climate risk and financial institutions - challenges and opportunities

8/8/2019 Climate Risk and Financial Institutions - Challenges and Opportunities

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Climate Risk and

Financial Institutions

CHALLENGES AND OPPORTUNITIES


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AuthorsVladimir Stenek, International Finance CorporationJean Christophe Amado, AcclimatiseRichenda Connell, Acclimatise

The authors wish to extend special thanks to IFCinvestment, industry, environmental and socialspecialists, who have provided signifcant inputs tothis document. Udayan Wagle (Director, BusinessRisk) is thanked or providing strategic direction.Samuel Dzotee (Senior Investment Ofcer),Graham Smith (Manager), and Jan Mumenthaler(Head) are thanked or their detailed and helpulcomments during the elaboration o the document.

This work benefted rom support provided by the Trust Fund orEnvironmentally & Socially Sustainable Development (TFESSD), madeavailable by the governments o Finland and Norway.

ReviewersWe thank the ollowing or their critical review and comments:Maarten Van Aalst, Craig Davies,Susan Holleran, Ajay Narayanan, SamanthaPutt del Pino, and Udayan Wagle

EditorsRachel Kamins, Anna Hidalgo, Vladimir Stenek,Richenda Connell


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ITABLE OF CONTENTS

TABLE OF CONTENTS

FOREWORD IV

EXECUTIVE SUMMARY V

Navigating this Report 1

Climate Risks in the Context oOverall Risk Management 2

PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS

CREDIT AND FINANCIAL RISKS 3

Overview 5

Management o Present-Day Climate andWeather Risks in Investment Appraisal 7

Financial and Credit Risk Analysis 8

Steps in the fnancial and credit risk analysis process 24

Corporate Disclosure andInvestment-Risk Management 24

Corporate Credit and Financial Risk 25

Deault probability 25

Return on equity 25

Value o assets used as collateral 26

Overall proft margins 27

Portolio risk management and perormance 27

STRATEGIC RISKS 29

Long-term Perormance 29

Development 30

Investment development perormance 30

Economic perormance 31

Environmental and social perormance 32

Private-sector development 34

Environmental and Social 35

Introduction 35


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II TABLE OF CONTENTS

Principles E&S underlying perormance standards 36 Social and environmental assessment and

management systems 38

Labor and working conditions 40

Pollution prevention and abatement 41

Community health, saety, and security 45

Land acquisition and involuntary resettlement 45

Biodiversity conservation and sustainableresource management 46

Indigenous Peoples 47

Cultural heritage 47

Conclusions 48

Reputation 49

Overview 49

Increased risk o water conictaround investments 51

Increased risk o protests against projects inenvironmentally sensitive areas 51

Increased risk o protests around communityresettlement and compensation 51

A lack o action on climate change adaptationcould put a fnancial institutionsreputation at risk 52

Conclusions 55

OPERATIONAL RISK 56

Processes 56

Sta, Buildings, and IT Systems 57

LEGAL RISK 61

Overview 61

Duty o Care, Skill, and Caution in ProvidingProessional Advisory Services 65

Climate Change Risk Management asPart o Fiduciary Duty 66

Conclusion 66

REFERENCES 67


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II ITABLE OF CONTENTS

PART II CLIMATE CHANGE AND INVESTMENT SECTORS

Introduction 76

Navigating this Report 77

Water Quality, Pollution Control, and Discharges 78

Energy Reliability and Security 83

Asset Design, Perormance, and Integrity 84

Raw Materials, Transport, Supply Chains, and Logistics 86

Site and Ground Conditions 88

Human Health and Saety 89

Markets 92

Communities 93

Air Emissions and Solid Waste Management 96

Ecosystem Services 98

Sector-Specifc Risks 100

Agribusiness 100

Water 103

Electric Power 106

Transport 108

Oil, Gas, and Mining 110

Appendix. Greenhouse Gas Emissions Scenarios 114

Reerences 117


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IV FOREWORD

FOREWORD

Climate change is set to have a dramatic economic impact. It is already altering the availability o and demand

or resources, supply and demand or products and services, the perormance o physical assets, and the need or

innovation. Failure to consider climate change in investment strategies can undermine projected fnancial returns and

aect the non-fnancial risk management o institutions, particularly on development, environmental, and social issues.

The challenges presented by climate change are magnifed in emerging markets, where most uture global economic

growth will take place. In these economies, climate change is shaping strategies to increase access to energy, clean

water, and other basic services or people who need them most.

As they channel investment, fnancial institutions have an opportunity and responsibility to take a leading role in

mitigating and adapting to climate change. Institutions managing investments in long-term assets should consider the

fnancial risks associated with climate change, as well as the opportunity to create value by working proactively with

clients and stakeholders to manage the risks.

IFC is supporting the eorts o several development and commercial fnancial institutions to take steps in this direction.

This publication is part o our work to help fnancial institutions analyze the risks associated with climate change.

Initiatives such as IFCs Climate Risk Pilot Program are also producing case studies that assess various approaches to

managing and adapting to climate change in the real sector.

As climate change adjusts the way we think and act to reduce poverty and secure sustainable economic growth, IFC is

committed to helping fnancial institutions meet the challenge. Our goal is to provide critical inormation and tools or

fnancial institutions and the private sector to make smart decisions in the ace o climate change, helping to create a

better and more prosperous uture or us all.

Rachel Kyte

IFC Vice President

Business Advisory Services


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VEXECUTIVE SUMMARY

EXECUTIVE SUMMARYMANAGING CLIMATE RISK IN

THE FINANCIAL SECTOR

How signicant are the impacts of

man-made climate change today?

The summer 2003 European heat wave had disastrous consequences:

water shortages shut down 14 nuclear plants at electricity producer EDF,

causing electricity price spikes o 1,300 percent, which, because they

could not be passed on to customers, resulted in a $300 million loss;

European agriculture lost an estimated $15 billion; and more than 35,000

people died.

The ripple eects dramatically aected upstream and downstream

sectors o various regions. France, the largest energy exporter in Europe,

cut its energy exports by more than 50 percent. Output o animal odder

ell by up to 60 percent, and despite imports rom countries not aected

by the heat wave, such as Ukraine, livestock producers were aected by

shortages and price hikes.

Without man-made climate change, a summer as hot as 2003 would

have been an exceptional 1-in-1,000year event. Due to mans

infuence on the climate, by 2003 the risk o such an event had already

more than doubled to 1 in 500 years. By 2040 summers as hot as 2003

will be normal, 1-in-2-year events, and by 2060 they will be cooler

than the average (COPA/COGECA 2004; Stott et al. 2004; UNEP 2004).

Temperature Changes across Europe,

19002100 (Relative to Baseline Summer

Temperatures in the Period 196190)

(Source: Stott et al, Hadley Centre and

Oxford University)


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VI EXECUTIVE SUMMARY

Do changing climate risks matter toshort-term investments?

While short-term investments have shorter exposure, the risks are not

completely eliminated. Extreme events, happening with increased

requency and intensity, can occur at any time. Furthermore, while

extreme events and their eects on investments oten grab the headlines,

creeping changes in average conditions are already causing material

changes in risk. For example, rising sea levels in some ports are reaching

the crests o protective seawalls and quays built some decades ago. Added

to this, the observed increased variability in wave heights and projected

increases in the intensities o tropical cyclones urther worsen risk proles.

Clearly, not all investments will be aected by climate impacts, nor

will they all be aected in the same ways. The severity o impacts will

depend on several actors, including its climatic sensitivity, location,

management practices, market conditions, existing policies and

regulations, and so orth. However, it is likely that the impacts will have

material eects on a signicant number o investments over time.

Some investment sectors are intrinsically more climatically sensitive,

because o the nature o their operations or supply chains, such as those

reliant on long-lived xed assets or requiring large volumes o water.

Othersnotably agribusiness, energy, and tourismoperate in markets

where supply, demand, and price fuctuate signicantly in line with

variations in the weather.

Climate change related impacts

that are material to investments

performance are already

occurring.

Impact of the 2003 European Summer Heat

Wave and Drought on Agriculture in Five

Countries (Source: Reprinted from UNEP 2004)


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VI IEXECUTIVE SUMMARY

Investments in some countries or specic locations, such as those in water-stressed regions, or close to food-prone rivers or coasts, are more exposed.

Economic conditions also aect levels o vulnerability and the ability o

economies to recover rom climate shocks. Strong and diverse economies

will be better placed to maintain the climate-resilient inrastructure and

services on which businesses depend.

At the level o an individual business, managements awareness and

treatment o climate risk actors will be key determinants o business

success. Proactive assessment and management will decrease the

likelihood o adverse impacts rom creeping changes or extreme events.

Additionally, the rst businesses to grasp new opportunities arising rom

changing conditions will be well positioned to gain competitive advantage.

Finally, knowledge about climate change and its impacts is evolving

rapidly, and many o the key acts are now well established. Continuous

advancement o inormation, supported by increased research and

evidence, along with the application o risk-management tools, will

acilitate incorporation o climate considerations into decision making.

Overall, this should result in investments that are more climate resilient or

better adapted to the changing conditions.

RISKS TO PROJECT FINANCE AND REAL

SECTOR INVESTMENTS

This report analyzes in some detail the risks to project nance and the

perormance o real-sector investments. Options, utures, derivatives,

oreign exchange and more exotic instruments are not specically

addressed. However, real-sector investments are undamental to

economies, and many instruments are directly or indirectly linked to or

infuenced by them. As the systemic risks o climate change will aect

whole economies, ew instruments can be considered completely immune

rom potential impacts.

The unexpected volatility o conditions created by unaddressed climate

impacts can aect projected results and weaken nancial conditions. Forgeneral debt instruments such as loans, or example, debt-repayment

capacity can be aected by the alteration o underlying cash-fow values

projected earnings and expensesdue to climate change, leading to

deterioration o nancial positions.

For equity investments, climate-driven deviations rom expected results

that aect an investments valuation are relevant or projecting returns

on equity and planning exit strategies. Some equity investments will also

be aected as analysts incorporate inormation about climate change

impacts into their company valuations.

Proactive risk management

will decrease the likelihood of

adverse impacts.


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VIII EXECUTIVE SUMMARY

Financial perormance and conditions or both equity and debt may beweakened by a number o actors:

Market conditions, particularly supply and demand, can be a

key determinant o uture prices. Both supply and demand can

be sensitive to climate actors. Future climate-driven changes in

prices may, in turn, aect the competitiveness o investments.

Eciency, output, and perormance o assets and equipment

may decrease due to changing climate conditions, with

consequences or revenue.

Operating costs (OPEX) may increase due to changes in theprice, availability, or quality o inputs. Maintenance costs may

also increase.

Insurance costs are likely to increase i climate-related claims

continue to rise as projected. A more disquieting possibility,

already a reality in some regions, is that insurance companies

may completely abandon particular markets.

Additional capital expenditure (CAPEX) may be required as

a result o asset damage or decreased asset perormance.

Further, complying with environmental regulations may require

additional CAPEX to upgrade acilities or equipment to copewith increased pollution risks.

Sta health, saety, and productivity may be impacted by climate

change, and this may lead to increased expenses.

Loss contingency projectionsreserves required to allow or

potential disasters or other known risksmay need to increase

as the risks o climate change become more likely and better

quantied.

Asset depreciation rates may increase. The rates currently used or

accounting purposes generally refect historical experience, butthe eective depreciation rates o assets due to climate change

may be considerably higher. Consequently, nancial models may

overestimate the real useul lives and value o physical assets.

Faster capital depreciation could mean that assets need replacing

more requently, negatively aecting projected cash fows.

The response of some insurance

companies to increased weather

impacts in the United States was

cutting down the number of

homeowner policies or complete

pull-out from regional markets.

Nearly 3 million U.S. households

remained without homeowners

coverage between 2003 and 2007.

Research in Alaska has shown that

capital depreciation of transport,

water, and sewage infrastructure

could increase by 1020 percent

by 2030 due to climate change.

The 20078 droughts in Australiacontributed to global wheat-price

hikes of up to 85%. By 2030, up

to 20% more drought months are

projected over most of Australia.

Change in Winter Cyclone Strengths


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X EXECUTIVE SUMMARY

THE NEED FOR INSTITUTIONAL RESPONSESMany nancial institutions, including IFIs, members o the United

Nations Environment Programme Finance Initiative (UNEP FI), and the

Equator Banks, have environmental and social goals associated with their

investments as do the major companies in which they invest. I changing

climate impacts are not taken into account, rates o noncompliance with

environmental and social standards may increase. Using only historical

data in environmental and social impact assessments is likely to disregard

material changes that occur during a projects liecycle, and investments

designed on the basis o such data may not be able to cope with new

climate conditions.

As a result, mitigation measures in environmental and social management

plans may not unction as intended. For example, the Indian states o

Rajasthan, Punjab, and Haryana have seen a net loss o more than 100

cubic kilometers o groundwater between 2002 and 2008, exacerbated

by increased crop irrigation (Rodell, Velicogna, and Famiglietti 2009).

Water-intensive industries in these and other water-stressed areas that ail

to consider the interactions between climate change, water supply, and

demand could put community livelihoods under greater pressure.

For institutions with a development mandate, ailure to take climate

change risks into account in investments may result in a deterioration

o development perormance, with all the components o developmentpossibly aected: nancial outcomes, economic, environmental, and

social improvements, and overall public- or private-sector development.

As recognized by the World Bank Group, Let unmanaged, climate

change will reverse development progress and compromise the well-

being o current and uture generations (World Bank 2009b).

The objectives o institutional investors, such as pension unds, include

creation o sustained revenues over a long period o time. Clearly, given

this long-term perspective, institutional investors need to be particularly

aware o growing risks to their investments in climatically sensitive sectors

or regions. The size o investments and the need or diversication make

many institutional investors universal owners whose success is dependentnot on the perormance o individual investments or sectors but on

the long-term perormance o the global economy. As already noted,

unmitigated climate impacts may aect economies o whole countries

and refect negatively on the universal portfolio.

Left unmanaged, climate

change will reverse development

progress and compromise the

well-being of current and future

generations.


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XIEXECUTIVE SUMMARY

Some legal advisers are beginning to acknowledge that there is nowsucient inormation available on climate change or it to be taken into

account in both strategic and operational decision making. This means

that climate change may be close to attaining legal signicance

in court. Indeed, recent cases have demonstrated the willingness o

courts and planning tribunals in Australia to accept evidence o climate

change risks related to planning decisions. I climate change impacts are

considered reasonably oreseeable by a court, decisions that do not

take these impacts into account may incur liability in negligence. Further,

some institutions may be alling short o inormation about climate their

duciary duties i they ail to assess and manage climate risks, especially

where long-term value creation is part o their mandate.

Reputational risks increase when there is a perception that an institution

has allen short o its stakeholders expectations. With the rapid evolution

o evidence about the impacts o climate change, expectations are

growing that these issues should be addressed. For example, a new

investment that is heavily reliant on water resources, in a region where

existing studies show uture decreasing water availability, may ace

considerable scrutiny. I it cannot demonstrate that it will not adversely

impact uture water availability or local environments and communities,

or or that matter uture water availability or the investments adequate

perormance, the sponsors reputation may suer, along with those o

its investors. Even i the impacts occur only ater investors have exited,

reputation may be an issue i at the moment o investment there wassucient inormation about potential risks and these were not addressed.

The increasing amount of

information about climate change

impacts is raising stakeholder

expectations about institutional

responses.


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XI I EXECUTIVE SUMMARY

CONCLUSIONS AND NEXT STEPSThis report demonstrates that climate change and its impacts are likely

to alter a number o conditions that are material to the objectives o

nancial institutions. I changing conditions are not actively managed,

investments and institutions may underperorm.

Most investments will be channeled through nancial institutions. Given

that the main eects o climate change are now well established, there is

a considerable opportunity, as well as a responsibility, or these institutions

to take a leading role in adaptation to climate change. Institutions

managing investments in long-lived assets have both a direct nancial risk

to consider and the opportunity to create value by working proactively

with their clients and other stakeholders to take steps to manage the

risks.

Each institution has specic objectives and procedures, and so approaches

to assessing and managing changing climate risks will vary. Many o the

risks highlighted here may already be part o institutions standard risk-

management processes. Rather than creating new instruments or climate-

related risks, the challenge or nancial institutions and companies will be

integrating investment-relevant inormation into existing procedures.

Several developmental and commercial nancial institutions are already

taking steps toward these goals. International Finance CorporationsClimate Risk Pilot Program has produced initial case studies that assess

approaches to real-sector climate risk and adaptation, in addition to the

present analysis o risks to nancial institutions. Going orward, IFC will

initiate the development o more general tools addressing climate risks

and investments.

There is a considerable

opportunity, as well as a

responsibility, for nancial

institutions to take a leading role

in adaptation to climate change.


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1NAVIGATING THIS REPORT

NAVIGATING THIS REPORT

References67

References117

Introduction7

6

WaterQuality

,Pollution

Control,andDi

scharges78

EnergyReliab

ilityand

Security83

AssetDesign

84

SupplyChain

86

SiteandGroun

dConditions88

HumanHealthandSa

ety89

Markets92

Communities9

3

AirEmissionsa

ndSolidWaste

Management9

6

EcosystemSer

vices98

Sector-Specifc

Risks100

CreditandFin

ancialRisks5

StrategicRisks2

9

OperationalR

isk56

LegalRisk59


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2 CLIMATE RISKS IN THE CONTEXT OF OVERALL RISK MANAGEMENT

Climate Risks in theContext o Overall RiskManagement

In making investments, institutions

assume various kinds o risks, including

credit risk, fnancial risk, strategic risk,

and operational risk. I climate change

is not considered, management o these

risks may become more difcult, and

the attainment o institutional goals

may be impacted.

Part I o this report discusses these

issues urther. Section 2 addresses

credit risk as a component o

investment appraisal and demonstrates

how the credit and fnancial risks rom

a changing climate may be relevant

to investment institutions. Credit

risk is defned by many fnancial

institutions as the potential reduction

in value o on- and o-balance-sheetassets due to a deterioration in the

credit profle o an institutions clients,

the countries in which it invests, or a

fnancial counterparty. Both investment

and treasury activities are at risk o

climate changeinduced degradation in

creditworthiness.

Financial risk relates to reducedliquidity available to meet an

institutions obligations to disburse

unds because o a loss in the value

o its investments or other assets, its

potential inability to access unding at a

reasonable cost, and the deterioration

in value o fnancial instruments

because o market changes.

Section 3 analyzes how climate

change may interact with an investment

institutions strategic risks, which

include the potential developmental,

environmental, social and reputational

consequences o ailure to achieve its

strategic mission and, in particular,

sustainable development goals.

The management o these risks is

crucial to institutions ability to brand

themselves as trusted partners or

uture collaboration. Indeed, building

enduring partnerships with emergingmarket players is another key strategic

issue or investors and can particularly

impact the ability o developmental

fnancial institutions to achieve good

development outcomes.

Section 4 discusses how climatechange could aect institutions

operational risk. Operational risk

includes the potential or loss resulting

rom events involving people, systems,

and processes. These include both

internal and external events.

Section 5 discusses the legal risks

that may result rom a fnancial

institutions ailure to manage adverse

environmental or social impacts, or

to meet its legal, fduciary, or agency

responsibilities.

Part II o this report reviews a range

o cross-cutting risks that can aect

the perormance o many investment

sectors. It also provides additional

evidence on climate change risks

or fve climatically sensitive sectors:

agribusiness, water, electric power,

transport, and oil, gas, and mining.


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3PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS

Part IClimate Risk andFinancial Institutions


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4 PART I CLIMATE RISK AND FINANCIAL INSTITUTIONS


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CREDIT AND FINANCIAL RISKS

Climate change will not necessarily

aect the fnancial perormance o

all investments. However, it is likely

that it will aect some, and certain

investments may ace signifcant risks.

The signifcance o the impacts o

climate change on investment bottom

lines depends on a combination o

actors: the climatic sensitivity o the

business (which depends on the nature

o its operations), its location (which

determines its exposure to climatic

events), and the management practices

it has in place. Additionally, there is

a nonstatic, temporal dimension to

climatic events. These elements in

the context o a companys suppliers,

partners, competitors, distributors,

communities, and customers also

determine the companys vulnerabilityto indirect risks.

By way o example, semiconductor

companies consume large amounts

o pure water. They are thereore

sensitive to climate change impacts

on water availability and quality,

insoar as an interruption to water

supply or a reduction in water quality

would translate into revenue losses

or increased operational costs (see

Section.). This sensitivity translates

into a risk when such companies

are located in areas where water is

scarce and water runo is projected

to decrease. When appropriate risk

management practices are in place,

the costs o climate change can be

signifcantly reduced.

Overview

Investment institutions credit

and fnancial risk may be aected

through a combination o direct

and indirect impacts:

Climate change will call into

question the way institutions

currently manage climate and

weather risks.

Changes in climate and their

impacts on socioeconomic

conditions will change some o

the parameters and methods

institutions use to develop

fnancial projections and evaluate

credit risks or their uture

investments.

These climate change impacts

have potential consequences or

corporate fnancial and creditperormance.

The report analyzes in more depth risks

and eects on instruments related

to project fnance, and perormance

o real sector investments. However,

similar implications will be applicable

to a number o other fnancial

instruments.

For debt fnancing, or example, a

relevant actor or repayment is how

projected annual variability in cash

ow is correlated with climatic actors.

Any long-term climate trends over an

investments lietime will superimpose

on preexisting variability, so that

minimum and maximum cash ow

values may change over time. For

example, understanding the correlation

o seasonal rainall and temperature

with river ows and a hydropower

plants output may be important to

determining the most appropriate debt

structure and repayment schedule or

that plant. Debt repayment could be

structured according to years o most

reliable and/or highest income and

adjusted to years o less reliable and/ordecreased income.

For equity investments, climate

change trends over the investment

lietime that may result in changes in

stock valuation may be most relevant

or projecting returns on equity and

planning exit strategies. Several

eatures o equity investments suggest

that they might, in general, be more

exposed to climate risks than debtinvestments are:

Equity repayment relies on the

realization o an exit strategy and

on the companys market value at

that time. Since equity investments

oten have longer terms than

debt, they are likely to be more

aected as climate risks intensiy.

Awareness o climate risks is

quickly growing among investors,

and it will become increasingly

difcult to exit successully rom

investments that are not climate-

resilient.

Equity investors normally

rank behind credit lenders in

liquidation.


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Equity investments are intendedto deliver a higher return overall,

which strongly depends on

managements quality and

ability to create value. Generally,

management capabilities around

climate risks are currently very low.

Box 1. Examples of Business Sensitivity and Business Risk in

the Context of Climate Change Impacts on Water and

Energy

Many industry sectors have critical logistics or operations or which even a short-termdisruption in water or energy supply creates signifcant losses and lower revenues. Forexample, semiconductor production requires large amounts o clean water to createand clean silicon waers: to make a single 200 mm waer, a typical semiconductorplant requires 7.5 m3 o ultrapure water.

It has been estimated or Intel and Texas Instruments that a shutdown o a actory ora delay in construction because o water unavailability or contamination could resultin $100$200 million in lost revenue during a quarter or a reduction in earnings pershare o $0.02$0.04, depending on which products were delayed. Semiconductor

manuacturing companies in countries where climate change may reduce wateravailability or quality (e.g., China and Bulgaria) ace additional business risks.

Signifcant costs as a result o power disruption can also occur or companies workingin cement, steel and other metals, and glass, where shutdown can lead to losses inmaterials. For example, a shutdown o power in a steel refnery or more than a ewhours can mean that the urnace has to be dynamited.

A urther example o the costs o supply disruption relates to drought-inducedelectricity rationing in Brazil. In 2001, the rains did not come, and reservoir levels wereat 30 percent o storage capacity. The eects o this drought, aggravated by decisionsin the energy sector, meant that the government had to take severe measures toration electricity. According to the U.S. Department o Energy, the governments aimwas to reduce electricity consumption by 1035 percent, based on the level o added

value o the industry and the number o jobs aected. The usage reduction quotasaected some industry sectors more than others; those that did not comply werefned or eventually had their power supply cut o .

One group that was particularly aected was private electricity generation companies,such as AES Tiete, which has 10 hydropower plants in So Paulo State with acombined generating capacity o 2,650 MW. According to the director o AES Tiete,Mr. Barbosa da Silva, the companys assets were aected by the rationing. In 2000,AES Tiete Holdings had closed a $300 million 15-year bond oering at 11.5 percent,but due to the rationing in 2001, the bond payment schedule had to be postponed.Though AES Tiete had cut costs dramatically in order to be able to pay dividends, thesituation was too extreme. Since the company had insurance coverage rom the U.S.Overseas Private Investment Corporation, it was able to negotiate a new paymentschedule with the bondholders at the end o 2003.

The impact o Brazils electricity rationing was national: it is estimated that thedrought led to a loss o approximately $20 billion, the equivalent o about 2 percent oBrazils GDP. This is evidence o the potential impacts o climate change on investmentcountry risk.

Sources: Klusewitz and McVeigh 2002; Morrison et al. 2009; Levinson, Klop, and Wellington2008; Cashmore et al. 2006; UNEP Finance Initiative 2005


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Because climate change may impactthe credit profle o clients, it may

have consequences or the returns o

investment institutions structured

products. For example, partial credit

guarantees (whereby an institution

promises ull and timely debt service

repayment up to a predetermined

amount, irrespective o the cause

o deault) agreed by an institution

to the beneft o investments that

are vulnerable to a climate-induceddeterioration in their fnancial capacity

may become less proftable as deault

probability increases throughout the

lives o the guaranteed instruments.

When an institution agrees to a

risk-sharing acility, it may incur

increased and/or unpredicted credit

risks or the pool o assets it guarantees

in cases where the underlying client

is in deault as a result o unmanagedclimate risks. For example, i the

institution guarantees a bank portolio

o loans to armers in an area severely

aected by water scarcity, it may

have to cover higher losses than

expected because o increased rates

o loan deault to the lending bank

as a consequence o decreased crop

production.

Management oPresent-Day Climateand Weather Risks inInvestment Appraisal

Few investment institutions are

incorporating consideration o present-

day climate and weather risks into

their investment appraisals, using

historical data on climate trends and

sector perormance. Many types o

investments have a strong intrinsicsensitivity to climatic conditions,

including natural resourcebased

investments (e.g., in agribusiness or

hydropower), as well as investments

with industrial processes requiring

water or processing, cooling, or steam

generation (e.g., in mining and power-

generation acilities). In those cases,

the impact o past climate variability on

perormance is an element to consider

at the investment appraisal stage.

However, in a changing climate,

relying on historical climate data

to make projections o fnancial

perormance is more likely to result

in ailure than using orward-looking

estimates incorporating climate

change projections. This is because the

seasonality, intensity, and requency o

weather patterns is changing and will

continue to change in the uture.

Consequently, relying solely onbackward-looking climate inormation

to build fnancial and credit projections

may be inadequate.

For example, agribusiness investments

are oten appraised on the basis o

comparisons o observed weather

records, climate trends, and geological

and environmental conditions with

crop suitability data. Agribusiness

clients usually have observed weather

data and understand the links

between weather patterns and output.

However, risk margins used to assess

the sensitivity o fnancial projections

or agribusiness investments may be

inadequate to reect climate change

impacts, as they are oten more

concerned with unit production costs

and how these compare to long-term

average market prices. These prices

are typically assessed using marketdata rom the previous fve years.

Using such short records means that

the inuences o past climatic events,

such as recurrent droughts, may not be

picked up, even though these may have

aected prices and the perormance o

past investments.


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Financial and CreditRisk Analysis

At most investment institutions,

proposed investments undergo a

thorough appraisal that includes a

fnancial and credit analysis based on

assumptions about uture investment

perormance and creditworthiness.

The results o the joint fnancial and

credit analysis are used to decide

on pricing and to structure deals in

the most optimal way. Financial and

credit indicators are then monitored

throughout the lietime o the

investment.

The set o established conditions and

assumptions upon which fnancial

projections are built aims to represent

investments perormance throughout

their lietimes. Examples o how climate

change may aect some o

the assumptions upon which fnancialanalysis rests are numerous. The key

areas o climate impact are:

Market conditions and demand,

Efciency, output, and

perormance o assets and

equipment,

Operating costs,

Maintenance costs,

Insurance costs Costs to maintain sta health,

saety, and productivity,

Compensation or damage,

Additional capital expenditure,

Asset depreciation rates,

Loss contingencies, and

Country credit risk.

Each o these issues is briey discussed

in turn overlea, illuminated by casestudies.

Market conditions (or supply anddemand) can be a key determinant o

uture prices. Demand can be sensitive

to climate actors and the supply o

certain commodities is vulnerable to

climatic conditions

(see Box 2). Future climate-related

changes in short- and long-term

average prices may, in turn, aect the

competitiveness o investments.


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Box 2. Market Risk and Opportunity: Impacts of Climate Change on Seasonal Energy Demand and

Market Prices for Agricultural Commodities

While uture energy demand and market prices or agricultural commodities are heavily inuenced by socio-economic actors, theywill also be aected by climate change. For energy, rising temperatures due to climate change will decrease winter heating demandand increase demand or cooling in summer. Extreme climate events can inuence supply and demand or agricultural products, andhence commodity prices. Recent recurrent droughts have aected agricultural output in Australia, leading to increased world priceso key commodities.

Warmer winters are already having signifcant e ects on the fnancial perormance o oil and gas companies. Due to warm weather,or example, KeySpan Energy Delivery in the United States (now National Grid) reported a decrease o 19 percent in its natural gassales in Massachusetts and New Hampshire between October 1 and December 30, 2006, compared to its orecasts. As a result, itsnet gas revenues were $51.8 million lower in 2006 than in 2005.

In Russia, it is estimated that a 2C temperature increase will decrease ossil uel demand by 510 percent and electricity demandby 13 percent. Winter heating demand in Hungary and Romania is expected to decrease in warmer winters by 68 percent bythe period 202150. Worldwide, while demand or space cooling is currently lower than or space heating, it is growing rapidly inboth high-income and emerging economies. Over the coming decades, research indicates that energy demand or residential airconditioning will increase most rapidly in South Asia, as the climate warms.

For agricultural commodities, the Organisation or Economic Co-operation and Development (OECD) and the Food and AgricultureOrganization (FAO) noted that Australian droughts were a actor in the sharp commodity price spikes witnessed between 2006 and2008.Various reasons have been put orward or the crisis, including the direct impacts o climate change on crop production whichare considered to have made a slight contribution.

The fgure below shows Australian production o wheat, grains, dairy, and oilseeds showing how drought in the Australian wheatbelt signifcantly reduced production in 20023, 20067, and 20078. According to the latest climate change projections orAustralia, up to 20 percent more drought months are predicted over most o the country by 2030, so commodity price uctuations

will likely occur more oten in the uture.

Additionally, increased ood prices driven by climatic actors may aect general price ination, with ood being a large component othe consumer price index (CPI) (an indicator o ination) in many countries.

Australian production (Mt) of wheat, grains (left axis), diary and oilseeds (right axis)

Sources: KeySpan Energy Delivery annual report, 2006; Kirkinen et al. 2005; Vajda et al, 2004; Islami 2009; Cartalis et al. 2001; Isaac and van Vuuren2009; CSIRO and Australian Bureau o Meteorology 2007; OECD/FAO 2008; Gregory and Ingram 2009; Wight and Laan 2008(source o fgure)


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Efciency,output, andperormance o assets and

equipment may decrease due to

changing climate conditions, with

consequences or revenue. Outputmay change due to changes in long-

term average conditions or because o

increased incidence o extreme events,

such as droughts, tropical storms, andheat waves (see Box 3).

Box 3. Climate Change May Reduce Output of Hydropower Plants, Decrease Productivity and

Output for Some Crops and Lead to Revenue Losses

Reduced output from hydropower plants

Renewable energy investments are vulnerable to climate change, because the availability and reliability o renewable energy sourcesare a unction o climate conditions. In Brazil, where hydroelectric power accounted or 83 percent o power generation in 2006,uture changes in rainall are anticipated to lead to decreases in river ows, aecting river basins. Recent research ound that undercertain greenhouse gas emissions scenarios, average annual ows in some rivers may decrease by more than 10 percent by 2035.As a consequence, it is estimated that average power production would decrease by up to 7.7 percent or the worst case (the SoFrancisco Basin). Across Brazil as a whole, guaranteed (frm) power output is projected to decrease by 1.63.2 percent.

Decreased crop productivity

In the near to medium term, the productivity o some crops is expected to be aected by climate change. For some crops, projectionsrange rom substantially negative to positive, depending on location (see fgure below). The fgure shows large ranges or the 25thand 75th percentile projections or some crops (shown by the colored bars) due to uncer tainties about uture precipitation changes.For other crops the range o projections is much smaller. In the longer term, the impacts o climate change on global crop productivitymay signifcantly aect proftable agricultural investments. There will be dierent levels o agricultural output exposure: Russia,European and Central Asian countries, parts o China, and Argentina may present more avorable conditions or agricultural output inthe uture, whereas many countries in Arica, South America, and South Asia may see losses in agricultural output.

Probabilistic Projections of Production Impacts in 2030 from Climate Change (% of 19982002 average yields)

Southern Africa Brazil Andean region Central America andCaribbean

Note: Bars extend to the 25th and 75th percentile projections; the middle vertical line within each box represents the median projection. Dashedbars extend to the 5th and 95th percentile projections. Red, orange, and yellow symbolize very important, important, and less important hunger

importance rankings (HIR), respectively. The HIR categorise crops according to their share in the average calorie intake o a malnourished population(based on data rom the FAO).

Performance losses for telecommunications companies in China

The most severe snowstorms in China in 50 years caused massive power blackouts in the winter o 2007/8, costing Chinesetelecommunication providers at least $152.8 billion in missed revenue during the frms peak business season. Operations at 24,000telecommunications base stations were disrupted by the snowstorms, leading 14,000 o the stations to run on makeshit dieselgenerators to provide a basic service. The other 10,000 stations were completely shut down. In addition, 150,000 telephone polescollapsed and 16,000 kilometers o wires had been damaged by February 2008.

Sources: Pereira de Lucena et al. 2009; Lobell et al. 2008 (source o fgure); Wai-yin Kwok 2008


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Operating costs (OPEX) may increasedue to changes in the price, availability,

or quality o inputs (see Box 4).

Box 4. Operating Costs May Increase as a Result of Climate

Change

Increased operating costs due to power cuts in Ghana

Power cuts began in August 2006 in Ghana when low water levels were registeredat Lake Volta, as the country relies on hydropower acilities or about 60 percent oits power. The Volta River Authority was orced to ration power supplies on a scalenot seen since 1983. The cr isis damaged the revenues o many o Ghanas smalland medium-size businesses. It also led to increases in operating costs or miningcompanies in Ghana and threatened mine closures. New mines had to be redesigned.As a result o energy disruptions, our mining companies collaborated to build a new80 MW dual-uel thermal power plant at an estimated cost o $45.5 million to ensureenergy security. While there is uncertainty about how rainall in Ghana will changein the uture due to climate change, rising temperatures are projected with highconfdence. This will lead to more evaporation rom Lake Volta and may increase riskso power shortages in the uture, unless adaptation actions are undertaken.

Increased commodity prices

World prices or various crops and livestock are projected to rise due to climatechange. This will result in increased input costs or agribusinesses, retailers, FastMoving Consumer Goods (FMCG) companies, and armers. The graphs below showworld prices or various crops (top graph) and livestock (bottom graph) in 2000 and2050. Three projected prices or 2050 are given: without climate change (blue bar);using the US National Centre or Atmospheric Research (NCAR) climate model (orangebar); and using the Australian Commonwealth Scientifc and Industrial ResearchOrganisation (CSIRO) climate model (horizontally-gridded bar) (excluding the eectso carbon ertilization (CF)). The 2050 no climate change prices are higher than 2000

prices due to drivers such as population and income growth, and biouel demand.

World prices of major grains and livestock products


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Maintenance costs may increase as

a result o climatic stresses (see Box 5). Box 5. Increased Maintenance Costs for Railways

Heavy rainfall causing landslides in India

The proft and loss account o the newly built 760 kilometer Konkan Railway in India (KRCL)shows that 6 percent o the annual budget is spent on repair and maintenance. Out o thetotal repair and maintenance budget, close to 70% goes towards permanent ways, bridgesand tunnels. According to the estimates o ofcials at KRCL, about 20% o this expenditureis used in addressing climate-related impacts, such as rain-induced landslides. Thisamounts to roughly $1 million spent annually. Operations are suspended or an average oseven days each rainy season due to such damage. Future climate change, such as moreextreme rainall events, could increase expenditure on repair and maintenance activities.

Sea level rise increasing maintenance costs for primary rail line in the UK

A section o railway on the main line rom London to Penzance in the UK is subject totemporary speed restrictions and repeated closures at Dawlish, due to its proximity to thesea. Sea level rise will result in more requent overtopping and make speed restrictionsand line closures more requent. There has already been an estimated 450mm rise in sealevels since the sea wall was built in the mid-nineteenth century.

Recent research assessing the sec tions o coast along which the train line runs indicatedthat the area was subject to an increase in the 1 in 100 year wave height o up to 9% inthe 2020s, a corresponding increase in wave energy o up to 18%, and an increase in the1 in 100 year wave height o up to 25% by the 2080s. As a result, disruptions rom waveovertopping are projected to increase in the uture, as shown below.

Projected percentage increase in future overtopping at Dawlishcompared to 1961-90 baseline climate

The owner and operator o the rail lines, Network Rail, spends signifcant amounts omoney to maintain the line rom London to Penzance. I t recently spent 9 million inengineering works, and a rapid response team is kept on constant guard. Maintenance orthe most aected section at Dawlish currently runs at 500,000 year. With rising sea levelsthese costs can be expected to increase over time. Network Rail is planning to invest inmoving the line all together in 2050.

Heavy rains damage transportation infrastructure in Tanzania

Flooding in the central Dodoma and Morogoro regions o Tanzania aected at least 28,000people in late December 2009 and January 2010. In January, President Jakaya Kikwete saidthat two weeks o El Niorelated rains had caused damage to the central railway line androads in the regions that would cost an estimated $4.8 million to repair. This money wouldhave to come rom government unds previously allocated to development, meaning thatthe countrys development plans would have to be postponed or abandoned, accordingto the president. The rainy season in Tanzania lasts until the end o May, meaning thatadditional ooding and diversion o government unds to emergency response couldpotentially continue or several months ater this episode.

Sources: IIM 2003; RSSB 2008; Mckie 2006 Tanzania: Floods Aect 28,000 in Central Regions,January 21, 2010, allArica.com, http://allarica.com/stories/201001210613.html(accessed March 24, 2010).


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Insurance costs may also increase,

and in some cases, insurance may

become unavailable (see Box 6).

Box 6. Insurance Costs Rise in Hurricane-Prone Areas andInsurance May Become Unavailable in Future in Some

Locations

Owners o oil rigs and oshore platorms in the Gul o Mexico have been hit hard byincreasingly scarce and expensive insurance coverage due to heavy asset damage bywindstorms and hurricanes over the past ew years. As a result, in 2009, many ownersdropped coverage and began sel-insuring, absorbing the risk o a high-impact hurricaneseason themselves. Major losses in 2008, especially rom Hurr icanes Ike and Gustav,signifcantly drove up prices or insurance coverage in 2009.

As sea surace temperatures (SST) increase due to climate change, asset owners willace a greater risk o more intense and more requent hurricanes in the Gul o Mexico.According to recent research, hurricane requency is highly sensitive to increased SST: a

0.5oC increase in AugustSeptember SST in the North Atlantic (where hurricanes that hitthe Gul o Mexico originate) could lead to a 40 percent increase in requency. Warmerseas also tend to lead to more intense hurricanes. This means that insurance prices couldcontinue to rise, as more intense hurricanes generally wreak greater damage on assets(see fgure).

Change in Winter Cyclone Strengths:Total Number of Events (left) and Number of Intense Events

Source: Lambert, S.J., and J.C. Fye, (2006)

One way or insurers to limit their exposure to high risk areas is to completely abandonthe market. This has already been observed in the Gul region in the United States.In 2004, The US insurer Allstate stopped writing commercial insurance policies inFlorida and decided not to renew 95,000 residential homeowner policies because othe our hurricanes that hit Florida in that year. The company has stated that climatechange has prompted it to cancel or not renew policies in many Gul Coast states, with

recent hurricanes wiping out all o the profts it had garnered in 75 years o sellinghomeowners insurance.

In 2008, State FarmFloridas largest private insurerstopped writing new policies inthe state. This was a ter suspending sales o new commercial and homeowners policiesin Mississippi the year beore.

Sources: Emanuel et al. (fgure); Environmental Deense 2007; Conley 2007; Garcia and Benn 2008;Mills et al. 2006


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Sta health, saety, andproductivity are likely to be impacted

by climate change and this may lead to

increased expenses (see Box 7).

Box 7. High Temperatures in Buildings and Reduced Worker

Productivity

Although perceptions o temperature vary rom individual to individual, most peoplebegin to eel uncomortable between 77F (25C) and 82F (28C). Research in theU.K., or example, considered that buildings which had reached a temperature o 28Cor above, or more than 1 percent o their occupied hours, had overheated (seetable below). Higher temperatures can have consequences or workers morale andproductivity and very extreme temperatures can result in potentially atal heat stress.

Temperature Thresholds in Buildings with Personnel

Warm temperaturethreshold: 25C (77F)

Hot temperaturethreshold: 28C (82F)

Thresholdsfor thermaldiscomfort

Building has overheated i it is hot or more than 1%o occupied hours.

Heat stress risk Indoor temperature above 35C (95F) or healthy adultsat 50% relative humidity.

Note: Temperature thresholds or workers health and saety depend on air humidity.

Projections o higher temperatures due to climate change will translate into increasedrequency o overheating. The fgure below shows that in some U.K. locations, somekinds o ofce buildings already overheat, while in others, this will only be an issuemany years rom now.

Change in Percentage of Hours During Which 1960s Ofce Buildings AreOverheated Under a Changing Climate for Three Cities in the United Kingdom

Note: Temperatures are or middle oors in buildings. Overheated indicates that the thresholdor hot temperature is exceeded.

Warmer temperatures and more requent heat waves will lead to increased energyuse or cooling, possibly osetting decreases in space heating during colder months.Buildings that were not designed to cope with higher temperatures may need to beretroftted to reduce cooling costs.

Sources: Shaw et al. 2007; (fgure) Hacker et al. 2005


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Compensation or damage mayresult in increased expenses because

o climate changeinduced incidents

(see Box 8.) or legal ees to deend

against climate changeinduced tort or

contractual claims.

Box 8. Class Action Launched by Australian Wildre Survivors

Against an Electricity Distribution Company

The largest class action in the history o the Australian state o Victoria commencedat the Supreme Court o Victoria in February 2009 against electricity distributioncompany SP AusNet and the Brumby government, in relation to a wildfre at K ilmoreEast, Victoria. During a period o extreme heat, high winds, and prolonged drought insouthern Australia, a power line may have allen and sparked a fre that caused seriousdamage to local communities and resulted in several atalities.

SP AusNet is a wholly owned subsidiary o Singapore Power Limited and is responsibleor maintaining most o the power transmission lines in Eastern Victoria. The classaction ocused on alleged negligence by SP AusNet in its management o theelectricity inrastructure. The plaintis include thousands o armers, as well as small

business owners, tourism operators, and residents who lost their homes.

Immediately ater the lawsuit was fled, SP AusNet shares dropped by more than 13percent.

The Insurance Council o Australia estimated the cost o the bush fres at about $A500 million. SP AusNets legal liability is limited at $A100 million under an agreementmade by the ormer Kennett government with private utility operators, when the StateElectricity Commission was privatized in 1995. As a result, the Brumby governmentcould be legally obligated to pay damages amounting to hundreds o millions odollars.

In addition to acing the class act ion, SP AusNet is dealing with damage to some o itselectricity assets by the Victoria wildfre. As a preliminary estimate, it is thought that

damage has been sustained to approximately one per cent o SP AusNets electricitydistribution network, mainly distribution poles, associated conductors and pole toptransormers, SP AusNet said in a statement to the Australian Securities Exchange.

According to the latest climate change projections or Australia, up to 20 percentmore drought months are predicted over most o the country by 2030, and hightemperatures will become much more common.

Source: Arique en ligne 2009


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Additional capital expenditure

(CAPEX) may be required as a result

o asset damage or decreased asset

perormance (see Box 9). Further,

complying with environmental

regulations may require additional

CAPEX to upgrade acilities or

equipment to cope with increased

pollution risks.

Box 9. Additional CAPEX Expenditure for Transport

Infrastructure due to Climate ChangeIncreased CAPEX to reduce the impact of permafrost thaw on the Tibetan Plateau

On the Tibetan Plateau, warming o the climate is already occurring, and the decreasingdepth o rozen soils threatens the stability o the $4.2 billion railway line connectingLhasa, Tibet, to the Chinese network in Qinghai, China, known as the highest railwayin the world.

The railway is built on warm permarost (defned as being warmer than 1.5C), with amean annual ground temperature ranging rom 0C to 1C. Monitoring confrmed thatthe soil under the rails is vulnerable: warm permarost is very sensitive to disturbancesrom engineering activities, which have an immediate and direct impact on its warmthand moisture regimes.

Permarost on the Tibetan Plateau has warmed by about 0.3oC over the past 30 years.Where human activity, such the construc tion o the railway, has disturbed the soil theincrease in temperature is doubleabout 0.6oC. The area o the Southern QinghaiTibet Highway with underlying permarost decreased by 36 percent between 1974 and1996, while the permarost area o the Northern QinghaiTibet Highway decreased by12 percent between 1975 and 2003. Research indicates that the permarost area on theplateau may be reduced by up to about 60 percent by midcentury.

To manage the impacts o the changing climate, engineering techniques were used tostabilize the ground by keeping it rozen well below 0C. At the design stage, the use othis cooling technique added costs representing 1 percent o total project expenditures.As the railway was built to withstand temperature increases o about 0.2C and 2Cor soil and air, respectively, over the next 50 years, i the Intergovernmental Panel onClimate Change (IPCC) higher-end projections o around 2C3C increase in annual

average air temperatures in the region by 2050 are realized, additional CAPEX may beneeded to ensure that the railway can continue to operate.

Higher and more frequent peak temperatures may restrict air transportation,unless runways are lengthened

Air temperature and air humidity are among the actors used to calculate densityaltitude (the air density at a certain altitude). This measurement determines both aircratcombustion efciency and the runway length needed or takeo and landing.

Both air temperature and humidity will be aected by uture climate change and arenegatively correlated with air density. In the uture, higher temperatures and potentialincreases in humidity will reduce air density and aircrat lit, requiring either longerrunways at specifed aircrat loads or a reduction o aircrat cargo. For example, a U.S.Department o Transportation report rom 2008 states that or aircrats that use up tomost o the pavement on even the longest runways, even a 1 or 2% increase in densityaltitude may put those aircrat out o commission or daytime operations on certaindays.

Adaptation to this climate change impact may include shiting ight schedules to earlymorning or evening, when the air is cooler, or making runways longer, with consequentCAPEX. However, retroftting may not always be possible: in the case o airportsconstrained in size by their surrounding environment the CAPEX needed to adjust thelength o runways to accommodate uture climatic conditions may be prohibitive.

Sources: Cheng et al. 2008; Cheng 2005; UNEP 2007; Wu et al. 2007; Miao 2009; IPCC 2007; Kar l etal. 2009; NRC 2008


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Asset depreciation rates may

increase. Although the rates currently

used or accounting purposes may

reect historic experience, the eective

depreciation o assets due to climate

change may be considerably aster.

Consequently, fnancial models may

overestimate the real useul lives and

value o physical assets (see Box

10). Faster capital depreciation could

mean that assets need replacing

more requently, negatively aecting

projected cash ows.

Box 10. Infrastructure and Assets Wear Out More Quickly

and Require Additional Capital Expenditure under aChanging Climate

Wear and tear on assets and inrastruc ture will increase due to climate change.Research in Alaska has estimated the additional impact o climate change on capitaldepreciation or the states inrastructure by calculating the baseline replacementcosts or public inrastructure based on documented lie spans o various assetclasses and standard fnancial techniques or calculating depreciation, and applyingannual engineering depreciation rates or percentage changes in temperature andprecipitation, based on asset class, topography, and proximity to oodplains.

The study investigated two scenarios. In the frst, adaptation is undertaken whenclimate change leads to a loss in useul asset lie o 20 percent or more, with anadditional associated cost o 5 percent, and allowing ull asset lie to be regained.Under the second scenario, without adaptation, public agencies simply react asclimatic conditions change: they continue to design and construct inrastructure takinginto account historical climatic conditions but not projected changes.

The study ound that, under the with adaptation scenario, climate change will add$3.6$6.1 billion (NPV, using a public sector discount rate o 2.85 percent per year) tothe costs o wear and tear between 2006 and 2030, across a range o climate changeprojections. These fgures equate to 915 percent o total asset value or a 1020percent increase in wear and tear costs (see fgure below). Without adaptation, thecosts o climate change are in the range $3.6$7 billion between 2006 and 2030.

Range of Additional Infrastructure Costs for Alaskan Assets, Medium Scenariowith Climate Change Adaptation, 2006-2030 (top) and 2006-2080 (bottom)

($ billions, NPV)

Capital depreciation due to climate change is context-specifc. In the case oinrastructure in Alaska, the main climate risks aecting wear and tear are thawingpermarost, increased ooding, and coastal erosion. In other parts o the world otherclimate risks will be relevant, such as droughts, wildfres, or snowstorms.

Source: Larsen et al. 2007


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Table 1. Climate Change and the Credit Risk Analysis Process

Phases in the credit riskanalysis process

Climate change risks Examples of impacts on credit risk analysis

Understanding the marketand the project

Obtaining and verifyinginformation

Market conditions may beinuenced by a changing climate.

Assessing an industry cycle andstructure could include looking atthe inuence o climate change onindustry competitiveness, growthprospects, and exports.

For highly climate-sensitiveinvestments, businessperformance indicators suchas fnancial projections and assetvaluations may not be accuratei not inormed both by past andcurrent climate conditions and bythe projected eects o climatechange.

For highly climate-sensitive sectorsor locations, the project sponsorsexperience in managing climate-related risks can be evaluated

as part o their managerialand nancial strengths andweaknesses.

Climate change may aect the comparativemarket performance o the company or project:production costs, sales, value, and growth ooperating margins and net income may all changecompared to competitors who have dierentvulnerabilities to climate, or who may or may notimplement adaptation actions.

Failure to consider the impacts o climate conditionson output may lead to inefcient investment

decisions: decreased output could limit internalcash generation and cause higher deaultprobability in the case o overleveraged companies.

Evidence that management has consideredthe inuence o ENSO on rainall patterns andinvestment perormance can be evidence o goodmanagement. On the other hand, a lack of industryexperience in a management team can lead to thepoor perormance o an investment.

Identifying critical investmentrisks

Performing credit riskanalysis

Among investment risks, climate-change impacts may inuencefnancial capitalization and liquidityrisk, project completion risk,technical and operational risks,market risk, industry risk, andenvironmental and social risk.

In a number o sectors andlocations, and depending on theinvestment time rame considered,

credit risk analysis may besignifcantly colored by climatechange impacts:

EBRD is currently working on integrating climatechange adaptation issues into its due diligenceprocesses (Box 23).

Climate changein particular, reducedrainallmay have signifcant macroeconomicconsequences or developing countries wherea large portion o the economy is dependent onactivities reliant on water resources.

Production could be at risk rom decreased supplyof energy or higher energy prices.


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Country riskmay beaggravated by climate changeimpacts on economic stability.

Financial ratios may beinuenced by climate changes,which can lead to violation oloan covenants.

In cases where the investment

relies on climate-sensitiveinputs, estimates o theinuence o climate changeon the availability and priceso these inputs could aectassumptions in the productionrisk analysis.

Company environmentalperormance may be impacted,and additional OPEX or CAPEXmay be required to achievecompliance.

Company social perormance

may also be aected.

Project economic perormanceand return to society may bereduced.

Capital adequacy and fnancialcapacity, which can be aectedby climate change, are keycomponents o analysis o acompany or projects balancesheets and income statements.

For equity investments, climatechange may be an important

element o planning or anexit strategy, as it can partlydetermine the uture growth othe company or project.

Noncompliance with environmental regulationscan also result in dierent orms o liability(contractual, civil, or penal) or the project owner,which may adversely aect cash ow (due to costsincurred), income (due to decreased sales), ormarket capitalization (due to loss o reputation).

Climate change can aect resettlement costsorinstance, the project sponsor may incur extra costsin ensuring that resettled communities have access

to sufcient water resources.

The extent to which an investment provides anet positive contribution to the national economyo a country (economic rate o return) may beinuenced by climate impacts. For example, climate-induced impacts on supply and demand may aectthe generation o tax revenues. In essence, theeconomic rate o return o investments under achanging climate depends on the adequacy o theseinvestments to cope with new climate conditionsand on their ability to increase the adaptive capacityo the communities that they inuence or serve.A climate change-resilient investment may have a

higher economic rate o return.

Changes in climate may aect project cash ows,asset values and the companys ability to accesscapital.

With regard to equity investments, early growthwill not be as aected by a changing climate aswill medium-term growth (ca. 10 years). Futurechanges in climate may have a positive inuenceon growth in some equities, particularly thosewhere management oresees the risks and plansproactively or climate resilience. In other cases, theinuence o climate


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Developing nancialprojections

Assessing cash owsensitivity

Analyzing key ratios

Evaluating the investment

The nancial models developedby fnancial ofcers to orecastcompanies ability to service debtand/or generate added value maybe awed i they do not considerthe fnancial consequences o utureclimate conditions.

The ollowing fnancial ratios may be impacted byclimate change:

The debt service coverage ratio may decrease asproject internal cash ows are aected.

The measure of current ratio may be awed, assome assets may be overvalued, not accuratelyrepresenting the companys or projects value atliquidation.

The nancial internal rate of return may decreaseas projections o uture cash ows are reducedbecause o climate-induced OPEX, CAPEX, orrevenue loss.

In the case o equity investments, proftabilityratios estimating uture return on equity may beaected, i the amount o interim payments received(dividends) and, more importantly, the companyslong-term market value is decreased because ochanges in company income.

The discount rates used in cash ow calculationsmay be awed i they do not reect the impacts o

climate change on country and investment risk.

Sensitivity analyses o the best- and worst-caseuture discounted cash ows may not be ullyexploring the range o risks and uncertaintiesregarding company or project perormance. The riskmargins used may be awed.

Mitigating credit risk Mitigating the risk that investeecreditworthiness may deteriorateduring the investment lietimeinvolves taking appropriatemeasures according to the risksidentifed and their probabilities ooccurrence.

Investors mitigation measuresmay be insufcient i they do notidentiy such risks and probabilitiesin the light o climate change.

Covenants based on balance sheets, proftability,or cash ow may be set incorrectly, as the risk odeault may be higher than anticipated.

The terms of the debt may be set incorrectly,as cash ows may not be able to match requiredrepayments, particularly or longer-term loans.

Asset value at liquidation may be reduced, andcosts o maintaining repossessed assets (land,property, or equipment) may increase.


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The clients ability to renance may becompromised once awareness o climate risks hasincreased, whereupon the client could becomeless attractive to uture investors, making it moredifcult or a current investor to exit. Other sourceso repayment may also be aected: income rom thesale o assets or equity by clients may be diminishedas climate change aects market values.

The cost oinsurance or clients may increase,

and exclusion clauses may become more onerous.In some locations, or or some risks, cover maycease to be available. As a result, some companiesmay sel-insure, which would require them tomake fnancial provisions to cover uture losses,aecting their fnancial capacity. It should benoted, o course, that insurance does not protectagainst gradual erosion in perormance caused byincremental changes in average cllimate conditions.


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Loss contingencies may need to

increase as the risks o climate change

increase and are better quantifed.

Loss contingencies typically cover risks

that can be exacerbated by climate

change, such as loss o or damage to

property or assets rom fre or other

hazards, or rom pending or threatened

litigation.c They are accrued on clients

income statements or probable losses

or which the amount o loss may be

reasonably estimated. d Other climate-

related risks that may all within the

scope o loss contingencies include

increased risks o pest and disease

outbreaks and o damaging droughts

(see Box 11.). It is possible that in the

uture some o these losses may not be

insurable.

c See IAS (International Accounting Standard)

37, Provisions, Contingent Liabilities andContingent Assets, http://ww w.iasplus.com/standard/ias37.htm (accessed July 29, 2009).

d Loss contingencies are recorded as ootnotesin the balance sheet. Losses that are probableor have a reasonable possibility o occurringshould be disclosed in nancial statements,indicating the nature o the liability and anestimate or range o possible loss. Probablemeans more likely than not, or having agreater than 50 percent chance o occurring.A reasonable possibility o occurring meansmore than a remote chance but less than 50percent. Only remote liabilities do not deservemention in nancial statements. Remotemeans the chance o occurrence is slight.

Box 11. Accounting for the Increased Risks of Fire and Pests and

Diseases in Forest and Plantation Asset ValuesAccounting for re risk in valuing forest plantations

According to its annual report, a orestry plantation in East Arica has a biologicalasset valuation model that calculates air value assuming that 8 percent o theplantation is destroyed by fre every third year. Due to changes in fre risk broughtabout by climate change, such assumptions may prove inaccurate in a ew years time,and uture income projections or orestry investments based on these assumptionsmay be awed. Recent research provides estimates o changes in the areas most proneto fre as a result o climate change, based on the IPCC A2 greenhouse gas emissionsscenario (see fgure).

Projected Changes in the Distribution of Fire-Prone Regions by the 2020s

Forest plantation asset value at risk from pests and diseases

Mountain pine beetle (MPB) inestations have been made worse by the eects oclimate change. In 2007, MPB inestations were recorded in 9.2 million hectares opine orests, and they destroyed millions o pine trees in British Columbia, Canada. Inrecent years, hotter and drier summers in conjunction with milder winters, have ledto the largest MPB outbreak in recorded history. The range o the MPB is currentlyexpanding northward and eastward into new habitats. Modeling has indicated thatavorable climatic conditions have recently increased the area o optimal MPB habitatby more than 75 percent. Anecdotal evidence suggests that a pine beetle inestationgenerally reduces the value o a private woodlot or ranch by about 20 percent.Further, beetle outbreaks also create major fre hazards by clearing large portionso orest. This risk is urther increased as Southeast Canada may also be prone toincreased fre risk as a result o climate change (see fgure above).

Sources: Herbohn and Herbohn 2006; Krawchuk et al. 2009 (fgure); Walker and Sydneysmith2008; Carroll et al. 2003


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STEPS IN THE FINANCIALAND CREDIT RISKANALYSIS PROCESS

Failure to consider the impacts o a

changing climate outlined above could

mean that investors credit risk analysis

processes are not robust, as climate

change may lead to a decrease in the

creditworthiness o certain investments.

Most fnancial institutions approaches

to credit analysis or debt, equity,

and guarantees have many aspects in

common. The ways that climate change

risks are relevant to phases in a typical

credit risk analysis process are outlined

in Table 1.

Corporate Disclosureand Investment-RiskManagement

It is clear that unmanaged climate

risks could eed through into the three

key fnancial statements o investee

companies: income statements,

balance sheets, and cash-ow

statements. At a company level, the

aggregation o climate risks may result

in decreased capacity to repay debt.

Globally, concerns over climate risks

to companies fnancial perormance

are beginning to drive changes in

regulatory requirements or improved

corporate disclosure:

In 2009, the U.S. NationalAssociation o Insurance

Commissioners adopted a

mandatory requirement that

insurance companies over a

certain size disclose to their state

regulators the fnancial risks they

ace rom climate change, as well

as the actions they are taking

to respond to those risks (NAIC

2009).

In January 2010, the U.S.Securities and Exchange

Commission (SEC) issued new

interpretative guidance on

Disclosure Related to Business or

Legal Developments Regarding

Climate Change to provide clarity

and enhance consistency or public

companies and their investors.

This comes rom the SECs

realization that climate risks may

hold fnancial costs that are notadequately eatured in companies

published statements (U.S. SEC,

2010).

The U.K. Climate Change Act o2008 gave statutory powers to

the secretary o state to direct

statutory undertakers o critical

inrastructure, such as utility

companies, to produce reports

on how their organizations are

assessing and acting on the risks

and opportunities o a changing

climate. The secretary o state

can also ask or a group o

organizations to report togetheron climate change adaptation

considerations related to a specifc

location or a particular sector.

In January 2009, the Japanese

Institute o Certifed Public

Accountants published a proposal

requiring companies to disclose

inormation related to the physical

eects o climate change on

fnancial perormance.e

e http://www.japans.org/en/pages/029237.html (accessed September 10, 2009).


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Investors can try to manage keyinvestment risks by recommending that

their clients carry a combination o

insurance policies. When investments

carry appropriate insurance coverage,

most o the fnancial impacts o

extreme climatic events should be

minimized, though the implications o

incremental changes in average climatic

conditions are unlikely to be covered.

However, a changing climate will aect

the likelihood, nature, and/or severityo extreme weather events, which

will change insurers risk exposure

and may trigger a review o policy

conditions and/or price upon insurance

renewal. In some locations, insurance

premiums will increase signifcantly

or instance, as ood, drought, or

hurricane risks increase (see Box 6

above). The development o limitation

clauses may also exclude coverage in

case o adverse business impactssuch as business interruptionthat

result rom unmanaged climate

conditions. In locations or sectors

where climate change will cause very

high risks o damage, insurance may

become unavailable. As a result, some

companies may be orced to start

sel-insuring, which requires making

fnancial provisions to cover uture

losses and which could aect their

fnancial capacity.

Corporate Credit andFinancial Risk

The risks to client fnancial perormance

described above could translate into

corporate fnancial risks or investment

institutions. It is difcult to predict

precisely how signifcant the fnancial

consequences o climate change or

investors will be, and it is unlikely

that climate change alone will aect

the liquidity or fnancial capacity o

an institution. However, it will add to

preexisting fnancial stressors, and

institutions may, as a result, suer

fnancial impacts.

The potential fnancial risks or

investment and treasury activities are

summarized below.

Deault probability

Lenders might experience increased

probability o client payment deault.

The proportion o impaired loans

in an institutions portolio may be

increased by more client liquidity

shortalls. Further, institutions might

ace increased liabilities associated with

the fnancial guarantees they provide to

their clients.

As regards investors balance sheets,

capital reserves requirements may

increase to cover higher on- and o-

balance-sheet exposures. Additionally,

high liquidity ratios might be more

difcult to maintain in the uture.


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Return on Equity

As outlined earlier, or those

investments where climate risks lead

to decreased net income and reduced

growth, the value o investors equity

holdings will be aected, and exit

strategies may not be realized.

Where climate change leads to

environmental damage rom an

investment or increased community

conict, the investor might suer rom

a reduction in capital gains realized on

equity sale because o the investments

poor reputation (see Box 13).

Value o Assets Used asCollateral

Collateral assets are an alternative

repayment source or debt in the case

o deault, provided they are valuable

and can be repossessed and disposedo reasonably quickly.

As inormation on climate risks and

their fnancial consequences improves,

it will become increasingly difcult to

sell assets that are recognized to be at

risk or that are difcult to insure against

climate risks. This is true o property,

land, and equipment held by lenders

as security. For example, i real estate

assets held as

climate risk and financial institutions - challenges and opportunities

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