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Climate risk tools: new guidance aids financial sector in navigating the market

© Shutterstock / Virrage ImagesWildfire burning through a forest.
Wildfire burning through a forest.

The UN Environment Programme’s Finance Initiative (UNEP FI) has published guidance for financial institutions on climate risk tools, exploring the major market trends and providing analysis of dozens of available offerings. 

  • The research intends to improve the global financial industry’s understanding of physical and transition climate risks, and the tools available to help the sector finance the transition.
  • Incorporating innovative techniques, such as those offered by geospatial data and machine learning algorithms, can help fill the information gaps in current climate-related financial analysis.
  • Financial institutions were provided with a roadmap to choosing risk assessment tools, taking into account the regulatory developments and updates in the marketplace.

Climate risk tools have been used increasingly by financial institutions (FIs) to evaluate climate-related risks and opportunities as well as formulate strategies. While the financial industry itself has been instrumental in the fast-paced development of these tools, the complexity of the risks and the rapid development in regulations require them to keep abreast of the new features on offer, and how to select the right tool for their business.

What is the motivation behind the UNEP FI’s latest climate risk report?

UNEP FI’s 2023 Climate Risk Landscape report is intended to help the financial services industry better understand how tools are evolving to keep pace with a rapidly changing environment. In addition to highlighting major market trends, the report provided a detailed analysis of the various individual tools available, guidelines for FIs to assess risks and opportunities and on engaging with clients, alongside a roadmap to choosing a risk assessment tool.

A group of 44 banks part of UNEP FI’s Climate Risk and TCFD Programme contributed to the latest report. It builds on the 2022 Supplement, which provided case studies of 15 FIs working with different climate-risk tool providers, and the 2021 Climate Risk Landscape Report, which summarised the tools and methodologies provided by third-party climate risk assessment providers.

The state of the market

The report looked at the development of climate risk tools in the context of regulation, industry action, provider market dynamics and new innovations. Among the various banking and FI commitments to net zero, the role of the Glasgow Financial Alliance for Net Zero (GFANZ) was acknowledged for its ability to address broad change across the industry. Indeed, it supports the seven net zero alliances that make up its membership with tools and frameworks to assist them with meeting its commitments, including adopting effective transition plans.

On the regulatory side, the EU’s taxonomy regulation, and Sustainable Finance Disclosure Regulation play a major role in determining the investment criteria and risk management strategies to address the transition to a low-carbon economy. The standard being set by International Sustainability Standards Board will provide further insight into some of the global baselines being set to mobilise sustainable finance across all industries and sectors. 

A rise in mandated climate-related disclosures in regulatory jurisdictions across the world, and the need to run climate stress tests and scenarios by central banks, are impacting the features and functionality of the tools being developed. This has led to an increase in scope and the ability to customise these tools based on specific FI needs.

The report found increased integration of the various kinds of climate risks among tool providers, enabling FIs to understand counterparty risk in their investments. While this has expanded the range of physical and transition use cases in the climate risk tools, the dynamic nature of these cases means that the work is not yet complete and requires constant monitoring. 

A particular focus of the various tools assessed in the report was the incorporation of a wider range of net zero scenarios, and details on sector-based decarbonisation pathways. Climate risk tools are being developed to help countries and companies set targets and strategies, along with the ability to monitor their alignment with regulations and goals.

Tool providers are also looking at technological innovations that can help distinguish their offerings in the market; indeed, a need to address data gaps and provide applications that aid strategy and decision-making was a top priority for many of the FIs participating in UNEP FI’s working group. They expressed an interest in using cutting-edge technologies such as satellites to improve the integrity and transparency of data, and also using algorithms based on machine learning to automate decision-making.

A roadmap for FIs to assess and select climate risk tools

UNEP FI has developed a roadmap for FIs to take a structured approach in choosing a suitable tool provider. The intention is to help FIs map their needs against the framework being provided by the tool, setting out a process that captures the various aspects of decision-making that go into their final selection.

It asked two sets of questions: “What do you want?”, and “What do you need?”, and provided options for each question, which can help FI’s determine the required specifications of the climate risk tool they need. 

These options to help determine ‘wants’ included deciding which asset class will be assessed, the scope of coverage or assessment, the types of scenarios that need to be considered and the format and metrics of the desired output.

Examples of asset classes included public or private equity, real estate, agriculture, or corporate or public debt. FIs may need to ensure the tool adequately covers the region, or sector of interest, and can provide assessments across the various climate risk categories, including physical and transition risks.

In constructing scenario analysis, the tool should incorporate International Energy Agency, Intergovernmental Panel on Climate Change or climate scenario frameworks, and be able to calculate their portfolio’s value at risk. In looking at the format and metrics of reporting, the tool should provide options across currencies and environmental factors, such as total and intensity-based emissions, or be able to generate reports aligned with the Task Force on Climate-related Financial Disclosures standards.

To help determine ‘needs’ the options include validity, usability, depth of analysis and transferability. In assessing the validity of the need, FIs need to consider transparency, verification and credibility of data and third-party information, and whether a science-based approach is necessary. 

Usability addresses the user-friendliness and flexibility of the tool, while the depth of analysis can help the FI decide to what degree the output needs to be interpreted and by who, as well as documentation on the uncertainties in the analysis. Transferability features refer to being able to pass on the results of the risk assessments to stakeholders and beneficiaries, while also allowing their use in other applications, such as portfolio monitoring and setting business strategy.

Climate risk tools must be used to aid credible environmental plans

Ultimately, however, the climate risk tools will be limited in their ability to help the FIs reach their sustainability targets. What is also needed from them is a commitment to make changes in the way they do business, such as stopping financing new fossil fuel projects, which will be critical in moving the needle toward achieving net zero by 2050.

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