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Climate-Related Financial Risk Projection Scenario Analysis in Malta:

Updated: Aug 19, 2023

Why do we need to engage in this?


Written by Galdies Charles and Borda Gabriella


Abstract

This paper highlights the importance of introducing in Malta climate-related financial risk projection scenario analysis. Climate change is one of the most pressing issues facing our world today. It is a risk multiplier that has the potential to cause significant economic damage and disruption. Climate Scenario Analysis (CSA) can be a critical tool used for climate risk management in Malta by helping to identify, assess and manage the financial risks associated with climate change. CSA involves the use of scenarios to project future climate-related financial risks and their impacts on businesses, investments and other economic activities. By using CSA, organizations can better understand the potential impacts of climate change on their operations and make informed decisions about how to mitigate these risks. Additionally, CSA can help organizations develop strategies for adapting to a changing climate and ensure that they are prepared for any potential future events. This analysis requires collaboration from stakeholders across sectors, including government, business, and civil society, in order to ensure that Malta is prepared for the challenges ahead.

Keywords

Climate Scenario Analysis, climate change, Malta, climate risk management, financial risks, climate risk mitigation, climate adaptation strategies.


Introduction

Climate risk and uncertainty have attracted considerable attention within the financial services industry, from creating the tools and analytics, to quantifying climate risk, and helping channel financing for resilience and adaptation projects within the constraints of financial stability itself (Keucheyan, 2018).


Climate change is the biggest risk multiplier facing our economies today which will require collaboration from different stakeholders to navigate through these evolving risks. Today, we are still in a situation where understanding sustainability and decarbonisation plans remain a challenge (Muinzer & Ellis, 2017). Data gaps, comparability issues and uncertainty around sustainability disclosures are some of the obstacles, whilst national and regional central banks, financial regulators and supervisors around the world have increasingly warned that the uncertainty, volatility and economic transformation related to climate change risks, can threaten the financial system as a whole.


Risk managers today must increasingly be aware of all these emerging outcomes and strategic risks for businesses must be evaluated at all levels. We must fundamentally rethink our investment processes as added uncertainty from change will most likely make the underwriting of long duration debt problematic. The timescale, uncertainty and magnitude of change need to be carefully considered, within the prevailing and expected shifts in national, regional and global governance and technological domains, in an ever-increasing multipolar world.


Our starting point: Malta’s climate

Climate change is a global issue that affects everyone. It is important for countries to take responsibility for their contribution to the problem and start taking measures to reduce greenhouse gas emissions.


Malta, with its small size and population, has less of an impact on the global climate than larger countries, but it urgently needs to make changes in order to tackle the ever-increasing impacts arising from a changing climate (Galdies et al., 2016). For example, Malta’s mean air temperature during 1952-2020 shows a local warming trend of +0.2 ◦C/decade, equivalent to an overall warming of 1.5 ◦C (Galdies, 2022). The total yearly rainfall for the same time period shows a negative trend of -10.3mm/decade reduction. Meanwhile, Malta’s coastal waters have been warming up by +0.4 ◦C/decade since 1978 (Galdies, 2022).


So, what could be the impacts of these climatic changes on the local socio-economic and environmental sectors? Galdies (2022) shows how increased drought conditions will bring about changes in land-use and crop production that will further intensify the pressures on Malta’s freshwater systems. Increased water temperature will result in coastal waters having less oxygen, as well as changes in water circulation to the detriment of local touristic and fishing sectors, including aquaculture. Moreover, Attard et al., (2018) showed that sea level rise can have detrimental consequences to important number of infrastructural assets situated along low-lying parts of the Maltese coastline, comprising of touristic, real estate and industrial assets, not to mention transportation.


Climate change can indirectly affect Malta's economic sectors in a number of ways, such as with disruptions to trade, or problems with supply chains (Gatt, 2022). All firms rely to a certain extent on suppliers, especially small islands such as Malta. It is therefore essential for us to develop integrated response strategies and have a clear understanding of the possible consequences of potential climate risks, so as to subsequently build socio-economic resilience along the supply chain.


What is Climate-Related Financial Risk?

Climate-related financial risks, referred to as climate risk in this paper, can affect financial balance sheets and lead to losses through standard channels such as diminished asset valuations or increased loan defaults (Maechler, 2022). Understanding climate risk requires a focus on understanding how physical climate hazards or drivers of economic low-carbon transition affect firms and financial outcomes. Viewing climate through a risk lens means zeroing in specifically in the ways in which climate change affects assets, through hazards and drivers, exposures and vulnerabilities and how they transmit into the real and financial economies, affecting households, governments, companies, and the financial institutions.


Climate risk is usually divided into two broad categories: physical risk and transition risk (Taylor, 2022). Physical risks arise from the physical climate and weather impacts that result from climate change hazards, whereas transition risks arise from the transformation and any dislocation needed to drastically reduce GHG emissions. Such hazards are usually sub-divided into weather-related or weather-exacerbated events, of which occurrence is increasing over time (such as floods and wildfires), whereas the latter includes the gradual, long-term trends such as Increasing heatwaves and sea-levels. The equivalent drivers of transition risk include factors such as technological changes, tighter government policies to reduce emissions and bottom-up consumer pressures.


In the face of these hazards and factors, different kinds of assets and companies will have differing levels of exposure and vulnerability. For example, a factory or a hotel situated in a low-lying coastal area would be exposed to sea level rise, whilst a high-emissions facility, such as a chemical company would be exposed to tighter climate policy such as a universal price for carbon. On the other hand, vulnerability refers to the predisposition of the asset to suffer adversely from its exposure to hazards (Zhang, 2022). Vulnerability to physical climate risk depends on physical infrastructure. For example, if in the case of two neighboring shopping malls located in a flood zone, only one would have flood pumps installed, this facility would not be impacted in the same way as the other mall that has no suitable safety measures for such an event. Another example of vulnerability would be the ease of a manufacturing company of reducing or eliminating emissions through conversion to innovative low-carbon technologies as opposed to having to close down a facility. At corporate level, vulnerability can refer to the lack of preparation for issues such as climate change mitigation and adaptation planning, or to a lack of financial resilience in light of extreme climate events.


Local economic sectors that are sensitive to Malta’s climate hazards include natural ecosystems, water resources, agricultural and fisheries sectors (including aquaculture systems), energy and industry (including power plants), coastal zones, financial services and insurance, transportation, and recreation (including sports and outdoor events). The agriculture sector is highly sensitive to climate risks, with the potential consequences ranging from crop failure and decreased agricultural productivity (Galdies & Meli, 2022) , to increased occurrence of pests and disease (Attard et al., 1996), heat stress on livestock (Galdies & Vella, 2019), water shortages, and more frequent weather extremes such as medicanes (Miglietta, 2019).


As in other countries, energy production is a primary driver of economic activities across most of Malta's sectors, such as freshwater production, manufacturing and transportation (EWA, 2023). The increased demand for energy to powered manufacturing and transportation could be disproportionately burdensome in a carbon-constrained future when alternative sources of energy are still in transition phase.


Overall, the interaction between hazards or drivers, exposures and vulnerability lead to an overall effect of climate change risk as described in table 1 below.






Table 1. Matrix analysis of climate risk attributed to physical and transition risks according to hazards type at various levels.


Climate risks as a major driver of market volatility

As described above, the physical climate is a major driver of market volatility. The global financial markets are already feeling the effects of climate change (Botham & Lauro, 2020). At this stage, it is important to note that climate risk is not just about specific climate change impacts but also about how companies and investors tend to manage their risks by means of appropriate business decisions. It is very important that investors are aware of these risks and equally for governments to work towards mitigating and avoiding risks through the necessary support to the various sectors.


Climate-related physical risks can affect assets and firms in several ways. Perhaps the most straightforward of these is supply chain risk on which most of the local businesses rely to a large extent. Even if temporarily broken, this can lead to considerable demand, and pricing effects (fig. 1). Another indirect risk is liability risk due to both physical and transition risks, where firms may suffer financial consequences after being held legally liable. There is then a third category of indirect physical risks that can be considered systemic on the basis of their widely spreading effects and their multifaceted nature. An example of such risk is the effect on workers’ productivity due to high rising ambient temperatures.


Projected impact of climate hazards on markets and trade patterns

Other sources of transition risks include the notion of market risk are seen in figure 1 that encompass a broad range of potential supply, demand and pricing effects (Zhang, 2022). As industries slowly transition to a greener economy, the demand for certain commodities will shift, with effects filtering through other sectors. Likewise, shifts in demand for low-carbon infrastructure may cause market disruptions.


The expected future trends of a number of climate change hazards are being generated by sophisticated climate models that are routinely updated mainly in view of the continued understanding of the climate system and with the re-shaping of future socio-economic and technological models (Jones et al., 2016). The computation of the magnitude of these hazards are in turn based on a number of climate scenarios that outline the changing nature of future climate-related risk factors associated with alternative pathways for greenhouse gas emissions, leading to a range of climatic outcomes. Multiple scenarios can be developed to cater for how climate-related risk factors might influence future sectoral costings, as well as potential policy changes, in response to alternative pathways for GHG emissions. In most cases, the scenarios help explore how a particular pathway (for example, aggressive mitigation) might influence these outcomes, while also providing insights into how climate-related policies can change over time depending on the urgency of mitigation.




Figure 1. Linkage between climate risks and financial stability as applicable to the Maltese scenario (adapted from FSOC).


The benefits of using scenario analysis to understand climate-related financial risk

Scenarios are critical tools used for climate risk management, as Climate Scenario Analysis (CSA) is flexible enough to draw together all the relevant issues, risks and their interrelationships, yielding results applicable for many purposes (Udeke et al., 2022). CSA can be extremely useful to assess the linkages between climate-related risks and economic outcomes by looking at the implications for institutional financial stability in a methodic way. Now they are being used in project and risk management since It can help decision makers understand the different potential outcomes of their decisions and allows them to plan accordingly. CSA can therefore make organizations become more resilient and responsive to possible changes in the environment or market (Bongiorno et al., 2022).


The future of climate-related financial risk projections

Over the past few years, the global landscape of regulations and supervisory expectations has grown, and as these mandatory frameworks become more ingrained, there will be an increase in the deployment of new tools to encourage financial institutions to manage climate-related risks more diligently. Physical impacts from climate change will have secondary and knock-on effects on migration, public health, food security and international trade. The consequences of multiple climate risks on society, the economy and the environment might not be clearly understood and current risk assessments approaches might be underestimating future climate risks.

Climate-risk assessment tools will become more sophisticated whilst deeper understanding of the risks will be gained on a more granular level. Walenta (2019) argues that climate risk assessments and science-based targets are the new quantitative tools to mobilize corporate action against climate change.


Comprehensive sets of analytics are becoming available that incorporate both bottom-up approaches to support security level or investment decision-making, as well as top-down assessment to inform strategic asset allocation.


Conclusion

Uncertainty about the magnitude, scoping and timing of the economic damages arising from climate change translate into financial risk, which in turn can adversely affect financial markets and asset classes, as well as the income and balance sheets of businesses, households and governments.


A useful tool for calibrating these risks is CSA, which explores the repercussions for financial institutions from different climate-related outcomes. There are many challenges to such detailed risk assessments, including the long-time horizons of a decade or more. Another challenge is tied to the fact that climate hazards can vary widely across local geographical areas and can be highly industry-specific, requiring thus granular data about the type and location of the underlying assets.


As a country, Maltese public and private entities should research more deeply its policy proposals, with particular emphasis on their likely future indirect impacts. Although the precise magnitude, timing and form of these effects are uncertain, Malta and its entities should be making progress on a path to identify, assess and manage the resulting climate-related financial risks.


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