Incorporating Climate Risk in Valuations

Kathryn Bakos:

We have resources available for the financial community to be more secure in their understanding and deployment of change on the ground. But those resources need to be used more readily so we can get risk out of the system. And all of these actions will help businesses identify and manage climate risk while potentially serving as a point of competitive differentiation.

Michael Torrance:

Welcome to Sustainability Leaders. I'm Michael Torrance, Chief Sustainability Officer at BMO. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic, and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices, and our world.

Melissa Fifield:

The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.

Hello, my name is Melissa Fifield, head of the BMO Climate Institute. In today's episode of Sustainability Leaders, we'll be talking about how climate change impacts financial markets, the regulatory landscape, and how investors can integrate climate risks and opportunities into their capital allocation strategies. To help me unpack this topic, I'm pleased to be joined by Kathryn Bakos, Managing Director, Finance and Resilience at the Intact Center on Climate Adaptation. Thanks for joining me today, Kathryn.

Kathryn Bakos:

Thanks so much for having me.

Melissa Fifield:

So maybe to get started, can you share a bit about your organization and your role specifically?

Kathryn Bakos:

Yes, of course. Well, the Intact Center on Climate Adaptation, the Intact Center, is an applied research center out of the University of Waterloo in Ontario, Canada that helps homeowners, communities, businesses, and governments reduce risks associated with climate change and extreme weather events. That's particularly in relation to flooding, wildfire, and extreme heat. And under my personal domain, I focus on engaging the financial community from investors, regulators, and supervisors, credit rate agencies, boards of directors in incorporating the physical risks of climate change into investment and business decision making.

Melissa Fifield:

So maybe starting big picture, can you discuss how climate change has the potential to impact financial markets?

Kathryn Bakos:

Yes. Well, climate change manifests as extreme weather, floods, wildfires, extreme heat, droughts, which cause widespread adverse impacts to individuals, communities, governments, and businesses. Transitioning to a low carbon global society is imperative to avoid the worst impacts of climate change in the future. But we know that due to the cumulative emissions of greenhouse gas emissions to date, a certain degree of climate change is already baked into the system and therefore it is in fact irreversible. So in response to the irreversibility of climate change, global warming, exacerbated extreme weather events, and the global response to these threats, the safety and soundness of the global financial system is expected to continue to be impacted because physical climate change and extreme weather adversely affect economic and financial outcomes across industry sectors through loss and damage to private and public infrastructure, negative supply chain shocks, disruptions to the continuity of business operations, reduced labor productivity, and rising mortality rates.

This prompts the assessment of asset values, changing the cost or availability of credit and insurance, which may affect the timing or reliability of cash flows. Impact could also be observed through micro and macroeconomic trends, jobs creation and loss, household income and debt, inflation, which could create and ultimately amplify financial risk.

Melissa Fifield:

The impacts are widespread, maybe from a different dimension. Can you talk a bit about how those impacts of climate change are shaping the evolution of reporting and disclosure requirements worldwide?

Kathryn Bakos:

Well, disclosure requirements have been driven by the needs of the marketplace. So to support efficient capital allocation towards companies responding to the threats of climate change, financial markets have to price risk an opportunity appropriately. And to do so, they must have accurate information to inform market participants. So within the growing field of sustainability and climate related disclosures, various frameworks and standard setting bodies exist to establish that foundational layer of data to inform decision making. So we could turn to the task force on climate related financial disclosures. So this is very high level framework that offers information needed to assess and price climate related risks and opportunities under their pillars of governance, strategy, risk management, and metrics and targets.

Now, if we wanted to get into more detail into the weeds a little bit, you have standards such as the Sustainability Accounting Standards Board, SASB, that's used to identify specific environmental, social and governance, ESG issues, most relevant to financial performance and enterprise value across 77 industry sectors. Now to consolidate this information, the International Sustainability Standards Board, the ISSB, many acronyms, many names, was created to develop a comprehensive global baseline, which has taken the TCFD and SASB and incorporated this into one voluntary framework. Voluntary frameworks have experienced significant gaps in reporting though, as not all issuers disclose risks that might be material to operations. So just as an example, many companies fail to consider the strategic and financial impacts physical climate risks have on their business, assessing only the impact their business has on the environment and climate, or vice versa. And so these voluntary disclosures have driven the marketplace towards mandatory disclosures.

So we've seen this develop here in Canada through our regulator, the Office of the Superintendent of Financial Institutions, their B-15 Climate Risk Management Guideline and the Canadian Securities Administrators have required for over 10 years that publicly traded companies disclose climate-related risks. Now in the United States, the Securities and Exchange Commission, the SEC, is proposing amendments to the Securities Act which builds off of the State of California, which is the first state in the US to pass legislation to mandate reporting for publicly traded companies. And in my opinion, the Europeans are by far leaders in this space, specifically the European Commission and their Sustainable Finance Disclosure Regulation.

Melissa Fifield:

Kathryn, how does your work complement the frameworks in the existing disclosure landscape to provide investors with an increased understanding of those climate risks and opportunities?

Kathryn Bakos:

Well, as I mentioned, global framework and standard-setting bodies such as TCFD, SASB, and ISSB have laid a strong foundation for disclosure requirements. They've done a great job. To make requirements more robust though, we, the marketplace, need to identify where there are gaps that need filling. From a physical risk perspective, current frameworks lack specificity in identifying what key physical climate risks will impact businesses operating within given industry sectors and what measures need to be put into place to reduce those risks. So the marketplace should want risk out of the system. So it's not just about risk identification, but it's about putting measures in place for risk reduction. To fill this gap, our team at the Intact Center, we've developed a globally scalable tool that complements global framework and standard-setting bodies. So we're not trying to replace what is existing and globally agreed upon already is best practice.

The Intact Center tool is intentionally designed to plug into existing frameworks to fill in the gaps by identifying the top key physical climate risks that could impact business operations within a given industry sector while more importantly, in my opinion, identifying what measures need to be put into place to reduce those risks. So we've dubbed this tool the Climate Risk Matrices and we've developed them for industry sectors, including utilities, financials, and commercial real estate. But what are the benefits of the Climate Risk Matrices, the CRMs, in short? Well, they act as a template to assist any business operating within a specific industry sector in identifying primary physical climate risks affecting operations and then determining where resources should be allocated to mitigate those risks. So there may be numerous risks a company needs to address, and yet most companies likely lack the resources, both time and money, to tackle them all.

So in context of physical climate change, businesses can now pinpoint their top one to two physical climate risks that could impact operations, and then identify what measures they need to mitigate them. Now, the CRMs, they also act as a benchmark for investors to easily understand the risk facing a given company operating within a given industry sector. So they can compare those results to other companies of which they might invest. So CRMs even offer questions that investors could ask an issuer to determine if these companies understand their risk and if they've put measures in place to reduce that risk. So basically the questions sum up to: Have you as an issuing company identified your risks and are you mitigating against those risks?

If either of those answers are no, no, we've not identified these risks and no, we've not put measures in place to reduce these risks, that could be a red flag to an investor and whether they'd want to invest assets in a company or other financial market participants, capital providers or insurers may not want to loan money or provide insurance, or they may loan money at a higher rate or provide insurance at a higher premium. So by utilizing the climate risk matrix tool, financial markets can actually ask the questions and receive answers that will allow for this pricing of climate risk and opportunity in the system.

Melissa Fifield:

So how can those insights derive from the work that you're doing, support and strengthen the global regulatory disclosure landscape?

Kathryn Bakos:

Well, the Climate Risk Matrices help inform an organization's governance and strategy around climate related risks and opportunities while providing the metrics and targets needed to identify, assess, and manage risk, which are the pillars of TCFD and more recently, ISSB. So governance, strategy, risk management, and metrics and targets. So to offer a little bit more of a specific example, we can actually turn to the regulator here in Canada, the Office of the Superintendent of Financial Institutions, OSFI. So OSFI's B-15 Climate Risk Management Sound Business Practice Guideline emphasizes that building resilience against climate related risks requires vulnerabilities to be addressed throughout business models, operations, and balance sheets. So businesses should identify, collect and use reliable, timely, and accurate data pertaining to physical risk concentrations.

So geophysical locations of exposure, sectors, and products relevant to its business activities to inform risk management and decision-making while Climate Risk Matrices provide a means to mobilize on OSFI's B-15 Climate Risk Management Guideline, because they identify and prioritize extreme weather impacts specific to the operations of an issuer and the actions the company should take to limit those risks. Now, when tools are developed by external third parties, OSFI advises that businesses should understand the data, methodology, assumptions, and limitations of the information being provided. Well, the value CRMs provide is that they're non-technical in nature. So interpretation of physical climate risk does not require in-depth expertise.

Anyone from retail investors to portfolio managers with or without expertise in a given industry sector could actually utilize this information. And finally, OSFI advises that climate related risks should be incorporated into internal monitoring and reporting to assess effectiveness of climate risk management. Well, CRMs offer that practical cost-effective and user-friendly method to incorporate physical climate risk into investment and business decision-making that complements those frameworks and standards that are already in the marketplace.

Melissa Fifield:

What additional tools or strategies might financial markets consider to mature their response to climate change?

Kathryn Bakos:

Well, that's a great question because we know that the physical impacts of climate change have and will continue to have direct impact across industry sectors, which could impact the financial condition of businesses, issuers, investors, and capital providers, which then could influence disclosure requirements by regulators. And so across industry sectors we need to ensure there's appropriate expertise to understand the evolving means by which climate change and extreme weather will be realized over the geographies of which businesses are operating and investors are investing. Can businesses demonstrate that they have done due diligence in understanding physical climate risks by utilizing the CRM tool I just described in addition to running scenario analysis to understand how and where physical climate risks will manifest? Hiring climate change experts. Can businesses put together climate change committees working with organizations like the Intact Center to advance understanding further? Do businesses and investors have the appropriate understanding of the guidelines and standards already developed to mitigate extreme weather risk?

So just as an example, guidelines and standards are already available to reduce the risks of flooding and wildfire. So are businesses deploying the operationalization of this information to reduce risk at the operational site level? And then are they working with suppliers and distributors up and downstream to ensure they're reducing risk? And there are even things that are not often considered that could have material impact on a business. So let's think about market access and lost time from work during extreme weather events. So just as an example, a flooded basement across Canada causes individuals to miss, on average, seven days lost time from work, and that's research that the Intact Center has completed. So that's a flooded basement. That is not your home burning down and that is not your home being washed away. That's purely just a flooded basement. People are missing seven days lost time from work.

So as a form of good governance, how could businesses provide information to customers, clients, and employees on ways to reduce extreme weather risk at the level of the home and community? Are businesses working with the municipalities in which they're operating within to ensure the municipalities themselves are aware of and are taking steps to mitigate these risks? So it's important to note that we have resources available for the financial community to be more secure in their understanding and deployment of change on the ground, but those resources need to be used more readily so we can get risk out of the system. And all of these actions will help businesses identify and manage climate risk while potentially serving as a point competitive differentiation.

Melissa Fifield:

Those are some great recommendations and great to know that those tools are available based on the work your team has done. What would you like our audience to take away from our conversation, Kathryn?

Kathryn Bakos:

Well, I think it's really important that we understand that the global financial system is at risk of being impacted by the physical risks of climate change. So so much of the conversation, which importantly so is focused on transitioning to a low-carbon global society, which is incredibly imperative and needed, but we have to be focusing on those physical risks of climate change as well. And to support that efficient capital allocation towards companies responding to these threats, financial markets have taken steps to price risk appropriately through climate related disclosures. But for those climate related regulations to continue to evolve, the marketplace needs to identify what information is lacking to continue to add to the robustness of disclosure requirements. So organizations like the Intact Center, we have done the work, identified some gaps, and offered some solutions.

We've developed a tool that can identify the top key physical climate risks that will impact the business operations of a company operating within a given industry sector, and more importantly what actions need to be taken to get risk out of the system. Is this all the information an investor needs to know? No, of course not, but it's a great place to start. The Intact Center has a wealth of freely available resources from what companies and investors should be doing in regards to physical risks of climate change to what individuals and communities can be doing. We know what to do to get risk out of the system. We just have to do it now.

Melissa Fifield:

Well, thank you very much, Kathryn, for joining me to discuss the evolving disclosure landscape and how capital markets can factor climate risk and opportunity into investment decisions.

Kathryn Bakos:

Thank you so much for having me.

Melissa Fifield:

Stay tuned for more episodes of Sustainability Leaders. We'll host leading experts and continue to explore the impacts of climate change on our social, financial, and natural systems.

Michael Torrance:

Thanks for listening to Sustainability Leaders. This podcast is presented by BMO. You can find our show on Apple Podcasts, Spotify, or your favorite podcast player. Press the follow button if you want to get notified when new episodes are published. We value your input, so please leave a rating, review, and any feedback that you might have or visit us at bmo.com/sustainabilityleaders. Our show and resources are produced with support from BMO's marketing team and Puddle Creative. Until next time, thanks for listening and have a great week.

Speaker 4:

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