesting. Kepler and Trevor and the co-firm. And they actually showed at that time the level of equity exposure of banks, other financial institutions, governments, individuals, industries, etc. to transition sensitive sectors like manufacturing, transportation, utilities, etc. And in 2018, the level of exposure We’re already reaching will be several trillion USD. So this means that every component of our financial and economic system is exposed, whether directly or indirectly to transition risk. And because of that transition risk is a major source of systemic risk.

Ravi Chidambaram: Thank you very much. Geraldine, we often hear about something called the carbon bubble. What exactly are we referring to when we talk about the carbon bubble?

What is the carbon bubble?

Dr. Géraldine Bouveret: So the carbon bubble refers to the fact that stock markets are not reflecting the risk posed on fossil fuel assets by a transition. So let me take an example here. There is a sink tank in London, which is called Carbon Tracker. In 2011, they released their seminal report titled Unburnable Carbon. And 10 years on, 10 years later, they released a follow-up report titled, not surprisingly, Unburnable Carbon 10 years on.

What they show is appalling, so they say that global stock markets are providing funding for companies that hold three times more coal, oil, and gas reserves that can eventually be burnt without surpassing the 1.5 Paris climate target. They also mentioned that the embedded emission in the fossil fuel reserves held by companies listed on global stock exchanges has risen by about 40-40 per cent over the last decade.

So clearly there is an oversupply of fossil fuel and this can lead to a long-term decline in prices and an increase in strained assets. An increase in the risk of having fossil fuel projects not delivering on the expected return or on the financial obligations that were initially required in order to build those projects.

We see through that, that stock markets are not adequately responding to the risk posed by transitioning, and this puts at risk the entire ecosystem of banks, insurance, lawyers, etc. And because of that, we are facing markets where fossil fuel assets are actually overpriced. What would make, so this is the reason why we say that we are facing a carbon bubble.

Now, what would make the carbon bubble burst? If governments start to take action and investors panic, then they may withdraw their capital. And then we will face a decline in share prices. And then what will be the consequences? There are some studies that have shown that in this case, in the case of a carbon bubble burst, we may face losses of the same order of magnitude as the one that we faced during the 2008 heat wave.

Ravi Chidambaram: Global financial crisis, I understand. Thank you very much. So it seems to me that banks are a very key factor in this. Banks, as you’ve pointed out, are major funders of different carbon types of projects, fossil fuel projects that continue to this day although some have signed up to the net zero banking alliance and so on, if banks are at the centre of this potential financial crisis how can they go about? Thank you for mitigating this and what should they do to avoid another 2008 GFC scenario?

What can banks do in this situation?

Dr. Géraldine Bouveret: Yes, it’s extremely critical for banks to start integrating those risks into their business model and into their risk management frameworks. Because this is the only way for them to mitigate their exposure to transition and physical risk, but also to align their lending and investment portfolio to the net zero greenhouse gas emission by 2050, and to support their client in their transition journey.

Now, what will happen if banks do not do that? Then creditors will be at risk of facing very huge and unexpected losses, putting the financial system at risk. Assets that do not meet risk standards can be accepted as collateral. Again, this puts the financial system at risk. Last but not least, having underestimated credit prices can send signals to investors that encourage them to allocate capital in a way that is not environmentally sustainable.

In 2022, there will be the European Central Bank, which has released a report. This report showed that most EU, most Eurozone banks actually do not include climate risk in their credit risk model. And they actually precise that 60 per cent of banks do not have a climate risk stress testing framework.

Only 20 per cent of banks actually take into account climate risk in their decision-making process before granting a loan, and they also add that two-thirds of a bank’s income from nonfinancial corporate customers actually comes from greenhouse gas-intensive industries.

Ravi Chidambaram: I understand, sorry to digress, but I have to ask a question. The non-banking financial system these days is as large, if not larger. Then the banking financial system. Isn’t there a risk that a lot of these fossil fuel projects get transferred to the non-banking financial system, either by traditional banks or by those actors such as sovereign funds, hedge funds, and other FinTech-type players that are also exposed to this?

Dr. Géraldine Bouveret: Yes, indeed, there is a risk. This is the reason why it is extremely important that supervisory bodies, and financial regulators Act on on creating some initiatives in order to promote the disclosure of climate-related risks and provide guidelines in order to mitigate those climate-related risks.

And this is what we are already witnessing today since I can just go to 2015 with the FSB and the TCFD regulation or in 2017 with the NGFS and now the ECB, which is also releasing guidelines on how to mitigate climate-related risk. There is also the European Banking Authority, which has released a roadmap on how sustainable finance will support the ECB.

EU energy transition. So it is extremely important to have government bodies, supervisory bodies, and financial actors in order to prevent the transfer that you are referring to and to make this climate risk disclosure and mitigation a key aspect to work on right now.

Ravi Chidambaram: Thank you. I think you very clearly pointed out that the more under-appreciated area of climate risk is transition risk, and that actually may be far more existential as a threat than physical risk going forward in the long run. How does one assess climate risk in general and maybe transition risk in particular?

How does one assess transition risk?

Dr. Géraldine Bouveret: Yes, so the mainstream approach so far is to use a scenario-based analysis. A scenario is a narrative that describes how climate change will affect the variables that are relevant for economic activities, how a transition to a more sustainable economy can mitigate those impacts, and also what type of measures to take in order to drive the transition.

Now, what is important to understand is that when it comes to assessing physical and transition risk, the assessment will involve different factors. However, both risks are two sides of the same coin. Why? Because low transition risk will imply high physical risk. So there is an interconnection between those two types of risks.

When it comes to physical risk scenarios, those scenarios are generated by the global climate model. They are based on assumptions on the severity of climate change, the type of the region of the analysis, and the granularity to use.

Now when it comes to transition risk scenarios, it’s a bit different. Those scenarios are being generated by a climate economic model that factors in myriad variables like economic trends, demographic trends, and energy use, as well as assumptions on the Level of ambition in terms of global warming, and the speed of the transition, it’s important to understand that an early and smooth transition will lower down the transition risk.

And also based on the assumptions that are being made on the three key drivers of the transition. If you recall at the beginning when I was defining transition risk, I mentioned that there are three main drivers to the transition. A change in consumer preferences, change in policies and regulation and change in technology, technological change.

So those assumptions will be taken into account in order to generate those scenarios. Now, once we have those scenarios, we’ll use the value projected by those scenarios. In order to create impact at the business unit level. So when it comes to physical risk, the impact will generally be at the physical asset level.

When it comes to transition risk, we will generally work at the financial statement level of the business unit. And once we have those projections and those impacts at the financial statement level for transition risk, then we are in capacity to compute relevant credit risk metrics. So this is the main, mainstream approach for assessing this type of risk.

Ravi Chidambaram: I think our listeners may appreciate the fact that scenario-based approaches are very linked to TCFD which is now mandatory in many jurisdictions around the world. Could you tell us a bit about TCFD and its scenario-based approach?

What is TCFD?

Dr. Géraldine Bouveret: So TCFD has been created by the FSB, and this is a task force on climate related financial disclosure, and within the TCFD there are so this is a quite comprehensive framework where they are a set of quantitative questions to answer from the business unit and also qualitative answer.

And for the quantitative analysis uh, this quantitative analysis relies on a scenario based analysis. So basically TCFD requires from the company to disclose its exposure to physical and transition risk using a scenario based approach. It also requires the company to disclose the type of metrics that have been used in order to assess this climate risk exposure.

It also requires the company to disclose the target that will be set, and defined in order to start acting and start mitigating this risk. This assessment. is a critical part in order to be able to design any mitigation plan.

Ravi Chidambaram: I think that’s a very important point for our listeners and the interesting point you made is that low physical risk implies high transition risk. Could you elaborate a bit more on this for our listeners?

Low transition risk implies high physical risk

Dr. Géraldine Bouveret: So we take the opposite, that is low transition risk implies high physical risk. Why is that? Because low transition risk means that we are not transitioning. And in the case where we are not, okay, there are two cases for facing a low transition risk.

Either we are in a situation where we are adopting an early and very smooth transition. So in this case, we are in a situation where indeed we will face a low transition risk because the transition is happening in a very smooth way. And at the same time, we are decreasing. The exposure to a physical risk, but low transition risk can also happen in the case where we are not transitioning.

So this is the reason why we are facing a low transition risk. High transitioning, high transition risk occurs when the transition is abrupt, sudden, and disorderly. And in this case, this means that we are not transitioning in time. And because of that, this means that we are facing a very high transition risk.

Now, if we face very low transition risk because we are not transitioning, of course, we will end up facing very high physical risk. Does that clarify?

Ravi Chidambaram: Yes, I think intuitively it does. At RIMM, you have developed a really interesting transition risk solution. called CR 360. I think it would be very interesting to elucidate on that and enlighten our listeners on what CR 360 offers.

What does CR 360 offer?

Dr. Géraldine Bouveret: Yeah, so the CR 360 is a solution that aims at assessing how resilient a business unit is to transitioning towards a low carbon economy. And as I was mentioning before, we are using the mainstream approach, which is scenario based analysis. So we are taking the projection of key macroeconomic variables.

Again, those projections are being made by climate economic models that factor in a different type of viable going from socioeconomic trend, demographic trend, energy use, et cetera. And we are using those projections in order to impact the business unit financial landscape. And this is extremely important.

Why? Because this will help business units identify their vulnerabilities. But not only actually, this will also help business units identify opportunities. Thanks to this analysis, they can identify opportunities for new things. Sustainable business model news, the development of a new line of green products, et cetera.

This may be also a way to identify some potential. Room for governance adaptation and also this is critical to boost transparency because having such disclosure. First make you TCFD compliant, but it’s also key to a bolster investor confidence, which is critical in order to attract capital and

There are some pain points when it comes to climate risk and transition risk assessment. And this solution is actually dealing with a few of them. So the first one is the fact that the solution is providing, uh, the relevant set of climate risk exposure metrics. Which is not something easy to perform.

Let’s take, for example, carbon footprinting. So carbon footprinting, for example, is a bit light as a metric. Why is that? Because it does not tell you anything about how firms will reduce their emissions, or how well prepared a firm is in order to adapt to the low carbon economy. So we had to work on defining some type of climate risk exposure metrics that were more insightful for the business unit holder in order to make decisions for his decision-making process.

Then we are dealing with another difficulty, which is to downscale the macroeconomic projection given by those scenarios down to impact at the business unit level. So this downscaling is also not easy. And this third pain point that we are dealing with is with the granularity of the analysis.

So this solution offers a very high level of granularity. We are acting at the business unit level and we have developed highly granular financial projection models. Now, the two things that I want to emphasise as well is the fact that the audience should bear in mind that when it comes to scenario analysis, It is extremely important to understand that the output will be highly sensitive to the assumptions that have been made when the scenarios have been generated.

So I think about the discount rate, the timing and order of the magnitude, the assumptions that have been made on the driver of the transition, etc. Also, the output will be highly sensitive to the complexity of the model that has been used to generate those scenarios. I mentioned before that the scenario being used for the transition risk scenarios, those scenarios are being generated by the climate economic model.

And those models are highly complex because they have to model the interaction between the physical and economic components, while those interactions are not observable. So there are many assumptions that are being made to model the non linearities.

relationship and the feedback effect that exists between those components. And therefore, it is extremely important for the audience to bear in mind that when it comes to scenario based analysis, there is a pain point that is. That will, that is directly related to the essence of what the scenario is, and therefore it’s important to work with a set of different scenarios in order to account somehow for the sensitivity of the output to the assumption that underlie the scenario generation.

Ravi Chidambaram: That’s a very complex model. Indeed. I think it may be helpful just to break down for our viewers, our listeners a little bit. A few things. One, the fact that this is a highly modular and automated solution. So I think you may want to talk Geraldine briefly about Grenoble City. Emissions footprint is calculated on the RIMM platform, how all of the different scenarios and variables that you talked about are all automatically integrated into the platform and how the financial modelling then also generates the outputs automatically.

Dr. Géraldine Bouveret: Modelling then also generates the outcomes automatically. The evolution of carbon emission that is provided by scenarios and the evolution of off energy prices.

And we are using those three components in order to impact and project the key financial variables at the business unit level from now up to 2050. And, so what the model is doing is that it is using two types of data. First, it is using data coming from the scenarios as I.

Just say that, but also data coming from our database. So at RIM we have a data science team which is working on enhancing a huge database. Of carbon related energy rated financial related data. So we are relying on this proprietary database and we are also relying on the data provided by the user and these providers with the.

Perfect level of granularity in order to assess those key relevant credit risk metrics. But we are not only working with carbon footprinting. As I said before, carbon footprint is a bit light as a measure. We are working with additional credit risk metrics that provide a little bit more insight. To the decision maker on how the transition will impact its financial projections based on the different types of decisions the decision maker can take.

Ravi Chidambaram: Yep. Said. Thank you. I wanted to ask you that, if you’d like to summarise all of your very insightful points into maybe a closing summary if you will.

Dr. Géraldine Bouveret: Yeah, so I would like to say that when it comes to climate risk, it’s extremely important not to overlook transition risk. So climate risk is not only about physical risk. Transition risk is a real threat that is not been properly addressed so far and is not properly reflected on stock markets. So this is really critical to start to act now on transition risk. Otherwise, we may face a situation where it is too late and where transition risk will be by far where the cost associated with transition risk will be far too high.

And we want to avoid facing a carbon bubble burst, as I mentioned before. And this is the reason why having a solution like the CR 360 is extremely important for business. You need to use it in order to start acting on their mitigation journey. Now, the other thing I would like to add to conclude is the fact that, uh, climate change and sustainability in general is a highly complex challenge to tackle and sustainability should not be a niche topic.

That should really be a cross cutting and integrating component across various fields and industries. And I think it’s. Critical sustainability is being used to guide decision making and practices across all sectors.

Closing

Ravi Chidambaram: Excellent. No, thank you, Geraldine. Let me also summarise the discussion for our listeners today, especially in the context of myth busting. I don’t think many people would associate the next major financial crisis with climate change. But Geraldine has very articulated that indeed the next GFC could be related to climate change.

Maybe it’s because it’s too complicated and too interconnected that people really only think of climate risk in the physical sense. All of the damage created by hurricanes and floods and earthquakes and wildfires and so on. And therefore, most climates are summed up with physical risks. But the reality is, as Geraldine is so well pointed out, that actually the invisible changes happening in the transition to a lower carbon economy are really the more fundamental systemic risks that we face.

And these have not been properly analysed. There are very few tools available in the market to do this analysis. People are underappreciating the depth of this analysis. And also not factoring this into their business modelling and this is really the crucial point that Geraldine brought out. And I think from a mythical perspective, in terms of priorities it’s very clear that the climate priorities have to shift away from just physical risk to transition risk.

And far more energy has to be expended to understand these risks, manage these risks, regulate these risks. So that really is the summary for today. Thank you all for joining us and busting some ESG myths. We hope you’ve gained some key insights and most importantly found new perspectives. Geraldine Thank you very much for your in depth expertise on climate risks. Thank you, Geraldine. Yeah, and dear listeners, we look forward to seeing you in two weeks to bust our next myth in the meantime Please do sign up, and subscribe to this podcast. I hope you’re finding it interesting And once again, thank you very much for today.

Our Guest:Dr Géraldine Bouveret

Dr Géraldine Bouveret is a PhD holder in Mathematics from the world-renowned Imperial College, London. Géraldine brings 10+ years of experience in academia and industry in the fields of Mathematics, financial engineering, risk modeling and sustainability. As CRO, she oversees Rimm’s research direction, providing new insights and models to develop Rimm’s methodology, which drives the knowledge behind the platform, simplifying sustainability through her expertise.