What does Climate Scenario Analysis Mean for all US Financial Institutions?
By, Rosanne Lam, Strategy Manager Climate & ESG Solutions, Ortec Finance
Ortec Finance, a prominent technology and solutions provider specialising in risk and return management for financial institutions, will be joining this year’s World Energy Transition Summit 2023, as Summit Partner. At the Summit, Climate Science Lead, Climate & ESG Solutions Bronwyn Claire, will bring forth her insights as a speaker during the closing session about transition trends and opportunities.
In this article, Rosanne Lam, the Strategy Manager Climate & ESG Solutions, shares her knowledge about the significance of climate scenario analysis for financial institutions in the United States.
At the beginning of this year, the US Federal Reserve released the details of its pilot climate scenario analysis exercise for the nation’s six major banks. This exercise requires some of the key players within the US’ financial sector to assess the magnitude of climate change’s impact upon their respective organisations by July 31. In our latest blog, the Climate & ESG Solutions team explores the overall implication this could have for other smaller banks and financial institutions.
When speaking to financial institutions over the last couple of months, I am struck by how many, regardless of whether they are being required to perform scenario analysis, are now actively assessing the potential impact of climate change on their portfolios. Some are undertaking this task with a large climate team but others with just a team of one. Some see the issue of climate change solely as an operational risk, whereas others are taking a layered approach to climate risk by incorporating tipping points and market risk. As we learn more about the complexities of climate change, it is becoming apparent that there are many known, unknown and layered risks that should be integrated into scenario analyses where possible.
The recent risk event witnessed by the global financial sector has taught us about the power of layered risks. Prior to March 10, 2023, a bank failure would have likely been perceived by many as a low probability risk. When this risk was realised, it took as little as two days for it to shutter the 16th largest bank in the US, making it the largest bank run in history. While the risk of a rising interest rate was known, it was an unprecedented combination of risks that finally raised the alarm for this specific institution before it was seized by regulators. The risks were always there, we just couldn’t see them. Carefully constructed scenario analyses allow financial institutions the opportunity to understand the impact of risks and possible aftermath and prepare for the risk before it becomes too late.
A quick turn in market sentiment, like the one recently witnessed, is a concern when modeling climate scenarios. Incorporating market risk that reflects a sudden awareness of climate risk not being priced into an asset can have a detrimental effect on the value of a company or a portfolio.
What makes it more difficult is that many traditional financial modeling approaches have been slow to incorporate climate change-related market risks within scenario analysis.
- Rosanne Lam, Strategy Manager Climate & ESG Solutions, Ortec Finance
This has led to the emergence of climate scenario analysis – a great structured tool that enables financial institutions to understand better how climate change may impact their portfolios.
Another risk that is now commonly discussed is groupthink. While financial institutions are focused on utilising a set of climate scenarios with plausible outcomes, there could be some significant ramifications in the event that another entirely different scenario eventuates. Bespoke, idiosyncratic or alternative scenarios are constructed to incorporate specific risks that would severely impact an institution based on its own business model, portfolio or footprint. This is what financial institutions should be exploring. Financial institutions with assets that are located in flood, drought and wildfire-prone areas should consider constructing climate scenarios or using alternative climate scenarios to help them understand how these climate change-related events can impact their institutions.
The signal that comes from this regulatory requirement is that climate change may create a financial impact and that US financial institutions, no matter how big or small, should incorporate risks arising from climate change into their investment strategy, decision-making and enterprise risk management frameworks. Not being able to fully determine how much of an impact is something that financial institutions will need to continue to explore and manage as data and models improve, but they can certainly focus on gaining a clearer understanding of the potential ramifications.
While large, diversified global banks may not be brought down by a single climate event, layered events could serve as tipping points. Mid-size and smaller, unprepared financial institutions with less diversification could be at risk. Banks have painfully learned that their customers are just a click away from transferring their accounts to a different institution – perhaps to one that takes climate change into account so they may feel safer.
About Ortec Finance
Ortec Finance is the leading provider of technology and solutions for risk and return management. It is their purpose to enable people to manage the complexity of investment decisions. Ortec Finance do this through delivering leading technologies and solutions for investment decision-making to financial institutions around the world. Their strength lies in an effective combination of advanced models, innovative technology and in-depth market knowledge. This combination of skills and expertise supports investment professionals in achieving a better risk-return ratio and thus better results. Headquartered in Rotterdam, The Netherlands, Ortec Finance also have offices in Amsterdam, London, Toronto, Zurich, New York, and Melbourne.
Read more: www.ortecfinance.com/climate
About the Author
As Strategy Manager within Ortec Finance’s Climate & ESG Solutions Team, Rosanne is responsible for staying updated with the latest climate-related regulatory, market and scientific developments worldwide. She works alongside the team to ensure that these developments are integrated into its investment decision-making technology and solutions, with a specific focus on climate scenario analysis and portfolio alignment. Rosanne joined Ortec Finance in 2019 and has played a key role in the creation of Ortec Finance’s net-zero alignment solution to enable financial institutions in their transition to net-zero. Her interdisciplinary background spanning across sustainable business strategy, environmental economics, global public policy and natural science reflects her passion in transitioning the world to a low-carbon economy. Rosanne holds a Master of Environmental Management majoring in business from Duke University and a Bachelor of Environmental Studies majoring in marine biology and ecosystem services from Lawrence University. She is certified in Sustainable Investing and Finance (CSIF) from DVIF Academie in Germany and obtained a fellowship in Energy, Environment & Economy from Duke University’s Global Policy Program in Switzerland.