Global financial systems currently fail to consider the risks posed by extreme weather, according to a new Royal Society report
The report also calls for changes to global financial accounting and regulation to ensure that extreme weather risk is correctly accounted for. At present, these risks are not systematically factored into investors’ valuations or assessed by creditors.
Business surveys, economic forecasts and country briefings that guide investment decisions and credit ratings are typically based on the availability of skilled labour, access to export markets, political and economic stability, and financial incentives – but there is little or no consideration of disaster risks.
Mr Rowan Douglas, member of the working group for the report said:
“If two otherwise identical international companies have different resilience to extreme weather risks that would impact their potential solvency or profit, for example one has unprotected factories located in high risk floodplains, then one should have a proportionately lower share price or valuation to reflect this higher financial risk. However, this rarely happens.”
“As the frequency and severity of extreme events is increasing, there is increasing exposure of assets to risk. This brings an ever larger disconnect between material risk and asset valuation. Unless financial reforms are made to correct this, we will condemn ourselves to building vulnerable cities in the coming decades at the cost of millions of lost lives and livelihoods and billions of lost dollars, often across regions and communities that can least afford these catastrophic setbacks.”
The report recommends that public and private sector institutions should report their maximum probable annual losses due to extreme events against their current assets and operations. This would effectively place a value on resilience and incentivise all capital owners, from homeowners to the largest multinational corporations, and even cities and countries, to build resilience.
Specifically, the Society suggests that an agreed spectrum of public and private institutions should report the following:
• 1 in 100 (1%) risk per year – a stress test for a company’s current solvency that evaluates the maximum probable annual losses expected for events that occur, on average, once in a hundred years or have a 10% chance of occurring every decade
• 1 in 20 (5%) risk per year – a stress test for a company’s annual earnings
• Annual Average Loss – a standardised metric for a company’s exposure to extreme events
The 1 in 100 risk per year recommendation was recently presented at the UN Climate Summit in New York. This engineering style approach draws upon the experience of the global re/insurance sector over the last 25 years that has steadily achieved greater resilience to growing losses to extreme weather through the efficient integration of science and regulation though disaster scenarios and stress tests.
As part of the ‘Integrating Disaster Risks into the Financial System’ initiative under the Resilience, Adaptation and Disaster Risk Reduction Action Area, the Climate Change Support Team, Executive Office of the Secretary-General, UNISDR convened a unique coalition of accounting organizations, asset managers, central banks, credit ratings agencies, risk modellers, financial regulators and science leaders at the Climate Summit 2014 where they confirmed the principles and a set of actions to take the initiative forward.
This initiative provides a forum where members of the Basel Framework of global financial regulators, accounting standards bodies and international institutions can work with banks, insurers, asset managers, regulators and accounting organisations to develop rules and reporting standards that could be implemented through local financial institutions to support widespread and consistent resilience to these, usually foreseeable, extreme weather risks.
The full report is available here.