Financial exposures to climate risks

Greetings Readers,

Physical climate risks are quite varied in their characteristics. Some risks are highly frequent, changing second to second (e.g. wind speed traveling through wind turbines) or day to day (e.g. snow falling upon a city or town). Others are chronic, evolving slowly over years or decades (temperatures rising streadily across a region or country). And still others are extreme, occurring infrequently and with immediate high impact (e.g. hurricanes, wildfires, severe thunderstorms). 

The financial exposures to climate risk are also varied. Climate risks can impact the value of an institution's assets (stuff it owns) and liabilities (stuff it owes). Climate risks can also cause an institution's revenue (money it earns) and costs (money it spends) to deviate from expectations.

The intersection of climate risks and financial exposures creates an opportunity to value climate risk and--if the value exceeds an institution's risk tolerance--transfer them. Below we provide examples of climate risk transfer opportunities that exist for each type of financial exposure.


Asset protection

Property: a power plant near the United States coastline purchases property catastrophe insurance to mitigate hurricane risk.

Natural resources: a timber company in the United States purchases parametric wildfire insurance to protect its tree stock against hot, dry, windy conditions that are conducive to wildfires.

Bank loans: an investment bank in Brazil purchases a low rainfall derivative to protect its agricultural loan portfolio against drought-induced credit risk.

Liability protection

Future insurance claims: an insurance company in India purchases crop reinsurance (i.e. insurance for insurance companies) to mitigate the impact of the failure of the summer monsoon (i.e. widespread drought) on the crop yield of farmers to whom it has sold crop insurance.

Revenue protection

Revenue uncertainty: an investor in a renewable energy project purchases a proxy revenue swap to fix the project's wind-dependent revenue and transfer its floating revenue to an insurer.

Cost protection

Cost uncertainty: a municipality purchases snowfall insurance, whereby any claim received during extremely snowy winters would partly offset abnormally high snow removal costs and stabilize the city's budget.


Together, the various types of climate risks and financial exposures can produce a wide range of financial outcomes for institutions: positive and money-making when the climate is favorable for business, and negative and money-losing when the climate is unfavorable for business.

And here we have discussed only physical climate risks, which are my expertise. In future posts we will explore transitional climate risks (e.g. the cost of stranded assets that can't be sold or utilized because regulators or capital have determined that they exacerbate climate change) and the types of financial exposures that can result from them. Until then!

Regards,

Prime








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