Cambridge Institute for Sustainability Leadership (CISL)
Embedding environmental scenario analysis into routine financial decision-making in Mexico and South Africa
November 2018 – Following on from its work as a knowledge partner to the G20’s Green Finance Study Group, CISL's Centre for Sustainable Finance has published reports on embedding environmental scenario analysis into financial decision-making in Mexico and South Africa.
In 2018 the World Economic Forum designated extreme weather events, natural disasters and failure of climate change mitigation and adaptation among the top five global risks in terms of likelihood and impact (WEF, 2018). Accordingly, the last five years have seen major global steps at the G20 level to ensure the financial system is taking due account of environmental risks and, as a consequence, capital is being allocated appropriately in support of sustainable economic development.
Accordingly, financial firms need to keep pace with these developments and expose their strategy, risk and regulatory affairs teams to new areas of knowledge (from drought risk to the energy transition) in such a way that confidence can be built and new decisions made. To facilitate this process in Mexico and South Africa, the Deutsche Gesellschaft für Internationale Zusammenarbeit’s (GIZ’s) Emerging Markets Dialogue on Finance (EMDF) and the University of Cambridge Institute for Sustainability Leadership’s (CISL’s) Centre for Sustainable Finance joined forces with the Instituto Tecnológico Autónomo de México (ITAM), Banco de México and the South African National Treasury on a project to promote the integration of environmental scenario analysis into practice in financial decision-making.
Specifically, the aim was to empower financial institutions across the banking, insurance and asset management sectors, and their respective regulators in both countries with insights that enable them to take demonstrable new actions to embed environmental scenario analysis into routine decision-making. The outcomes of the project include two tailor-made roadmaps for the South African and Mexican regulators and financial firms on how to develop environmental scenario analysis relevant to their own national contexts.
Based on the analysis of the national context, coupled with the knowledge CISL has gathered about the approaches of various G20 members to understanding and incorporating environmental scenario analysis in their mainstream financial decision-making, the report provides information about data sources, scenarios and tools required to put environmental scenario analysis in practice. Further, the report elucidates the main challenges faced by the Mexican and South African financial system along with recommendations for addressing these challenges. Although South Africa and México have very different institutional and regulatory backgrounds, environmental challenges faced by these countries are similar. In terms of physical sources of risk, water risks feature prominently. Within transition sources of risk, both countries currently are highly dependent on fossil fuels. Further, social issues underline the need for a ‘just’ transition. The two roadmaps and recommendations therein reflect those similarities. The recommendations fall into three groups: recommendations for financial firms, recommendations for regulatory authorities and recommendations for the collaboration between the two.
The recommendations for Mexico
1. Financial firms to develop methodologies and tools that enable incorporation of environmental scenario analysis into financial decision-making.
2. Financial firms to ensure that senior management is committed to implementing environmental risk analysis via scenario analysis.
3. Environmental authorities and the National Statistics Institute (INEGI) to proactively disclose environmental sources of risk data relevant and material for the financial system.
4. Financial regulators to develop, through the work of a high-level advisory group on sustainable finance, a deeper understanding of environmental sources of risk for the financial sector. Based on this understanding, regulators to introduce a clear position and agenda on environmental sources of risk.
5. Financial regulators to signal that environmental scenario analysis is a mainstream issue by adding priority environmental sources of risk to the country into the risk register for prudential supervisory activities.
6. Financial regulators to supplement this with regular in-person Board-level roundtables to discuss recent developments.
7. Convene a multi-stakeholder group (including industry practitioners, financial and environmental regulators and academic experts) to foster dialogue about environmental scenario analysis, construct a roadmap to implementation and explore creating a repository of risk data, scenarios and tools for environmental risk analysis.
Translated with the support of the Mexican-German Climate Change Alliance and the Bank of Mexico, a Spanish language version of this report is available to access here.
The recommendations for South Africa
1. Financial firms to develop methodologies and tools that enable incorporation of environmental scenario analysis into financial decision-making.
2. Financial firms to ensure that senior management is committed to implementing environmental risk analysis via scenario analysis.
3. Financial regulatory authorities to introduce a clear position and agenda on the environmental sources of risk.
4. Financial regulatory authorities to signal that environmental scenario analysis is a mainstream issue by adding priority environmental sources of risk into the risk register for prudential supervisory activities.
5. Financial regulatory authorities to supplement this with regular in-person Board-level roundtables to discuss recent developments.
6. Convene a multi-stakeholder group (including industry practitioners, regulators and academic experts) to create a repository of existing risk data, scenarios and tools that industry could be using and provide recommendations that would address existing gaps, such as in the area of disclosure.
Conclusions
Worldwide, the cost of 6°C global warming could lead to a present value loss of USD 13.8 trillion. In Mexico, the average annual cost of natural disasters has been rising steeply (National Risk Atlas, 2018). The slowdown of South Africa’s 2015 GDP growth was driven by a severe drought (DEA, 2018). Against this backdrop, it is vital that Mexican and South African financial firms and regulatory authorities take due account of material environmental sources of risk. However, there is a growing recognition that traditional approaches to incorporating environmental factors into risk management systems are insufficient in the face of the changing scale, likelihood and interconnectedness of environmental sources of risk (CISL, 2016). This calls for the use of environmental scenario analysis as a key tool to allow financial firms to analyse, measure and manage material sources of environmental risk. Putting environmental scenario analysis in practice would ensure that capital is appropriately allocated in support of financial stability and sustainable economic development that is consistent with the conservation and rational use of its natural capital and renewable energy resources. Both Mexico and South Africa have already embarked on this journey, however it should take further steps to enable its financial firms and regulatory authorities to incorporate new areas of knowledge (from drought risk to the energy transition) and methodologies (such as environmental scenario analysis) in their daily financial decision-making in such a way that confidence can be built and better decisions made.
Citing these reports
Please refer to these reports as:
University of Cambridge Institute for Sustainability Leadership (CISL). (2018, October). Embedding environmental scenario analysis into routine financial decision-making in Mexico. Cambridge, UK: Cambridge Institute for Sustainability Leadership.
University of Cambridge Institute for Sustainability Leadership (CISL). (2018 October). Embedding environmental scenario analysis into routine financial decision-making in South Africa. Cambridge, UK: Cambridge Institute for Sustainability Leadership.
