Climate Risk and SME Credit Analytics: An Urgent and Emerging Discipline
Climate and environmental risk analytics are increasingly important drivers of lending and investing decisions for every financial services player. However, while large corporates have started to disclose more data about their carbon consumption and emission targets, SMEs are severely lagging. The lack of climate and environmental risk analytics for SMEs, even at a high level, may become yet another barrier to accessing funding for these companies that constitute the backbone of many national economies.
We have developed a breakthrough technology to provide SME data and credit risk analytics to the financial services industry. We believe that adding ESG, and specifically Environmental Risk analytics to our solution will provide our clients with valuable insight that will strengthen their ability to understand and assess an SME’s exposure to climate risk and thereby improve the deployment of capital over the coming years and decades. It will take time for frameworks and standards to mature and become broadly adopted and it will take time before useful and granular data is published by every business.
As governing and oversight bodies across different regions, including the UK, EU, Singapore and India standardize their frameworks for ESG disclosures, we expect the focus on climate risk and its relation to financing to mature and accelerate. What might these frameworks look like as they relate to climate risk?
In their upcoming stress test, the ECB distinguishes transition risk from physical risk in their overarching climate risk nomenclature. The Bank of England’s climate risk framework establishes a similar distinction. Transition risk refers to the impact on a company’s performance produced by the transition from fossil fuels to renewable energy sources. This is a result of increasing carbon emission prices which will force companies to account for higher operating costs. It also takes into account the increase in fossil fuel prices, which will drive operating costs up and weaken a company’s risk profile.
In their stress testing documentation, the ECB notes that while transition risk is expected to first impact industries with carbon-intensive exposure, “green industries” are also susceptible to emerging credit risk factors. Green industries face uncertainty in terms of future technology paths, government subsidy regimes, increased competition, and over-funding in this high growth but volatile segment. Assessing their resilience will become an increasingly important capability.
In the context of climate risk, physical risk refers to a business’s exposure to extreme weather events which could limit or severely damage the ability to deliver their goods and services and therefore result in material financial loss. Examples of physical risk include the impact of severe flooding and extreme heat waves.
While the frameworks, methodologies and data related to climate risk are maturing, much more is required before financial institutions can accurately and reliably assess a business’s exposure, mitigants and ultimately, the impact of climate change on credit worthiness.
At Wiserfunding, we have started wrestling with these issues. Deploying our unique risk modeling expertise, we have begun adding climate and environmental analytics to our solution. This will enable financial institutions to quickly identify an SMEs likely exposure to key climate risks and start asking the right questions. We hope this will in turn provide SMEs with the opportunity to demonstrate their level of adherence to the environmental and climate standards. Our goal is twofold: first, to enable our clients to anticipate and manage the urgency and importance of climate risk factors as it impacts their credit portfolios. Second, by providing these insights and analytics at scale, we will help SMEs better understand their risks and accelerate the considerable contribution they must make to support the global climate agenda.
We will continue investing in and developing risk models that estimate how carbon intensity affects credit risk. For now, we are looking forward to making our early innovations available to our clients next month! Please contact us if you would like to learn more about this urgent and emerging discipline.