How data and analytics can help financial institutions meet the challenge of climate change
It’s no exaggeration that climate change is one of the biggest challenges facing the global community. With political leaders coming together to reach consensus on how best to tackle it, the desire to act is now at the very top of the agenda for countries around the world.
Climate change will impact every facet of business and society, and financial services are not immune. Data and analytics will be crucial in helping lenders manage their portfolios, creating new risk assessments and modelling future scenarios. Firms should start integrating climate risk factors into their decision making now, or face being left exposed to significant challenges which are still to come.
The regulatory landscape
Before the Covid-19 pandemic begun, the Prudential Regulation Authority (PRA) regulated that the industry should conduct climate-related stress tests on their portfolios, with the aim of encouraging lenders to understand their exposure to climate risk. This could, for example, be related to the volume of housing stock in flood-risk areas, or the number of individuals vulnerable to job losses in non-green industries.
Furthermore, the Bank of England identified two fundamental risks that financial institutions need to manage: transition risk and physical risk.
Transition risk is the combination of the policy, legal, technological, market and reputational risks associated with the adoption of a lower-carbon economy and the substantial economic and societal upheaval needed to achieve the ambitious target.
Physical risk is split into two categories. Acute risks, which include the increasing severity and occurrence of extreme weather events, and chronic risks, which are longer-term shifts in climate and weather such as rises in temperatures and sea levels.
How financial institutions can meet the challenge of climate change
These stress tests and scenarios are the foundation of understanding the risk climate change poses to financial services in the years ahead. Lenders will need to identify customers and businesses working in at-risk sectors as the UK transitions towards the green economy and amend their strategy accordingly.
They will need to revisit their risk models and apply scenarios and models specific to climate risk to understand the changing and evolving face of affordability, vulnerability, and creditworthiness.
They may have to provide specific support for unemployment in certain sectors. Alternatively, the green economy will see some sectors booming, and new ones emerging, creating new opportunities.
How can they do this? By deploying cutting-edge analytics to truly understand the risk posed by climate change.
Advanced analytics can help lenders better determine risk in their portfolios now and in the future. -and manage them as appropriate, much of it through automated processes. By embedding climate-related variables into their risk management and governance processes, lenders will be able to make better, more efficient business and customer decisions, improving their resilience for whatever lies ahead.
Eventually, new products and services will also be developed and meet new demands from customers, while transparent disclosures to regulators around climate-related risk will help the whole industry rise to the challenge.
The bedrock of this is analytics. Only by truly understanding the forces at play now and in the future – on both the wider economy and individual customers – can financial services thrive.
Author:
Steve Pulley, Managing Director Decision Analytics, Experian UK&I