Resources

• Kevin Stiroh’s full remarks on Climate Change and Risk Management in Bank Supervision, which define the risks associated with climate change, discuss how these risks are changing the practice of risk management at financial institutions, and explain the need for bank supervisors to focus on this risk.
• The GARP Risk Institute’s 2019 Climate Risk Management at Financial Firms: Challenges and Opportunities provides a result of a global, cross-sectoral survey of financial institutions to determine how mature firms are in their approach to climate risk management.
• Building on the regulatory theme, the June 2020 Ceres report Addressing Climate as a Systemic Risk: A Call to Action for U.S. Financial Regulators incorporates input from expert practitioners and analysts from across the financial sector, argues that financial regulators need to act immediately to address climate change, and provides more than 50 recommendations for regulators and financial firms.

Guests

Host: Mike Toffel, Senator John Heinz Professor of Environmental Management and faculty chair of Business and Environment Initiative

Moderator: Ramana Nanda, Sarofim-Rock Professor of Business Administration and co-director of the Private Capital Project

Guest: Robert Litterman, Risk Committee Chairman at Kepos Capital, and former head of risk at Goldman Sachs

Guest: Nushin Kormi, a trustee and partner at Loring, Wolcott, & Coolidge

Guest: Kevin Stiroh, executive vice president at the Federal Reserve Bank of New York

Transcript

Robert Litterman:
The purpose of risk management is not to minimize risk, but to make sure we were getting paid appropriately for taking that risk. And that really is the fundamental problem, in both the coronavirus case and climate change. We're not pricing the risk, okay. And if you don't price the risk, you take too much risk.

Mike Toffel:
This is Climate Rising, a podcast from Harvard Business School. And I'm your host, Mike Toffel, a professor here at HBS. This is the fourth episode of Climate Rising that highlights some key insights from financial experts who spoke at the Harvard Business School Conference on Risks, Opportunities, and Investment in the Era of Climate Change, held in early 2020.

We've heard from those running pension funds, large banks and other investment institutions about how they are changing their policies and approaches to doing business. Some investors are developing models to incorporate data on climate risks and opportunities into their investment allocation decisions.

In today's episode, we'll hear from three experts, how investors and financial regulators are incorporating climate risk into those models. We'll hear from Robert Litterman, risk committee chairman of Kepos Capital, and former head of risk at Goldman Sachs. We'll also hear from Nushin Kormi, a trustee and partner at Loring, Wolcott & Coolidge, a wealth management firm focusing on family offices, and from Kevin Stiroh, executive vice president at the Federal Reserve Bank of New York, who joined the session remotely.

First up is Robert Litterman, who shares lessons we can learn from other areas of financial risk management, and speaks about transition risk, and how we should be preparing for a scenario where policymakers suddenly slam on the brakes, by taking aggressive measures to slow climate change. He also shares some parallels he was seeing between climate change and the coronavirus crisis.

Robert Litterman:
What I'd like to first talk about is some of the lessons from financial risk management, and how they apply to both actually climate change, and also think about the coronavirus issue that's going on right now, because both of these are just horrible risk management failures. And so there's a lot of commonality here.

But the first lesson from risk management, and I don't think you'll find any of these surprising or hard to understand, the first is you have to think about worst case scenarios. There's always going to be a distribution of potential outcomes in the future. The purpose of risk management is to think about how bad could it be. Now, as you probably know, in many contexts, there is no answer to that. On Wall Street we came up with something called Value at Risk, which is a probabilistic statement about some point in the distribution or the expected loss past that point. But what management always wants is, what's the worst case?

So today, in the financial markets, we don't talk about worst case. We talk about extreme, but plausible, scenarios. So think about the extreme but plausible scenarios with respect to both climate and a virus that we're dealing with right now.

Number two is, it's always an urgent problem when it's a risk management problem. If you have enough time, you can solve just about anything. It's when you run out of time that a risk problem becomes a catastrophe. And in both of these contexts, we've probably gone way longer than we should have to address them.

The third lesson of risk management is, and this one may be not as intuitive, but trust me on it, the purpose of risk management is not to minimize risk. When Goldman Sachs said, "Bob, we want you to be head of risk management," they didn't want to reduce the risk. They wanted to make sure we were getting paid appropriately for the risks that we took. And if we weren't getting paid, why are we taking that risk? Hedge it.

And that really is the fundamental problem, in both the coronavirus case and climate change. We're not pricing the risk, okay. And if you don't price the risk, you take too much risk. And that's where we're at.

Now the final thing I'll mention. Economists often make a distinction between risk and uncertainty. And risk is a measurement that we get from a model. So something like Value at Risk or volatility, those are measures of risk. The real world is not a model. The real world is much more complicated. And particularly with respect to both the coronavirus and climate change, we're basically doing an experiment. And there's tremendous uncertainty.

So what's the implication? The implication is when you have an uncertain situation, you don't trust your model as much. And you err on the side of caution, which means, where we should be pricing risk, both in terms of the coronavirus, and in terms of climate risk, is that the high end of what might otherwise seem to make sense.

With respect to climate risk, what does it mean for investors? We're not pricing the risk. In fact, the incentives globally go strongly in the wrong direction. We're actually subsidizing fossil fuel production and consumption globally around the world. Now trust me, as long as those subsidies are in that direction, emissions are going to increase. Most investors think we're going to smoothly deal with this. We're starting to deal with it. And there's going to be a smooth transition to a low carbon economy over some period of time. It's not going to be smooth. We're not pricing the risk. It goes in the wrong direction. When we decide we're going to price the risk globally, we're going to be in what I call a slam-on-the-brakes scenario.

Okay, right now most investors think that we're going to ease on the brakes. We're not. We're going to slam on the brakes, because we're going to recognize the risk. We're going to recognize what we did wrong, and we're dealing with an uncertain situation. And so when we start to price it, we're going to err on the high side. So that leads to transition risk.

Transition risk is the risk that we're going to have a phase change in the economy when we price the risk. And what's that going to do to valuations of securities and other aspects of society? And the answer is, it's already happening, because investors don't wait for the actual pricing of the risk. They see it coming, and they're reacting to it.

So about a little over six years ago, at the World Wildlife Fund, where I chaired the investment committee, we said, "We have to align our portfolio with our mission here to protect nature." And so we talked about should we divest? I'm a big proponent of, this morning, we heard about value versus values. I'm a value guy, okay. So I said, "No, we don't want to divest." What we want to do is we want to recognize that there's going to be a rapid transition to a low carbon economy, and that that's going to affect the valuation of assets.

Now that was six years ago. We weren't very sophisticated. We said, "All right, there's stranded assets out there. We don't want them in our portfolio." Our advisor said, "You know, that's going to cost you an arm and a leg, and think about the monitoring of all your managers. You've got coal, and private equity. You've got hedge funds. You've got active managers. You have to turn over half your portfolio. It's going to cost you and arm and a leg. And by the way, you only have a tiny amount of this risk in your portfolio, less than 1%." We said, "Well, look, we're the World Wildlife Fund. That's not an adequate answer. What should we do?" They came up with a very innovative solution, and I love it. They said, "All right, don't touch the portfolio. Use an overlay, what we called a stranded asset, total return swap." We basically sold our stranded assets to a counterparty, and they paid us the total return. We sold our total return on those assets. We held them. But we sold the total return to a counterparty, and they gave us back the total return on the S&P 500.

Now I'm often asked, who would do that? Why would someone take the other side of that bet? But from our perspective, it was very nice, because for the last six years, we've watched this bet. Just think of it as a bet that we made, and we said, "These assets are going to underperform these assets." Well, I thought, "You know, that's probably a good bet. I don't know. Maybe we'll make a few percent a year on this."It's been over a hundred percent in that period of time. This is the best performing asset in our portfolio. So if any of you haven't noticed that, these big energy companies, we defined stranded assets as coal, tar sands and oil exploration and production.

By the way, it's accelerating. Last year those industries underperformed the S&P 500 by 27%. It's accelerating, my friends. This year those assets have underperformed the S&P by 20% in two months. And I think this transition is coming very soon. And there's a lot of things going on. But one of them is that the financial regulators around the world have been addressing climate, and that's true in the US.

Now for political reasons, the Fed has been afraid to publicly take a position. Well, we have a representative. I'll let him talk about that. But the CFTC said, "Look, if the Fed and the SEC are not going to do it, someone's got to do it. So we're going to form a climate-related market risk subcommittee, and we've got 35 people representing, really terrific folks, representing the banks, insurance companies, academics, nonprofits, data companies, a couple of oil companies, couple of Ag companies. And we're going to write a report that'll come out with recommendations to the ... It's really, we have a broad mandate. Recommendations to the financial regulatory community, and frankly, the entire financial markets, about what needs to be done. And we'll talk about the risks. We'll talk about the implications for financial stability. We'll talk about what corporations should be doing, in terms of disclosure, in terms of scenario analysis. We'll talk about the need to have a globally harmonized approach, in terms of regulations. And finally, we'll talk about the huge need to channel investments into the low carbon economy, and what can the financial regulators do to accelerate that."

Now the first thing to say, and maybe the only thing to say, is as long as the incentives go the wrong way, we're going to be moving in the wrong direction. So we absolutely need a carbon tax. We need it immediately. But I sit on the board of something called the Climate Leadership Council. We're the sponsors of the Baker-Schultz Carbon Dividend Plan. And that's something that has broad support from the entire corporate universe, as well as virtually every economist in the country, and the environmental community as well.

I think we're very close to getting a carbon tax. Everyone in Congress is really aware of this. The Republicans have now said, "Well, we know it's real now, and we need innovation." Well, trust me, you don't get innovation without incentives. And we're not going to get there until we start.

One final thing, if I may say so. I talked about the urgency of this, and I'm not a climate scientist. But you can model what the impact of pricing will be on emissions. And that's how you think about what's the optimal price.

And one of the things you learn is the long tail that you have. We're currently at one degree C approximately, but we've built in best case, if we slam on the brakes today, and price emissions at a high level globally, and of course, that's going to happen. But if that were to happen today, we would still probably hit about 1.8 degrees C. And that'll happen, best case, we'll get to zero emissions in 30 years. And the peak temperature comes several decades after that, as the Earth comes into equilibrium. So that's 50 years from now. That's when my grandchildren are adults. We're going to be close to two degrees. And that's if we slam on the brakes today.

Now here's the scary thing. If we don't slam on the brakes, and we wait another three years, that's a 10th of a degree. So you can do the math. And we cross two as the minimum temperature in something like six years, if we don't price emissions immediately. And you probably read the IPCC report on the difference between one and a half degrees and two degrees C. One and a half degrees C, we lose 70 to 90% of coral reefs, and that's gone. That's coming. It's going to be worse than that.

At two degrees C, we're going to lose over 99% of coral reefs. And we're about six years away from that. So this is a climate crisis. We absolutely have to slam on the brakes. I think we will. I think we will get that political will in the US very soon. And I think that globally, the rest of the world is ready to move as soon as we do.

Mike Toffel:
That was the voice of Robert Litterman, the risk committee chairman of Kepos Capital. Next we'll hear from Nushin Kormi of Loring, Wolcott & Coolidge, a wealth management firm focusing on family offices. Nushin describes her firms approach as long-only equity investors with long multigenerational time horizons. She's a partner and trustee at the firm, and focuses on sustainable investing.

Nushin Kormi:
Climate is an extremely important aspect of understanding long term prospects of a company. For me, as an investor, the challenge remains that to systematically methodically integrate this information into my investment decisions is a hard thing to do. I have to be able to define what the relevant sustainability information is. What is that data that I want to use? I then need to be able to find that information consistently across companies in my investment universe. And I need to be able to devise a way to have that data actually inform my investment decision.

I've been searching for a way to try to figure out how to actually analytically appropriately integrate sustainability metrics into my investment decisions. As you're all aware, there are all the rating agencies out there, and the different providers who will give you information on, "Well, this company looks good from a sustainability perspective. That one doesn't." You'll have the same company and two different providers give you completely different takes on that company.

So we really had a hard time trying to figure out a way that was standardized, where we could look at our portfolios and make judgment calls. So we started thinking, how can we actually come up with something ourselves? And we wanted something that could be married with traditional finance as well. And the reason I say that is because ultimately, I think all of us in this room would like something standardized where it could be across all the equity analysts out there are incorporating climate change into their models. That would make my job a lot easier, and I'm guessing it would make the jobs of a lot of people in the audience a lot easier as well.

So we came up with something. We have called it a Climate Change Valuation Premium. I describe it on a very high level as analogous to a Country Risk Premium. The big structural difference is, a Climate Change Valuation Premium can be positive, negative or zero. So if a company is very well-positioned to do well with climate change, then they will get a premium. If they are not positioned well, it would be a discount. And if they are at a neutral level, it would be zero.

And the premise of the CCVP, as we call it, is how a company is positioned to handle the impacts of climate change, is going to impact the long term value of the company, both in a positive and negative way.

So we have three components to this approach, to try to get a holistic assessment of climate risk. And the first is assessing the climate risk of a company's operations and its value chain. So think of things like emissions. The second is taking into account a company's exposure to high risk natural resources. So think water and land-related resources, relative to the company's business model and value chain. And the third is to really look at each sector relative to the global universe, and each company relative to its sector, so think relative positioning. And we separate out sector, business model, and management risks to determine both how much of a company's risk is due to the sector itself versus the company, and whether management is proactively reducing risks or seizing opportunities associated with climate change.

And as I mentioned, the purpose for coming up with something like this, is to inform our own investment decisions internally, as it relates for what we want to be able to provide our clients with. It really provides us with a quantitative way to engage with the companies that we're invested in. When we do our corporate engagement and our shareholder advocacy, it gives us real data to stand on.

Another thing I should mention is, while we can think about climate change and the impact on companies are things that are slow-moving, that we can really account for, then you have the climate events, something like a pandemic that happens, or like a climate event that happens. Those things are difficult to predict, and that makes it ... I would be naive in saying that our model is really capturing that type of risk. But we are trying to get a bit closer to quantifying and standardizing our analysis as it relates to climate risk. To be able to incorporate the Climate Change Valuation Premium as something that will impact the cost of equity, I think, is a way that hopefully we can start having climate change really incorporated into valuation.

Mike Toffel:
That was Nushin Kormi, partner and trustee at Loring, Wolcott and Coolidge. Next we'll hear from Kevin Stiroh, of the Federal Reserve Bank of New York. He joined the event remotely, and he brought the important perspective of a regulator. He shares his views on how large banks need to assess both the physical and transition aspects of climate risk, and how models need to change going forward.

Kevin Stiroh:
In the last few years, we have seen a growing focus of central banks on the financial risks related to climate change. Within the Federal Reserve, Governor Brainard has detailed how climate change impacts all of our key objectives and responsibilities, including monetary policy, financial stability, supervision and regulation, consumer affairs, and the payment system.

So today I'm going to take a slightly more narrow perspective, and talk about climate change from the perspective of risk management at the financial institutions that we supervise. Before proceeding, I need to emphasize that I'm speaking for myself today, and not necessarily the Federal Reserve Bank of New York, or the Federal Reserve System.

At a practical level, risk managers and financial institutions need to develop the appropriate tools to identify, monitor, and manage these risks. From one perspective, these climate-related risks may manifest themselves as realizations of familiar risks, credit risk, market risk, operational, legal, or reputational risk. But I think the tools that managers use will need to change to reflect new data, changing relationships, and evolving interconnections.

Traditional backward-looking models based on historical trends will no longer be reliable. So we'll need to develop more forward-looking approaches grounded in scenario-based analysis. Perhaps more important, physical and transition risks will also likely introduce new strategic risks associated with both the challenges and the opportunities of sector or reallocations of economic activity, new production patterns, and evolving industry exposures. So given these emerging risks, what are the large financial institutions actually doing to identify, monitor and manage them? This is a new and rapidly-evolving field. So we are far from coalescing around industry best practices. We observe a range of practices.

I'll begin with governance. Boards of directors and senior managers are increasingly attuned to the risks posed by climate change as pressures from various stakeholders intensify. Some firms are establishing internal climate-related working groups to develop enterprise-wide climate frameworks. Senior leaders are discussing materiality, and geographical and sectoral reviews, incorporating the results of forward-looking scenario analyses. Based on our observations, information flows and detailed climate reporting appear more prevalent at the management committee level, rather than boards of directors.

Turning to risk identification and management, some firms are beginning to assess how gradual changes in climate impact their operational resilience, and the potential for their own business disruption. This work builds on experience managing risks posed by disaster events, which impact through operations and infrastructure, such as branches, equipment, and data centers. This includes leveraging disaster response playbooks, and business continuity plans to address the results and operational risk.

In terms of credit or market risk, firms are building ex ante climate risk assessments into their sectoral and industry reviews. Examples include heightened monitoring of mortgage concentrations in certain high risk areas, modified risk limits, or reduced tenors for transactions with certain carbon-intensive sectors.

Climate-related scenario analysis is an emerging practice at multiple firms, and used to identify lending portfolio sensitivity to both physical and transition risks. For physical risks for example, this might include stress testing mortgage lending in discrete geographic areas against a range of possible outcomes. As an example of a transition risk scenario, firms are using their energy-lending portfolios as a starting point to model the impact of a change to a different carbon intensity.

Finally, firms are also evaluating how to best execute on their public commitments to transparency in the climate space. Nearly all global systemically important banks, including the eight in the US, have signed onto the Task Force for Climate Related Financial Disclosures. And many of these firms have started disclosing under this framework.

Firms continue to be challenged however, in the identification and measurement of climate risk. So their disclosures may take some time to develop, as the industry considers how to establish common standards.

Now I'll turn to the perspective of a bank supervisor. In this context of climate change, in my view, bank supervision needs to focus on ensuring the appropriate risk management frameworks are in place. And we should use our oversight tools to ensure that financial institutions are prepared for and resilient to all types of relevant risks, including climate-related risks. From that perspective, climate change introduces specific challenges for supervisors related to the time horizon, to data limitations, and the inherent complexity of the work.

One question that gets particular attention centers around the time horizon and prioritization. More specifically, given the many risks that financial firms face, think about cybersecurity, geopolitical uncertainty, the current events around the coronavirus, or the credit cycle, to name just a few, and consider the relatively long time horizon, and a question could be, why should supervisors focus now on this particular risk? I think that's a fair question, and I think there are good answers to it.

First, we are already observing the impact of climate change on financial firms. The evidence continues to grow that climate change is affecting economic and financial market outcomes. As has been mentioned several times today, the evidence from climate science suggests that further physical impacts are locked in due to past emissions. We've seen some investors consider the assessment of sustainability to be integral to their fiduciary responsibilities. And as I described earlier, supervised firms are already choosing to build capacity in this area. So supervisors need to understand and assess those changes to the risk management framework. So in sum, that is a risk managing question for today, with direct implications for the safety and soundness of the individual firms that we supervise.

A second challenge is the complexity of the problem. And we all need more time to build data models and our intellectual capacity to address these risks. Looking back, it took the better part of a decade to approach a steady state and central bank's stress-testing capabilities for more familiar and arguably less complex risks, like credit card losses, or shocks to asset values from interest rate spikes. The economics of climate change are much more complex, with feedback effects, nonlinearities, and massive uncertainty that will require a massive investment to understand.

And third, financial markets and institutions continue to face the potential for what's been called a Minsky moment, related to climate change, an abrupt repricing in assets in response to a catastrophic event, or a change in investor perceptions. Financial firms and supervisors both need to consider the potential impact of that type of sudden event.

So to conclude, the impact of climate change on the structure and the performance of the economy is happening now, and will continue. Conferences like this help us further our awareness and build our understanding of this critical issue.

Mike Toffel:
That was the voice of the Federal Reserve Bank of New York's Kevin Stiroh. You can see his full remarks in our show notes on Climate Rising's website, ClimateRising.hbs.edu. Also in the show notes, a link to a report released by CERES in June 2020, that outlines more than 50 recommendations for financial regulators to better address systemic risk of climate change.

And that's it for this episode of Climate Rising. And this concludes our Season two. We'll be back with Season three in the coming months, with more conversations of those working at the intersection of climate change and business.

Thanks for joining us. I'm your host, Mike Toffel. This is Climate Rising, a podcast produced by the Business Environment Initiative at Harvard Business School. You can subscribe on Apple podcasts or wherever you listen, and please leave us a review. We appreciate the feedback. You can also find show notes and links to resources discussed on this episode on the Climate Rising website, ClimateRising.hbs.edu.