How to act in the new regulation of financial sector

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Our world is changing. Because of that regulators around the world are taking ambitious steps to improve the sustainability of the financial sector and guide capital towards sustainable economic activity. Especially in EU we are seeing a high level of regulations. These regulatory interventions present complex and sensitive legal challenges for financial sector firms, which require executive and board-level attention.

The tragic events in Germany, Luxembourg, and Belgium this summer showed us, that already the climate changes dramatically have changed our peaceful Europe. We are not used to the weather representing a threat to our daily life, but as our climate gets warmer, we here in Europe like the rest of the world needs to expect these incidents. UN predict that what we in the past expected to be a 100-year event, now will be a yearly event. This means properties and other physical assets are now in danger of being destroyed. That is why regulators around the world are so active with legislation. They fear a collapse of the financial sector due to overvalue of assets in the books due to climate changes – a new risk we all now need to get used to.

“Sustainability objectives are expected to be established and integrated into decision-making by the end of this year.”

Sustainable finance has a key role to play in delivering on the policy objectives under the European green deal as well as the EU’s international commitments on climate and sustainability objectives.

Boards and managers of financial institutions may need to act on sensitive and complex issues that are not always easily addressed, such as reducing the impact of supply chains on biodiversity and ensuring what is called green is fighting the climate change. As regulators require firms to consider sustainability in governance, capital allocation and investment decisions, sustainability will increasingly provide grounds for regulators and stakeholders to question the appropriateness, and potentially legality, of decisions.

Institutional investors such as pension funds and insurance companies – and the managers who invest on their behalf – control trillions of dollars of assets. Using that money to generate financial returns is critical to support people in their retirement, cover the cost of policy payouts and drive growth for shareholders. In the past it was accepted that investors had no wider responsibility than this. But can delivering financial returns be their sole objective now the world has broader environmental and societal goals, such as tackling climate change have an impact on asset values? If it should be, does that exclude the pursuit of environmental and social goals? To what extent can – and should – institutional investors use their power and influence to generate a positive sustainability impact? And what role does the law play in supporting this process?

For asset managers, regulators increasingly expect them to identify and respond to clients’ sustainability preferences. Given the complexity and growing breadth of the concept of sustainability, this presents the challenge of helping clients identify and articulate sustainability goals. Even more challenging, firms then need to balance clients’ sustainability goals with financial and risk objectives. Existing processes for liaising with clients, researching and identifying suitable investment strategies may need to be re-engineered.

What qualifies a sustainable investment? To get the answer you need sound data and expertise

Even once sustainability objectives are established and integrated into decision-making, the concept of sustainability will present challenges when determining what qualifies as a sustainable investment. Should a ‘green bond’ to finance the development of carbon capture technology be considered sustainable if issued by an oil and gas company? What if a potential investee company is making positive contributions to reducing climate change, but performs badly in terms of the gender or racial balance of its board? Decisions on what sustainability issues to prioritize and how to measure performance will need to be carefully thought through to avoid regulatory attention and claims from disappointed stakeholders.

Across the whole financial sector, the availability of reliable data is already presenting challenges. Many regulatory interventions are based on concepts for which the data are not always available or reliable. Even third-party standards or certifications vary significantly in their approach and outcomes. Without sound data, it is difficult to implement and assess sustainability policies. Requirements to disclose detailed sustainability data, even where it is limited, add pressure, and potentially provide grounds for claims by those stakeholders who feel they are being let down. To limit liability risks, firms will need to ensure that their investment decisions and internal policies combine robust and consistent use of data with clear explanations.

IBM and The Climate Service

Data is in the heart of all IBM does. That is why we in the sustainability group at IBM is working so hard to solve this issue of reliable data for the financial sector. We have therefore partner up with a company The Climate Service  that have some of the finest climate experts. Together we have created a Software as Service platform that incorporates scenarios based on the Representative Concentration Pathways (RCPs) from the International Panel on Climate Change (IPCC).

The RCPs were chosen to represent a broad range of climate outcomes. The synthesis of climate variables for each emission/RCP pathway forms the basis of TCS hazard metrics.

A little deep dive around scenario-based analytics that can bring clarity

So, let’s look into two scenarios.   

RCP8.5 “High Emissions”

This scenario assumes that no major global effort to limit greenhouse gas emissions will go into effect. RCP 8.5 is characterized by increasing greenhouse gas emissions over time representative for scenarios in the literature that lead to high greenhouse gas concentration levels. It is estimated that end-of-century increases in global mean surface temperature will be in the range of 4.2 to 5.4°C.

RCP4.5 “Low Emissions”

This scenario implies coordinated action to limit greenhouse gas emissions to achieve a global temperature warming limit of approximately 2 degrees Celsius. It is a stabilization scenario where total radiative forcing is stabilized before 2100 by employment of a range of technologies and strategies for reducing greenhouse gas emissions. If the pledges and voluntary agreements of the Paris agreement were implemented in full, the implied warming is approximately 3.0 degrees Celsius. Within this scenario itself, it is estimated that end-of-century increases in global mean surface temperature will be in the range of 1.7 to 3.2°C.

With this implemented the Software as a Service platform – called Climanomics – therefore allow institutional investors to understand atmospheric data related to temperature, precipitation, drought, wildfire, as well as other data related to coastal flooding, tropical cyclones, water stress, and fluvial flooding to provide a rigorous estimate of risk under various conditions. The Climanomics platform enables climate risk reporting and disclosure aligned with the Task Force on Climate-Related Financial Disclosures (TCFD) framework. The platform has integrated five award-winning models and based on images from NASA’s satellite network allowing institutional investors to understand, quantify and mitigate climate risk exposure in financial terms. Based on institutional investors selected assets on portfolio level insights and point-and-click scenario analysis the quantified output can be used for future decision-making and investments and give a precise dollar value on deflation of assets due to climate risks.

The Climanomics Platform can help institutional investors quantify:

  • Physical risk assessment that models the impact of hazards including extreme weather conditions and vulnerability of each type of asset to each type of hazard.
  • Transition risks asses the legal, regulatory, and market conditions.
  • Opportunities assessments that incorporate energy efficiency, materials use efficiency, renewable price stability.

The scenario analysis creates 1–80 years horizon covering any point on the planet. The refined and granular analysis starts at the property and asset level and can then be scaled to the company and portfolio level analysis.

Associated Partner Sustainability Services, IBM

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