ENHANCING ENVIRONMENTAL RISK ASSESSMENT IN FINANCIAL DECISION-MAKING In support of the G20 Green Finance Study Group July 2017 Enhancing Environmental Risk Assessment in Financial Decision-makingThis background paper has been prepared by specialists from the Bank of England, the UN Environment Inquiry and the University of Cambridge Institute for Sustainability Leadership with inputs from 2 Degrees Investing Initiative, ICBC, Natural Capital Finance Alliance and UN Environment Finance Initiative. The views expressed in this paper are those of the authors and do not necessarily represent the views of the GFSG. Disclaimer: The designations employed and the presentation of the material in this publication do not imply the expression of any opinion whatsoever on the part of the United Nations Environment Programme concerning the legal status of any country, territory, city or area or of its authorities, or concerning delimitation of its frontiers or boundaries. Moreover, the views expressed do not necessarily represent the decision or the stated policy of the United Nations Environment Programme, nor does citing of trade names or commercial processes constitute endorsement. Enhancing Environmental Risk Assessment in Financial Decision-makingContents Executive summary ..........4 1. Introduction .10 1.1. GFSG Work on ERA to date .........10 1.2. Why Focus on ERA ...........11 1.3. Building Momentum on ERA ......11 1.4. GFSG Approach in 2017...12 2. The Environmental Risk Analysis Toolbox .........13 2.1. How to Price Environmental Risks .......13 2.2. Using Archetypical Financial Tools for Environmental Risk Analysis .......13 3. Case Studies .17 3.1. Transition Risks ........17 3.2. Physical Risks: Natural Hazards, Climate Events, Water and Natural Capital ....34 4. Discussion .....46 4.1. Lessons from Practice ........46 4.2. Key Challenges ........47 4.3. Key Priorities .49 5. Policy Options ..........52 Enhancing Environmental Risk Assessment in Financial Decision-makingExecutive summary The effective identification, pricing and management of risk is an essential feature of efficient and resilient financial markets. Physical and transition factors (including environmental externalities, trends and events) are resulting in a range of financial risks, with implications for both financial institutions and financial authorities,1 and are likely to increase in significance in the future. The G20 Green Finance Study Group (GFSG or “Study Group”) aims to develop options “to enhance the ability of the financial system to mobilize private capital for green investments”. As recognized by G20 delegates in the Study Group’s first year, Environmental Risk Analysis (ERA) is an important and relevant cross-cutting topic that supports the GFSG’s overall strategic objective. ERA describes a portfolio of tools and methodologies that enable financial decision-makers to integrate environmental data into the decision-making process from the risk management and asset allocation perspective. In 2016, the GFSG undertook a stocktake of environmental risk analysis activities in banking, bond markets, among institutional investors and insurance firms as well as financial authorities.2 The stocktake identified a wide range of international ERA practices. Activity by financial institutions to assess environmental risks has been under way for several decades, but this has been sporadic in nature, confined to specific financial subsectors and far from a mainstream practice. A small percentage of financial institutions currently employ ERA in their investment decision-making processes,3 hence, strong governance is needed to drive education, identify and obtain relevant data and build capacity within the financial system. The nascent nature of many approaches and the financial significance of factors such as climate change, pollution and resource degradation led the GFSG to conclude in its 2016 Synthesis Report that “the GFSG/G20 could encourage further dialogue on environmental and financial risk, to facilitate knowledge exchange on methodologies for environmental risk analysis and management within the financial sector.” As a result, in 2017 the GFSG is deepening its approach to how ERA is advancing across five areas of work: i) Understanding practice via case studies; ii) Categorizing existing ERA practices; iii) A desk review evaluation of effectiveness through case analysis; iv) Identifying barriers to effective usage of ERA methodologies; and v) developing options to promote wider adoption of ERA practices. The key lessons and findings from market and policy experts are captured in the ERA Background Paper. Environmental risk assessment: increasing momentum but not yet systematic Environmental factors are increasingly recognized as among the most important risk factors for the global economy. The World Economic Forum’s 2017 Global Risks Report, for example, concludes that four of the five top risks in terms of impact are environmentally linked: extreme weather events, water crises, major natural disasters and the failure of climate change mitigation and adaptation.4 These physical risks and the associated transition risks (e.g. policy action to mitigate climate change) are now recognized by some leading insurance companies, asset managers and banks as potential drivers of financial losses, increasing market volatility and sector instability. Examples from practice in several G20 economies show air pollution, water scarcity and natural capital degradation may also act as sources of credit, market and legal risks for financial institutions. Efforts by financial institutions to assess the financial impacts implied by environmental risks have begun to increase in terms of their analytical scope and sophistication. This includes, for example, considering a wider range of environmental factors, such as those from policy and technological responses (transition risks), as well as considering the impacts of environmental events and physical
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