Yes folks, it’s been awhile hasn’t it? Well from the beginning I promised that I wouldn’t write unless there was something that would be both interesting and impactful to you, the readers. Well it seems that things have been a little quiet in the past month or so but this report is certainly worth waiting for.
Today, I bring to you some highlights of a new report that has been released by the International Finance Corp (IFC) called “Climate Risk and Financial Institutions: Challenges and Opportunities” (link to follow). This one has particularly caught my eye as I sense that globally, some financial institutions are embracing and understanding these issues, while the majority of our North American institutions have yet to fully integrate these issues into their thinking / culture. The real opportunity that lie ahead of them is in both the protection of their credit and investment portfolios, but also in the product development. And for corporations, how they assess and price their lending / products to you.
Given my background in the capital markets, I would like to note that this report does a particularly good job of highlighting some of the reasons that financial performance and conditions for both equity and debt may be weakened by climate issues. They include:
- Market conditions, particularly supply and demand, can be a key determinant of future prices. Both supply and demand can be sensitive to climate factors. Future climate-driven changes in prices may, in turn, affect the competitiveness of investments.
- Efficiency, output, and performance of assets and equipment may decrease due to changing climate conditions, with consequences for revenue.
- Operating costs (OPEX) may increase due to changes in the price, availability, or quality of inputs. Maintenance costs may also increase.
- Insurance costs are likely to increase if climate-related claims continue to rise as projected. A more disquieting possibility, already a reality in some regions, is that insurance companies may completely abandon particular markets.
- Additional capital expenditure (CAPEX) may be required as a result of asset damage or decreased asset performance. Further, complying with environmental regulations may require additional CAPEX to upgrade facilities or equipment to cope with increased pollution risks.
- Staff health, safety, and productivity may be impacted by climate change, and this may lead to increased expenses.
- Loss contingency projections—reserves required to allow for potential disasters or other known risks—may need to increase as the risks of climate change become more likely and better quantified.
- Asset depreciation rates may increase. The rates currently used for accounting purposes generally reflect historical experience, but the effective depreciation rates of assets due to climate change may be considerably higher. Consequently, financial models may overestimate the real useful lives and value of physical assets. Faster capital depreciation could mean that assets need replacing more frequently, negatively affecting projected cash flows.
- Country risk may be aggravated by climate change impacts, particularly in economies where GDP is reliant on scarce water resources, or in smaller economies that are more vulnerable to catastrophic climate events. Significantly, studies show that rising temperatures in some regions are linked to increased risk of armed conflicts.
Specific case studies for each of these noted impacts are included in the report.
The report goes on to talk about the particular impact for both debt financing and equity investments, which are obviously of interest to those readers who work in the investment field within these financial institutions or at corporations.
For debt financing, for example, a relevant factor for repayment is how projected annual variability in cash flow is correlated with climatic factors. Any long-term climate trends over an investment’s lifetime will superimpose on preexisting variability, so that minimum and maximum cash flow values may change over time. For example, understanding the correlation of seasonal rainfall and temperature with river flows and a hydropower plant’s output may be important to determining the most appropriate debt structure and repayment schedule for that plant. Debt repayment could be structured according to years of most reliable and/or highest income and adjusted to years of less reliable and/or decreased income.
For equity investments, climate change trends over the investment lifetime that may result in changes in stock valuation may be most relevant for projecting returns on equity and planning exit strategies. Several features of equity investments suggest that they might, in general, be more exposed to climate risks than debt investments are:
- Equity repayment relies on the realization of an exit strategy and on the company’s market value at that time. Since equity investments often have longer terms than debt, they are likely to be more affected as climate risks intensify. Awareness of climate risks is quickly growing among investors, and it will become increasingly difficult to exit successfully from investments that are not climate- resilient.
- Equity investors normally rank behind credit lenders in liquidation.
- Equity investments are intended to deliver a higher return overall, which strongly depends on management’s quality and ability to create value. Generally, management capabilities around climate risks are currently very low.
Overall a great report that walks one through the change in assumed conditions and the change in risk profile, all while highlighting how to walk through a credit risk assessment. Great resource for those who would like to understand more about what to expect from the finance sector as it continues to develop.