Episode 02: Analyzing Climate Risk for Financial Markets

TRANSCRIPT:

John Colas: I’m John Colas, a partner and vice chairman of Oliver Wyman Financial Services Americas. What makes the most difference is ensuring that the team itself is committed to the importance of climate risk and is seeing climate risk as a significant financial risk to the organization but also to see it as an opportunity. Those firms that have this deeper understanding of the risks that climate presents, will also be best placed to be advisors and helping clients think about their own business models, their own resiliency and opportunities for them to innovate and advance their business practices around sustainability and growth.

Michael Torrance: Welcome to “Sustainability Leaders.” I’m Michael Torrance, Chief Sustainability Officer with BMO Financial Group. 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.

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

Michael Torrance: Today I’ll be speaking with John Colas, who’s a partner and vice chairman of Oliver Wyman, based in New York. Beyond his work on strategy, regulation, risk and capital management for the financial services and public sectors, John serves on Marsh & McLennan’s Climate Risk and Sustainability Task Force. In particular, John is currently leading the team, assisting the United Nations’ Environment Program Finance Initiative, or UNEPFI, to develop a framework to assess and disclose climate-related risk factors for business. This project is attempting to pilot the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosure, or TCFD, and its recommendations around scenario analysis of climate risk. BMO is a public supporter of the TCFD’s recommendations and is joining one of the UNEP pilot initiatives. We’ll be discussing this work with John and how he is translating his experience in risk and strategy to the topic of sustainability and climate change. John, before we get started into the main questions, can you just tell me a little bit about who you are and the work that you do?

John Colas: Sure. So I’ve had the pleasure and privilege of serving here as vice chairman in the Americas for Oliver Wyman Financial Services, and I’ve had a long career in management consulting principally focused on advantage senior executives on key issues of strategy, risk and capital management, and I’m proud of the firm that we’ve built and delighted to share perspectives with you.

Michael Torrance: And I know that some of the work that you do is around climate risk. What is climate risk, and what does it mean to you?

John Colas: So, Michael, as you may be aware, Oliver Wyman, over the years, has developed deep expertise in the category and subject area of risk management, so you may have heard of our firm at different points in time given our specialization and expertise in and around risk management. And our key strengths in risk management have always been around credit risk, capital and, more recently, stress testing in scenario design and development. And using those tools and techniques, we felt it natural to apply those to the topic of climate risk as we see climate risk as one of the most important emerging financial risks in the financial system, and we thought it was only appropriate to take our advanced expertise and talents and apply them to what is a very important and pressing challenge for, not only our clients, but for society as a whole.

Michael Torrance: And Oliver Wyman advised the UNEPFI pilot that was piloting the recommendations of the TCFD. Can you tell me a little bit about that pilot and what its origins and goals were?

John Colas: So we had a tremendous opportunity to collaborate with the United Nations Environment Program and, in particular, their public-private partnership with financial institutions, and the backdrop to that project essentially was all of the work that had preceded our pilot led by the Task Force on Climate-related Financial Disclosures, or the TCFD. As you may know, the TCFD began its work in earnest in 2016, and members of the task force included a colleague of mine who sits on our Corporate Climate Resilience Task Force and through her involvement in that work, Oliver Wyman was introduced. I had the opportunity to attend the readout of the recommendations for public comment in London in December 2016 and then, of course, the final recommendations of the task force where we leased in July of 2017. Over the summer of 2017, the United Nations Environment Program approached us as a potential advisor to them and a working group in order to really help accelerate the adoption of the TCFD recommendations. As you may know, the TCFD recommendations are voluntary, and the United Nations Environment Program is very committed to catalyzing and promoting and ultimately mainstreaming sustainable finance, and so a working group of 16 global banks was formed. We were fortunate to be selected to advise that working group, and our focus was really on the transition risk components of the TCFD recommendations, and what we were really tasked to do was to bring to life in a very pragmatic and applied way the recommendations of the TCFD Task Force. So it was really translating, if you will, the recommendations into concrete actions and methodologies that the banks could subsequently apply, and given the United Nations Environment Program’s broader commitment to climate and the environment, the report was done in an open-source way. So it’s public disclosure, and the banks, in essence, have prepared a methodology and shared the methodology as a means to help catalyze and better inform and accelerate practices that may then cascade throughout the global financial-services industry.

Michael Torrance: The recommendations of the TCFD are new as you mentioned, being first released in 2017, so the UNEPFI pilot was really breaking new ground in many ways. How did your background in traditional types of risk management translate to the issues that were presented by climate risk as a specific type of risk?

John Colas: What I would say is that there are many aspects of risk management that are common, whether it be a more classical credit risk issue versus a new or emerging risk issue or even the financial risks associated with climate risk, but at the core, there are many important components that are shared, and in particular, we would look at both risk identification as a key element of robust risk management and then applying also key components of scenario-based analysis and forecasting. So in practice, we were able to leverage our long history and expertise on credit-risk management and to then marry our experience developing and designing and implementing stress testing in order to bring to bear climate-specific scenarios with the associated effort of both the risk-management teams and the sustainability teams of the member banks.

Michael Torrance: Can you tell us a little bit more about the methodology that you developed for the UNEP project and some of the key elements?

John Colas: Sure, Michael. So we focused on climate risk very much as a financial risk, and we wanted to make sure that it was being captured as part of traditional risk-management practices, and this is, I think, a very important point, which is, we wanted to ensure that the methodologies were ones that could be implemented and anchored to establish practices within the banks while also innovating on some of the key elements of risk management. So in our work together with the UNEPFI, we had developed a methodology that really combined two different aspects. There was a bottom-up aspect, which really was customer or counterparty or borrower-specific, and then a top-down aspect, which was really more fundamentally looking at portfolio-level exposures and risks. And the key method, the logical challenge was really to take a climate scenario and then look at the risk drivers that that climate scenario would present and how it might impact and affect the credit worthiness and performance of the banks, customers and counterparties under a specific scenario. So it is much more of a what-if-type approach with a certain set of climate-based risk drivers, and for those risk drivers and those climate scenarios, rather than have those predefined or specified by the banks themselves, we turn to the climate science community to really help provide those elements associated very much with the evolution of the climate and specific scenarios from the experts in the climate science community.

Michael Torrance: And so you’ve mentioned scenario analysis, and that’s obviously a key aspect of the TCFD’s recommendations. What does scenario analysis mean, and what are the different scenarios that it contemplates?

John Colas: So in terms of the scenarios they, if you go back to the Paris Accord and you look at many of the other scenarios that often get talked about with respect to climate, there is a core commitment that’s often associated with a temperature-based scenario. So you have often heard of a 2-degree temperature-based scenario or 4-degree temperature-based scenario, so those were sort of the anchor scenarios that we used specific to the work we concluded with the UNEPFI. But there are also event-based scenarios, which are important, that are really looking at some of the more closer-in issues and risks associated with disruption around climate change and climate risk. Some of those could translate to opportunities for banks in terms of capital formation and lending, and some of those can also present risks to banks. So as you think about transition risks as we move toward a low-carbon economy, there could be a very smooth and orderly transition in terms of the adoption of electric vehicles, capital formation for new clean and green energy sources, and all of those actually present opportunities for the banking sector.

Michael Torrance: And you’ve mentioned some types of climate-related risks, including transition risks and physical risks. Can you just explain or define what those types of risks are, how they materialize and what the relationship between them is, if anything?

John Colas: The term physical risk is really mostly associated with the physical effects of climate change, and often you’ll see that most frequently sighted around things like sea level rise, so that would be a physical risk if you will. Transition risks are really more those risks associated with the evolution of the economy itself in terms of the pathway to potentially a low-carbon economy. And how they would interrelate, if you will, is, the more that we address the transition risks confronting climate, the less the physical risks will manifest themselves, so the more action that is taken on managing transition risks and mobilizing capital to address those, then the less severe one would expect the physical risks to become, and so that’s the interplay between the two.

Michael Torrance: And when you talk about scenario analysis, there’s an inherent uncertainty around it. I mean, by definition, it’s considering what-if scenarios, and all sorts of scenarios will present some kind of risk. As you said, there’s that trade-off between transition and physical risk, but there’s still a great deal of uncertainty as to exactly what the future will hold. So how did you grapple with that, and what have you been recommending to companies that are using scenario analysis despite the uncertainty associated with it?

John Colas: What I would say is, when one looks at the TCFD recommendations or one thinks about the spirit behind the TCFD, the real overarching motivation is to make climate-related financial risk disclosures more consistent, more comparable, more accessible and ultimately project back a strong faith in the markets to integrate and use this information in pricing and resource allocation decisions. So the motivation is very much around transparency in order to enable markets to function better. So a key issue and a key challenge in doing a what-if temperature-based scenario or a transition risk scenario is to make certain that the disclosures are transparent in what the key assumptions are. So in other words, none of the outputs represent a predefined and specific forecast. They’re really meant to be what they are, which is a what-if scenario, and it’s important for financial institutions and investors alike to understand the set of assumptions underlying those scenarios and to interpret those in a way that is constructive reflecting the bank’s climate risk awareness and the bank’s commitment to measuring, managing and ultimately mitigating climate-related risks.

Michael Torrance: And what are you observing in terms of the adoption and implementation of the TCFD’s recommendations, including scenario analysis, both in the financial sector and beyond to other sectors of the economy?

John Colas: Well, we are continuing to see tremendous interest and engagement across the entire landscape as it relates to the TCFD recommendations. As of this past September, there were over 500 global institutions, corporates, investors, financial institutions, who have all stepped up as supporters of the TCFD recommendations. So we are seeing companies very committed to embracing the letter and the spirit of the TCFD, but we also acknowledge that it will be an evolutionary path, and it’s not a straightforward, simple exercise, and it does require bridging capabilities that exist in companies across the finance risk, sustainability and strategy teams along with the business leaders. So we are seeing strong interest in adoption, and a lot of work is being done, both in the corporate and investor as well as the financial-institution space, to advance the recommendations of the task force.

Michael Torrance: BMO publicly supported the TCFD’s recommendations, and we’re taking steps internally to try to implement them, including scenario analysis, and I’ve seen that there’s challenges, of course, in trying to implement such a new concept and methodology, including identifying data sources and then even just reconciling the long-term focus of the TCFD’s recommendations, which what are often shorter-term horizons of financial risks and opportunities. What are some of the challenges that you’ve seen when you’re helping companies to try to implement scenario analysis or the TCFD recommendations more broadly, and what would you recommend companies do to try to overcome these?

John Colas: So what I would say, Michael, there, is that as you think about advancing the TCFD recommendations, it’s very important to note that the implications are far-reaching so that it’s not an initiative that can solely be undertaken by the Chief Sustainability Officer or the Chief Risk Officer or the Chief Financial Officer. It really touches all aspects of risk measurement, management and financial reporting. I think the first thing is to ensure close coordination and collaboration across the key functional capabilities within a given firm. I think it’s important to mobilize the expertise that the risk team and others bring to the topic, and then I do think it’s very important to ensure that everyone is aligned in terms of what this represents in terms of an evolutionary path to embrace a set of recommendations and essentially develop a first-generation output, which will of course be improved over time as more data becomes available, as more information is shared. Where the methodological challenges are particular acute is certainly the time horizon. You will see climate scenarios that go out 20, 30, 50 years, and those are certainly horizons that most risk teams are not accustomed to addressing. Certainly in the banking world, the duration and maturity of the loan portfolios is significantly shorter, but insurers and long-term investors, they do have exposures that go out much longer. So one thing to address is, how do you address this time-horizon challenge? I think that is a very important point to raise, and then, I think the other is to really make sure that the scenarios themselves and the assumptions and sourcing of that data is very transparent and well understood.

Michael Torrance: So just to probe a little bit on that, what would you say the way to reconcile the very long time horizons of the TCFD’s recommendation are? How do you reconcile that with existing business models?

John Colas: So there is a general view that, as the world evolves, business practices will evolve as well, so the idea that a firm’s business model will stand still in a 10, 20 or 30-year horizon is a very risky assumption to make, and so what we think is particularly important is to really think closer-term with respect to, how would the credit-risk profile of the customers you serve today change? And while there may be an ability to reprice customers or to change and respond to their business practices, we do think it’s important to recognize that, in the end, the banks will want to continue to serve these customers, so it’s best to take a view of the customer’s risk profile and think about how you might change the services and pricing and risk profile of that customer as you continue to serve them, and many of these customers of course will remain bank customers well into the future.

Michael Torrance: And do you foresee that this type of analysis of climate risk is going to become commonplace in the financial sector or even other sectors, and if so, why?

John Colas: So I do believe that this type of analysis will become commonplace. In many respects, if you will, Michael, I think the future of business is sustainability that ultimately good business practices will consider and take into account the externalities and risks associated with their business and will want to continue to promote resiliency in their operations and continue to manage to a lower risk profile. In addition, there continues to be growing interest in ESG investment products, and as that takes hold in the investment landscape, it also represents new opportunities for companies to diversify their funding sources and to essentially access an even larger pool of potential investors. So I do think that the direction of travel is toward more climate risk awareness, more climate-risk-related disclosures and more proactive efforts from a strategy side, both in managing the risk and capturing the opportunities in a decarbonizing economy.

Michael Torrance: What is your sense of how regulators will be acting in the coming years? TCFD implementation is really being led by the private sector, but we are seeing some regulator activity, like, in the EU and in the UK. They’re taking steps to introduce some proposals, regulatory proposals, around climate risk analysis and to encourage sustainable finance. Do you see any trends and have a sense of where that regulator activity will go?

John Colas: Well, Michael, I definitely agree with your observations, that we do see this as a trend and an important trend, and in particular, we do see a lot of activity in the supervisory community and, in particular, at the country level in Europe. So there has been a lot of progress and a lot of advancement, both at the EU level as well as by the Bank of England. I think one of the most noteworthy things for listeners to pay attention to is the most recent supervisory statement that the Bank of England PRA put out with respect to climate risk management. Without yet knowing how far that will go in terms of regulation and recommendations, I do think that, as a supervisory statement, it is a very important signal to the financial services industry in terms of expectations and objectives and the thinking that is emerging within the supervisory community.

Michael Torrance: In your view, what does climate risk mean for the investment community, and what do you think that the evaluation of climate risk by corporates and issuers will mean for investors and their decision-making?

John Colas: I think that investors will want to continue to see companies report an understanding of their exposure to climate-related risks and really be in a position to answer two key questions: how climate-resilient is your organization and how do you know? And I think that investors are looking at this issue and, in many respects, have already taken actions. So the market is evolving quite quickly with respect to capital flows around ESG products. And if you do look at some of the data that has been produced, there are interesting observations around companies achieving higher financial returns through ESG factor and corporation. And so the more data that becomes available, the more interest I believe the investment community will continue to have in seeking high-quality returns from responsible corporate issuers.

Michael Torrance: John, I’ve seen some of the work that Oliver Wyman has done around developing heat maps, and it really flags what areas of lendings portfolios or industrial activity are most sensitive to climate-related risks. Can you tell us a little bit about what that methodology does and how it’s helpful to help companies identify areas of climate risk?

John Colas: We definitely see a need to make certain that the efforts are focused in the highest-priority areas, and the notion of a heat map is really to help companies from a top-down perspective really hone in on those critical business areas where climate risk and climate change will present the most consequential impacts on the business and on the customers of the bank. And so we believe there are extremely high financial stakes in certain sectors of the economy from real estate to oil and gas to power generation and other carbon-intensive sectors, and understanding where those sectors are and their relative magnitude and importance in the portfolio, we think, is a very important and helpful step to setting up any enterprise program. And the heat map just becomes a good risk-awareness tool to know from an evolutionary perspective, where would you focus first and make sure that you’re pinning down and optimizing and making the best decisions with respect or your largest climate-related exposures.

Michael Torrance: Climate change in the global transition is, in many respects, unprecedented, and that kind of wording has been used even by the IPCC in their recent report, but are there any comparable historical examples to climate risk and how such innovation was being used to identify and manage risk and how the private sector is being asked to respond by initiatives like the TCFD and the UNEP work, how the private sector is being asked to respond by initiatives like the TCFD and the UNEP work?

John Colas: I think that there have always been throughout history periods of transition or disruption in the economy, so in some ways, the transition risks associated with climate, whether it be the adoption of electric vehicles or clean energy sources, there certainly could be historical analogies back to the adoption of electricity or back to the adoption of digital cameras. So there are examples, if you will, of disruptions that have occurred throughout the economic history and development of our economy, but when you think about climate, what’s different in this regard is many risk models are calibrated off of historical experience. And so when you think about risk ratings and you think about decisions people make about who to extend credit to and their ultimate credit worthiness, oftentimes those models are predicated on historical data where there is a population of companies that have defaulted or gone bankrupt, and those insights and learnings feed the decision analytics associated with risk-taking and risk management. Fortunately for us, we don’t have a data set of historical defaults and delinquencies associated with climate-related risks, and so therefore that becomes the big challenge, and it does put us in a new space where we’re looking into the future without perfect information in terms of historical experiences directly related to climate.

Michael Torrance: What concluding thoughts do you have on climate change and what it means for business?

John Colas: As a concluding thought, what I would say, Michael, is we certainly view a need to continue to raise climate risk awareness throughout the economy, and we believe, by working in partnership with the banks and the financial system, that there is really an opportunity to drive enhanced decision-making that will lead to not only better risk management but also to the mobilization of capital around cleaning and greening of the global economy. And by advancing the risk management practices of the financial-services industry, we are contributing in a small way to the compounding effects of enhanced decision-making and risk management, and we believe that the work of the United Nations Environment Program together with the 16 global banks in the consortium really did a great service in helping advance practices and break new ground in partnership with the climate science community and really making climate risk sort of central as one of the key financial risks that we need to advance our sophistication in measuring and managing and ultimately mitigating.

Michael Torrance: And if people want to reach you, how should they do so?

John Colas: I can always be reached directly on my e-mail address here at the firm, so that’s john.colas@oliverwyman.com, and I would also encourage all listeners to visit our Confronting Climate Risk Hub that’s located on our website, oliverwyman.com, and there you’ll be able to find our latest insights on climate risk and sustainability. And then lastly, on behalf of Oliver Wyman, Michael, I would really like to thank you for this opportunity to share perspectives, and also thank you for all your efforts advancing sustainability. It’s been a real pleasure speaking with you.

Michael Torrance: Great. Thanks so much for your time, John.

John Colas: Thank you.

Michael Torrance: Thanks for listening to “Sustainability Leaders.” This podcast is presented by BMO Financial Group. To access all the resources we discussed in today’s episode and to see our other podcast, visit us at bmo.com/sustainability leaders. You can listen and subscribe free to our show on Apple Podcast or your favorite podcast provider, and we’ll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO’s marketing team and Puddle Creative. Until next time, I’m Michael Torrance. Have a great week.

Legal Disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal or tax advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment, tax and/or legal professional about their personal situation. Past performance is not indicative of future results.