Climate Risk Regulations: Transitioning from Thinking into Action

Authors:
Elizabeth Gillam, Head of EU Government Relations and Public Policy, Invesco
Maria Lombardo, Head of ESG Strategy EMEA, Invesco

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As we move closer to the 26th UN Climate Change Conference, insurers are facing a growing expectation to integrate climate risk into their business. A flood of new supervisory guidelines and, increasingly, regulatory rules is already upon us, which we expect will soon become fully integrated and mandatory. It's clear we're now moving from 'thinking' to 'action'.

The links between climate risk and financial stability are becoming more evident, risks that are complex and far reaching. We can categorise these into two principal types- physical risks or transition risks:

Physical risks are costs relating to damage to infrastructure due to extreme weather events, or to changes in the natural environment such as water scarcity and rising sea levels.

Transition risks are costs relating to policy changes such as carbon pricing, technological changes such as developments in carbon capture and renewables, or changes in consumer attitudes such as moving to electric vehicles.

72% of surveyed insurers globally believe climate change will have an impact on their business. But only 20% of those have taken steps to implement the Task Force on Climate-related Financial Disclosures (TCFD) recommendations. Physical risks have, to a certain degree, been taken into account by the insurance industry given the impact on their liabilities given that the number of registered weather-related losses has tripled since the 1980s. But there are concerns that while insurers have been assessing the physical risks, there's been less of a focus on the larger transition risks in their investment portfolios¹.

The need for strategic responsibility

Climate and ESG used to be seen through the lens of Corporate Social Responsibility. Now the industry is being asked to be more strategic in managing climate risks, and in how it responds to the increasing focus on these risks. Europe in particular is in the process of adopting a lot more 'hard' law requirements, making this a strategic responsibility that will need to be discussed at board level.

While supervisory guidelines and expectations are still being developed, we see emerging consensus around the following four areas:

• Adapting governance – along with board-level oversight, firms should establish responsibilities and accountability across all functions involved in climate risk.
• Risk management and metrics – firms need to move towards more quantitative assessments of climate risks. Scenario analysis and stress testing should be more future-focused to understand the financial risks to their business.
• Scenario analysis – firms are expected to conduct scenario analysis to inform their strategic planning and determine the impact of these financial risks. The approaches used for this analysis should also evolve over time.
• Disclosure – insurers already have to disclose information on material risks under Solvency II, and should consider further disclosures in line with TCFD.

A strong theme that's emerged is the push to integrate climate risk within existing regulatory frameworks. That said, there's a lack of reliable data that effective analysis tools can be built on. So, there's a need to make climate data increasingly available so more granular models can be developed.

Starting the journey

We know that backward-looking frameworks can't effectively provide the analysis needed to tackle climate risks that will arise in the future. That's why scenario analysis has moved up the agenda, becoming a key focus for regulators when looking to develop forward-looking analytical tools, something still very much in its infancy.

While they recognise that this is just the start of the journey, regulators are very keen to spur on activity in this area. Insurers in Europe will be increasingly expected to run climate simulations and improve their internal capabilities in modelling impacts on their assets and liabilities. And as more and more legislation is introduced, insurers will need to be constantly aware of upcoming laws.

Financial regulators are naturally focused on risk, but insurers are increasingly seeing climate change as a source of returns. Many firms are developing tools that will allow the implementation of net-zero investment strategies in their portfolios, and this will only increase over time.

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