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Transcript of Climate Risk and Financial Institutions - Challenges and Opportunities
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Climate Risk and
Financial Institutions
CHALLENGES AND OPPORTUNITIES
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AuthorsVladimir Stenek, International Finance CorporationJean Christophe Amado, AcclimatiseRichenda Connell, Acclimatise
The authors wish to extend special thanks to IFCinvestment, industry, environmental and socialspecialists, who have provided signifcant inputs tothis document. Udayan Wagle (Director, BusinessRisk) is thanked or providing strategic direction.Samuel Dzotee (Senior Investment Ofcer),Graham Smith (Manager), and Jan Mumenthaler(Head) are thanked or their detailed and helpulcomments during the elaboration o the document.
This work benefted rom support provided by the Trust Fund orEnvironmentally & Socially Sustainable Development (TFESSD), madeavailable by the governments o Finland and Norway.
ReviewersWe thank the ollowing or their critical review and comments:Maarten Van Aalst, Craig Davies,Susan Holleran, Ajay Narayanan, SamanthaPutt del Pino, and Udayan Wagle
EditorsRachel Kamins, Anna Hidalgo, Vladimir Stenek,Richenda Connell
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ITABLE OF CONTENTS
TABLE OF CONTENTS
FOREWORD IV
EXECUTIVE SUMMARY V
Navigating this Report 1
Climate Risks in the Context oOverall Risk Management 2
PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
CREDIT AND FINANCIAL RISKS 3
Overview 5
Management o Present-Day Climate andWeather Risks in Investment Appraisal 7
Financial and Credit Risk Analysis 8
Steps in the fnancial and credit risk analysis process 24
Corporate Disclosure andInvestment-Risk Management 24
Corporate Credit and Financial Risk 25
Deault probability 25
Return on equity 25
Value o assets used as collateral 26
Overall proft margins 27
Portolio risk management and perormance 27
STRATEGIC RISKS 29
Long-term Perormance 29
Development 30
Investment development perormance 30
Economic perormance 31
Environmental and social perormance 32
Private-sector development 34
Environmental and Social 35
Introduction 35
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II TABLE OF CONTENTS
Principles E&S underlying perormance standards 36 Social and environmental assessment and
management systems 38
Labor and working conditions 40
Pollution prevention and abatement 41
Community health, saety, and security 45
Land acquisition and involuntary resettlement 45
Biodiversity conservation and sustainableresource management 46
Indigenous Peoples 47
Cultural heritage 47
Conclusions 48
Reputation 49
Overview 49
Increased risk o water conictaround investments 51
Increased risk o protests against projects inenvironmentally sensitive areas 51
Increased risk o protests around communityresettlement and compensation 51
A lack o action on climate change adaptationcould put a fnancial institutionsreputation at risk 52
Conclusions 55
OPERATIONAL RISK 56
Processes 56
Sta, Buildings, and IT Systems 57
LEGAL RISK 61
Overview 61
Duty o Care, Skill, and Caution in ProvidingProessional Advisory Services 65
Climate Change Risk Management asPart o Fiduciary Duty 66
Conclusion 66
REFERENCES 67
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II ITABLE OF CONTENTS
PART II CLIMATE CHANGE AND INVESTMENT SECTORS
Introduction 76
Navigating this Report 77
Water Quality, Pollution Control, and Discharges 78
Energy Reliability and Security 83
Asset Design, Perormance, and Integrity 84
Raw Materials, Transport, Supply Chains, and Logistics 86
Site and Ground Conditions 88
Human Health and Saety 89
Markets 92
Communities 93
Air Emissions and Solid Waste Management 96
Ecosystem Services 98
Sector-Specifc Risks 100
Agribusiness 100
Water 103
Electric Power 106
Transport 108
Oil, Gas, and Mining 110
Appendix. Greenhouse Gas Emissions Scenarios 114
Reerences 117
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IV FOREWORD
FOREWORD
Climate change is set to have a dramatic economic impact. It is already altering the availability o and demand
or resources, supply and demand or products and services, the perormance o physical assets, and the need or
innovation. Failure to consider climate change in investment strategies can undermine projected fnancial returns and
aect the non-fnancial risk management o institutions, particularly on development, environmental, and social issues.
The challenges presented by climate change are magnifed in emerging markets, where most uture global economic
growth will take place. In these economies, climate change is shaping strategies to increase access to energy, clean
water, and other basic services or people who need them most.
As they channel investment, fnancial institutions have an opportunity and responsibility to take a leading role in
mitigating and adapting to climate change. Institutions managing investments in long-term assets should consider the
fnancial risks associated with climate change, as well as the opportunity to create value by working proactively with
clients and stakeholders to manage the risks.
IFC is supporting the eorts o several development and commercial fnancial institutions to take steps in this direction.
This publication is part o our work to help fnancial institutions analyze the risks associated with climate change.
Initiatives such as IFCs Climate Risk Pilot Program are also producing case studies that assess various approaches to
managing and adapting to climate change in the real sector.
As climate change adjusts the way we think and act to reduce poverty and secure sustainable economic growth, IFC is
committed to helping fnancial institutions meet the challenge. Our goal is to provide critical inormation and tools or
fnancial institutions and the private sector to make smart decisions in the ace o climate change, helping to create a
better and more prosperous uture or us all.
Rachel Kyte
IFC Vice President
Business Advisory Services
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VEXECUTIVE SUMMARY
EXECUTIVE SUMMARYMANAGING CLIMATE RISK IN
THE FINANCIAL SECTOR
How signicant are the impacts of
man-made climate change today?
The summer 2003 European heat wave had disastrous consequences:
water shortages shut down 14 nuclear plants at electricity producer EDF,
causing electricity price spikes o 1,300 percent, which, because they
could not be passed on to customers, resulted in a $300 million loss;
European agriculture lost an estimated $15 billion; and more than 35,000
people died.
The ripple eects dramatically aected upstream and downstream
sectors o various regions. France, the largest energy exporter in Europe,
cut its energy exports by more than 50 percent. Output o animal odder
ell by up to 60 percent, and despite imports rom countries not aected
by the heat wave, such as Ukraine, livestock producers were aected by
shortages and price hikes.
Without man-made climate change, a summer as hot as 2003 would
have been an exceptional 1-in-1,000year event. Due to mans
infuence on the climate, by 2003 the risk o such an event had already
more than doubled to 1 in 500 years. By 2040 summers as hot as 2003
will be normal, 1-in-2-year events, and by 2060 they will be cooler
than the average (COPA/COGECA 2004; Stott et al. 2004; UNEP 2004).
Temperature Changes across Europe,
19002100 (Relative to Baseline Summer
Temperatures in the Period 196190)
(Source: Stott et al, Hadley Centre and
Oxford University)
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VI EXECUTIVE SUMMARY
Do changing climate risks matter toshort-term investments?
While short-term investments have shorter exposure, the risks are not
completely eliminated. Extreme events, happening with increased
requency and intensity, can occur at any time. Furthermore, while
extreme events and their eects on investments oten grab the headlines,
creeping changes in average conditions are already causing material
changes in risk. For example, rising sea levels in some ports are reaching
the crests o protective seawalls and quays built some decades ago. Added
to this, the observed increased variability in wave heights and projected
increases in the intensities o tropical cyclones urther worsen risk proles.
Clearly, not all investments will be aected by climate impacts, nor
will they all be aected in the same ways. The severity o impacts will
depend on several actors, including its climatic sensitivity, location,
management practices, market conditions, existing policies and
regulations, and so orth. However, it is likely that the impacts will have
material eects on a signicant number o investments over time.
Some investment sectors are intrinsically more climatically sensitive,
because o the nature o their operations or supply chains, such as those
reliant on long-lived xed assets or requiring large volumes o water.
Othersnotably agribusiness, energy, and tourismoperate in markets
where supply, demand, and price fuctuate signicantly in line with
variations in the weather.
Climate change related impacts
that are material to investments
performance are already
occurring.
Impact of the 2003 European Summer Heat
Wave and Drought on Agriculture in Five
Countries (Source: Reprinted from UNEP 2004)
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VI IEXECUTIVE SUMMARY
Investments in some countries or specic locations, such as those in water-stressed regions, or close to food-prone rivers or coasts, are more exposed.
Economic conditions also aect levels o vulnerability and the ability o
economies to recover rom climate shocks. Strong and diverse economies
will be better placed to maintain the climate-resilient inrastructure and
services on which businesses depend.
At the level o an individual business, managements awareness and
treatment o climate risk actors will be key determinants o business
success. Proactive assessment and management will decrease the
likelihood o adverse impacts rom creeping changes or extreme events.
Additionally, the rst businesses to grasp new opportunities arising rom
changing conditions will be well positioned to gain competitive advantage.
Finally, knowledge about climate change and its impacts is evolving
rapidly, and many o the key acts are now well established. Continuous
advancement o inormation, supported by increased research and
evidence, along with the application o risk-management tools, will
acilitate incorporation o climate considerations into decision making.
Overall, this should result in investments that are more climate resilient or
better adapted to the changing conditions.
RISKS TO PROJECT FINANCE AND REAL
SECTOR INVESTMENTS
This report analyzes in some detail the risks to project nance and the
perormance o real-sector investments. Options, utures, derivatives,
oreign exchange and more exotic instruments are not specically
addressed. However, real-sector investments are undamental to
economies, and many instruments are directly or indirectly linked to or
infuenced by them. As the systemic risks o climate change will aect
whole economies, ew instruments can be considered completely immune
rom potential impacts.
The unexpected volatility o conditions created by unaddressed climate
impacts can aect projected results and weaken nancial conditions. Forgeneral debt instruments such as loans, or example, debt-repayment
capacity can be aected by the alteration o underlying cash-fow values
projected earnings and expensesdue to climate change, leading to
deterioration o nancial positions.
For equity investments, climate-driven deviations rom expected results
that aect an investments valuation are relevant or projecting returns
on equity and planning exit strategies. Some equity investments will also
be aected as analysts incorporate inormation about climate change
impacts into their company valuations.
Proactive risk management
will decrease the likelihood of
adverse impacts.
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VIII EXECUTIVE SUMMARY
Financial perormance and conditions or both equity and debt may beweakened by a number o actors:
Market conditions, particularly supply and demand, can be a
key determinant o uture prices. Both supply and demand can
be sensitive to climate actors. Future climate-driven changes in
prices may, in turn, aect the competitiveness o investments.
Eciency, output, and perormance o assets and equipment
may decrease due to changing climate conditions, with
consequences or revenue.
Operating costs (OPEX) may increase due to changes in theprice, availability, or quality o inputs. Maintenance costs may
also increase.
Insurance costs are likely to increase i 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 o asset damage or decreased asset perormance.
Further, complying with environmental regulations may require
additional CAPEX to upgrade acilities or equipment to copewith increased pollution risks.
Sta health, saety, and productivity may be impacted by climate
change, and this may lead to increased expenses.
Loss contingency projectionsreserves required to allow or
potential disasters or other known risksmay need to increase
as the risks o climate change become more likely and better
quantied.
Asset depreciation rates may increase. The rates currently used or
accounting purposes generally refect historical experience, butthe eective depreciation rates o assets due to climate change
may be considerably higher. Consequently, nancial models may
overestimate the real useul lives and value o physical assets.
Faster capital depreciation could mean that assets need replacing
more requently, negatively aecting projected cash fows.
The response of some insurance
companies to increased weather
impacts in the United States was
cutting down the number of
homeowner policies or complete
pull-out from regional markets.
Nearly 3 million U.S. households
remained without homeowners
coverage between 2003 and 2007.
Research in Alaska has shown that
capital depreciation of transport,
water, and sewage infrastructure
could increase by 1020 percent
by 2030 due to climate change.
The 20078 droughts in Australiacontributed to global wheat-price
hikes of up to 85%. By 2030, up
to 20% more drought months are
projected over most of Australia.
Change in Winter Cyclone Strengths
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X EXECUTIVE SUMMARY
THE NEED FOR INSTITUTIONAL RESPONSESMany nancial institutions, including IFIs, members o the United
Nations Environment Programme Finance Initiative (UNEP FI), and the
Equator Banks, have environmental and social goals associated with their
investments as do the major companies in which they invest. I changing
climate impacts are not taken into account, rates o noncompliance with
environmental and social standards may increase. Using only historical
data in environmental and social impact assessments is likely to disregard
material changes that occur during a projects liecycle, and investments
designed on the basis o such data may not be able to cope with new
climate conditions.
As a result, mitigation measures in environmental and social management
plans may not unction as intended. For example, the Indian states o
Rajasthan, Punjab, and Haryana have seen a net loss o more than 100
cubic kilometers o groundwater between 2002 and 2008, exacerbated
by increased crop irrigation (Rodell, Velicogna, and Famiglietti 2009).
Water-intensive industries in these and other water-stressed areas that ail
to consider the interactions between climate change, water supply, and
demand could put community livelihoods under greater pressure.
For institutions with a development mandate, ailure to take climate
change risks into account in investments may result in a deterioration
o development perormance, with all the components o developmentpossibly aected: nancial outcomes, economic, environmental, and
social improvements, and overall public- or private-sector development.
As recognized by the World Bank Group, Let unmanaged, climate
change will reverse development progress and compromise the well-
being o current and uture generations (World Bank 2009b).
The objectives o institutional investors, such as pension unds, include
creation o sustained revenues over a long period o time. Clearly, given
this long-term perspective, institutional investors need to be particularly
aware o growing risks to their investments in climatically sensitive sectors
or regions. The size o investments and the need or diversication make
many institutional investors universal owners whose success is dependentnot on the perormance o individual investments or sectors but on
the long-term perormance o the global economy. As already noted,
unmitigated climate impacts may aect economies o whole countries
and refect negatively on the universal portfolio.
Left unmanaged, climate
change will reverse development
progress and compromise the
well-being of current and future
generations.
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XIEXECUTIVE SUMMARY
Some legal advisers are beginning to acknowledge that there is nowsucient inormation available on climate change or it to be taken into
account in both strategic and operational decision making. This means
that climate change may be close to attaining legal signicance
in court. Indeed, recent cases have demonstrated the willingness o
courts and planning tribunals in Australia to accept evidence o climate
change risks related to planning decisions. I climate change impacts are
considered reasonably oreseeable by a court, decisions that do not
take these impacts into account may incur liability in negligence. Further,
some institutions may be alling short o inormation about climate their
duciary duties i they ail to assess and manage climate risks, especially
where long-term value creation is part o their mandate.
Reputational risks increase when there is a perception that an institution
has allen short o its stakeholders expectations. With the rapid evolution
o evidence about the impacts o climate change, expectations are
growing that these issues should be addressed. For example, a new
investment that is heavily reliant on water resources, in a region where
existing studies show uture decreasing water availability, may ace
considerable scrutiny. I it cannot demonstrate that it will not adversely
impact uture water availability or local environments and communities,
or or that matter uture water availability or the investments adequate
perormance, the sponsors reputation may suer, along with those o
its investors. Even i the impacts occur only ater investors have exited,
reputation may be an issue i at the moment o investment there wassucient inormation about potential risks and these were not addressed.
The increasing amount of
information about climate change
impacts is raising stakeholder
expectations about institutional
responses.
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XI I EXECUTIVE SUMMARY
CONCLUSIONS AND NEXT STEPSThis report demonstrates that climate change and its impacts are likely
to alter a number o conditions that are material to the objectives o
nancial institutions. I changing conditions are not actively managed,
investments and institutions may underperorm.
Most investments will be channeled through nancial institutions. Given
that the main eects o climate change are now well established, there is
a considerable opportunity, as well as a responsibility, or these institutions
to take a leading role in adaptation to climate change. Institutions
managing investments in long-lived assets have both a direct nancial risk
to consider and the opportunity to create value by working proactively
with their clients and other stakeholders to take steps to manage the
risks.
Each institution has specic objectives and procedures, and so approaches
to assessing and managing changing climate risks will vary. Many o the
risks highlighted here may already be part o institutions standard risk-
management processes. Rather than creating new instruments or climate-
related risks, the challenge or nancial institutions and companies will be
integrating investment-relevant inormation into existing procedures.
Several developmental and commercial nancial institutions are already
taking steps toward these goals. International Finance CorporationsClimate Risk Pilot Program has produced initial case studies that assess
approaches to real-sector climate risk and adaptation, in addition to the
present analysis o risks to nancial institutions. Going orward, IFC will
initiate the development o more general tools addressing climate risks
and investments.
There is a considerable
opportunity, as well as a
responsibility, for nancial
institutions to take a leading role
in adaptation to climate change.
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1NAVIGATING THIS REPORT
NAVIGATING THIS REPORT
References67
References117
Introduction7
6
WaterQuality
,Pollution
Control,andDi
scharges78
EnergyReliab
ilityand
Security83
AssetDesign
84
SupplyChain
86
SiteandGroun
dConditions88
HumanHealthandSa
ety89
Markets92
Communities9
3
AirEmissionsa
ndSolidWaste
Management9
6
EcosystemSer
vices98
Sector-Specifc
Risks100
CreditandFin
ancialRisks5
StrategicRisks2
9
OperationalR
isk56
LegalRisk59
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2 CLIMATE RISKS IN THE CONTEXT OF OVERALL RISK MANAGEMENT
Climate Risks in theContext o Overall RiskManagement
In making investments, institutions
assume various kinds o risks, including
credit risk, fnancial risk, strategic risk,
and operational risk. I climate change
is not considered, management o these
risks may become more difcult, and
the attainment o institutional goals
may be impacted.
Part I o this report discusses these
issues urther. Section 2 addresses
credit risk as a component o
investment appraisal and demonstrates
how the credit and fnancial risks rom
a changing climate may be relevant
to investment institutions. Credit
risk is defned by many fnancial
institutions as the potential reduction
in value o on- and o-balance-sheetassets due to a deterioration in the
credit profle o an institutions clients,
the countries in which it invests, or a
fnancial counterparty. Both investment
and treasury activities are at risk o
climate changeinduced degradation in
creditworthiness.
Financial risk relates to reducedliquidity available to meet an
institutions obligations to disburse
unds because o a loss in the value
o its investments or other assets, its
potential inability to access unding at a
reasonable cost, and the deterioration
in value o fnancial instruments
because o market changes.
Section 3 analyzes how climate
change may interact with an investment
institutions strategic risks, which
include the potential developmental,
environmental, social and reputational
consequences o ailure to achieve its
strategic mission and, in particular,
sustainable development goals.
The management o these risks is
crucial to institutions ability to brand
themselves as trusted partners or
uture collaboration. Indeed, building
enduring partnerships with emergingmarket players is another key strategic
issue or investors and can particularly
impact the ability o developmental
fnancial institutions to achieve good
development outcomes.
Section 4 discusses how climatechange could aect institutions
operational risk. Operational risk
includes the potential or loss resulting
rom events involving people, systems,
and processes. These include both
internal and external events.
Section 5 discusses the legal risks
that may result rom a fnancial
institutions ailure to manage adverse
environmental or social impacts, or
to meet its legal, fduciary, or agency
responsibilities.
Part II o this report reviews a range
o cross-cutting risks that can aect
the perormance o many investment
sectors. It also provides additional
evidence on climate change risks
or fve climatically sensitive sectors:
agribusiness, water, electric power,
transport, and oil, gas, and mining.
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3PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Part IClimate Risk andFinancial Institutions
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4 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
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5PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
CREDIT AND FINANCIAL RISKS
Climate change will not necessarily
aect the fnancial perormance o
all investments. However, it is likely
that it will aect some, and certain
investments may ace signifcant risks.
The signifcance o the impacts o
climate change on investment bottom
lines depends on a combination o
actors: the climatic sensitivity o the
business (which depends on the nature
o its operations), its location (which
determines its exposure to climatic
events), and the management practices
it has in place. Additionally, there is
a nonstatic, temporal dimension to
climatic events. These elements in
the context o a companys suppliers,
partners, competitors, distributors,
communities, and customers also
determine the companys vulnerabilityto indirect risks.
By way o example, semiconductor
companies consume large amounts
o pure water. They are thereore
sensitive to climate change impacts
on water availability and quality,
insoar as an interruption to water
supply or a reduction in water quality
would translate into revenue losses
or increased operational costs (see
Section.). This sensitivity translates
into a risk when such companies
are located in areas where water is
scarce and water runo is projected
to decrease. When appropriate risk
management practices are in place,
the costs o climate change can be
signifcantly reduced.
Overview
Investment institutions credit
and fnancial risk may be aected
through a combination o direct
and indirect impacts:
Climate change will call into
question the way institutions
currently manage climate and
weather risks.
Changes in climate and their
impacts on socioeconomic
conditions will change some o
the parameters and methods
institutions use to develop
fnancial projections and evaluate
credit risks or their uture
investments.
These climate change impacts
have potential consequences or
corporate fnancial and creditperormance.
The report analyzes in more depth risks
and eects on instruments related
to project fnance, and perormance
o real sector investments. However,
similar implications will be applicable
to a number o other fnancial
instruments.
For debt fnancing, or example, a
relevant actor or repayment is how
projected annual variability in cash
ow is correlated with climatic actors.
Any long-term climate trends over an
investments lietime will superimpose
on preexisting variability, so that
minimum and maximum cash ow
values may change over time. For
example, understanding the correlation
o seasonal rainall and temperature
with river ows and a hydropower
plants output may be important to
determining the most appropriate debt
structure and repayment schedule or
that plant. Debt repayment could be
structured according to years o most
reliable and/or highest income and
adjusted to years o less reliable and/ordecreased income.
For equity investments, climate
change trends over the investment
lietime that may result in changes in
stock valuation may be most relevant
or projecting returns on equity and
planning exit strategies. Several
eatures o equity investments suggest
that they might, in general, be more
exposed to climate risks than debtinvestments are:
Equity repayment relies on the
realization o an exit strategy and
on the companys market value at
that time. Since equity investments
oten have longer terms than
debt, they are likely to be more
aected as climate risks intensiy.
Awareness o climate risks is
quickly growing among investors,
and it will become increasingly
difcult to exit successully rom
investments that are not climate-
resilient.
Equity investors normally
rank behind credit lenders in
liquidation.
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6 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Equity investments are intendedto deliver a higher return overall,
which strongly depends on
managements quality and
ability to create value. Generally,
management capabilities around
climate risks are currently very low.
Box 1. Examples of Business Sensitivity and Business Risk in
the Context of Climate Change Impacts on Water and
Energy
Many industry sectors have critical logistics or operations or which even a short-termdisruption in water or energy supply creates signifcant losses and lower revenues. Forexample, semiconductor production requires large amounts o clean water to createand clean silicon waers: to make a single 200 mm waer, a typical semiconductorplant requires 7.5 m3 o ultrapure water.
It has been estimated or Intel and Texas Instruments that a shutdown o a actory ora delay in construction because o water unavailability or contamination could resultin $100$200 million in lost revenue during a quarter or a reduction in earnings pershare o $0.02$0.04, depending on which products were delayed. Semiconductor
manuacturing companies in countries where climate change may reduce wateravailability or quality (e.g., China and Bulgaria) ace additional business risks.
Signifcant costs as a result o power disruption can also occur or companies workingin cement, steel and other metals, and glass, where shutdown can lead to losses inmaterials. For example, a shutdown o power in a steel refnery or more than a ewhours can mean that the urnace has to be dynamited.
A urther example o the costs o supply disruption relates to drought-inducedelectricity rationing in Brazil. In 2001, the rains did not come, and reservoir levels wereat 30 percent o storage capacity. The eects o this drought, aggravated by decisionsin the energy sector, meant that the government had to take severe measures toration electricity. According to the U.S. Department o Energy, the governments aimwas to reduce electricity consumption by 1035 percent, based on the level o added
value o the industry and the number o jobs aected. The usage reduction quotasaected some industry sectors more than others; those that did not comply werefned or eventually had their power supply cut o .
One group that was particularly aected was private electricity generation companies,such as AES Tiete, which has 10 hydropower plants in So Paulo State with acombined generating capacity o 2,650 MW. According to the director o AES Tiete,Mr. Barbosa da Silva, the companys assets were aected by the rationing. In 2000,AES Tiete Holdings had closed a $300 million 15-year bond oering at 11.5 percent,but due to the rationing in 2001, the bond payment schedule had to be postponed.Though AES Tiete had cut costs dramatically in order to be able to pay dividends, thesituation was too extreme. Since the company had insurance coverage rom the U.S.Overseas Private Investment Corporation, it was able to negotiate a new paymentschedule with the bondholders at the end o 2003.
The impact o Brazils electricity rationing was national: it is estimated that thedrought led to a loss o approximately $20 billion, the equivalent o about 2 percent oBrazils GDP. This is evidence o the potential impacts o climate change on investmentcountry risk.
Sources: Klusewitz and McVeigh 2002; Morrison et al. 2009; Levinson, Klop, and Wellington2008; Cashmore et al. 2006; UNEP Finance Initiative 2005
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7PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Because climate change may impactthe credit profle o clients, it may
have consequences or the returns o
investment institutions structured
products. For example, partial credit
guarantees (whereby an institution
promises ull and timely debt service
repayment up to a predetermined
amount, irrespective o the cause
o deault) agreed by an institution
to the beneft o investments that
are vulnerable to a climate-induceddeterioration in their fnancial capacity
may become less proftable as deault
probability increases throughout the
lives o the guaranteed instruments.
When an institution agrees to a
risk-sharing acility, it may incur
increased and/or unpredicted credit
risks or the pool o assets it guarantees
in cases where the underlying client
is in deault as a result o unmanagedclimate risks. For example, i the
institution guarantees a bank portolio
o loans to armers in an area severely
aected by water scarcity, it may
have to cover higher losses than
expected because o increased rates
o loan deault to the lending bank
as a consequence o decreased crop
production.
Management oPresent-Day Climateand Weather Risks inInvestment Appraisal
Few investment institutions are
incorporating consideration o present-
day climate and weather risks into
their investment appraisals, using
historical data on climate trends and
sector perormance. Many types o
investments have a strong intrinsicsensitivity to climatic conditions,
including natural resourcebased
investments (e.g., in agribusiness or
hydropower), as well as investments
with industrial processes requiring
water or processing, cooling, or steam
generation (e.g., in mining and power-
generation acilities). In those cases,
the impact o past climate variability on
perormance is an element to consider
at the investment appraisal stage.
However, in a changing climate,
relying on historical climate data
to make projections o fnancial
perormance is more likely to result
in ailure than using orward-looking
estimates incorporating climate
change projections. This is because the
seasonality, intensity, and requency o
weather patterns is changing and will
continue to change in the uture.
Consequently, relying solely onbackward-looking climate inormation
to build fnancial and credit projections
may be inadequate.
For example, agribusiness investments
are oten appraised on the basis o
comparisons o observed weather
records, climate trends, and geological
and environmental conditions with
crop suitability data. Agribusiness
clients usually have observed weather
data and understand the links
between weather patterns and output.
However, risk margins used to assess
the sensitivity o fnancial projections
or agribusiness investments may be
inadequate to reect climate change
impacts, as they are oten more
concerned with unit production costs
and how these compare to long-term
average market prices. These prices
are typically assessed using marketdata rom the previous fve years.
Using such short records means that
the inuences o past climatic events,
such as recurrent droughts, may not be
picked up, even though these may have
aected prices and the perormance o
past investments.
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8 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Financial and CreditRisk Analysis
At most investment institutions,
proposed investments undergo a
thorough appraisal that includes a
fnancial and credit analysis based on
assumptions about uture investment
perormance and creditworthiness.
The results o the joint fnancial and
credit analysis are used to decide
on pricing and to structure deals in
the most optimal way. Financial and
credit indicators are then monitored
throughout the lietime o the
investment.
The set o established conditions and
assumptions upon which fnancial
projections are built aims to represent
investments perormance throughout
their lietimes. Examples o how climate
change may aect some o
the assumptions upon which fnancialanalysis rests are numerous. The key
areas o climate impact are:
Market conditions and demand,
Efciency, output, and
perormance o assets and
equipment,
Operating costs,
Maintenance costs,
Insurance costs Costs to maintain sta health,
saety, and productivity,
Compensation or damage,
Additional capital expenditure,
Asset depreciation rates,
Loss contingencies, and
Country credit risk.
Each o these issues is briey discussed
in turn overlea, illuminated by casestudies.
Market conditions (or supply anddemand) can be a key determinant o
uture prices. Demand can be sensitive
to climate actors and the supply o
certain commodities is vulnerable to
climatic conditions
(see Box 2). Future climate-related
changes in short- and long-term
average prices may, in turn, aect the
competitiveness o investments.
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9PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Box 2. Market Risk and Opportunity: Impacts of Climate Change on Seasonal Energy Demand and
Market Prices for Agricultural Commodities
While uture energy demand and market prices or agricultural commodities are heavily inuenced by socio-economic actors, theywill also be aected by climate change. For energy, rising temperatures due to climate change will decrease winter heating demandand increase demand or cooling in summer. Extreme climate events can inuence supply and demand or agricultural products, andhence commodity prices. Recent recurrent droughts have aected agricultural output in Australia, leading to increased world priceso key commodities.
Warmer winters are already having signifcant e ects on the fnancial perormance o oil and gas companies. Due to warm weather,or example, KeySpan Energy Delivery in the United States (now National Grid) reported a decrease o 19 percent in its natural gassales in Massachusetts and New Hampshire between October 1 and December 30, 2006, compared to its orecasts. As a result, itsnet gas revenues were $51.8 million lower in 2006 than in 2005.
In Russia, it is estimated that a 2C temperature increase will decrease ossil uel demand by 510 percent and electricity demandby 13 percent. Winter heating demand in Hungary and Romania is expected to decrease in warmer winters by 68 percent bythe period 202150. Worldwide, while demand or space cooling is currently lower than or space heating, it is growing rapidly inboth high-income and emerging economies. Over the coming decades, research indicates that energy demand or residential airconditioning will increase most rapidly in South Asia, as the climate warms.
For agricultural commodities, the Organisation or Economic Co-operation and Development (OECD) and the Food and AgricultureOrganization (FAO) noted that Australian droughts were a actor in the sharp commodity price spikes witnessed between 2006 and2008.Various reasons have been put orward or the crisis, including the direct impacts o climate change on crop production whichare considered to have made a slight contribution.
The fgure below shows Australian production o wheat, grains, dairy, and oilseeds showing how drought in the Australian wheatbelt signifcantly reduced production in 20023, 20067, and 20078. According to the latest climate change projections orAustralia, up to 20 percent more drought months are predicted over most o the country by 2030, so commodity price uctuations
will likely occur more oten in the uture.
Additionally, increased ood prices driven by climatic actors may aect general price ination, with ood being a large component othe consumer price index (CPI) (an indicator o ination) in many countries.
Australian production (Mt) of wheat, grains (left axis), diary and oilseeds (right axis)
Sources: KeySpan Energy Delivery annual report, 2006; Kirkinen et al. 2005; Vajda et al, 2004; Islami 2009; Cartalis et al. 2001; Isaac and van Vuuren2009; CSIRO and Australian Bureau o Meteorology 2007; OECD/FAO 2008; Gregory and Ingram 2009; Wight and Laan 2008(source o fgure)
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10 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Efciency,output, andperormance o assets and
equipment may decrease due to
changing climate conditions, with
consequences or revenue. Outputmay change due to changes in long-
term average conditions or because o
increased incidence o extreme events,
such as droughts, tropical storms, andheat waves (see Box 3).
Box 3. Climate Change May Reduce Output of Hydropower Plants, Decrease Productivity and
Output for Some Crops and Lead to Revenue Losses
Reduced output from hydropower plants
Renewable energy investments are vulnerable to climate change, because the availability and reliability o renewable energy sourcesare a unction o climate conditions. In Brazil, where hydroelectric power accounted or 83 percent o power generation in 2006,uture changes in rainall are anticipated to lead to decreases in river ows, aecting river basins. Recent research ound that undercertain greenhouse gas emissions scenarios, average annual ows in some rivers may decrease by more than 10 percent by 2035.As a consequence, it is estimated that average power production would decrease by up to 7.7 percent or the worst case (the SoFrancisco Basin). Across Brazil as a whole, guaranteed (frm) power output is projected to decrease by 1.63.2 percent.
Decreased crop productivity
In the near to medium term, the productivity o some crops is expected to be aected by climate change. For some crops, projectionsrange rom substantially negative to positive, depending on location (see fgure below). The fgure shows large ranges or the 25thand 75th percentile projections or some crops (shown by the colored bars) due to uncer tainties about uture precipitation changes.For other crops the range o projections is much smaller. In the longer term, the impacts o climate change on global crop productivitymay signifcantly aect proftable agricultural investments. There will be dierent levels o agricultural output exposure: Russia,European and Central Asian countries, parts o China, and Argentina may present more avorable conditions or agricultural output inthe uture, whereas many countries in Arica, South America, and South Asia may see losses in agricultural output.
Probabilistic Projections of Production Impacts in 2030 from Climate Change (% of 19982002 average yields)
Southern Africa Brazil Andean region Central America andCaribbean
Note: Bars extend to the 25th and 75th percentile projections; the middle vertical line within each box represents the median projection. Dashedbars extend to the 5th and 95th percentile projections. Red, orange, and yellow symbolize very important, important, and less important hunger
importance rankings (HIR), respectively. The HIR categorise crops according to their share in the average calorie intake o a malnourished population(based on data rom the FAO).
Performance losses for telecommunications companies in China
The most severe snowstorms in China in 50 years caused massive power blackouts in the winter o 2007/8, costing Chinesetelecommunication providers at least $152.8 billion in missed revenue during the frms peak business season. Operations at 24,000telecommunications base stations were disrupted by the snowstorms, leading 14,000 o the stations to run on makeshit dieselgenerators to provide a basic service. The other 10,000 stations were completely shut down. In addition, 150,000 telephone polescollapsed and 16,000 kilometers o wires had been damaged by February 2008.
Sources: Pereira de Lucena et al. 2009; Lobell et al. 2008 (source o fgure); Wai-yin Kwok 2008
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11PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Operating costs (OPEX) may increasedue to changes in the price, availability,
or quality o inputs (see Box 4).
Box 4. Operating Costs May Increase as a Result of Climate
Change
Increased operating costs due to power cuts in Ghana
Power cuts began in August 2006 in Ghana when low water levels were registeredat Lake Volta, as the country relies on hydropower acilities or about 60 percent oits power. The Volta River Authority was orced to ration power supplies on a scalenot seen since 1983. The cr isis damaged the revenues o many o Ghanas smalland medium-size businesses. It also led to increases in operating costs or miningcompanies in Ghana and threatened mine closures. New mines had to be redesigned.As a result o energy disruptions, our mining companies collaborated to build a new80 MW dual-uel thermal power plant at an estimated cost o $45.5 million to ensureenergy security. While there is uncertainty about how rainall in Ghana will changein the uture due to climate change, rising temperatures are projected with highconfdence. This will lead to more evaporation rom Lake Volta and may increase riskso power shortages in the uture, unless adaptation actions are undertaken.
Increased commodity prices
World prices or various crops and livestock are projected to rise due to climatechange. This will result in increased input costs or agribusinesses, retailers, FastMoving Consumer Goods (FMCG) companies, and armers. The graphs below showworld prices or various crops (top graph) and livestock (bottom graph) in 2000 and2050. Three projected prices or 2050 are given: without climate change (blue bar);using the US National Centre or Atmospheric Research (NCAR) climate model (orangebar); and using the Australian Commonwealth Scientifc and Industrial ResearchOrganisation (CSIRO) climate model (horizontally-gridded bar) (excluding the eectso carbon ertilization (CF)). The 2050 no climate change prices are higher than 2000
prices due to drivers such as population and income growth, and biouel demand.
World prices of major grains and livestock products
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12 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Maintenance costs may increase as
a result o climatic stresses (see Box 5). Box 5. Increased Maintenance Costs for Railways
Heavy rainfall causing landslides in India
The proft and loss account o the newly built 760 kilometer Konkan Railway in India (KRCL)shows that 6 percent o the annual budget is spent on repair and maintenance. Out o thetotal repair and maintenance budget, close to 70% goes towards permanent ways, bridgesand tunnels. According to the estimates o ofcials at KRCL, about 20% o this expenditureis used in addressing climate-related impacts, such as rain-induced landslides. Thisamounts to roughly $1 million spent annually. Operations are suspended or an average oseven days each rainy season due to such damage. Future climate change, such as moreextreme rainall events, could increase expenditure on repair and maintenance activities.
Sea level rise increasing maintenance costs for primary rail line in the UK
A section o railway on the main line rom London to Penzance in the UK is subject totemporary speed restrictions and repeated closures at Dawlish, due to its proximity to thesea. Sea level rise will result in more requent overtopping and make speed restrictionsand line closures more requent. There has already been an estimated 450mm rise in sealevels since the sea wall was built in the mid-nineteenth century.
Recent research assessing the sec tions o coast along which the train line runs indicatedthat the area was subject to an increase in the 1 in 100 year wave height o up to 9% inthe 2020s, a corresponding increase in wave energy o up to 18%, and an increase in the1 in 100 year wave height o up to 25% by the 2080s. As a result, disruptions rom waveovertopping are projected to increase in the uture, as shown below.
Projected percentage increase in future overtopping at Dawlishcompared to 1961-90 baseline climate
The owner and operator o the rail lines, Network Rail, spends signifcant amounts omoney to maintain the line rom London to Penzance. I t recently spent 9 million inengineering works, and a rapid response team is kept on constant guard. Maintenance orthe most aected section at Dawlish currently runs at 500,000 year. With rising sea levelsthese costs can be expected to increase over time. Network Rail is planning to invest inmoving the line all together in 2050.
Heavy rains damage transportation infrastructure in Tanzania
Flooding in the central Dodoma and Morogoro regions o Tanzania aected at least 28,000people in late December 2009 and January 2010. In January, President Jakaya Kikwete saidthat two weeks o El Niorelated rains had caused damage to the central railway line androads in the regions that would cost an estimated $4.8 million to repair. This money wouldhave to come rom government unds previously allocated to development, meaning thatthe countrys development plans would have to be postponed or abandoned, accordingto the president. The rainy season in Tanzania lasts until the end o May, meaning thatadditional ooding and diversion o government unds to emergency response couldpotentially continue or several months ater this episode.
Sources: IIM 2003; RSSB 2008; Mckie 2006 Tanzania: Floods Aect 28,000 in Central Regions,January 21, 2010, allArica.com, http://allarica.com/stories/201001210613.html(accessed March 24, 2010).
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13PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Insurance costs may also increase,
and in some cases, insurance may
become unavailable (see Box 6).
Box 6. Insurance Costs Rise in Hurricane-Prone Areas andInsurance May Become Unavailable in Future in Some
Locations
Owners o oil rigs and oshore platorms in the Gul o Mexico have been hit hard byincreasingly scarce and expensive insurance coverage due to heavy asset damage bywindstorms and hurricanes over the past ew years. As a result, in 2009, many ownersdropped coverage and began sel-insuring, absorbing the risk o a high-impact hurricaneseason themselves. Major losses in 2008, especially rom Hurr icanes Ike and Gustav,signifcantly drove up prices or insurance coverage in 2009.
As sea surace temperatures (SST) increase due to climate change, asset owners willace a greater risk o more intense and more requent hurricanes in the Gul o Mexico.According to recent research, hurricane requency is highly sensitive to increased SST: a
0.5oC increase in AugustSeptember SST in the North Atlantic (where hurricanes that hitthe Gul o Mexico originate) could lead to a 40 percent increase in requency. Warmerseas also tend to lead to more intense hurricanes. This means that insurance prices couldcontinue to rise, as more intense hurricanes generally wreak greater damage on assets(see fgure).
Change in Winter Cyclone Strengths:Total Number of Events (left) and Number of Intense Events
Source: Lambert, S.J., and J.C. Fye, (2006)
One way or insurers to limit their exposure to high risk areas is to completely abandonthe market. This has already been observed in the Gul region in the United States.In 2004, The US insurer Allstate stopped writing commercial insurance policies inFlorida and decided not to renew 95,000 residential homeowner policies because othe our hurricanes that hit Florida in that year. The company has stated that climatechange has prompted it to cancel or not renew policies in many Gul Coast states, with
recent hurricanes wiping out all o the profts it had garnered in 75 years o sellinghomeowners insurance.
In 2008, State FarmFloridas largest private insurerstopped writing new policies inthe state. This was a ter suspending sales o new commercial and homeowners policiesin Mississippi the year beore.
Sources: Emanuel et al. (fgure); Environmental Deense 2007; Conley 2007; Garcia and Benn 2008;Mills et al. 2006
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14 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Sta health, saety, andproductivity are likely to be impacted
by climate change and this may lead to
increased expenses (see Box 7).
Box 7. High Temperatures in Buildings and Reduced Worker
Productivity
Although perceptions o temperature vary rom individual to individual, most peoplebegin to eel uncomortable between 77F (25C) and 82F (28C). Research in theU.K., or example, considered that buildings which had reached a temperature o 28Cor above, or more than 1 percent o their occupied hours, had overheated (seetable below). Higher temperatures can have consequences or workers morale andproductivity and very extreme temperatures can result in potentially atal heat stress.
Temperature Thresholds in Buildings with Personnel
Warm temperaturethreshold: 25C (77F)
Hot temperaturethreshold: 28C (82F)
Thresholdsfor thermaldiscomfort
Building has overheated i it is hot or more than 1%o occupied hours.
Heat stress risk Indoor temperature above 35C (95F) or healthy adultsat 50% relative humidity.
Note: Temperature thresholds or workers health and saety depend on air humidity.
Projections o higher temperatures due to climate change will translate into increasedrequency o overheating. The fgure below shows that in some U.K. locations, somekinds o ofce buildings already overheat, while in others, this will only be an issuemany years rom now.
Change in Percentage of Hours During Which 1960s Ofce Buildings AreOverheated Under a Changing Climate for Three Cities in the United Kingdom
Note: Temperatures are or middle oors in buildings. Overheated indicates that the thresholdor hot temperature is exceeded.
Warmer temperatures and more requent heat waves will lead to increased energyuse or cooling, possibly osetting decreases in space heating during colder months.Buildings that were not designed to cope with higher temperatures may need to beretroftted to reduce cooling costs.
Sources: Shaw et al. 2007; (fgure) Hacker et al. 2005
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15PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Compensation or damage mayresult in increased expenses because
o climate changeinduced incidents
(see Box 8.) or legal ees to deend
against climate changeinduced tort or
contractual claims.
Box 8. Class Action Launched by Australian Wildre Survivors
Against an Electricity Distribution Company
The largest class action in the history o the Australian state o Victoria commencedat the Supreme Court o Victoria in February 2009 against electricity distributioncompany SP AusNet and the Brumby government, in relation to a wildfre at K ilmoreEast, Victoria. During a period o extreme heat, high winds, and prolonged drought insouthern Australia, a power line may have allen and sparked a fre that caused seriousdamage to local communities and resulted in several atalities.
SP AusNet is a wholly owned subsidiary o Singapore Power Limited and is responsibleor maintaining most o the power transmission lines in Eastern Victoria. The classaction ocused on alleged negligence by SP AusNet in its management o theelectricity inrastructure. The plaintis include thousands o armers, as well as small
business owners, tourism operators, and residents who lost their homes.
Immediately ater the lawsuit was fled, SP AusNet shares dropped by more than 13percent.
The Insurance Council o Australia estimated the cost o the bush fres at about $A500 million. SP AusNets legal liability is limited at $A100 million under an agreementmade by the ormer Kennett government with private utility operators, when the StateElectricity Commission was privatized in 1995. As a result, the Brumby governmentcould be legally obligated to pay damages amounting to hundreds o millions odollars.
In addition to acing the class act ion, SP AusNet is dealing with damage to some o itselectricity assets by the Victoria wildfre. As a preliminary estimate, it is thought that
damage has been sustained to approximately one per cent o SP AusNets electricitydistribution network, mainly distribution poles, associated conductors and pole toptransormers, SP AusNet said in a statement to the Australian Securities Exchange.
According to the latest climate change projections or Australia, up to 20 percentmore drought months are predicted over most o the country by 2030, and hightemperatures will become much more common.
Source: Arique en ligne 2009
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16 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Additional capital expenditure
(CAPEX) may be required as a result
o asset damage or decreased asset
perormance (see Box 9). Further,
complying with environmental
regulations may require additional
CAPEX to upgrade acilities or
equipment to cope with increased
pollution risks.
Box 9. Additional CAPEX Expenditure for Transport
Infrastructure due to Climate ChangeIncreased CAPEX to reduce the impact of permafrost thaw on the Tibetan Plateau
On the Tibetan Plateau, warming o the climate is already occurring, and the decreasingdepth o rozen soils threatens the stability o the $4.2 billion railway line connectingLhasa, Tibet, to the Chinese network in Qinghai, China, known as the highest railwayin the world.
The railway is built on warm permarost (defned as being warmer than 1.5C), with amean annual ground temperature ranging rom 0C to 1C. Monitoring confrmed thatthe soil under the rails is vulnerable: warm permarost is very sensitive to disturbancesrom engineering activities, which have an immediate and direct impact on its warmthand moisture regimes.
Permarost on the Tibetan Plateau has warmed by about 0.3oC over the past 30 years.Where human activity, such the construc tion o the railway, has disturbed the soil theincrease in temperature is doubleabout 0.6oC. The area o the Southern QinghaiTibet Highway with underlying permarost decreased by 36 percent between 1974 and1996, while the permarost area o the Northern QinghaiTibet Highway decreased by12 percent between 1975 and 2003. Research indicates that the permarost area on theplateau may be reduced by up to about 60 percent by midcentury.
To manage the impacts o the changing climate, engineering techniques were used tostabilize the ground by keeping it rozen well below 0C. At the design stage, the use othis cooling technique added costs representing 1 percent o total project expenditures.As the railway was built to withstand temperature increases o about 0.2C and 2Cor soil and air, respectively, over the next 50 years, i the Intergovernmental Panel onClimate Change (IPCC) higher-end projections o around 2C3C increase in annual
average air temperatures in the region by 2050 are realized, additional CAPEX may beneeded to ensure that the railway can continue to operate.
Higher and more frequent peak temperatures may restrict air transportation,unless runways are lengthened
Air temperature and air humidity are among the actors used to calculate densityaltitude (the air density at a certain altitude). This measurement determines both aircratcombustion efciency and the runway length needed or takeo and landing.
Both air temperature and humidity will be aected by uture climate change and arenegatively correlated with air density. In the uture, higher temperatures and potentialincreases in humidity will reduce air density and aircrat lit, requiring either longerrunways at specifed aircrat loads or a reduction o aircrat cargo. For example, a U.S.Department o Transportation report rom 2008 states that or aircrats that use up tomost o the pavement on even the longest runways, even a 1 or 2% increase in densityaltitude may put those aircrat out o commission or daytime operations on certaindays.
Adaptation to this climate change impact may include shiting ight schedules to earlymorning or evening, when the air is cooler, or making runways longer, with consequentCAPEX. However, retroftting may not always be possible: in the case o airportsconstrained in size by their surrounding environment the CAPEX needed to adjust thelength o runways to accommodate uture climatic conditions may be prohibitive.
Sources: Cheng et al. 2008; Cheng 2005; UNEP 2007; Wu et al. 2007; Miao 2009; IPCC 2007; Kar l etal. 2009; NRC 2008
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Asset depreciation rates may
increase. Although the rates currently
used or accounting purposes may
reect historic experience, the eective
depreciation o assets due to climate
change may be considerably aster.
Consequently, fnancial models may
overestimate the real useul lives and
value o physical assets (see Box
10). Faster capital depreciation could
mean that assets need replacing
more requently, negatively aecting
projected cash ows.
Box 10. Infrastructure and Assets Wear Out More Quickly
and Require Additional Capital Expenditure under aChanging Climate
Wear and tear on assets and inrastruc ture will increase due to climate change.Research in Alaska has estimated the additional impact o climate change on capitaldepreciation or the states inrastructure by calculating the baseline replacementcosts or public inrastructure based on documented lie spans o various assetclasses and standard fnancial techniques or calculating depreciation, and applyingannual engineering depreciation rates or percentage changes in temperature andprecipitation, based on asset class, topography, and proximity to oodplains.
The study investigated two scenarios. In the frst, adaptation is undertaken whenclimate change leads to a loss in useul asset lie o 20 percent or more, with anadditional associated cost o 5 percent, and allowing ull asset lie to be regained.Under the second scenario, without adaptation, public agencies simply react asclimatic conditions change: they continue to design and construct inrastructure takinginto account historical climatic conditions but not projected changes.
The study ound that, under the with adaptation scenario, climate change will add$3.6$6.1 billion (NPV, using a public sector discount rate o 2.85 percent per year) tothe costs o wear and tear between 2006 and 2030, across a range o climate changeprojections. These fgures equate to 915 percent o total asset value or a 1020percent increase in wear and tear costs (see fgure below). Without adaptation, thecosts o climate change are in the range $3.6$7 billion between 2006 and 2030.
Range of Additional Infrastructure Costs for Alaskan Assets, Medium Scenariowith Climate Change Adaptation, 2006-2030 (top) and 2006-2080 (bottom)
($ billions, NPV)
Capital depreciation due to climate change is context-specifc. In the case oinrastructure in Alaska, the main climate risks aecting wear and tear are thawingpermarost, increased ooding, and coastal erosion. In other parts o the world otherclimate risks will be relevant, such as droughts, wildfres, or snowstorms.
Source: Larsen et al. 2007
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Table 1. Climate Change and the Credit Risk Analysis Process
Phases in the credit riskanalysis process
Climate change risks Examples of impacts on credit risk analysis
Understanding the marketand the project
Obtaining and verifyinginformation
Market conditions may beinuenced by a changing climate.
Assessing an industry cycle andstructure could include looking atthe inuence o climate change onindustry competitiveness, growthprospects, and exports.
For highly climate-sensitiveinvestments, businessperformance indicators suchas fnancial projections and assetvaluations may not be accuratei not inormed both by past andcurrent climate conditions and bythe projected eects o climatechange.
For highly climate-sensitive sectorsor locations, the project sponsorsexperience in managing climate-related risks can be evaluated
as part o their managerialand nancial strengths andweaknesses.
Climate change may aect the comparativemarket performance o the company or project:production costs, sales, value, and growth ooperating margins and net income may all changecompared to competitors who have dierentvulnerabilities to climate, or who may or may notimplement adaptation actions.
Failure to consider the impacts o climate conditionson output may lead to inefcient investment
decisions: decreased output could limit internalcash generation and cause higher deaultprobability in the case o overleveraged companies.
Evidence that management has consideredthe inuence o ENSO on rainall patterns andinvestment perormance can be evidence o goodmanagement. On the other hand, a lack of industryexperience in a management team can lead to thepoor perormance o an investment.
Identifying critical investmentrisks
Performing credit riskanalysis
Among investment risks, climate-change impacts may inuencefnancial capitalization and liquidityrisk, project completion risk,technical and operational risks,market risk, industry risk, andenvironmental and social risk.
In a number o sectors andlocations, and depending on theinvestment time rame considered,
credit risk analysis may besignifcantly colored by climatechange impacts:
EBRD is currently working on integrating climatechange adaptation issues into its due diligenceprocesses (Box 23).
Climate changein particular, reducedrainallmay have signifcant macroeconomicconsequences or developing countries wherea large portion o the economy is dependent onactivities reliant on water resources.
Production could be at risk rom decreased supplyof energy or higher energy prices.
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19PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Table 1. Climate Change and the Credit Risk Analysis Process
Phases in the credit riskanalysis process
Climate change risks Examples of impacts on credit risk analysis
Country riskmay beaggravated by climate changeimpacts on economic stability.
Financial ratios may beinuenced by climate changes,which can lead to violation oloan covenants.
In cases where the investment
relies on climate-sensitiveinputs, estimates o theinuence o climate changeon the availability and priceso these inputs could aectassumptions in the productionrisk analysis.
Company environmentalperormance may be impacted,and additional OPEX or CAPEXmay be required to achievecompliance.
Company social perormance
may also be aected.
Project economic perormanceand return to society may bereduced.
Capital adequacy and fnancialcapacity, which can be aectedby climate change, are keycomponents o analysis o acompany or projects balancesheets and income statements.
For equity investments, climatechange may be an important
element o planning or anexit strategy, as it can partlydetermine the uture growth othe company or project.
Noncompliance with environmental regulationscan also result in dierent orms o liability(contractual, civil, or penal) or the project owner,which may adversely aect cash ow (due to costsincurred), income (due to decreased sales), ormarket capitalization (due to loss o reputation).
Climate change can aect resettlement costsorinstance, the project sponsor may incur extra costsin ensuring that resettled communities have access
to sufcient water resources.
The extent to which an investment provides anet positive contribution to the national economyo a country (economic rate o return) may beinuenced by climate impacts. For example, climate-induced impacts on supply and demand may aectthe generation o tax revenues. In essence, theeconomic rate o return o investments under achanging climate depends on the adequacy o theseinvestments to cope with new climate conditionsand on their ability to increase the adaptive capacityo the communities that they inuence or serve.A climate change-resilient investment may have a
higher economic rate o return.
Changes in climate may aect project cash ows,asset values and the companys ability to accesscapital.
With regard to equity investments, early growthwill not be as aected by a changing climate aswill medium-term growth (ca. 10 years). Futurechanges in climate may have a positive inuenceon growth in some equities, particularly thosewhere management oresees the risks and plansproactively or climate resilience. In other cases, theinuence o climate
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Table 1. Climate Change and the Credit Risk Analysis Process
Phases in the credit riskanalysis process
Climate change risks Examples of impacts on credit risk analysis
Developing nancialprojections
Assessing cash owsensitivity
Analyzing key ratios
Evaluating the investment
The nancial models developedby fnancial ofcers to orecastcompanies ability to service debtand/or generate added value maybe awed i they do not considerthe fnancial consequences o utureclimate conditions.
The ollowing fnancial ratios may be impacted byclimate change:
The debt service coverage ratio may decrease asproject internal cash ows are aected.
The measure of current ratio may be awed, assome assets may be overvalued, not accuratelyrepresenting the companys or projects value atliquidation.
The nancial internal rate of return may decreaseas projections o uture cash ows are reducedbecause o climate-induced OPEX, CAPEX, orrevenue loss.
In the case o equity investments, proftabilityratios estimating uture return on equity may beaected, i the amount o interim payments received(dividends) and, more importantly, the companyslong-term market value is decreased because ochanges in company income.
The discount rates used in cash ow calculationsmay be awed i they do not reect the impacts o
climate change on country and investment risk.
Sensitivity analyses o the best- and worst-caseuture discounted cash ows may not be ullyexploring the range o risks and uncertaintiesregarding company or project perormance. The riskmargins used may be awed.
Mitigating credit risk Mitigating the risk that investeecreditworthiness may deteriorateduring the investment lietimeinvolves taking appropriatemeasures according to the risksidentifed and their probabilities ooccurrence.
Investors mitigation measuresmay be insufcient i they do notidentiy such risks and probabilitiesin the light o climate change.
Covenants based on balance sheets, proftability,or cash ow may be set incorrectly, as the risk odeault may be higher than anticipated.
The terms of the debt may be set incorrectly,as cash ows may not be able to match requiredrepayments, particularly or longer-term loans.
Asset value at liquidation may be reduced, andcosts o maintaining repossessed assets (land,property, or equipment) may increase.
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21PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Table 1. Climate Change and the Credit Risk Analysis Process
Phases in the credit riskanalysis process
Climate change risks Examples of impacts on credit risk analysis
The clients ability to renance may becompromised once awareness o climate risks hasincreased, whereupon the client could becomeless attractive to uture investors, making it moredifcult or a current investor to exit. Other sourceso repayment may also be aected: income rom thesale o assets or equity by clients may be diminishedas climate change aects market values.
The cost oinsurance or clients may increase,
and exclusion clauses may become more onerous.In some locations, or or some risks, cover maycease to be available. As a result, some companiesmay sel-insure, which would require them tomake fnancial provisions to cover uture losses,aecting their fnancial capacity. It should benoted, o course, that insurance does not protectagainst gradual erosion in perormance caused byincremental changes in average cllimate conditions.
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22 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Loss contingencies may need to
increase as the risks o climate change
increase and are better quantifed.
Loss contingencies typically cover risks
that can be exacerbated by climate
change, such as loss o or damage to
property or assets rom fre or other
hazards, or rom pending or threatened
litigation.c They are accrued on clients
income statements or probable losses
or which the amount o loss may be
reasonably estimated. d Other climate-
related risks that may all within the
scope o loss contingencies include
increased risks o pest and disease
outbreaks and o damaging droughts
(see Box 11.). It is possible that in the
uture some o these losses may not be
insurable.
c See IAS (International Accounting Standard)
37, Provisions, Contingent Liabilities andContingent Assets, http://ww w.iasplus.com/standard/ias37.htm (accessed July 29, 2009).
d Loss contingencies are recorded as ootnotesin the balance sheet. Losses that are probableor have a reasonable possibility o occurringshould be disclosed in nancial statements,indicating the nature o the liability and anestimate or range o possible loss. Probablemeans more likely than not, or having agreater than 50 percent chance o occurring.A reasonable possibility o occurring meansmore than a remote chance but less than 50percent. Only remote liabilities do not deservemention in nancial statements. Remotemeans the chance o occurrence is slight.
Box 11. Accounting for the Increased Risks of Fire and Pests and
Diseases in Forest and Plantation Asset ValuesAccounting for re risk in valuing forest plantations
According to its annual report, a orestry plantation in East Arica has a biologicalasset valuation model that calculates air value assuming that 8 percent o theplantation is destroyed by fre every third year. Due to changes in fre risk broughtabout by climate change, such assumptions may prove inaccurate in a ew years time,and uture income projections or orestry investments based on these assumptionsmay be awed. Recent research provides estimates o changes in the areas most proneto fre as a result o climate change, based on the IPCC A2 greenhouse gas emissionsscenario (see fgure).
Projected Changes in the Distribution of Fire-Prone Regions by the 2020s
Forest plantation asset value at risk from pests and diseases
Mountain pine beetle (MPB) inestations have been made worse by the eects oclimate change. In 2007, MPB inestations were recorded in 9.2 million hectares opine orests, and they destroyed millions o pine trees in British Columbia, Canada. Inrecent years, hotter and drier summers in conjunction with milder winters, have ledto the largest MPB outbreak in recorded history. The range o the MPB is currentlyexpanding northward and eastward into new habitats. Modeling has indicated thatavorable climatic conditions have recently increased the area o optimal MPB habitatby more than 75 percent. Anecdotal evidence suggests that a pine beetle inestationgenerally reduces the value o a private woodlot or ranch by about 20 percent.Further, beetle outbreaks also create major fre hazards by clearing large portionso orest. This risk is urther increased as Southeast Canada may also be prone toincreased fre risk as a result o climate change (see fgure above).
Sources: Herbohn and Herbohn 2006; Krawchuk et al. 2009 (fgure); Walker and Sydneysmith2008; Carroll et al. 2003
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24 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
STEPS IN THE FINANCIALAND CREDIT RISKANALYSIS PROCESS
Failure to consider the impacts o a
changing climate outlined above could
mean that investors credit risk analysis
processes are not robust, as climate
change may lead to a decrease in the
creditworthiness o certain investments.
Most fnancial institutions approaches
to credit analysis or debt, equity,
and guarantees have many aspects in
common. The ways that climate change
risks are relevant to phases in a typical
credit risk analysis process are outlined
in Table 1.
Corporate Disclosureand Investment-RiskManagement
It is clear that unmanaged climate
risks could eed through into the three
key fnancial statements o investee
companies: income statements,
balance sheets, and cash-ow
statements. At a company level, the
aggregation o climate risks may result
in decreased capacity to repay debt.
Globally, concerns over climate risks
to companies fnancial perormance
are beginning to drive changes in
regulatory requirements or improved
corporate disclosure:
In 2009, the U.S. NationalAssociation o Insurance
Commissioners adopted a
mandatory requirement that
insurance companies over a
certain size disclose to their state
regulators the fnancial risks they
ace rom climate change, as well
as the actions they are taking
to respond to those risks (NAIC
2009).
In January 2010, the U.S.Securities and Exchange
Commission (SEC) issued new
interpretative guidance on
Disclosure Related to Business or
Legal Developments Regarding
Climate Change to provide clarity
and enhance consistency or public
companies and their investors.
This comes rom the SECs
realization that climate risks may
hold fnancial costs that are notadequately eatured in companies
published statements (U.S. SEC,
2010).
The U.K. Climate Change Act o2008 gave statutory powers to
the secretary o state to direct
statutory undertakers o critical
inrastructure, such as utility
companies, to produce reports
on how their organizations are
assessing and acting on the risks
and opportunities o a changing
climate. The secretary o state
can also ask or a group o
organizations to report togetheron climate change adaptation
considerations related to a specifc
location or a particular sector.
In January 2009, the Japanese
Institute o Certifed Public
Accountants published a proposal
requiring companies to disclose
inormation related to the physical
eects o climate change on
fnancial perormance.e
e http://www.japans.org/en/pages/029237.html (accessed September 10, 2009).
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25PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Investors can try to manage keyinvestment risks by recommending that
their clients carry a combination o
insurance policies. When investments
carry appropriate insurance coverage,
most o the fnancial impacts o
extreme climatic events should be
minimized, though the implications o
incremental changes in average climatic
conditions are unlikely to be covered.
However, a changing climate will aect
the likelihood, nature, and/or severityo extreme weather events, which
will change insurers risk exposure
and may trigger a review o policy
conditions and/or price upon insurance
renewal. In some locations, insurance
premiums will increase signifcantly
or instance, as ood, drought, or
hurricane risks increase (see Box 6
above). The development o limitation
clauses may also exclude coverage in
case o adverse business impactssuch as business interruptionthat
result rom unmanaged climate
conditions. In locations or sectors
where climate change will cause very
high risks o damage, insurance may
become unavailable. As a result, some
companies may be orced to start
sel-insuring, which requires making
fnancial provisions to cover uture
losses and which could aect their
fnancial capacity.
Corporate Credit andFinancial Risk
The risks to client fnancial perormance
described above could translate into
corporate fnancial risks or investment
institutions. It is difcult to predict
precisely how signifcant the fnancial
consequences o climate change or
investors will be, and it is unlikely
that climate change alone will aect
the liquidity or fnancial capacity o
an institution. However, it will add to
preexisting fnancial stressors, and
institutions may, as a result, suer
fnancial impacts.
The potential fnancial risks or
investment and treasury activities are
summarized below.
Deault probability
Lenders might experience increased
probability o client payment deault.
The proportion o impaired loans
in an institutions portolio may be
increased by more client liquidity
shortalls. Further, institutions might
ace increased liabilities associated with
the fnancial guarantees they provide to
their clients.
As regards investors balance sheets,
capital reserves requirements may
increase to cover higher on- and o-
balance-sheet exposures. Additionally,
high liquidity ratios might be more
difcult to maintain in the uture.
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26 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS
Return on Equity
As outlined earlier, or those
investments where climate risks lead
to decreased net income and reduced
growth, the value o investors equity
holdings will be aected, and exit
strategies may not be realized.
Where climate change leads to
environmental damage rom an
investment or increased community
conict, the investor might suer rom
a reduction in capital gains realized on
equity sale because o the investments
poor reputation (see Box 13).
Value o Assets Used asCollateral
Collateral assets are an alternative
repayment source or debt in the case
o deault, provided they are valuable
and can be repossessed and disposedo reasonably quickly.
As inormation on climate risks and
their fnancial consequences improves,
it will become increasingly difcult to
sell assets that are recognized to be at
risk or that are difcult to insure against
climate risks. This is true o property,
land, and equipment held by lenders
as security. For example, i real estate
assets held as