5 August 2021

A Delphic moment in climate risk

Only by measuring the downside can we truly know our climate selves, writes Woody Bradford

Woody Bradford

The most famous of the three Delphic maxims, "know thyself," has been interpreted many ways over time. Frequently heroes are asked to tap into a kind of situational awareness—to assume an honesty about their position before plotting a path forward. Self-knowledge, it implies, makes all of us embrace the role of risk manager.

In 2021, corporations, financial institutions, and many other organisations are scrambling to be seen as climate activists. Emerging from the Covid-19 pandemic with reset global agendas, environmental concerns have been an accelerating priority.

Will this posturing work? In this cacophony of pronouncements and admirable goal-setting, we've seen a raft of calls for "more action and less talk" around climate. But thinking "big thoughts" about climate reputation has glossed over some crucial constraints. A better approach first asks: what is truly at risk, and how should we measure it?

A history of what-ifs

An inflection point seems to have arrived where there is broad recognition that climate risk will likely impact every business and investor. In this environment, a systematic approach to measuring exposure to climate risk today will be as important as any bold 2035 objectives.

Historically, climate risk has been seen as difficult to measure, given the lack of clear and consistent data necessary for making informed business decisions and driving effective government policy. For companies and investors, applying these exogenous risk factors to a business or balance sheet remains a somewhat arbitrary process. Reengineering a supply chain, divesting from a profitable line of business, or executing a new carbon offset programme can be difficult and costly when compared to unmeasured risks.

However, insurers—the largest group of clients we serve at Conning—can help show us the way forward. They have long been evaluating and placing a value on the risk of environmental catastrophe to the physical assets protected by their policies. Insurance products that mitigate risk surrounding climate events have been built successfully using sophisticated actuarial modeling approaches for decades.

Meanwhile, today's organisations are asked to develop, report, and act upon more climate-related data (ESG programme requirements being the most obvious driver). More than ever, it is clear that progress in managing climate risk will require accurate data and modeling prowess that reaches well beyond deep thoughts or splashy commitments.

The way forward

So where are the standards and datasets that will make a climate risk programme work? While a fair question, these are only two of the initial components required to develop an effective climate strategy.

Defining a set of climate risk measurables is similar to defining a framework for responsible investing: no one standard exists, though today there are useful examples like the Bank of England (BOE)'s Insurance Stress Test (and its follow-on Biennial Exploratory Scenario for financial services).

"More than ever, it is clear that progress in managing climate risk will require accurate data and modeling prowess that reaches well beyond splashy commitments" Woody Bradford, Conning

In the US, the National Association of Insurance Commissioners (NAIC), along with the states of California and New York – both viewed as first-movers in state regulatory requirements – now require that insurers provide company-level climate-risk impact assessments. The operating principles need to consider the impact of both physical and transition risks on the balance sheet and operations. Importantly, additional data to assess climate risks can now be developed and captured using artificial intelligence and sentiment analysis.

Another important consideration lies in the type of modeling deployed. Stochastic modeling techniques – which forecast the probability of various outcomes under different conditions, using random variables – can consider the broad set of potential outcomes and timing at play in measuring climate risk and enable us to factor uncertainty into our estimates. Recognising uncertainty is important; for example, a number of climate scenarios underestimate or ignore potential technological progress (e.g., reduced costs of solar power, advances in battery storage and energy transmission, scaled technology to remove carbon dioxide from the air, etc.). Over a 50- or 100-year timeline, this could significantly impact results in ways that deterministic approaches typically fail to consider.

It will also be increasingly important to integrate these outputs into broader enterprise risk management protocols. The range of climate risks in scope has become more diverse and esoteric, and an effective roadmap needs to identify, measure, monitor, manage, control and report on transition-related risks.

Many companies are still getting organised around climate risk, running hard to get their capabilities caught up to evolving regulatory requirements and public commitments. The good news is that technology to measure climate risks continues to improve, and the consensus is building to understand and address the potentially severe risks associated with climate change. A concern in the process, though, is to ensure that what we are measuring and addressing what matters and that evolving policy and regulation remains supportive rather than a roadblock in our shared pursuit of effective solutions.

Only when investors and business leaders truly understand the nature and quantum of risks driven by climate change — including a surer sense of where an organisation stands, how it is exposed, and the options to respond — can we begin to meet this Delphic moment. Along with aspirations and narratives, we have the opportunity to be truly heroic, with a path to genuinely know our climate selves.

Woody Bradford is CEO and chair of Conning, an investment manager serving the insurance industry.

Woody Bradford