What is climate risk and why does it matter?
The Prudential Regulation Authority defines three types of financial risk from climate change: physical risk, transition risk and liability risk.
Physical risks from climate change arise from a number of factors, and relate to specific
weather events, such as heatwaves, floods, wildfires and storms, and longer-term shifts in the climate – such as changes in rainfall, extreme weather variability, sea level rise, and rising average temperatures.
“Some examples of physical risks crystallising include increasing frequency, severity or volatility of extreme weather events impacting property and casualty insurance,” the PRA explains in its Supervisory Statement on enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. “And increasing frequency and severity of flooding leading to physical damage to the value of financial assets or collateral held by banks, such as household and commercial property.”
Transition risks can arise from the process of adjustment towards a low-carbon economy.
A range of factors influence this adjustment, including climate-related developments in policy and regulation, the emergence of disruptive technology or business models, shifting sentiment and societal preferences, or evolving evidence, frameworks and legal interpretations.
“Examples include tightening energy efficiency standards for domestic and commercial buildings impacting the risk in banks’ buy-to-let lending portfolios,” the PRA explains. “Or rapid technological change, such as the development of electric vehicles or renewable energy technology, affecting the value of financial assets in the automotive and energy sector.”
Liability risks arise from parties who have suffered loss or damage from physical or transition risk factors and seek to recover losses from those they hold responsible.
For example, the physical risk of flooding affecting the value of property assets can lead to increased credit risks, particularly for banks, or to underwriting risks for liability insurers, if it results in legal claims to recover financial losses from this physical damage.
There is a transition risk that companies in the wider economy who fail to mitigate, adapt, or disclose the financial risks from climate change are exposed to climate-related litigation.
This could impact their market value or lead to higher claims for insurers that provide liability cover to those companies.
“The legal risks from climate-related liabilities can be of particular importance to insurance firms, given these risks can be transferred through liability protection, such as directors’ and officers’ and professional indemnity insurance,” the PRA says.
As the extent, magnitude and time horizon of financial risks from climate change are unknown, the PRA’s position is that firms need to act now, with urgency.
“A ‘too little, too late’ scenario, where significant action is taken, but too late to achieve climate goals, could result in the most severe financial risks crystallising in the banking and insurance sectors,” it says.
“Financial risks from climate change will be minimised if there is an orderly market transition to a low-carbon world, but the window for an orderly transition is finite and closing.”