Climate resilience is essential for a sustainable financial system

By Michael Mullan, OECD Environment Directorate

At the start of the 2000s, consumers were surprised to discover that some of their “beef” lasagne was instead made out of horsemeat. Several years later, the global financial system was brought to its knees by the discovery that some triple-A securities were made out of distinctly subprime ingredients.

These are clearly very different situations, but the underlying point is that people need to know what they are getting for their money. With what we know – and what we are already seeing – about climate change, we need to know if people’s savings for the future are being invested in ways that are undermining that future. This is no longer viewed as a purely environmental issue: it is now firmly within the mainstream of discussions about the financial system.

A central focus of these discussions is on the financial system’s role in enabling the transition to net zero emissions, but it is also essential to prepare for the climate impacts that are already being felt. We need to become more resilient – better able to plan, prepare, absorb and adapt – to the growing physical impacts of climate change.

Understanding and managing physical climate risks

A sustainable financial system cannot be maintained upon an increasingly fragile physical environment. The UK, for example, has already witnessed several “worst case scenarios” for flooding in the past few years. Globally, we are faced with a future where today’s extreme events become tomorrow’s norm. These physical climate risks are manifesting in predictable ways, such as damage to assets and disruption of supply chains. But, we are also starting to see less-predictable links come to the fore: the recent freak weather in Texas led to the bankruptcy of one electricity supplier, but also generated trading revenues of hundreds of millions of dollars for at least one major bank. As the complexity and diversity of risks increase, the past will become an increasingly unreliable guide to the future. Systemic risks will arise with material consequences for the financial system.

Understanding the exposure of the financial sector to physical climate risks is increasingly recognised as being part of competent risk management. The recommendations of the Task Force on Climate-related Disclosure’s call for assessment and reporting on physical climate risks for all finance flows, whether these are labelled as sustainable or not. This is complementary to the efforts of central banks, regulators and others to manage the systemic risks arising from climate change.

However, better understanding and managing risks within the financial system is the start, rather than the finish line. To be environmentally and socially sustainable, sustainable finance needs to drive investments in the real economy towards activities that strengthen resilience. Increased investments such as climate-resilient infrastructure, drought-resistant agriculture, and nature-based solutions would be a good start.

Three actions to shift to climate-resilient investments:

1. Support the development of scalable business models for investment that deliver climate resilience. Approaches such as nature-based solutions have huge economic potential – with ten dollars of benefits for every dollar invested. Yet, despite growing interest from investors, current projects tend to be small scale and dependent on public and/or philanthropic funding. The underlying challenge lies in translating this economic potential into viable business models. There is an urgent need to identify and scale-up models that can deliver impact by sharing examples of success, improving the regulatory environment, and applying innovation to bundle co-benefits into a viable business case.
2. Demonstrate impact. Investments that are described as contributing to resilience need to deliver an attractive financial return, but also genuine social and environmental impact – not just “greenwashing” of business-as-usual. Providing investors with comparable, relevant and targeted metrics for assessing corporates and portfolio-level impacts in strengthening resilience will build market confidence. It’s a complex question, but we’re not starting with a blank page. Valuable work is already underway in assessing environmental materiality of investments, as well as the initiatives to develop metrics and rating systems for resilience.
3. Encourage socially-responsible risk management. Economic and social vulnerability is linked to climate vulnerability, with lower-income communities often being located in higher risk areas. It is essential that efforts to increase transparency of physical risks within the financial system do not inadvertently discourage investment in infrastructure in areas where it is most needed. Addressing this will enhanced public-private collaboration and support for win-win approaches that manage risks by increasing the resilience of communities.

These are systemic challenges, and addressing them is requiring unprecedented collaboration within and beyond the financial system. At OECD, we are working with leaders across the financial system to help make progress on these issues, building on our analytical strengths, role in setting international norms, and “whole of government” perspective.  This initiative includes developing data and analysis to understand key trends, knowledge exchange, and the identification of principles for good practice. Our work will be undertaken collaboratively with the Centre for Green Finance and Investment, as well as key initiatives such as the Roundtable on Financing Water.

If you would like to join this effort, please contact: env.contact@oecd.org

Further reading

OECD (2020), “Building back better: A sustainable, resilient recovery after COVID-19”, OECD Policy Responses to Coronavirus (COVID-19), OECD Publishing, Paris, https://doi.org/10.1787/52b869f5-en.

OECD (2020), “Nature-based solutions for adapting to water-related climate risks”, OECD Environment Policy Papers, No. 21, OECD Publishing, Paris, https://dx.doi.org/10.1787/2257873d-en.

OECD (2020), Developing Sustainable Finance Definitions and Taxonomies, Green Finance and Investment, OECD Publishing, Paris, https://doi.org/10.1787/134a2dbe-en.