Life-Cycle Information for Banks and Investors

Never before have climate risks been so starkly visible. This Ocotober, the worst floods in a decade killed 600 in Nigeria. In September, Hurricane Ian devastated swaths of Florida, causing 100s of billions USD in damage. In August, one third of Pakistan was flooded and 33 million people had to flee their homes, including 600,000 pregnant women. At the same time, droughts in China, Europe, and the US threatened water supplies, crops, and electricity production. Passing the 1C temperature, it appears that we are already living in the permanent climate emergency akin imagined by wheather forecasters for 2050. These forecasts were created in collaboration with the WMO in 2014 to scare governments into action.

For investors and businesses, climate change presents a real risk, as Mark Carney called out in 2015. On the one hand, their assets and supply chains are at risk from climate events. On the other hand, their assets are at risk from litigation by those experiencing damage, or an abrupt tightening of climate policy. Therefore, regulators around the world are preparing rules to identify climate risks and execute risk assessments, both for investors and for financial institutions.  

Litigation risks are mostly faced by those who have cause emissions directly or profited from the emissions as producers of fossil fuels. Transition risks – the impacts of abruptly more stringent climate policies can in the mean time be felt along the supply chain. So whether you purchase inputs produced with high emissions, such as aluminium, or produce products that cause high emissions, such as internal combustion engines, your business is at risk.

The point of the regulations is that such risks should be identified and investment portfolios should be tested against such risks. This implies that companies and financial institutions such as banks and pension funds need to put procedures in place to manage these risks, run risk modeling exercises. Further, they need to disclose the risks, including emissions.

In a recent Policy Forum article in Science, co-authors Carattini, Melkadze, Shrader and I defend the proposed rule on climate risk disclosure by the Securities and Exchange Commissions, the most powerful financial regulator in the world. The US is a little behind in timing compared to European and Asian regulators in implementing the recommendations on climate risk disclosure, but the proposed rule is ambitious, containing requirements for scope 2 and scope 3 emissions. We highlight the systemic importance of the proposed rules, the benefits to investors, and the potential threat not only to individual investors but the financial system of the current hodgepodge of voluntary disclosure.

Doing research on this paper, I realize that the understanding of transition risks is incomplete and that there are more types of risks, some of which can be modelled with input-output models, but are not captured by the scope 3 terminology. If you are interested in these, please check the recommendations of our paper.

For a journalistic summary, see here.