Climate and ESG increasingly crucial in risk management

Important factors must be included in organizations’ risk models, says expert

Climate and ESG increasingly crucial in risk management

Risk Management News

By Gabriel Olano

Multiple recent scientific findings have suggested that the climate change crisis is worse than previously estimated and immediate action is needed to mitigate its effects. Investors are increasingly aware of these issues, with ESG (environmental, social and governance) issues now playing a major role in their business decisions.

In response to the growing importance of these factors, risk and capital management services provider Conning recently incorporated indices dealing with climate and ESG criteria into its GEMS economic scenario generator software.

The new models, Conning said, allow risk professionals to easily incorporate projection data based on climate- and ESG-weighted indices into their stochastic modelling of equity and corporate bond returns. These allow financial risk professionals to explore the possible impact of climate change and ESG-related factors on asset allocation strategies.

According to Matthew Lightwood (pictured above), Conning’s head of risk solutions, while there is some overlap in climate change and ESG, the issues involved in each are slightly different.

“Climate tilts toward a focus on overlaying natural and transitional risks onto more traditional measures like market and credit risk,” he told Corporate Risk and Insurance. “ESG, meanwhile, is more of a data collection, standardization and disclosure challenge.”

Risk managers need to properly account for climate and ESG indicators in their models, and failing to do so could prove detrimental to the company’s business, Lightwood said.

“Insurers, for example, could face a wide array of issues and significant market consequences,” Lightwood said. “If they are unable to properly model climate transition and decarbonisation scenarios, for instance, their portfolios may not be effectively constructed to meet liabilities over the long term.”

The field of climate science is constantly changing, as shown by recent updates to projections painting a grimmer image of the future. Risk managers must be on top of these updates and factor them into the business’ decisions.

“New climate events and data are changing how we think, measure, and ultimately allocate assets,” Lightwood said. “The same can be said for risks associated with ESG – it is rapidly becoming the case that companies need to be able to access their assets’ ESG scoring in an on-demand snapshot and adjust portfolios as necessary. The less informed companies are, the more likely they are to miss an opportunity, and the universe of solutions becomes smaller and more expensive. Insurers also need to think how to approach the analysis of climate risk from a quantitative perspective and how this will drive the qualitative discussions that are needed in the short to medium term to satisfy regulatory requirements, particularly around the Own Risk and Solvency Assessment (ORSA).”

The pandemic has made many businesses more reliant on technology to facilitate operations remotely. According to Lightwood, this has increased the demand for more advanced methods of risk management.

“Many companies are looking to technology providers such as Conning to build best-of-breed, software-as-a-service and on-demand risk platforms that can leverage rich datasets, new kinds of scenario analysis, and, in particular, sophisticated stochastic modelling techniques that go beyond deterministic models,” Lightwood said. “This has proven truer following the pandemic, both because of the increased attention now placed on climate risk matters, and because of the technological realities of remote work.”

In the future, Lightwood expects the role of climate and ESG factors in risk management to grow even further.

“As ESG frameworks continue to evolve and mature and climate risk gains greater mindshare, we are likely to see more and more of the investment process guided and impacted by these considerations, and to this extent, more rulemaking and regulation is likely as well,” he said. “This augurs an exciting time for risk management, as we’ll see far more attention paid to each aspect and a new competition could well unfold as insurers and their investment managers stake their own claims to leadership on these issues and their approach to solving them.”

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