To start with: Climate-related and environmental risks[1] comprise
- physical risks – the financial impact of changing climate and of environmental degradation; categorized into acute (when arising from floods, storms, droughts, or similar types of risk drivers) and chronic (when originating from, e.g., constantly increasing temperatures, loss of biodiversity or resource scarcity and the like);
- and transitions risks – an institution´s financial loss which can result as a consequence of the adjustment processes towards an environmentally more sustainable economy (e.g., due to abrupt changes in climate policy or technological progress).
It is the general understanding that physical and transition risks manifest themselves through the existing risk categories – credit risk, operational risk, market risk, liquidity risk, and also non-Pillar 1 risks, such as migration risk, credit spread risk, real estate risk, or strategic risk.
Economic sectors that are more likely to be physically impacted are, inter alia, agriculture, forestry, fisheries, human health, energy, mining, transport, infrastructure, and tourism. Sectors which will, on the other hand, be probably affected by the transition to a low-carbon economy include energy, transport, manufacturing, construction, and agriculture.
The Network for Greening the Financial System[2] published in May 2022 a status report on the progress made by financial institutions, credit rating agencies and supervisors in accounting for climate-related risk differentials (meaning, risk differentials between green and non-green assets or activities). Financial institutions represented in this NGFS survey are banks, insurance companies and development banks (in the ratio of: 65-29-3). Participants come mainly from Asia, Europe and North America. The survey sought to identify the most advanced practices in green vs. non-green classification and in the assessment of risk differentials. Some of the results with respect to financial institutions, and which seem to be especially important to us, are presented in the following.
Results with respect to financial institutions:
The NGFS study results show that there is still limited empirical evidence of ex-post risk differentials.
Persistent methodological and data-related challenges in conducting risk differential analysis exist.
Methodological challenges, as the survey reveals, are:
- Financial institutions´ approaches to classification are still rather heterogeneous (regarding methods and definitions, as well as regarding coverage and granularity). This hampers accurate and consistent assessment of risk differentials.
- Classification methods are applied at the activity or asset level, and do not directly relate to risk differentials at the counterparty level. Reference possibilities between the two have to be increased, further analysis in this context is required. And finally, there is also need for greater interoperability between classification approaches, and for development of clear transition taxonomies.
- Risk profiles of assets are highly dependent also on factors that are not always controlled for in risk differential analysis (especially in transition risk with multiple idiosyncratic and non-climate-related factors).
- Conventional risk differential analysis (backward looking, based on historical data,…) is unable to (fully) account for
-
- the longer time horizon of climate-related risk analysis,
- the uncertain and non-linear nature of
- the impact of materialization of climate-related risks, and
- the likelihood of materialization of climate-related risks.
These phenomena are difficult to model.
Against this background, financial institutions in the survey are turning to other methodologies for identifying and assessing climate-related risks. For doing so they use various qualitative and quantitative tools – such as heat mapping, scoring, concentration analysis, sensitivity and scenario analysis.
Financial institutions´ and credit rating agencies´ methods suggest a moving away from classification-based, which means backward-looking, assessment towards a forward-looking – and more granular – assessment of climate-related risks.
Financial institutions explore also transition readiness of counterparties in non-green sectors as potential indicator for risk differentials. What therefore could deserve further analysis, according to NGFS, is differentiating in the evaluations between green – transition-ready – and transition-unprepared companies.
Financial institutions´ forward looking approaches need to be further refined (including methods to analyze the credibility of their counterparties´ transition plans and methods for scenario analysis and stress testing).
What also becomes clear from the NGFS survey is that the majority of respondents have not implemented changes in their IRB systems to factor in climate-related risks. Key challenges to model the impact of climate-related risks on PD, LGD and EAD are, among others, the lack of high-quality data and different reference horizons of model parameters and climate (-related) risks.
Furthermore, metrics to monitor exposures to climate-related risks are under development at financial institutions. Most respondents pursue a portfolio level approach to monitor their exposures to ESG (environmental, social, governance)-sensitive sectors. Combined approaches (tracking exposures at counterparty and portfolio level), on the other hand, are still rare at this stage.
There are only a few of the participating financial institutions which are also exploring the integration of sustainability risks into their pricing and collateral valuation. Pricing, however, will ultimately require a more refined analysis of risk differentials.
Overall, development of key quantitative metrics, indicators and limits remains work in progress for many financial institutions.
Possible inspirations from credit rating agency approaches:
How, up to NGFS, financial institutions could benefit from credit rating agencies in respect of climate-related risk evaluation is that credit rating agencies´ methodologies can provide a complementary perspective on financial risk impacts of these risk drivers. And they can also help improve the financial institutions´ analytical approaches for assessing risk differentials towards a more forward-looking and granular perspective.
Specifically, this could mean gaining valuable insights on how to assess transition readiness of counterparties or how to apply / design scenario analyses in order to undertake medium- to long-term risk explorations.
Possible additional support from supervisory side:
Concerning supervisory work and what might possibly be an additional support for financial institutions on the climate risk agenda, NGFS derives from its survey results the following three main suggestions.
First: Scenario analysis and stress testing: Supervisors could encourage financial institutions to further improve their forward-looking tools. Despite some challenges (mainly scenario design related) and limitations (to mention data availability), these are seen to be helpful instruments to assess the magnitude and range of the risks, and the resilience of the financial institutions´ business models. Refining scenario analysis is therefore crucial, points the NGFS. Furthermore, this could be complemented by considerations of how to account for climate risk mitigation and counterparties´ adaptation strategies.
Second: Enhance transition risk monitoring and management: Here supervisors could examine the envisaged role of counterparties´ transition plans. For financial institutions – to consider the different transition paths of different sectors and different geographical regions, and to proactively manage the resulting risks – consistent and systematic elaboration of transition plans by non-financial corporates is necessary, and guidance on it is required.
Third: Further work on how to integrate climate-related and environmental risks into credit ratings and financial institutions´ internal credit risk modelling could be undertaken to improve the understanding of the mechanisms.
Other risk differential and pricing results:
To bring for comparison purposes in addition an example on investigating risk differentials from outside the NGFS survey – and in the setting of capital market data – we refer to a recent Working Paper from the Bank for International Settlements[3] on carbon premia identification and quantification in the US corporate bond market. The authors of the BIS paper confirm with their results that a carbon premium exists, and they find that the size of the premium varies across maturities and, sector-wise, is larger in energy-intensive sectors. With respect to the dimension of the carbon premia, it has to be noted that a (considerable) 50% reduction in carbon emissions by an energy-intensive corporate in the maturity range of the most affected maturities (15-20 years) achieved a credit spread reduction of above 10 basis points. There seems to be some room left for environmental sensitivity.
So for the concluding sentence let us get back to the NGFS study: To integrate climate-related risks into risk management processes, business strategies, and capital allocation decisions requires to identify, quantify and price them.
[1] The following three paragraphs are based on: European Central Bank, Banking Supervision (ECB), Guide on climate-related and environmental risks, Supervisory expectation relating to risk management and disclosure, November 2020, pp.10-13.
[2] Network for Greening the Financial System (NGFS), Technical document, Capturing risk differentials from climate-related risks, A Progress Report: Lessons learned from the existing analyses and practices of financial institutions, credit rating agencies and supervisors, May 2022.
[3] Bank for International Settlements (BIS), Dora Xia and Omar Zulaica, The term structure of carbon premia, BIS Working Paper, No 1045, 25 October 2022.
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