Listen: Masters of Risk | Episode 2: A Discussion with Ilya Khaykin

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Yashi Yadav

Welcome to Masters of Risk, the podcast where we uncover what is top of mind for business leaders today. I'm Yashi Yadav, and I will be your host every month. Let's get started.

Hello, everyone, and thank you for joining Episode 2 of Masters of Risk. Joining me today here is Ilya Khaykin. He is a partner at Oliver Wyman, which is a global management consultancy. He is the leader of Oliver Wyman's Climate and Sustainability platform for Financial Services in the Americas, and he's based out of here in New York. Hey, Ilya, how are you doing?

Ilya Khaykin

I'm good. Hi, Yashi. Thanks for having me on.

Yashi Yadav

Yes, I'm super excited. I feel like a lot of the things that we're going to be covering today are super topical, and I'm hoping that our listeners enjoy tuning in.

So without further ado, let's just get into it. I think to give the backdrop of the conversation, it would be helpful to kick this off by asking you, what is climate risk, right? Like what is it? What kind of risks are we looking at? What are the different dimensions? Just maybe give us a little bit of a baseline for this conversation.

Ilya Khaykin

Sure. Happy to do that. Yes. So climate risk usually is divided into 2 broad categories, right? And the first one is called physical risk, and that's what we tend to think about traditionally, right? And so that includes things like rising sea levels over time. That includes potentially increased floods, heatwaves, those types of physical events. Physical risks often they divide it into acute, so like a flood versus chronic sea level rise, for example, going up slowly over time. And the physical risks, of course, those have impacts that we've been starting to see globally and have been -- have drawn a lot of attention. So that's one category.

Now the other category that's particularly also relevant for financial institutions is called transition risk. And transition risk relates to the transition to a low carbon economy, right? And the idea is that, while we've started to transition to a low-carbon economy, there's much more that needs to be done. But that transition, right, it comes with it changes in the economy, changes in the investment landscape, changes in the commercial and economic dynamics for different sectors of the economy, right?

And notably, for example, if we are going to transition to a low-carbon economy, we can't continue to pull as much oil and gas out of the ground as we want, coal out of the ground as we want and burn that, right? And so what is the implications if we do transition and some of that behavior is reduced relative to, otherwise, what's the implication of that for the companies that operate in those sectors for the financial institutions that are investing and lending to those companies. So that's transition risk. Basically, all those risks associated with transition to a low-carbon economy and what the implications of that on the economy.

And then often also and more and more relevant is another category related to legal risks. So there are numbers of lawsuits related to climate. There are different types of lawsuits. Greenwashing is a particular area that has emerged as a hot point, which, essentially, there are a number of different ways of defining the term, but often it relates to risks related to misstatement of green credentials that aren't really as green. So when, for example, a fund may label themselves as ESG or green, are they actually -- is there actually the processes and conditions for that to be true? And so any kind of mislabeling, that's often called greenwashing now. So there are legal risks around that as well.

Yashi Yadav

That's really interesting. I guess, something that I'm curious to understand is, do you find that the greenwashing occurs primarily with, as you mentioned, a fund or a financial institution? Or are you noticing that type of a legal risk come up in nonfinancial corporates as well?

Ilya Khaykin

No, it can certainly apply to corporates in addition to financial institutions, really a big area is just -- this is -- as companies are disclosing more and more about their ESG and climate characteristics and they've been under pressure to disclose more and more, this kind of risk can also increase, right? Because they're putting more information out there, and the onus is really on them to make sure that information is fully accurate, right? And that what they're doing is having an impact, right? It isn't just marketing, but it's having an impact on the climate. So it applies across sectors. And the legal risks also apply across sectors. We're seeing this come up with financial institutions but, of course, there have been big lawsuits of oil and gas majors and other industry groups.

Yashi Yadav

Yes. No, that was my first assumption went, right, oil and gas, any sort of those more heavily carbon-emitting sector is where I would -- where my thoughts would go in terms of the impact sort of being greater.

Now when you talk about the pressure that firms are facing across all sectors, is there more pressure regionally? And what I mean by that is we know that the U.S. has been regulatory light per se in terms of the conversation around climate compared to the EU. Do you mind just sharing what some those differences look like even just maybe from a regulation standpoint or how companies or firms are having to behave differently in those geographies?

Ilya Khaykin

Sure. And maybe just to give a little context to this. I think a lot of this work on ESG and sustainability has been going on for quite some time, but I think a key point for the industry was when the TCFD recommendations came out, and I think that's 2017. It's possible that it was 2016, but I think it was 2017. And those recommendations, essentially -- the TCFD stands for Task Force on Climate-Related Financial disclosures, and it was a group that was sort of set up by the Financial Stability Board. And it was headed then by Mike Bloomberg, and there was this whole steering committee.

And they came out with a set of recommendations that basically said that companies should disclose their climate risks and their climate opportunities and have much more detail on what that disclosure should contain. But the idea behind that was that by promoting disclosure, then you're going to bring the market in. And if investors in the market understand what the risks and opportunities are, that's going to drive the flow of capital, right? And capital is going to, all else equal, move away from the risks and towards the opportunities. That's also going to be beneficial. That's also going to be beneficial because if there are activities that are very risky, say, from a transition risk perspective, right, then that may move capital actually towards the greener activities that are, in some respects, potentially less risky at least from a climate standpoint.

So that set of recommendations came out, and it had a kind of a global scope and it applied globally. And we saw, globally, companies around the world signing up to that. And what we saw is financial regulators in different jurisdictions starting to pick up and also look at, ask, well, how are financial institutions themselves managing these risks, right? And we also have started to see securities markets regulators and other regulators pick up on the disclosure side of this to mandate, to start to require disclosures of relevant climate information.

Now a lot of that happened in Europe before it happened in the U.S. I think the U.S. was relatively more silent on the topic under the prior administration. And then more recently, in the U.S., we've seen a lot more movement both from the prudential regulators and from the SEC on the disclosure side. There's kind of a few year difference in terms of timing of when all this was started.

I think at this stage, though, what I would say in the U.S., we have the regulators, which have come out with principles for climate risk management at this stage. There's a proposal that has come out on that. The regulators have also now started. The Fed has started to -- has started a climate scenario analysis exercise that applies to the 6th largest banks. And so they're trying to check on and learn about and enhance the capabilities of the financial institutions.

In Europe, they actually were doing this earlier. The ECB had to run an exercise on the system, which included climate scenario analysis. I think the Bank of England was one of the earlier ones to do something like this. Banque de France, the Central Bank in the Netherlands as well had run these kinds of exercises already going back a few years now. So we're playing a little bit of catch-up in the U.S., but things are certainly moving.

Yashi Yadav

I think that's really interesting. I'm curious to see how things progress in the coming sort of years. Do you know what the Fed has put out in terms of the different stress test exercises? Are they similar to what we've seen already put out by, as you mentioned, the ECB or Banque de France? Or are we looking at different factors here?

Ilya Khaykin

Yes. So one of the good pieces of news on this front is that we have an organization called the NGFS, the Network for Greening the Financial System. And that's a collection of regulators and central banks from around the world. And the U.S. joined that at the start of this administration -- well, the Fed joined that at the start of this administration. And that has come out with recommendations and best practices on these topics. And so what we are seeing around the world is there is a common reference to that -- to those approaches.

Now regulators are always going to do what they think is in the best interest of their scope and their mandate, the markets that they cover. So we do see some differences across the jurisdictions. There are differences in terms of scope, right? So for example, the Fed has included the 6 largest institutions. There are differences in terms of some of the methodology details, right? There's been variation where I think some of what the Bank of England, for example, came out with was relatively detailed in some areas in terms of what they were asking for. Others have been more open ended. There are some different methodology choices that the different regulators have made. But I would say, by and large, it's relatively consistent overall.

Yashi Yadav

Okay. Yes, I know sometimes we can have some differences in terms of how we regulate. We can be a little bit less prescriptive giving, obviously, institutions a bit more opportunity to pursue their own route and framework.

Ilya Khaykin

For example, one of the differences is that the Fed has used a time horizon of 10 years when the -- for the part of the exercise that's focused on transition risk, transition risk of corporates. And other regulators went out farther than that, for example, that longer time horizons. That's one example of one type of difference.

When I think everyone could have a different -- even with the same understanding of the factual differences between the exercises in Europe and the exercises in the U.S., different folks could have different views on the materiality of that. I sometimes compare this to what the regulatory context during the financial crisis. And at that point, of course, there wasn't the same opportunity for coordination, right? Everybody had to move pretty quickly. And of course, there was coordination, but you didn't have this kind of group like the NGFS. You didn't have these sort of years of developing recommendations beforehand.

And so while different jurisdictions at the time had stress tests that they applied, those stress tests look different. Some were a little more centrally run versus distributed. Those -- there are kind of a lot of differences on that front, I think. And by comparison, my own view is that this is more coordinated and a little bit more consistent. The scenarios, for example, that everyone is using largely come from the NGFS, right, and that helps.

Yashi Yadav

Okay. Yes. No, that definitely makes a lot of sense. So I guess switching gears a little bit here, I am curious taking all of this into a much broader context. What are some of the opportunities in the space that exists for financial institutions? And then we can jump into the flip side in terms of what are some of those challenges.

Ilya Khaykin

Sure. So we have different analyses of what would be required to transition to a low-carbon economy, right? And those scenarios and those analyses come with different estimates of the investment required to get there. But they, by and large, all show that investment required is huge. It's in the order of trillions of dollars per year of investment need.

Now that varies depending on how quickly we transition, how aggressively we transition, but we already do start to see that transition happening, right? We see increasing share of renewables. We see policy programs like the IRA and others. And so we can say like there is some transition happening. And if we believe that, if we believe it's going to happen even if it doesn't happen at the exact pace we would ideally like, then the implication is that there are going to be big changes in the economy and even bigger changes in that investment landscape.

And so for a financial institution or for investors whose job is to invest, right, those changes in the investment landscape are really critical and really important. And so one needs to be positioned to take advantage of that, to make good on that. And so the types of -- there are different types of opportunities, but a lot of it is coming from provision of financing and provision of services from financial institutions to their clients in order to help them transition, right, in order to help them adapt to a changing climate.

So that would include things like investment in renewables. That would include things like carbon markets, right, the potential for large and significant markets that are trading carbon credits and using carbon credits as a tool to offset emissions on the one hand, but really to capture emissions to reduce the emissions elsewhere. There are products on the retail side, right, because retail customers now also are focused on this topic, carbon calculators, carbon offset programs, lending for green mortgages, green products. So there's a kind of an array of financial products that can come about in relation to this very kind of significantly changing investment landscape.

Yashi Yadav

Do you feel like there's a certain time horizon within which most institutions are going to have to implement some shape or form of sustainability-related, I guess, product or service or whatever it might be in the future? Or like how long is it going to really take for firms to take advantage of these opportunities?

Ilya Khaykin

It's starting to happen, right? We can look at, for example, sustainable. As you mentioned, there are different products out there like green bonds, green loans, sustainability-linked bonds, things like that, so we can see the trajectory of those. So we've seen growth over the last year, so there was a little bit of plateauing more recently.

So it has already started to happen. And then we also see many financial institutions have made commitments. There are different types of commitments they made, but among them are typically commitments to a certain amount of sustainable finance investment. And some of those are quite sizable in the billions and even trillion. And financial institutions are going after those opportunities. They are lending. They're looking to do more lending in the space of renewables, more lending to climate solutions, to technologies that will help us reduce our dependency on fossil fuels.

To do this well, I think it takes time, right? It involves some new capabilities as well for financial institutions in my view. And the opportunity set is starting to emerge more and more. For example, the IRA creates all new opportunities. Frankly, it's been slow on the policy side, on the government side. We need strong government action really to help make these opportunities commercially viable to help manage the risks, to create the right regulatory framework in place for this transition. So we're starting to see that, but there's a lot more to go.

Yashi Yadav

Ilya, I know some of your work does revolve around the more strategic aspect of helping institutions think in this direction. Is there maybe a particular story or something that you could share in terms of like work you've done in that space?

Ilya Khaykin

Sure. So this is one example where we were working with a -- in this case, we work with different types of financial institutions. In this case, this was work we did within an infrastructure and infrastructure equity investor.

Yashi Yadav

Interest.

Ilya Khaykin

And we helped them to develop risk management capabilities and climate scenario analysis capability so that they could look at a couple of their big -- they have a sort of large, lumpy portfolio of big exposures. And we looked at a few of their transactions, and we developed an approach to apply different climate scenarios to that. So what happens if we transition aggressively or what happens if we don't transition and it takes much longer and then to look at the performance of those investments in the context of those scenarios.

And we did that work and that our client went off and also replicated that. And when we heard back from them, we heard that not only was the work great in terms of helping them to understand the risks and before they make an investment, have that understanding of what the possible outcomes will be in those different states of the world. But their sort of capabilities became better known in the industry, and they actually got more co-investors to be interested in working with them because those co-investors knew that they were able to really do a good job on understanding the potential outcomes and the risks associated with those deals.

Yashi Yadav

Wow. So I mean that, in and of itself, sounds like an opportunity, right? I guess a question that I have on the flip side of this then is the challenges that you see for this industry given the current market environment, all the volatility that we're seeing, the pressure that's on not just large banks, but some of these smaller and midsized banks now with what just happened with SVB. But what are the implications that this type of an environment has on the work that you were doing?

Ilya Khaykin

Yes. So yes, it's challenging, right, because we -- in some respects, there's only so much focus that we can get from senior management. And when they're worried about other crises happening, then they may not be as focused.

But look, I think, by and large, what we've seen in the current environment is continued work on the topic. At this stage, most financial institutions have developed, have put in place new teams that are focused on climate risk and these climate opportunities. So while over the years, there has been a lot of other things going on, right? We had COVID, and we've all been dealing with the economic effects of that. Now we have other bank failures in the U.S. Because at this stage, new teams have been put in place and those teams really focus on this issue, I think the work larger continues.

And that work -- to your earlier question around what are the challenges, that work is difficult, right? And among those challenges, there are different types. I think data is one of the big ones, right, because to do this well, you need to understand your clients really well. You need to understand the business profile of your clients. You also need to understand emissions profile. And that's a new piece of information that financial institutions are trying to get a hold on directly from their clients, from their disclosures or through platforms such as what S&P has with true cost in the emissions data there.

So that's -- the data side of it is a big challenge. There are new analytics as well that need to be created to do this well. And then the other type of challenge is that, particularly in the U.S., so there are very different views on this issue, and navigating that landscape is not easy. And that applies both externally, right? You have different clients and different stakeholders, which have different perspectives on the topic, but also internally within the organizations often, right? And so developing kind of a viewpoint that is robust, and a strategy around that, I think, is important.

Yashi Yadav

Oh, yes. Of course. Definitely. We see a variation of opinion in-house here as well, along with just the clients that we speak to. You'll have a huge variety across corporate financial institutions. It all depends on who you're talking to and where the relevance is for them, even though we might think it's universally applicable. So I guess to wrap this up, I know we've taken up a good amount of your time and I've learned a lot from this conversation so I'm really glad that we were able to have you on, can you share with us a little bit about your work with S&P Global, again, on the topic of sustainability and climate risk?

Ilya Khaykin

Of course, happy to. So when we started working on this topic in earnest after the TCFD recommendations came out, we did some work with the United Nations Environment Program in a group of 16 banks that expanded beyond that to try to develop some of the first analytics for climate scenario analysis on bank portfolios. And then after that work, we teamed up with your colleagues at S&P to develop a product together, which is called Climate Credit Analytics. And it's really a kind of in-depth analytics tool that looks sector by sector and company by company and brings together the really deep data that S&P has, both financial data, emissions data through specific data like the cost of extracting coal from different mines and oil and gas production costs and things like that, auto projections from the IHS business, bringing all of that together with analytics that we had been working on the Oliver Wyman side to help financial institutions, banks, asset owners, asset managers, insurers project the impact of different climate scenarios on their portfolios.

And so that's really been the bulk of the work together over the past couple of years, and it's been a great kind of teaming on both sides. And I would say that we're proud that product has become a leader in the space. We have a number of the large U.S. institutions that are part of that Fed exercise, for example, using it, large clients outside the U.S. and Europe and Asia as well. So that's been the bulk of our work together in the recent years on this topic.

Yashi Yadav

Yes. I know we've definitely enjoyed working with you a lot. We've learned a lot from the Oliver Wyman team. So thank you guys for that.

Ilya Khaykin

And same on the cent.

Yashi Yadav

Awesome. Perfect. Thank you, Ilya, for joining us here on Masters of Risk. I had a great time chatting with you on what has been top of mind for institutions and regulators in the sustainability space. And I'm really looking forward to continuing our conversation in future, of course, as the environment continues to...

Ilya Khaykin

Thank you. Yashi. It was really my pleasure. Thanks for having me on. Love the conversation. This is really interesting stuff. I look forward to hearing your next podcasts.

Yashi Yadav

Perfect. Talk soon. Bye.