Enhancing your ESG response: the strategic role of the risk manager

Introduction: doing nothing is not a viable option!
Environmental Social Governance (ESG) factors have been around for the last few decades, but whereas they were once considered “nice to have” principles or an ethical stamp of approval to show that you were a good, moral company, times have changed. ESG has now become a financial and strategic imperative; many ESG factors are now demanding Board level attention with climate change particularly dominating recent discussions at the World Economic Forum in Davos¹.

Doing nothing is not a viable option, particularly in the energy sector; investors are demanding climate disclosure, central banks are working together to ‘green the financial system’ and expectations of employees and customers are rapidly shifting as ESG truly enters the mainstream. If your CEO or CFO hasn’t been asked about your company performance through an ESG lens, then rest assured it is coming, and coming soon.The strategic role of the risk manager
The good news is that risk managers can be proactive in response to ESG; furthermore, many industries are finding that the insurance sector is uniquely placed to help them, given our experience of being on the front-line of a changing climate over many decades. As we explain in this article, there’s never been a better time for risk managers to bring together a system-wide perspective and play a critical strategic role in guiding the Board’s response and pivot from risk to opportunity.
ESG drivers: a changing climate, and a climate of change
Since the industrial revolution, and particularly over the last 50 years, the world has experienced significant economic growth, powered by ever increasing use of natural resources, driven by a substantial increase in global energy demand. This increase in human activity is known as ‘The Great Acceleration’ and has resulted in many benefits, lifting millions out of poverty and creating our modern world; however, it has also had some unintended consequences, including unprecedented changes in our climate.

Indeed, events that would have seemed unimaginable only a few years ago, such as PG&E becoming the first recognised corporate casualty of climate risks², or the Chairman and CEO of Black Rock discussing climate risk and referring to a fundamental reshaping of finance³, are now becoming the norm.

To more fully understand why there has been such a significant shift in the ESG zeitgeist, it is useful to understand current views of the science, the frameworks being used, and the actions that central banks, regulators and investors are taking.These factors will have a big impact on your role as an energy risk manager, and there has never been a better time to get up to speed with the ESG landscape and help your Board develop a strategic response.

As shown left, 2020 represents a fundamental fork in the climate change road. The actions we take now, and in the coming years, may well determine the future of the world’s climate system. Views on how extreme weather events will change in a warmer world vary, depending on the type of event and its individual characteristics. This is where modelling future climate scenarios using state of the art scientific knowledge can play a key role in your strategic planning and risk management processes.

While a 2°C increase in temperature may not seem important, it’s worth bearing in mind that for the last 10,000 years, it’s the relative climate stability of +/- 1°C that has, at least in part, been the foundation of our collective progress today: a climatically stable nursery for civilizations to grow. Beyond 2°C, or even 1.5°C according to a recent IPCC (Intergovernmental Panel on Climate Change) report⁴, we are going in to uncharted territory with increasing risk of climate tipping points.

There has been a significant and rapid increase in concentrations of atmospheric carbon dioxide (CO₂), especially since the 1970s, reaching levels unprecedented for at least 800,000 years, during which time we’ve been through many ice ages and warm periods (inter-glacials, such as our pre-industrial climate). In fact, palaeoclimatological evidence shows that the last time CO₂ concentration was this high was at least 3 million years ago. Temperatures were two or three degrees higher than pre-industrial climate and seas were 15-25 metres higher. CO₂ is a greenhouse gas that acts like a thermal blanket around the Earth, and it’s getting thicker every year. In response, our planet is warming, sea levels are rising and weather patterns are changing⁵.

The rapid increase in CO₂ takes time to exert these impacts on the planet, and so the emissions produced already will continue to affect our climate for centuries to come. If we continue along a similar pathway – continuing to increase carbon emissions – global temperatures could rise over 4°C by the end of the century, and this has been quoted by some as being an uninsurable world⁶.

The current ESG landscape: a framework for climate-related financial risks
As the worlds of ESG, climate science and finance have come together in recent years, a new language of climate-related financial risk and disclosure has developed.One framework you may be increasingly aware of is the “physical, transition and liability” financial risks from climate change, which Margaret-Ann Splawn referenced in the previous article. This framework was first set out in a report by the Bank of England in 2015⁷, published alongside a seminal speech on ‘Breaking the Tragedy of Horizon’ by the Governor of the Bank of England, and Chair of the Financial Stability Board, Mark Carney.

As illustrated by Margaret-Ann, these three channels of climate risk are highly relevant to the energy sector and are already having a meaningful financial impact. In her article Margaret-Ann pointed out that they feature prominently in the recent bankruptcy of PG&E, one of the first major corporate casualties of climate change. Few people expect it to be the last⁸.As a quick reminder:

Physical risks are the direct risks arising from damage, loss of business or supply chain disruption due to increasing intensity of extremes of weather and climate. Assessment of physical risk can help an energy company understand its operational risks and respond to extreme events. Insurance industry catastrophe modelling techniques can be applied to assess risks to infrastructure or incorporate IPCC-projected climate scenarios to investigate extreme events and changes to energy demand.

Transition risks are the financial impacts of moving towards a low or zero-carbon economy, such as re-pricing of carbon intensive assets, the opportunity costs of making the transition too fast or too slowly or choosing sub-optimal technological solutions. For the energy sector, this might take the form of changes in government policy, for example through taxes to limit supply or demand; or through improvements in technology, enabling more efficient and cheaper supply; or changing the demand for energy through electrification.

Liability risks include those that arise from parties who have suffered loss or harm due to climate change and seek to recover damages from those who are judged by law to be responsible. Liability settlements, or costs of court cases, may well grow if such cases start to win compensation from high carbon sectors. While liability risks can be passed to insurance firms if policies allow and the market capacity is there, damage to reputation and subsequent uninsurable claims could be significant. These risks could arise from a failure to adapt, mitigate or disclose the financial risks from climate change.

In many ways, these risks are not new per se; they translate into existing categories of financial risk such as credit, market, business, operation and legal risks that risk managers have been managing effectively for many years. For example, physical risks such as storms and floods can lead to operational risks in the form of business disruption, or climate liabilities can result in legal risks as those who have suffered damages seek to recover losses.

But as new sources of financial risk they do present new challenges, not least a more extensive modelling of the natural world and developing a much more granular understanding of the transition to a ‘net zero’ future (see Figure 1 for more details).

That’s one of the reasons why Willis Towers Watson is now working in multiple sectors and geographies across the world to help clients manage and respond to ESG and climate risks.What’s coming next: a strategic opportunity for risk managers
Over the last year or two, there has been an equally important development which is only just beginning to filter into financial markets, and in turn, into the energy sector.

Many of the world’s central banks and supervisors, through the Network for Greening the Financial System (NGFS), have upgraded their view on the financial risks from climate change.

As highlighted in Figure 3 overleaf, the risks from climate change are now increasingly seen as having ‘distinct characteristics’ which means these risks need to be ‘considered and managed differently’. Key areas where questions are now being asked include:

Board response: regulators are setting clear expectations that managing the financial risks from climate change requires a long-term strategic response owned by the Board, with the premise of ‘if you don’t consider climate risk to be material, then tell us why’.

Individual accountability: in some countries, such as the UK, banks and insurers are being required to nominate a specific senior executive to be responsible for climate risk⁹. A common home for this is the Risk management team, with the CRO named as the individual accountable.

Climate Stress Testing: at least 15 countries are now preparing climate stress tests¹⁰, including the need to consider risks up to 2050 and how banks and insurers are adapting their business model to a changing climate and net zero future. Risk managers should keep an eye on the outputs, because they are testing future lending conditions.

This step change in action by central banks is being matched by the private sector, with many companies already signed up to voluntary climate risk initiatives such as the Task Force for Climate-related Financial Disclosures (TCFD).

And some of the world’s largest investors and banks are now going further, not only disclosing risk but also committing to align their investment or loan portfolios to the ‘well below 2⁰C’ goal of the Paris Agreement on climate change¹¹. The Global Sustainable Investment Alliance (GSIA) estimates that ESG investments, i.e. sustainable investing, represent in excess of $30 trillion globally, with industry research suggesting that this will double in the next three years.

As the landscape continues to shift, the demands on firms in the wider economy to respond to ESG measures will only increase. And sectors such as energy, that can play a central role in ensuring an orderly transition to a resilient, net zero future are likely to be at the centre of the ESG storm.

Climate Quantified: a new way of enhancing your ESG response
Climate Quantified brings together our deep weather and climate analytical experience from the (re)insurance and investment markets, our extensive academic, research and institutional investor relationships, and our multi-discipline expertise and capabilities in a fully integrated service offering.Furthermore, it embodies a proactive approach to helping shape the global community’s response to climate risks. For example, through our $50 million investment in the award winning Willis Research Network¹² to support open climate and natural hazard research, insights from our Thinking Ahead Institute¹³ to influence change in the investment world and our founding role, with the World Economic Forum, in the Coalition for Climate Resilient Investment¹⁴.

We find the starting point for many clients is modelling the impact of the current physical risks from a changing climate, such as storms, floods and other extreme weather events, on an operational site-by-site basis. We’ve helped a number of clients along this journey; for example, supporting a large bank to understand its climate risk exposure on a large rail infrastructure project. This engagement focused on physical risks to assets and anticipated downtime following damage as part of creating a common asset resilience language.

Modelling the likely amounts of damage or financial losses linked to future climate scenarios – i.e. 2030, 2050, 2100 – can help to make the impacts of possible future climates more tangible. Knowledge fosters understanding, and then action. Your company will also be much better prepared to respond to increasing expectations of lenders and investors around climate disclosures, and to guide future planning, risk management, and strategy.

Risk managers are uniquely placed to ensure their companies are prepared to meet the increasing expectations of disclosure by investors and regulators, embed climate risk into existing frameworks and ensure Boards are taking a strategic approach.A changing landscape means there are new business opportunities and the potential to redeploy existing resources for new revenue generating activity.
Transitioning to low-carbon energy technology represents a tangible opportunity for market differentiation.There are roles for everyone, and risk managers have a unique opportunity to facilitate them in key areas, including:

Governance, including the board’s role in providing oversight of climate risk responses and defining management responsibility for climate risk and ESG.

Risk identification, identifying the key channels through which climate risks can impact the company.

Risk appetite, including forming a view as to whether climate risk should be considered as a separate element or part of aggregate risk.

Risk measurement and reporting, including how to incorporate climate risk into financial risk models and reports and deciding on relevant metrics for decision making, a key element of TCFD disclosure.

Reputation risk, including identifying public communications needs and a strategy for communicating a firm’s climate and ESG response.

Having a solid understanding within the business will not only prepare you for the changes that are already happening, but also those that are coming down the pipeline. By engaging with Climate Quantified, risk managers can benefit from a structured, data-driven and strategic approach and deeper insights into ESG issues. And by being proactive, risk managers can be far better prepared to meet the demands of their regulators, investors and Boards.

Conclusion: is it time to quantify your climate risk and develop a strategic response?While there may be challenges ahead, the mainstreaming of ESG presents a strategic opportunity for risk professionals, particularly in the energy sector. As Boards grapple with the ESG onslaught, risk managers can play a lead role, providing not only risk quantification and analysis but also strategic insight into a rapidly evolving ESG landscape.

Matt Scott is a Senior Director in the Climate and Resilience Hub at Willis Towers Watson in London.

Geoffrey Saville is Weather and Climate Risks Hub Leader for the Willis Research Network at Willis Towers Watson in London.

Lucy Stanbrough is Emerging Risks research manager for the Willis Research Network at Willis Towers Watson, London.

¹ https://www.euractiv.com/section/climate-environment/news/davos-wrap-up-forum-runs-out-of-steam-as-climate-becomes-king/
² https://www.wsj.com/articles/pg-e-wildfires-and-the-first-climate-change-bankruptcy-11547820006
³ https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter
⁴ https://www.ipcc.ch/sr15/
⁵ https://www.climate.gov/news-features/understanding-climate/climate-change-atmospheric-carbon-dioxide
⁶ https://www-axa-com.cdn.axa-contento-118412.eu/www-axa-com%2Ff5520897-b5a6-40f3-90bd-d5b1bf7f271b_climatesummit_ceospeech_va.pdf
⁷ https://www.bankofengland.co.uk/climate-change
⁸ https://www.wsj.com/articles/pg-e-wildfires-and-the-first-climate-change-bankruptcy-11547820006
⁹ https://www.bankofengland.co.uk/prudential-regulation/publication/2019/enhancing-banks-and-insurers-approaches-to-managing-the-financial-risks-from-climate-change-ss
¹⁰ https://www.bankofengland.co.uk/-/media/boe/files/speech/2020/the-road-to-glasgow-speech-by-mark-carney.pdf?la=en&hash=DCA8689207770DCBBB179CBADBE3296F7982FDF5
¹¹ See, for example, https://www.unepfi.org/net-zero-alliance/ and https://www.unepfi.org/banking/bankingprinciples/
¹² https://www.willistowerswatson.com/en-GB/Insights/research-programs-and-collaborations/willis-research-network
¹³ https://www.thinkingaheadinstitute.org/
¹⁴ https://www.willistowerswatson.com/en-GB/Insights/trending-topics/climate-risk-and-resilience