Climate risk mispricing: why better assessments matter in financing for development
Is climate change a financial risk that financial institutions need to worry about? Despite the rapid increase in climate financing and the rise of the dominant discourse on the importance of climate change and environmental, social and corporate governance (ESG) criteria, financial markets do not seem to show much sensitivity to the increasing climate risks. This paper considers why effective climate risk assessment should matter for financial institutions,
This paper presents different approaches to measuring climate risk used by European financial institutions with a public mandate, including a multilateral development bank (MDB) – the European Investment Bank (EIB), development financial institutions (DFIs) – the British International Investment (BII) and the Dutch entrepreneur development bank (FMO), national promotional and development banks – the German Kreditanstalt für Wiederaufbau (KfW) and Italian Cassa Depositi e Prestiti (CDP); and export credit agencies – the Atradius Dutch State Business (Atradius DSB), and French Bpifrance.
A range of limitations that could lead to mispricing are encountered, including: 1) underestimation/overestimation of the climate risks; 2) lack of proper methodologies to measure climate risk; 3) assessments generally undertaken at the macro-level; 4) climate-risk variables data often missing; 5) a lack of central database providing climate risk indicators; 6) and no harmonised industrial standards or regulatory framework
This necessitates that financiers and investors, in general, alter their strategies, incentives and approaches, including by exploiting the opportunities provided by climate risk assessment models and strategies.
Key policy recommendations for financial institutions include: 1) Develop a reliable database to provide information on climate-related risks; 2) improve the transparency of the risk assessment methodologies; 3) develop harmonised climate risk assessment methodologies; 4) support the establishment of project-level climate risk assessment; 5) exploit the potential of insurance companies; 6) address the information asymmetry; 7) enforce climate-related regulation at all levels; 8) embody climate-risk assessment in overall sustainable investment strategy and use concessional financing to cover high climate risks; 9) explicitly price climate risks and net returns from climate adaptation
