Which comes first, calculation or capital allocation?

By Georgina Woods, Head of Impact, The Climate Risk Group.

Wednesday, 12 April 2023

Climate Risk - Which comes first, calculation or capital allocation?

“With every increment of warming, climate change impacts and risks will become increasingly complex and more difficult to manage.” (IPCC Sixth Assessment Report Synthesis Report)

Capturing the range of complex but material physical risks facing the financial sector is crucial both for prudent risk management and for accurate weighing of the cost of failing to meet the Paris Climate Agreement goals. In 2020, BlackRock CEO Larry Fink predicted that as climate risk is priced into financial markets, “we will see changes in capital allocation more quickly than we see changes to the climate itself.” European Central Bank Executive Board member Frank Elderson recently reminded a roomful of bankers that the guiding principle behind central banks’ response to climate change is “ensuring that no material risks are left unaddressed.” Elderson highlighted that virtually all banks have blindspots in their identification of climate and environmental risks and nominated lack of consideration of physical risk as the first of these. 

XDI has already written about the “disclosure gap” whereby more attention is paid to transition risk than physical risk: more financial institutions and companies disclose transition risk, and what they report is more comprehensive for transition risk than physical risk. But there’s another aspect to the disclosure gap and it’s one that XDI and other climate data providers and modellers are partly responsible for closing – climate physical risk that can be modelled and quantified for banks now is a fraction of the wider spiral of cascading and compounding physical risk that the IPCC’s Sixth Assessment Report summarises.

Closing this gap was already a priority for our company, but we were spurred to work faster and harder last week when the Reserve Bank of Australia (RBA) last week released a Climate Change and Financial Risk bulletin which used XDI data to explore capital adequacy risk in Australia. Using extreme weather-driven property value change as an overlay, the RBA calculated the associated change in CET1 and concluded that Australian banks would not experience capital deterioration as a result of the calculated loss of property value. To its credit, the RBA also noted that, “the lack of impact on bank capital in later periods raises questions about how well physical climate shocks have been captured.” The bank recognises that asset damage in mortgage lending, while important, is only one component of physical climate risk. 

The IPCC’s Sixth Assessment Report synthesis report challenges the finance industry to undertake better assessment of climate-related risks and investment opportunities within the financial system. Public and private finance flows for fossil fuels are still greater than those for climate adaptation and mitigation, and yet, there is sufficient global capital to close the global investment gaps. One of the barriers to mobilising this finance is the “systemic underpricing of climate-related risks.” (Which is itself just a smaller part of a fundamental failure to properly value the role of a functioning planet in our economies and our lives.) Data and modelling experts like XDI share responsibility to remove this barrier – to calculate the broader risks of climate change or, while complete calculation eludes us, ensure that our clients understand the limits of calculation. We take this responsibility seriously because we want it to remain possible that “we will see changes in capital allocation more quickly than we see changes to the climate itself.”



Petrana Lorenz, Director of Communications: +61 405 158 636