Climate risk assessment and identification of adaptation opportunities – our work in practice

The first step in Finnfund’s investment process is an initial project screening followed by a clearance in principle (CIP) from the Investment Committee to proceed with a more complete assessment of the investment. Physical climate risks and adaptation potential are included in this first screening with an aim to assess an investment’s exposure and vulnerability to climate related risks and hazards.

The identified risks guide us in identifying appropriate measures through which such risks can be mitigated or decreased. In addition, identification of climate risks enables us to build an understanding of the climate change adaptation needs of the investee.

At this stage we therefore also assess the potential contribution that the investment may have to adaptation and climate change resilience, either focusing on the economic activity itself, or looking at the wider business environment and at the system and society levels.

As illustrated in the image below, both acute hazards and chronic changes are included in the physical risk screening, and their relevance to the business is assessed. The investment team’s Environmental and Social Advisor undertakes the physical risk screening. Every investment receives a climate risk rating (high-moderate-low) that guides the next steps of the process. The risk rating is made based on a combination of the location specific risks, sector vulnerability and business vulnerability with regard to those risks.

In turn, the investment team’s Development Impact Advisor assesses potential adaptation opportunities, which also contributes to the development effect scoring of the investment.

After CIP approval by the Investment Committee, the investment case enters the due diligence phase.

Any climate risks or adaptation potential identified in the initial screening will be further assessed. The assessment covers the company’s capacity to mitigate the identified climate risks. To build a comprehensive understanding of the risks and adaptation potential, Finnfund’s analysis covers the main supply chains of the economic activity as well as market aspects.

The risks are also assessed through a ‘gender lens’, in other words guiding questions are used to assess whether the risks and vulnerabilities differ between the company’s stakeholder groups, and men and women.

In case the company’s activities increase adaptive capacity and resilience beyond the company’s own activities, Finnfund will specify the adaptation product or service and its benefits, beneficiaries, and the scale of benefits.

In case the due diligence process identifies a need to improve the mitigation and adaptation efforts in the company, they may be included in the Environmental and Social Action Plan (ESAP) or in other contractual documents between Finnfund and the investee company. The identified risk mitigation measures and their impact contribute to a final physical climate risk rating, which Finnfund flags as the investment’s residual climate risk.

Before the investment decision, Finnfund also carries out a credit risk rating process to define different credit risks related to an investment. This process results in a credit risk category for the investment; categories vary from AAA to D. Since 2021, Finnfund has included a consideration of physical and transition climate risks in internal credit risk rating methodology. Based on the outcomes of the climate risk assessment undertaken in the due diligence phase, Finnfund applies standardized metrics as inputs in its credit risk rating.

Example 1: A forestry company plants indigenous tree species in the buffer zones of their plantations as part of their land use and buffer zone planning. In case the region is hit by extreme weather conditions such as an exceptionally heavy storm, these trees can protect the plantation from more serious damage.

Example 2: Droughts linked to climate change amplify the threat of fires in plantation forests. Implementing well designed fire breaks serves as an important mitigation measure. These firebreaks can also be used for small-holder farming purposes, providing agricultural opportunities for local communities. This can be an option as long as crop selection is done correctly, and other necessary measures are taken to maintain the function of the firebreak.

Example 3: Climate change increases the risk of drought and makes weather patterns more unpredictable. While a large part of agricultural production in many developing countries is still rain-fed, agricultural actors also use various irrigation methods. To conserve water and ensure shared access to essential resources, producers can introduce drip irrigation, for example, providing a more regular and measured water supply to agricultural products.

After the investment agreement, Finnfund continuously monitors and works with its investee companies. In addition, through an annual reporting process, Finnfund reviews investees’, environmental and social and development impact performance. Climate risk monitoring is included in this process, based on the risk rating and identified climate events which may affect the target country or investment. For example, measures included in the Environmental and Social Action Plan will be monitored annually to ensure compliance. Changes in the risk level of the investment – positive or negative – may also affect the credit risk rating of the investment.

In 2021, Finnfund joined the Adaptation and Resilience Investors Collaborative, a joint initiative of 18 development finance institutions active in adaptation and resilience finance. Part of the work of this initiative includes work on harmonized metrics and indicators for monitoring adaptation impact. Once further progress on these metrics has been made, Finnfund will review its own processes.

Since 2021, Finnfund has also developed its approach to assessing and managing climate-related risks. This approach is aligned with the four pillars of the Task Force on Climate-related Financial Disclosures (TCFD): governance, strategy, risk management, and metrics and targets. Finnfund’s TCFD report is published annually as part of our Annual Report.