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Are regulations promoting or hindering progress in the industry?
There is a critical need for clear definitions, ideally establishing common standards across the globe on climate data, reporting and scenario analysis. This will contribute to a better understanding of the risks and opportunities inherent in the transition to a greener economy. Regulators play a vital role, by establishing prudential policies including tests that look at the resilience of the financial system to climate-related shocks, due to physical or transitions risks. It is also important to strike a balance between a detailed understanding about the financial impact and keeping in sight the broader picture, so that scenario analysis leads to actionable insights.
What type of models are used in assessing the impact of climate risk on credit portfolios? How can we assess the robustness of these models?
One of the major challenges is that quantitative models cannot be backtested, because we are talking about unprecedented phenomena and dynamics that will change over the next decades. S&P Global Market Intelligence and Oliver Wyman have developed a suite of statistical models that cover some of the most carbon-intensive sectors, as well as a multi-purpose general model for the remaining sectors. Our models build on the unique and granular datasets on company financials and company/sectors specific information, including S&P Global Market Intelligence's company financials and sector specific information and Sustainable1's carbon emission datasets, to produce bottom-up estimations of the financial impact of energy transitions risks. These models can be used on a standalone basis, to support scenario analysis in TCFD reporting or in stress-testing exercises. Since there is no established methodology and each model has its own advantages/limitations, we believe our models can also provide robust benchmarks to other internally built models.
Which scenarios do you use?
Our tools embed the Network for Greening the Financial System (NGFS) scenarios (version 1). These scenarios were generated using integrated models, including the interplay between carbon tax, energy supply and demand, carbon emissions, pollution, and the overall economy. We are currently updating the tool to reflect the latest set of NGFS scenarios, that were released in late June 2021.
How do you integrate a country's climate risk into a counterparty's climate risk?
The newest NGFS scenarios, released last June, already account for many dynamics across each country, based on several actions that governments may adopt to attain a certain temperature warming by a certain year. There is always a possibility that a country will not adhere to country pledges; therefore, scenario analysis becomes particularly important, as one can get useful perspectives on a variety of cases and response types.
How do you see climate risk impacting credit management not only for financial institutions and large global corporates, but middle-market companies, SMEs, and their related supply chains?
We see this as an exciting challenge, and believe that automated solutions, where possible, offer great opportunities. We produced an analysis, last year, using Sustainable1's data and studying the environmental impact of SMEs, and found that SMEs have lower environmental impact by virtue of the industries they mainly work in. Thus, the major direct effects of climate change may be related to physical risks events. This is obviously a critical aspect, due to its direct effects and the disruption it can cause on supply chains, and we are starting to look at it.
What is the common practice in managing climate risk as a financial risk in banks?
There is emerging consensus among financial regulators, globally, regarding the need to assess the risks and opportunities posed by the energy transition to a low carbon economy. Many regulators have already introduced or are in the process of introducing climate-related stress testing exercises for financial institutions. This is important to test their resilience to climate shocks, related to physical or transition risks. Regulators are starting to be mindful about the burden posed to financial institutions, especially for modelling risks and opportunities in a nascent yet prominent field like climate management. We see a two-pronged approach, for example in the Bank of England's guidelines, with a deep-dive analysis of the financial impact required for biggest exposures/large-revenue companies, and an aggregate view for the remainder of the portfolio.
Integrating Climate Risks into Credit Risk Portfolios with Climate Credit Analytics