Climate Risk Measurement & Management Latest Update 2023/20

Climate Risk Measurement & Management Latest Update 2023/2024 Chapter 6 Risk Management Structured approach to monitoring, measuring and managing exposures to reduce the potential impacts of uncertain occurrences, and it has long been practiced by non-financial corporations and financial corporations alike. Climate Risk Management When practiced proactively, can help mitigate the impacts of climate change, both from physical impacts and transition impacts, on a financial institution's portfolio or corporations operations. Needs for understanding transition risk Not only 1. solid data on GHG emissions attributable to a company or asset but also an understanding of the 2. evolving climate policy landscape, 3. technological changes, and 4. evolving consumer and broader societal preferences, as well as 5. market sentiment. Needs for understanding physical risk Requires 1. forward-looking climate models and 2. historical weather data, as well as information on 3. physical geography, 4. adaptive infrastructure, 5. market responses, 6. cross-correlations, and 7. Distributions. NGFS economic transmission channels (micro) Businesses - Property damage and business disruption from severe weather, stranded assets and new capital expenditure due to transition, changing demand and costs, legal liability from failure to mitigate or adapt. Households - Loss of income from weather disruption, health, or labour market frictions, property damage. NGFS economic transmission channels (macro) Aggregate impacts on the macroeconomy - capital depreciation and increased investment, shifts in prices, productivity changes, labour market frictions, socioeconomic changes, other impacts on international trade, gov revenue, fiscal space, output, interest rates and exchange rates. Micro (Company-level) climate risks 1. Operational, 2. Credit, 3. Liquidity, 4. Insurance - some of these can also pose a system risk. Operational risk The risk inherent in doing business, and its reflects potential losses from inadequate or failed internal processes, systems, human erorr, or outside events such as extreme weather or terrorist attack. Operational risk metrics 1. Proportion of facilities in risky areas. 2. Level of company preparedness. Operational risk MICRO-level (company-specific) PHYSICAL risk - more frequent, severe extreme weather can cause property DAMAGE and business INTERRUPTION, both to company and suppliers. Heat can also affect worker productivity. TRANSITION risk - transmit to operational risk in case of abrupt POLICY changes leading to facility shutdowns. Operational risk MACRO-level (systemic/financial stability) Potential for climate to cause systemic/financial stability risk iis LIMITED. Only under a specific set of circumstances, such as where a sector has high geographic concentration. Ex: 2011 Thai floods and effects on supply chain for semiconductor production. Subcomponents of Operational risk 1. External risk, 2. People Risk, 3. Systems Risk, 4. Internal Process Risk, 5. Legal Risk, 6. Stratgic risk / reputational risk. Example: PHYSICAL risk of increased temperature and heatwaves results in dimished worker productivity which results in Operational Risk transmitted through people risk. Credit risk Measures the creditworthiness, or ability a borrower has to pay back a loan. Credit risk metrics 1. Probability of default (PD), 2. Loss given default (LGD), 3. Exposure at default (EAD). Probability of default (PD) The likelihood that a borrower will be UNABLE to pay back a loan. Loss given default (LGD) The amount a lender loses when a borrower is unable to pay back a loan. Exposure at default (EAD): The PREDICTED amount of loss a bank may be EXPOSED to when a debtor defaults on a loan. EAD is a dynamic number that changes as a borrower repays a lender. Credit risk MICRO-level (company-specific) Physical risks causing property damage and business interruption can lead to loss of revenue and lower profits, worsening a firm's financial position and increasing probability of default. Transition risk causing asset stranding can worsen a firm's financial position, increasing its probability of default, and increasing the loss given default for a lender given the lower asset valuation. Credit risk MACRO-level (systemic/financial stability) Potential for climate to cause system/financial risk is SIGNIFICANT. Sector-wide asset stranding or changes in demand can impact sector revenues and increase sector-level PD, posing financial stability risks in the case of important sectors and for exposed financial institutions. Ex: changing demand and cost structures affect revenues and profits. Liquidity risk Losing access to liquidity - the ability to quickly and easily convert assets into cash. Liquidity risk metrics 1. Loan to deposit ratio (banks), 2. liquidity ratios, 3. Bid-ask spreads (markets) Loan to deposit ratio A ratio to compare a bank's total loans to its total deposit. Bid-ask spreads The difference between what a buyer is willing to pay and the selling price of an asset. Liquidity ratio A liquidity ratio is a type of financial ratio used to determine a company's ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities (CFI definition) Liquidity risk MICRO-LEVEL (company-specific) Abrupt physical and transition risk-related events such as natural disasters or abrupt policy changes can prompt sharp repricing and sudden market re-evaluation of a firm's viability, leading to liquidity shocks. This can lead to widening of bid-ask spreads. Abrupt climate events can prompt large demand for deposit withdrawals at banks, raising their loan-to-deposit ratios. Liquidity risk MACRO-level (systemic/financial stability) The potential for climate to cause system and financial stability risk is SIGNIFICANT. 1. A "climate MINKSY moment" (wholesale, abrupt and board-based re-evaluation of climate risks by markets, causing massive repricing of assets and pro-cyclical crystallization of losses) could cause abrupt and wide enough repricing and dislocation to constitute a market liquidity shock. 2. If enough households, corporations and financial firms sharply increase their demand for precautionary liquidity after a severe natural disaster, this can be a systemic enough scale to necessitate INTERVENTION by central banks. Ex: 2011 EARTHQUAKE in Japan (not climate change), Bank of Japan had to offer record amounts of liquidity to banks to ensure stability in the markets. Underwriting risk key metrics 1. Changes in insurance premiums 2. Availability of insurance Underwriting risk MICRO-level (company-specific) Physical risk can lead to higher insurance premiums for corporations, or, in severe cases, for certain facilities in vulnerable areas. For some locations, insurance may become unavailable. Transition risk can lead to less insurance availability as some insurers refuse to underwrite certain kinds of activities and facilities, such as thermal coal power plants. Underwriting risk MACRO-level (systemic/financial stability) The potential for climate to cause system and financial stability is SIGNIFICANT. If a number of insurers withdraw or refuse coverage, this might leave firms completely without coverage, potentially amplifying risks to financial stability. Annual probability of occurrence (2017 Houston hurricane ex) 1% in 1981 to 2000, 6% by 2017 - Harvey occurred, and 18% by 2081 to 2100 under the worst case climate scenario. Macro climate risks primarily macroeconomic level - 1. MARKET 2. SOVEREIGN , Macro and micro level - 3. Operational, 4. Credit, 5. Liquidity, 6. Insurance. Climate risk translates to MARKET risk through 1