What conclusions should financial institutions take from the latest IPCC report?

This week the Intergovernmental Panel on Climate Change (IPCC) launched the second part of its 6^th Assessment Report, drawing on seven years of research from peer-reviewed scientists. The report provides an alarming summary of the increasingly devastating impacts of climate change on societies and economies, their vulnerabilities and how we may adapt to inevitable climate change. UNEP FI’s Paul Smith provides a summary of the key implications for financial institutions.

Last August, the first part of the IPCC’s report on the physical science basis of climate change provided unequivocal evidence that human influence was responsible for global warming. The report also gathered further evidence of the direct impacts of climate change on the world’s natural cycles, underlining the impacts on natural systems including more extreme and frequent droughts, extreme weather, heatwaves, wildfires, landslide, to name but a few. This first report also outlined a set of “shared socio-economic pathways” (SSPs), which aim to estimate potential climate impacts according to different climate, social and economic scenarios.

This second report outlines how far climate change has affected societies and ecosystems, with future impacts expected to be more devastating and pervasive than reported in the IPCC’s 5^th Assessment Report, published in 2014. Ecosystem impacts, in particular, are far greater than previously reported, with many ongoing irreversible changes, such as species’ extinction, habitat loss, changes to hydrological regimes and impacts on coastal, mountain and polar ecosystems. The United Nations’ Secretary General, Antonio Guterres, has described this report as ‘an Atlas of human suffering and a damning indictment of failed climate leadership’. We pick out some of the key messages from this week’s report for the global finance sector:

1. Climate change will affect all regions, with impacts more far-reaching than previously thought. Some of these impacts have already reached the limits of adaptation and will be irreversible, which underlines the importance of acting now.  For financial institutions, no one sector will be unaffected by climate change: there are no ‘safe havens’ from climate change.

2. Risk underpins the report’s framework for understanding the increasingly severe, interconnected and irreversible impacts of climate change. Understanding future climate impacts in the future requires modelling which is itself based on parameters and assumptions. Risk depends not only on modelling of climate hazards, but also exposure and vulnerability to these hazards – variables which can be controlled by adaptation measures. As discussed later, finance sector responses to climate impacts depend on assessments of these forward-looking climate risks and preferably disclosure of these risks to enable investors, governments, and society to better understand the potential impacts of climate change on businesses. Risk should also inform adaptation solutions: risk mitigation and risk sharing are at the heart of the report’s framing of adaptation and resilience, creating a collaborative framework for institutions from the public and private sectors, together with civil society.

3. Climate change is creating complex, compound and cascading risks that are far more difficult to assess and manage than individual physical climate risks. Multiple risks can interact and amplify risks from individual climate risks, e.g. rising sea levels with increasingly frequent and more powerful storms (Zscheischler, J. Westra, S., van den Hurk, B.J.J.M. et al., 2018), or the interaction of climate risks with other risks such as pandemics (Ranger N, Mahul O, Monasterolo I. 2021).  Such complex risk mechanisms can increase the complexity of modelling and assessment and are rarely integrated into climate risk assessments, potentially underestimating the potential financial impacts of medium- to-long-term climate change.  Furthermore, adaptation solutions that address single risk factors and locations in isolation often lead to maladaptation, which is difficult and expensive to unwind.

4. The mid- to long-term impacts of climate change may be multiple times higher than currently observed, with the economic costs of climate change rising exponentially with temperature rise. Reducing emissions should therefore remain the top priority with a focus on action by 2030 in line with low-overshoot pathways. High overshoot will lead to increased climate risks for vulnerable regions and societies as well as irreversible impacts in vulnerable ecosystems, such as polar, coastal and mountain regions.  This means implementing and delivering ambitious 2030 greenhouse gas emissions targets.

5. Vulnerability to climate impacts is also widespread and disproportionately affects already poor and marginalised communities and regions. The report estimates that 3.3 to 3.6 billion people live in contexts that are highly vulnerable to climate change, with over 1 billion at increased risk from coastal impacts alone.  Billions more will also be exposed to climate-sensitive transmissible diseases, with dengue fever highlighted as a particular risk due to longer seasons and wider geographic distribution.  Vulnerability is exacerbated by marginalisation, poor governance, poverty and unsustainable resource use.

6. Transformational adaptation is necessary to deliver successful climate resilient development. Just as economics need to transform over the next decade in order to deliver the emissions reductions necessary to limit global temperature rise to +1.5°C by 2100, a more integrated and holistic approach is required to meet adaptation needs.  Current approaches are often piecemeal, localised and incremental, designed only to respond to short-term risks or current impacts.

7. Climate-resilient development is proposed as an approach to achieve development goals while integrating adaptation solutions and reducing greenhouse gas emissions. This approach has multiple pathways and emphasises flexibility to adjust to changing circumstances.  Climate resilient development also emphasises recognition of the role of ecosystem services and the importance of inclusion across all sections of society.  However, the window of opportunity for climate resilient development narrows with every 0.1°C rise in temperature: +1.5°C constitutes a ‘critical level’ above which development pathways are increasingly constrained.

8. The role of government is critical. The impacts of climate change cut across sectors and geographies, requiring a strong coordinating role for government. Public institutions can also create the enabling environment for adaptation action through “institutional frameworks, policies and instruments that set clear adaptation goals”. The report underlines the key role for instruments, including budgetary allocations, statutory planning, monitoring and evaluation frameworks.  Perhaps most importantly for the finance sector, the report highlights economic instruments intended to address market failures, such as climate risk disclosure.

9. Climate change adaptation cannot be delivered without consideration of biodiversity and ecosystems. Climate change has already caused substantial damage to ecosystems, with losses irreversible in many cases. Pollution, unsustainable land-use and overconsumption are exacerbating these pressures. Temperature rise will increase the rate of extinction – for example, the report estimates that very high extinction risk in biodiversity hotspots will increase tenfold as temperatures rise from +1.5°C to +3°C. Given their multiple roles in adaptation and mitigation, ecosystems are crucial to climate resilient development, as well as providing important services for water, food, bioenergy and public health.  Effective Ecosystem-based Adaptation (EbA) can reduce climate change risks to people, biodiversity and ecosystem services, with multiple co-benefits including carbon sequestration.

10. Financing adaptation is a huge challenge and will require cross-government support with the development of new business cases for drawing in private sector flows. As UNEP’s Adaptation Gap Report 2021highlighted, the annual costs of adaptation in developing countries alone will be $140-300bn by 2030. These are relatively dated figures given that they were originally estimated for UNEP’s 2016 Adaptation Gap report, and no comprehensive calculations have been made since then, but it could be expected that those estimates have increased given that climate hazards are becoming more frequent and more extreme than previously thought – as highlighted in the IPCC’s Working Group 1 report last year. Meanwhile, COP26 last year highlighted the failure to deliver $100bn climate finance for both mitigation and adaptation by 2020, as promised in the 2009 Copenhagen Accord. Clearly the gap is significant, widening with every passing year, and governments are unable to meet this gap or even the more modest targets agreed over a decade ago. Meanwhile losses from climate-related impacts continue to mount – 2021 losses were estimated by Munich Re to be the second highest in history – and these financial impacts are a clear risk to societies, businesses and the economy.

Private finance therefore must play a role and despite the challenges of financing adaptation, there are green shoots, some of which are highlighted in the extended report (IPCC 2022). Estimating risks from physical climate impacts is an important starting point and a handful of open data providers are pulling together the forward-looking information necessary to estimate risks, such as OS-Climate, ESG Books, while certain central banks are supporting scenario analysis and climate stress testing to better estimate financial risks from climate impacts. Going one step further, financial institutions need better methodologies to integrate these risks into asset valuations. Green, sustainable and resilience bonds are vehicles whose proceeds can be used to finance activities with positive climate adaptation goals, based on qualitative guidelines such as the Climate Bond Initiative’s Climate Resilience Principles, which forms the basis for the European Bank for Reconstruction and Development’s 2019 Climate Resilience Bond. A qualitative methodology has been developed by the Coalition for Climate Resilient Investment (CCRI) to price future physical climate risks into major investments – initially focusing on large-scale infrastructure. Where this approach goes further is in estimating the costs of adapting those projects, including consideration of nature-based adaptation solutions, and effectively building a business case for investing in adaptation.  Insurers are also a fundamental part of the puzzle, with parametric risk insurance products such as the African Risk Capacity and Caribbean Catastrophe Risk Insurance Facility, enabling post-disaster responses.  Combined with public and private sector investment, insurance can even be a driver of climate resilient development, such as the V20 Sustainable Insurance Facility.

With the announcement of the Glasgow-Sharm El Sheikh work programme to define a Global Goal on Adaptation at COP26, and Egypt hosting COP27 this November, international climate dialogue will increasingly focus on climate-vulnerable countries. Consequently, UNEP FI’s members have also underlined the need for greater action on adaptation. The Principles for Responsible Banking (PRB) will this year be developing a set of recommendations for integrating climate adaptation as an impact area for the PRB, while our TCFD programme will scale up its work on physical climate risk assessment.