What role can banks play in helping their customers adapt to physical risks?

Adaptation to climate change must be addressed in tandem with the low-carbon transition

According to the latest IPCC report, the Earth's average temperature is already 1.1°C above pre-industrial levels^[1]. While the low-carbon transition of the economy is urgent and essential to limit climate change, adaptation to climate change must be addressed in parallel and in very concrete terms in our regions to limit the consequences that are already underway.

In recent years, many examples come to mind to illustrate the possible consequences of climate change: exceptional heat waves in Canada, heavy rains in the Roya and Vésubie valleys in France, drought combined with a heat wave leading to wildfires in Greece… Regardless of the efforts made to reduce emissions, these weather events will increase in frequency and intensity in the coming decades and have significant consequences for the economy and the functioning of our regions.

Insurance will not be able to compensate for the losses caused by climate change

There are two types of damage caused by weather events:

• Certain weather events will damage property, which will need to be repaired, thereby increasing maintenance costs for that property and possibly requiring investments for restoration. For example, in France, climate change will intensify the alternation between periods of drought and periods of heavy rainfall, which will cause clay soils to shrink and swell, leading to cracks in the buildings built on top of them. These buildings will need to be repaired or even relocated if the damage becomes severe.
• Other weather-related events will temporarily disrupt business operations, leading to a decline in revenue: for example, a hairdresser who cannot use their salon in the event of a flood.

In both cases, significant financial consequences are to be expected, as studies of past climate events show. Today, only a portion of these risks is insured, and as the frequency of damage increases in the future, the insurance coverage rate will decline, as acknowledged by Denis Kessler, CEO of SCOR^[2]. The financial consequences will therefore be borne in part directly by individuals and businesses, and consequently by the financial institutions that finance them.

All sectors of the economy are at risk, and a company faces physical risks not only at its own sites but also throughout its value chain.

Once again, there are many examples to cite. In 2018, the exceptionally low water level of the Rhine disrupted river freight traffic, causing a BASF plant to shut down^[3]. In California, PG&E was found liable for the wildfires fueled by drought and heat, which led to its bankruptcy.

This risk is currently managed through voluntary or regulatory reporting. Initially, this was done through non-binding reporting frameworks such as the TCFD or the CDP, and more recently through the CSRD at the European Union level. The example of PG&E illustrates the importance of addressing this issue to protect against both financial and regulatory risks.

Physical Risk Management by Financial Institutions

Financial market participants have been working on this issue for several years to identify their most exposed investments. As part of this effort, Carbone 4 has developed the CRIS methodology, which enables an analysis of the risks associated with investments in publicly traded companies.

These institutions have a diversified portfolio in terms of both geographic regions and business activities, unlike local commercial banks operating within a specific region. Local banks finance less diverse activities than global players and operate within a limited geographic area, making them more exposed to specific weather events. As a result, damage caused by weather events can have far more severe consequences for these banks.

With the growth of climate finance, banks have embraced the issue of the energy transition through new financing products designed to reduce emissions from the projects they finance. But all new financing will also have to take physical risks into account. This is the principle of double materiality, highlighted by the SFDR regulations for financial institutions. The economy must no longer focus solely on its impact on the climate but must also consider the climate risks to which its activities are exposed.

The challenge for banks is to protect themselves from risks related to climate change while working to raise awareness among their customers in order to steer financing requests toward lower-risk products. Through this approach, banks are attempting to protect themselves from the risk of having customers default on their loans because they are unable to live in the home they purchased with a 25-year mortgage—a home that is exposed to physical risk and not covered by a natural disaster declaration.

Methodology for Analyzing Physical Risks

The first step for all financial institutions is to determine their exposure to physical risks.

These vary depending on the industry sectors and geographic regions covered by the financing.

For a given climate hazard, the associated physical risk is a result that combines the evolution of the climate hazard, the vulnerability of the sector under study to that hazard, and the exposure, which depends on the distribution of funding across sectors.

To assess a bank’s loan portfolio’s exposure to physical risks, Carbone 4 adapted its physical risk analysis methodology for the real estate, agriculture, and corporate sectors.

These methodologies make it possible to adapt to the level of detail in the data available to the bank in order to determine the vulnerability of the financed activities.

Climate projections with a geographic grid resolution of 8 km × 8 km are then used to model climate change in the region under consideration. The risk level determined for each activity is then used to assess the future risk to which the financing portfolios will be exposed if they remain unchanged.

The Role of Banks in Strengthening the Resilience of Their Regions

Once the portfolio’s current and future exposure has been determined, the bank must fulfill several roles:

• manage risk internally, for example, by adjusting the insurance rates offered to reflect the level of physical risk associated with the various products
• introduce new offers better suited to the region’s future climate, as well as offerings that enable customers to implement solutions that strengthen their resilience to physical risks
• take on an advisory role to inform its clients about the risks and connect them with organizations offering adaptation solutions
• work in partnership with local stakeholders

Banks can tailor their offerings in two ways:

• Identify adaptation solutions for current activities in outstanding balances and put together attractive offers for fund these adaptation solutions in collaboration with insurers. One example could be providing financing at favorable rates for building renovations to improve thermal insulation and, consequently, occupants’ comfort during heat waves.
• For new financing, banks can redirect their funding toward more resilient activities, just as they would redirect funding toward low-carbon activities. Here’s an example from the agricultural sector: droughts will increase significantly in southern France, and one possible adaptation strategy is to encourage corn farmers to switch to crops that are more drought-resistant.

To raise customer awareness of climate risks, all advisors must be trained.This awareness-raising effort serves both the bank’s interests—to ensure that customers will be able to repay their loans—and the customers’ own interests. Banks should no longer limit their analysis of loans to customers' ability to repay; they should also assess the climate risks associated with each loan in order to guide their customers toward less risky choices.

The incorporation of climate risks into bank financing will transform regional economies. Banks are not the only stakeholders involved and must work in collaboration with local stakeholders. In the agricultural sector, banks must work in collaboration with chambers of agriculture, which serve as experts and advisors on adaptation solutions that can be adopted.

In conclusion, The damage caused by climate change will increase in the coming years, and it is clear that, in addition to building a low-carbon society, we must build a society that is resilient to climate-related events. It will not be possible to file insurance claims for all types of damage, as Henri de Castries already pointed out in 2015^[4] and as Denis Kessler acknowledged more recently. Financing must therefore undergo an exposure analysis to assess risk and be redirected toward sustainable activities, both in terms of their impact on the climate and the climate’s impact on them. The adaptation solutions to be found are local in nature, and banks play a vital role in helping regions adapt.