” Climate is what we expect, weather is what we get.” - Robert Heinlein
With the weather in Texas and the damages caused by Winter Storm Uri continuing to dominate the news cycles, I’m reminded of Heinlein’s quote, especially in the scope of forecasting. Climate is defined as a long-term average of a time period’s weather. Climatologists can use historical climate data to forecast the weather trends of the next set of years, whereas meteorologists use both climate data and statistical forecasting to determine the short-term weather conditions. So, I am thinking long term when I think of climate change. This makes it a risk topic because expectations are what is looked at when considering the risk of something. Believing or not believing is irrelevant when defining the risk aspects of a topic. Likelihood, impact, certainty, and scenarios are what should get our attention. For a community bank, it can be tough to get your arms around a topic like climate change.
As with countless other events in the last year and a half that have shifted our perspective in various fields, the weather events (from the Australia and California wildfires to the current cold spell) gave a tangible look at the effects of climate change. With a significant increase in the number of “extreme weather events” over the last 20 years, determining your institution’s preparation path in the case of a continuous streak of these events is critical to mitigating risk. This is especially apparent when considering estimates that climate change will put somewhere between 2 and 10 percent of all financial assets at risk by 2100. Moving this forward to the present period we focus on, with some our longest assets having a potential life of 30 years and the bulk somewhere between five and fifteen years, what should a community banker be thinking about.
With that lens in mind, it’s worth separating out the two ideas: risk “weather,” or what to do to handle weather events in the short-term, and risk “climate,” what to do to handle weather events in the long-term. Note that for the purposes of this article, I’m focused more on the space of community financial institutions, and also that “climate risk” is separate from “risk climate” (more on that in a second).
Risk “Weather:” Active Adaptation and Resilience
First things first: we all know that weather predicting, much like risk modeling, is statistically difficult. If there weren’t a consistently high-level of uncertainty, risk management wouldn’t be nearly as complex. However, that’s not the only way the two overlap. The concept of climate risk essentially denotes the effect of weather- and climate-related factors on financial importance. In the short-term lens where we start the conversation, this is mainly focused on ways to react to modern weather crises (like the current one in the southern states impacted by ice and snow).
A central theme of handling short-term climate risk is in the form of resilience. Resilience is an idea introduced into risk management, defined somewhat loosely as “the ability to return to the status quo after a disturbing event.” In situations like the unprecedented cold in Texas, resilience is key. Expecting to prepare for one-off extreme events is nearly impossible but taking the opportunity to study their negative effects on the community and understanding how to react properly later is crucial.
Forming a culture of resilience against climate risk can take a lot of different forms, depending on your local area. For example, a community bank in an area of California regularly affected by wildfires typically accounts for an associated increase in credit risk when considering their mortgage portfolios, due to their effect on property values and defaults. This type of plan is adjusted, however, for an institution in the southeast that has consistent flooding issues. And this specific credit risk might not pose as much of an issue for a northern Midwest state that does not have as prevalent of flooding or wildfire concerns. For those northern banks, climate risk could take a palpable form in dealing with the harsh winters. If climate change events become the “new normal”, an adaptive planning process is vital, and the use of scenario discussions builds the basis for change and resiliency. As an example, I worked with a financial institution in Texas several years ago as we were assisting them with their Disaster Recovery Plan. He said to me, “the problem I have with this sort of planning is that we really don’t have a significant exposure to the types of weather events others may experience”. We never even considered the impact of a long cold spell and the havoc it could wreak as we put the plan together. But now, reactively, it is going in the plan. Reactive risk management is not a strong place to play from.
Risk “Climate:” Long-Term Planning
Those examples, of course, are about the short-term reactions to one-time or recurring major weather events. In the long-term lens, the question of adjusting for climate risk is a bigger one: what paths can you put yourself on now to ensure your institution is prepared to handle climate changes in the larger scope, even if you’re a community bank?
Principally, this is similar to the ideas addressed in the “risk weather” section, in that the areas of focus will need to be tailored to your community’s particular climate. As an example, certain community banks are always at a risk of a decrease in revenue and an increase in loan defaults for any of their agricultural borrowers. If your institution’s portfolio is made of a considerable number of agricultural loans, I am certain you are assessing the full risk of these sorts of major market shifts in your area and considering how to angle your response. But one thing to consider is how many of your agricultural borrowers are involved in adopting new products or developing programs for helping with the transition to climate-resilient agricultural methods. The idea here is to ensure that those agricultural borrowers have the means later down the line to stifle those negative impacts of climate change.
In a wildfire area like California, of course, a community bank may have trouble seeing the direct benefit from these agricultural-focused methods. It’s the problem with long term risks like climate change. I could go into examples of what different communities might consider, but a more general perspective is worth taking in a large-scale shift like this one. With climate risk analysis being an inexact science (and the estimated rate of climate change ever-changing), taking time to consider all potential climate exposures is an early step, with risk rating borrower assessments possibly becoming a component of the underwriting process. This is not to mention the necessary strategic planning and potential allocation of financial risk management teams to governance methods.
Although all of this can seem like an undertaking with a vague payback, consider that this is predominantly an exercise in forethought and laying down groundwork for the future. There is a good deal of time; however, getting a head start sooner rather than later means less work if (or when) the extreme events or conditions are more frequent.
Climate Adaptation and Resilience
The reality of the situation, much like all of risk management, is that the solution for climate risk is far from an absolute and one-time answer. Adapting to changing weather and climate conditions is a difficult and ongoing process. Smaller communities are in a unique position where they can synthesize information, not only from the worldwide short- and long-term actions but also from the impact that climate changes will bring to their particular area. Of course, even when preparing with the best intentions, considering climate risk is still an imperfect process, just like predicting the weather. The next crisis could happen any time, and without warning. For those unexpected times, adaptation and resilience are critical—a topic we’ll go more in-depth into in the future.