Embracing Climate Change
New investment opportunities, new risk-return calculations
by David Knipe
Richard Smith-Bingham
Climate change might appear to be a slow burn issue for the financial sector. But growing consumer and business awareness, changing regulation, and a confluence of extreme weather events in recent years have convinced a wide range of financial institutions, largely in Western Europe and the U.S., to engage with this agenda. Climate change thus has become a phenomenon as much as a reality; and over the next 20 years will likely be affected as much by societal anticipation of future catastrophes as by actual physical events.
Climate change, and the range of pre-emptive actions that are already under way, is creating new markets and new risk-return calculations for financial services, as for all industries. Financial institutions, thanks to the high mobility of their capital, are much better equipped to react than many other industries. The capacity of financial institutions to hedge themselves and their customers against a range of business risks, develop new products to cater to changing demand, and invest in growing markets means the sector is inherently well-placed to cope with most of the scenarios that might materialize.
However, the ability of firms to create value from the opportunities and threats depends on how their leaders and managers anticipate and address the changing business environment. This article outlines the factors that managers must address in order to excel in societies
increasingly attuned to climate change.
The Positives: New Markets
Measures by industries, governments, and consumers to reduce their carbon emissions and protect themselves against climate uncertainties will progressively strengthen demand for existing and new financial products.
Financing and advisory
Firms in carbon-intensive sectors are already seeking financing to help them reduce greenhouse gas emissions. Clean technology and renewable energy firms represent attractive sectors for investment and, over the next decade, they may become sizeable markets, attracting $225 billion of new investment a year by 2016.
Among the major players, the Royal Bank of Scotland is the largest financier of renewable energy and clean technology projects, with over $2 billion committed in 2006 alone. Goldman Sachs has to date invested over $1.5 billion in alternative energy projects in the U.S., Europe, and Asia, while Citigroup has committed to investing $31 billion in clean tech and alternative energy over ten years.
A particularly interesting and influential player is the Consensus Business Group, principal advisor to the Tchenguiz family trust, which is exploiting its extensive investments in environmental assets in three ways. First, it is using its position as a major property investor to facilitate the transfer of new technologies to house builders faced with stiffer energy efficiency regulations. Second, it is acting as a principal investor in new power generation technologies such as solar energy that have predictable, securitizable income streams and exhibit high growth potential. Third, it is developing an innovative new platform to facilitate delivery of corporate offset obligations through the transfer of environment-related technologies and intellectual property into target countries.
Hedging and trading
Demand from industry is rising for a range of risk-transfer mechanisms to protect firms against the rise in energy prices, changing
weather patterns, and the possible failure of new technologies. The emergence of carbon as a tradable commodity has given rise to sophisticated products that are beginning to attract large financial institutions and enable a fuller exploitation of the asset.
Consumer revenues
Awareness of green issues is encouraging growth in socially responsible investment by institutions and consumers alike and, although
the retail market for loans, mortgages, and insurance that reward low carbon behavior is currently small, it could take off quickly.
Likewise, greater awareness of flooding and windstorms has begun to increase the appetite of at-risk customers for property and casualty insurance.
More and more firms have entered this market. The Canada Mortgage and Housing Corporation offers mortgages and home equity loans for homes that meet energy-efficiency criteria; Citigroup also offers loans for the installation of renewable energy equipment, such as solar panels. Other examples within banking include Barclays, which has introduced the Breathe credit card with low borrowing rates for consumers buying green products and services. The bank subsequently gives 50% of the card’s profits to fund emissions reduction projects worldwide.
Within insurance, meanwhile, firms such as Tokio Marine & Nichido have begun to offer discounts on auto insurance for low pollution, low fuel consumption, and low emission vehicles, while Aviva offers car insurance that bases premiums more precisely on mileage.
The Negatives: Greater Risks
Credit quality and losses
Climate change will alter the quality of lenders’ and investors’ credit portfolios, increasing the chance of defaults, write-offs, and asset value decline. The challenge for financial institutions will be to spot, in the absence of robust data, potential anomalies in achievable risk premium, and to establish those markets in which they should be competing aggressively and those in which they need to increase margin and collateral requirements. Moreover, insured losses from extreme weather events could, on current trends, rise to $150 billion a year by 2030, which would threaten insurer profitability, particularly if necessary premium rises are depressed by regulatory bodies or high levels of competition.
Economic slowdown
The very factors that make the financial sector resilient to climate change—its global interconnectedness and the mobility of its capital—also mean it is susceptible to threats that cannot easily be mitigated. Over time, the complexity and unpredictability of climate change, and its interdependence with other global risks, may reveal unprotected exposures and aggravate systemic vulnerabilities. The economic impact of global temperature rises and stringent greenhouse gas abatement measures will gradually outstrip the opportunities, and could lead to a loss of over $530 billion in revenues for the industry by 2030, which would be largely shouldered by the top players.
Priorities for the Near Future
Some of the largest institutions have developed responses that cover their strategic positioning, product development, operational processes, and stakeholder relations, but for many firms climate change remains a low-priority issue. Western European firms have been the most broadly dynamic, on the back of a stronger regulatory environment for greenhouse gases. In the U.S., there is a sharp distinction between the active investors in this area and those that have given the issue little attention. Interest from firms in emerging markets is often driven by emissions trading opportunities resulting from European regulation.
However, the combination of positives and negatives implies that climate change could overtime drive a significant wedge in the relative
performance of the most exposed institutions. Our analysis suggests that outperformance, as demonstrated by the ability to anticipate how and where value will shift, will rely on five key factors.
1. Portfolio reappraisal. Financial institutions need to re-examine their strategic positioning in terms of the likely impacts of climate change and societal responses to it. At the highest level this means reviewing the geographic spread of the firm, its geophysical context, and its business portfolio under particular global warming trajectories. This may lead to the reprioritization of certain regional and national markets and business lines according to their likelihood of being net beneficiaries or casualties. As a result, some portfolios might require further diversification. Similarly, firms should undertake a detailed exploration of their exposures to climate risk through loan books, investment assets, and insurance portfolios, stress-testing them against particular physical, regulatory, and market-based vulnerabilities where appropriate.
A focus on emerging data and trends will help institutions improve their understanding of the likely boundaries of risk/return and the best markets on which to focus their efforts. Firms should, therefore, develop a comprehensive dashboard of indicators that will help them monitor the issue as it evolves, quantify emerging risks, and guide decision-making. In particular, firms will need to understand the implications of different carbon scenarios for their capital requirements. As part of this they should also monitor the directions, details, and implications of greenhouse gas policy and regulation; emerging liability issues; the capacities of the market for technological change; and increasing public activism.
2. Innovation. Financial institutions should explore how they might use the likely volatilities generated by climate change to increase appetite for financial products, improve the match between risk managers and speculators, and exploit arbitrage opportunities between different markets. Substantial revenues can already be derived from specialist advisory, transactional, and hedging services, while the consumer market remains largely untapped, and there is considerable scope for insurance innovation in emerging economies.
The unpredictability of climate change will place a greater premium on the pace of innovation at a product design level, and firms must develop a highly responsive capability in order to meet and anticipate new market conditions. The most agile firms will be able to react quickly to changes in demand, but also avoid committing resources too early or to markets that lack substance.
3. Brand. Firms should seek to develop and leverage a strong, credible brand to strengthen relationships with existing customers and secure new ones. Consumers and new recruits will be attracted by a sense of shared values in markets where financial institutions are virtually indistinguishable by image, loyalty is low, and climate change concern is high. Industry will attach importance to the careful marketing of innovative thinking around climate risk, abatement, and adaptation options and growth strategies. Governments, which will become increasingly significant as customers, will arguably seek partners who can demonstrate both
aligned values and expertise.
Green credentials remain, for the moment at least, a way in which small providers can get themselves noticed and an issue that global institutions can work across business lines and geographies, with stakeholders of all types. There is still scope in many regions for firms to seize the role of the green financial institution. However, while firms who are slow to market their environmental awareness may come to suffer the consequences,firms will need to be alive to climate change fatigue and accusations of “green wash” and recognize that it will not be long before green branding becomes widespread and, thus, of little value in terms of differentiation.
4. Governance and execution. Financial institutions need to develop a coherent stance across the firm, which ensures a growing capability is both employed throughout the organization and matched by the firm’s own impact on the environment. In other words, firms should develop structures whereby climate risk and opportunities are reported on and used to inform strategy; environmental criteria might be rolled out across a range of products; and measures are taken to reduce emissions from infrastructure and travel.
5. Collaboration. The complexity and reach of climate change suggest that the largest, most global financial institutions should work with each other, governments, non-governmental organizations, and customers in ways that strengthen not only the intelligence, customer relationships, and reputation of individual firms,but also that of the industry as a whole. Equally, industry leaders should work together to influence policy solutions to climate change that will best leverage the power of capital markets, and ensure that individual governments steer away from unilateral policies that are likely to create significant moral hazard and thereby latent costs for taxpayers.
Building Green Credentials
Financial services are in a unique, privileged position with respect to climate change. The net winners from global warming will be those firms that best understand the risks and can take advantage of a changing business environment. Against this backdrop the capacity of financial institutions to hedge themselves and their customers against a range of business risks; develop new products and services to meet changing customer needs; and invest in growing markets means the sector is inherently well placed to cope with any of the scenarios that the future might bring.
The financial sector is not, however, immune to global warming and, while a degree of volatility may strengthen revenues, the very factors that make the industry resilient to climate change —its global interconnectedness and the mobility of its capital—also mean it is susceptible to broad-based threats that cannot easily be mitigated. Coinciding with an economic downturn and high levels of price-based competition, unanticipated climate-driven disturbances could lead to substantial losses and write-offs, and perhaps even revenue decline.
In this current, possibly transitional, phase in the move to a low-carbon economy, there may only be a short period within which firms can obtain distinct competitive advantage by strengthening their green credentials and developing new products and services to meet changing customer demand. An active approach along the lines indicated in this article can put all financial services firms on a footing that will lead to social and financial rewards.
With national and international policies under review and consumer interest perhaps approaching a tipping point, this is an ideal time for financial services executives to engage with the issue. Moreover, the sector as a whole can exercise a degree of leadership that will minimize climate-related economic volatility and enable long-term bets in pursuit of environmental improvements and commercial returns.
