Risk Expertise, Capital Mobility Will Help FIs Respond To Climate Change

December 12, 2007

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Financial institutions should act now to respond to changing demand due to climate change, and also protect themselves against the longer term erosion of value, according to a new report from Oliver Wyman. The report stresses that the multiple unknown impacts of climate change on financial firms will be driven as much by customer perception and public policy decisions as by environmental change or weather events.

Oliver Wyman believes that the industry is uniquely well positioned to cope with climate change, due to its risk expertise and capital mobility. Financial institutions’ ability to hedge business risks for themselves and customers, develop new products quickly, and invest in new markets means that the sector is well placed for most scenarios, with new climate change related opportunities already apparent and growing.

The report examines the likely effects across the financial services sector:

- Corporate/institutional banking and asset management will see the strongest upsides, with new carbon markets, growing demand for hedging innovation to manage energy prices and changing weather patterns, and clean tech financing and advisory revenues (potentially attracting $225bn of new investment a year by 2016).

- Insurance faces the greatest threats, and could suffer up to $150bn of annual weather-related losses by 2030, with risk pricing anomalies as underwriters adjust and necessary premium rises possibly depressed by regulation or high levels of competition.

- The “green” banking market is currently tiny, but “green” could increasingly influence consumer choice of retail bank over time.

- Longer term, climate change will increase the chance of defaults, and asset value decline in credit portfolios. Financial institutions will have to spot, in the absence of robust data and with changes in historic risk/return characteristics, anomalies in achievable risk premium, and thus decide where to compete aggressively and where to increase margin and collateral requirements.

In addition, the very factors that make the financial sector resilient to climate change – its global nature and its mobile capital – also mean it is susceptible to threats that can’t be mitigated. The economic impact of temperature rises and tough greenhouse gas abatement measures will gradually outstrip the opportunities, and could lead to a loss of over $530bn in industry revenues (compared to a non-climate change adjusted base case) by 2030.

Some of the largest institutions have in place integrated approaches covering strategic positioning, product development, operational processes, and stakeholder relations, but for many firms climate change remains below the radar.

Over time, the mixed effects of climate change could lead to significant divergence in firms’ performance, and Oliver Wyman outlines five recommendations for institutions aiming to outperform:

1. Re-appraise the firm’s portfolio, stress testing its geographic and business exposure to climate risk. Firms may need to re-prioritise regional markets and business lines according to their likelihood of being net beneficiaries or casualties, while monitoring regulation, emerging liability issues, technological change, and increasing public activism.

2. Innovate to capture the increased appetite for climate change related financial products, and exploit arbitrage opportunities between different markets. The consumer market is largely untapped, and there is considerable scope for insurance innovation in emerging markets. The unpredictable implications of climate change necessitate rapid innovation which is highly responsive to changing market conditions.

3. Develop the brand – consumers and new recruits will be attracted by a sense of shared values in markets where financial institutions are virtually indistinguishable, loyalty is low, and climate change concern is high. In many regions there is still scope for firms to seize the role of the green financial institution. But while firms may suffer by being slow to market their eco awareness, they must also be alert for climate change fatigue and “green wash” accusations, recognizing that green branding will soon become a hygiene factor.

4. Deliver effective “climate change governance” – financial institutions must instill a coherent stance at firm level, ensuring that a growing capability is both utilised across the organisation and matched by internal performance. Firms need structures whereby climate risk and opportunities are reported on and used to inform strategy and products, and measures are taken to reduce emissions from infrastructure and travel.

5. Collaborate with governments, NGOs, customers and competitors – the complexity of climate change means that the biggest financial firms should work collaboratively in ways that strengthen not only their individual reputations, but also that of the industry as a whole. Industry leaders should actively work to influence policy solutions to climate change that best leverage the power of capital markets for the common good, helping advise governments to steer away from unilateral policies that could create significant moral hazard and thereby latent costs for taxpayers.