Climate risk innovation of the year: Baringa and XDI

Energy Risk Awards 2020: Baringa and XDI’s climate risk scenario model takes in physical and transition risk at global, portfolio and asset level

Colin Preston

Over the next several decades, climate change will up-end the global economy. Both physical and transition risk will cause the repricing of climate-exposed and climate-resilient assets worldwide.  

However, predicting the impact on investment portfolios is extremely challenging. The degree of warming is uncertain, the timing and stringency of regulations unknown, the interconnections between different sectors and markets highly complex, and the number of assets involved enormous.

“Most financial services institutions currently don’t understand the climate risk inherent in the assets that they own and the lending that they make, or the temperature alignment of those assets,” says Colin Preston, global financial services sector and climate change lead at consultancy Baringa. “That is a huge risk to those institutions as well as to the planet. And, if you don’t understand the risk or temperature alignment, that’s going to drive the misallocation of capital and future losses.”

Step forward the Climate Change Scenario model that Baringa has developed with partner consultancy XDI, and which won Energy Risk’s Climate risk innovation award. The model was built with financial services group Legal & General, whose assets of £1.14 trillion ($1.39 trillion) make it the UK’s largest asset manager. The aim was to embed climate change scenarios into its risk management framework.

“What we’re dealing with here is an interconnected system of intense complexity,” says Nick Stansbury, head of commodity research at the firm’s investment management unit Legal & General Investment Management (LGIM). While climate change models have been built by academic researchers, “what we needed was something built for finance professionals”.

That need brought together Legal & General and Baringa in a development project that combined Baringa’s modelling framework with Legal & General data and insights to develop the L&G Climate Risk Framework. “We understand asset markets, valuation, credit risk models really well. What we wanted to improve was our understanding of how to connect it to the world of climate and energy transition risk,” Stanbury says.

Key criteria for Legal & General were that the model was internally consistent and methodologically rigorous, and captured both the effects of the low-carbon transition and the physical effects of a changing climate. That requirement encouraged Baringa – which has been modelling transition risks for some 20 years – to team up with Australia-based XDI Systems, which has what Baringa’s head of climate risk James Belmont describes as “industry-leading” physical risk information, with an ability to assess the changing risk across all hazard types, based upon leveraging detailed data on the location and characteristics of 70 million assets globally, owned by 4 million companies.

Rohan Hamden

“We’ve been in the market for 10 years – we’ve solved a lot of the technical and data problems that the new entrants haven’t even come across yet,” says XDI’s chief executive Rohan Hamden. The firm’s analysis involves building virtual models of every physical asset, taking into account the materials with which they are built and the engineering standards to which they are constructed, and then subjecting those assets to eight physical hazards, such as windstorm, sea level rise, flooding, etc.

“We’ve learned to work with really complex climate and weather models and translate these into how the assets respond in location. That’s completely unique,” he adds.

By integrating physical and transition risks, Baringa’s Climate Change Scenario model generates an estimate of the financial impacts of different climate scenarios at the portfolio, company and individual asset level, says Oliver Rix, Baringa’s head of climate change, energy and environment. 

“One of the biggest challenges is that you need a framework that [allows you to] look at a scenario that’s aligned with a particular global greenhouse gas pathway and temperature outcome, all the way down to a particular physical asset or company,” he says. “That’s the value of the model.”

LGIM also wanted the model to be configurable at every level, allowing its analysts to plug in their own assumptions about the changing climate, regulations, technologies and the responses of particular sectors and companies. “The great advantage of the model is that every part of the calculation framework can be adjusted, adapted, configured and stress tested,” says Stansbury.

Oliver Rix

The model can generate a climate value-at-risk figure for an entire portfolio, as well as provide company-level insights that can prompt dialogue with company management. It is also able to meet reporting requirements in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), the initiative set up by the Financial Stability Board.

And, just as the risks and opportunities that climate change present are economy-wide and all-pervasive, so too is the application of the information the model generates, says Belmont. “The model is designed to support use-cases all the way from TCFD down through investor relations, strategy formation and individual front-office and risk management decisions”.

While Legal & General is the solution’s reference client, Preston says Baringa is working with several other banks to embed the model in their organisations, and is in advanced conversations with many leading financial institutions: “We want this to become a global standard in how our clients manage climate risk and understand temperature alignment, and how they communicate [the] impact they’re having.”