How to avoid unnecessary harm? Climate change events are becoming more extreme every day and will affect companies’ business operations. But there are countless risks and endless scenarios a company must consider, so where can it start from?
Climate scenario analysis can make a difference, helping proactively manage risks by assessing the impact of potential future events and situations. For wealth and asset managers, this means understanding and estimating the effects of different climate scenarios and risks on the portfolio and then taking action to optimize those risks and the associated performance.
Not considering a variety of scenarios can expose the portfolio and company not only to climate risk but also to unnecessary regulatory, market and reputational risks.
Still Fragmented and Under Development
While the regulatory environment for wealth and asset managers is still fragmented and under development, it is moving in a clear direction. Some international frameworks and initiatives, such as the Task Force on Climate-related Financial Disclosure (TCFD) or The Net Zero Asset Managers, respectively, are being adopted by regulators, corporations, and financial institutions as a method for measuring and disclosing climate-related risks and are pushing the industry towards net-zero alignment.
In Switzerland, the Swiss Climate Scores, developed by the Confederation and the financial industry, which also includes the Asset Management Association Switzerland (AMAS), established best-practice climate transparency of financial investments to help reach climate goals.
Risks That Count: Transition and Physical
Climate-related risks can be categorized within Transition (risks that depend on societal and economic shifts towards a climate-friendly future, such as public policies or technology), and Physical Risks (risks from the physical effects of climate change, such as hurricanes or increasing sea levels). Scenarios allow an organization to explore and develop an understanding of how various combinations of both transition and physical risks can affect a portfolio company’s (that is, a company the portfolio is invested in) business, strategy, and financial performance over time.
How can wealth and asset managers be prepared? Climate risk engines fed with a variety of scenarios should be the foundation of the approach, allowing them to test and optimize their portfolios.
Different Climate Scenarios
A transition risk engine uses company and market data, carbon taxes and commodity prices to estimate and forecast a company’s budget (such as its revenues) and associated implications on portfolios according to different climate scenarios.
Everything is based on official NGFS scenarios and provides invaluable insights into the impact of risks such as carbon pricing and fuel costs on the portfolio, and to then understand a portfolio company’s relative positioning within its industry.
A 360-Degree Overview of Climate-Related Risks
A physical risk engine estimates and forecasts the effect of physical hazards, such as flooding, wildfires, or hurricanes, on the value of real estate, for either single assets or real-estate portfolios, under many diverse scenarios. A proper tool considers physical risk exposure, damage functions and the geographical area in which the assets are located to fully support the physical risk analysis of portfolios.
Adopting tools to manage the transition and physical climate-related risks can provide wealth and asset managers with the capabilities necessary to ensure a 360-degree overview of climate-related risks of their portfolios, under any scenario.
But is the industry actually adopting climate scenario analysis tools and preparing for future climate-related risks?
Climate Scenario Analysis: A Private Equity Example
Prometeia, with its most recent study on «Sustainability Practices Among Private Equity Managers» has shed light on the sustainability practices, and the use of climate scenario analysis, among private equity (PE) managers, providing more clarity and crucial insights into the industry.
The research shows that the adoption of climate scenario analysis is still scarce within the industry. PE firms are currently unprepared to assess the impact of climate-related risks, future scenarios, and events as 87% of respondents (a wide sample of PE firms managing more than 200 billion euros) reported their climate scenario analysis capabilities as either non-existent or under development, dealing a significant blow to the sustainability profile of the entire industry as climate scenario analysis becomes increasingly important.
ESG Due Diligence
In other areas, the sustainability picture of the industry is murky with good and bad news, as ESG due diligence in investment memorandums is performed 86 percent of the time, while ESG KPI tracking is performed to a lesser extent at 67 percent of the time, with almost no smaller PE firms providing ESG reporting.
Prometeia, a leading provider of software, data and consulting solutions for financial institutions provides the Transition & Physical Risk Engines that guide wealth and asset managers’ ESG transition, supporting the entire industry and equipping it with the proper toolset to manage climate risks in a proactive and efficient way.
«Prometeia’s risk engines are an integral piece of the climate scenario analysis puzzle. By assessing the impact of potential future events wealth and asset managers can adequately prepare their portfolios and companies for any circumstance and ensure that climate-related risks are the foundation of the company-wide strategy,» comments Gianmatteo Guidetti, Principal of Prometeia.
