During RMA’s installment of the Risk Readiness Webinar Series, Chris Lafakis, director, Moody’s Analytics and Gary Way, senior vice president of Credit Strategy and C&I Portfolio Management, PNC, discussed how to ready your institution for one of the defining issues of our century.

Climate change presents both physical and transitional risks to the assets financed by financial institutions. Physical risks include phenomena like shrinking coastlines and increased risks of crop failure. Transition risks include the possibility that regulatory or marketplace changes will devalue things like oil and cars with internal combustion engines.

Lafakis shared Moody’s work in quantifying the critical risks of climate change and creating scenarios that are consistent with international benchmarks established by the Intergovernmental Panel on Climate Change (IPCC). Moody’s assessed six impact channels to determine how they would be affected by temperature increases. These channels include sea level rise, agricultural productivity, heat and labor productivity, human health, tourism, and energy demand. Emerging economies will suffer the most in these scenarios, particularly Saudi Arabia who will face a GDP 10% lower than it is currently because of the potential for a decline in oil prices due to a reduction in heating demand. Winners include countries that will benefit from increased temperatures. European countries like Denmark, Austria, and Sweden will experience increased agricultural productivity and rises in tourism due to warmer temps and will not be affected by a decline in oil prices.

Transitional risks refer to the system-wide costs and sector costs associated with transitioning to a closer-to-zero carbon world. Sectors impacted include fossil fuel producers, utility companies, and the transportation industry. Subsequently, Lafakis and Way recommended that financial institutions exercise caution when issuing credit to companies that could be affected by transitional risks, for example, those that leave a large carbon footprint.

Climate change stress testing at banks is challenging because it does not fit in the current stress testing paradigm, which features a five-year time horizon. Since the effects of climate change will compound over time, this threshold is not useful for projections. The U.S. is behind on quantifying climate change risk and there is no consensus from regulatory agencies on how to address stress testing. As such, no requirements have been issued for banks in the U.S. in 2020.

Although climate change risk management is in the initial stages, financial institutions can find opportunities to position themselves favorably. Lafakis and Way suggested that institutions become knowledgeable about how different countries and companies will be affected by the physical and transition risks of climate change, both the winners and losers, and adjust lending policies and deployment of capital accordingly.

If you missed the live webinar, you can purchase a recording here.