Assessing forward-looking climate risks in investors’ portfolios: from theory to practice

Climate-related financial risk is characterised by endogeneity and deep uncertainty. The inadequacy of standard financial risk approaches to deal with these dimensions is a challenge for a smooth transition to a low-carbon economy. Across the last five years, we have developed a stream of work addressing this issue using a framework for climate financial risk management under uncertainty. This framework has been applied to the analysis of climate risk of financial portfolios, in collaboration with financial supervisors.

With this project, we aim to mainstream such a framework in microprudential and macroprudential policies implemented by financial supervisors and financial institutions belonging to the NGFS. We have engaged with relevant NGFS stakeholders through bilateral meetings, focus groups, and international conferences to co-develop narratives related to two main questions:

  • How can the available scientific knowledge on climate change mitigation be best applied to identify relevant scenarios of disorderly low-carbon transition?
  • What are the implications of scenario selection for investor decisions and for financial stability?

We found there is great importance to foster central banks’ and financial regulators’ understanding about:

  • Climate change mitigation scenarios (e.g., those co-developed and used by the NGFS), their limits and opportunities, and the conditions to use them to inform climate stress tests exercises;
  • The endogeneity of climate-related financial risks in climate stress test; and
  • The conditions for finance to be a driver or a barrier to the transition.

The stochastic impact of extreme weather events

In this project, we assess the impact of abnormal weather shocks on the global macroeconomy. Extreme weather events are random in size and location. We use stochastic trials to generate a distribution of weather shocks across the world and use NiGEM, a large macroeconometric model, to quantify the impact of these shocks on the macroeconomy. NiGEM links countries through trade and non-trade channels, and as such, a shock that impacts a single country or region will reverberate to other parts of the world. Our project captures the direct and the indirect impact of extreme climate events. Our analysis shows that extreme weather events cause economic volatility and that spillover effects magnify these events. We show that international spillover effects from trade and financial markets are important transmission channels, particularly for small open economies that are densely populated.

Our research has implications for at least two areas of central bank policy. The most proximate area of intervention is through the stress-testing framework where financial institutions should, in our view, disclose the risks posed by extreme weather events. Central banks can also adjust capital buffers to specifically account for assets that are exposed to such events and intervene in a more granular way using lending metrics such as the loan-to-value ratio. Second, where possible, the central banks can adjust the haircut imposed on the collateral that it accepts in its monetary policy refinancing operations by taking into account the financial risk posed by extreme weather events.

Low-carbon Transitions and Systemic Financial Risk

The transition to a low-carbon economy has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Most notably, Mark Carney’s ‘Tragedy of the Horizons’ speech warned of the potential of a transition-driven ‘Minsky moment’ whereby a disorderly process leads to a sudden collapse in asset prices.

We identify the channels through which a transition shock could lead to a systemic disruption. These include the downward repricing of carbon-intensive (or green) assets and a reduction in emissions-intensive production. We outline the approaches developed by existing studies to assess systemic risk, including the tracking of transition risk indicators such as bank exposure to emissions-intensive sectors, stress-testing frameworks, and network modelling approaches.

There is still much uncertainty on how to best measure the level of systemic risk posed by the transition, and therefore the size of this risk. Paradoxically, the realisation of systemic risks is more likely when the source of risk is not well understood. It is therefore important to consider the possible channels and work on their potential implications.

NGFS Scenarios Portal

Changes to our climate are unprecedented and so past data are a poor guide to the risks that may materialise in the future. The NGFS scenarios provide a framework to assess and manage the future financial and economic risks that changes to our climate might bring. They provide a coherent set of transition pathways, climate impact projections, and economic indicators at country-level, over a long time horizon and under varying assumptions. The NGFS scenarios provide a foundation for scenario analysis across many institutions, creating much-needed consistency and comparability of results.

1in1000

This new research program that aims to integrate future risks and challenges, notably those related to climate change, ecosystem service loss, and social resilience, into financial processes and regulations. The program will act as host to 2DII’s research and partnerships with financial institutions, central banks, NGOs, academia, and financial policymakers on three key areas:
– Developing performance standards and metrics to define what is a ‘long-term investor’ and a ‘long-term bank’;
– Designing risk management tools and frameworks to quantify climate change-related risks and related issues, notably ecosystem service and biodiversity loss, and threats to social cohesion & resilience;
– Building capacity, policies, and incentives to help financial institutions and supervisors mitigate and adapt to future risks and challenges.

Finance, climate-change and radical uncertainty: Towards a precautionary approach to financial policy

Climate-related financial risks (CRFR) are now recognised by central banks and supervisors as material to their financial stability mandates. But while CRFR are considered to have some unique characteristics, the emerging policy framework for dealing with them has largely focused on market-based solutions that seek to reduce perceived information gaps that prevent the accurate pricing of CRFR. These include disclosure, transparency, scenario analysis and stress testing. We argue this approach will be limited in impact because CRFR are characterised by radical uncertainty and hence ‘efficient’ price discovery is not possible. In addition, this approach tends to bias financial policy towards concern around avoiding short-term market disruption at the expense of longer-term, potentially catastrophic and irreversible climate risks. Instead, an alternative ‘precautionary’ financial policy approach is proposed that offers an intellectual framework for legitimizing more ambitious financial policy interventions in the present to better deal with these long-term risks. This framework draws on two existing concepts — the ‘precautionary principle’ and modern macroprudential policy — and justifies the full integration of CRFR into financial policy, including prudential, macroprudential and monetary policy frameworks.

Financial Supervision beyond the Business Cycle. Towards a new paradigm

At the turn of the decade, a specific class of risks are coming increasingly into focus – long-term risks (LTRs). Pandemic, climate change, and social resilience represent major threats both to economies and sound and stable financial markets. This paper explores both the extent to which these types of risks are on the radar of financial supervisors and central banks, and mechanisms to drive financial supervision “beyond the business cycle”.

To this end, the paper reviews over 2,000 speeches, reports, and press releases as well as other public documentation such as Financial Stability Reports across eight major central banks (CBs) in the Global North & South. It presents an audit of the risk management activities of the eight central banks – categorized into measuring, monitoring and mitigation activities – and comes to the following conclusions:
Most quantitative measuring activities – in the form of stress testing – do not extend beyond the business cycle. The focus of those CBs that include LTRs is limited to climate change, and the regulatory use of climate stress tests remains unclear.
Monitoring of LTRs – tracked through Financial Stability Reports – is mostly backward and not forward-looking. The most monitored risks are those LTRs that recently materialized, such as Covid-19.
Mitigation policies, such as decarbonizing monetary policy, or setting green capital requirements rarely consider LTRs. Even though we argue that mitigation policies are the most important step of risk management, CBs – in particular CBs of the Global North – do not have mitigation policies in place that included LTRs.
The way forward:
Having identified long-term risk management gaps, the paper takes a step back and discusses a required shift in thinking needed to address these gaps.
As for the required shift, the paper calls for capacity-building – such as implementing precautionary measures and supporting effective policy coordination – in order to better prepare for long-term risks.

Low-Carbon Transitions and Systemic Risk

The low-carbon transition has been cited by policymakers as a potential driver of systemic risk that could lead to financial instability and negative macroeconomic outcomes. Transition risk refers to the economic and financial risks associated with a disorderly transition to a low-carbon economy. Policymakers have highlighted that the systemic nature of transition risk could lead to an adverse impact on financial stability. In particular, several have warned of the potential for a transition-driven ‘Minsky moment’ whereby a disorderly transition leads to a sudden collapse in asset prices. This work draws on the frameworks of central banks and academic studies to identify the channels through which an adverse shock can lead to a realisation of systemic risk. Systemic risk can be defined as the risk of a shock that has negative externalities on economies and financial systems via networks. This risk can be realised when a large number of financial market participants are impacted simultaneously or when a sectorspecific shock leads to contagion and feedback loops that amplify the impact. The realisation of systemic risks can also be more likely when the source of risk is not well understood. This makes it inherently challenging to identify them ex ante, but therefore important to consider the multiple possible channels and work through their potential implications.
The report then considers the channels through which systemic risk could materialise under a low-carbon transition. The main sources of risk identified in the context of a low-carbon transition are a sudden downward repricing of carbon-intensive (orlow-carbon) assets and energy price shocks. The repricing of assets would lead to losses for those directly and indirectly exposed. Feedback loops can also amplify the initial losses and have a negative impact on the wider economy. Further, a disorderly transition could lead to an energy price shock which has a large negative impact on economic growth. Within these main sources, we outline the detailed transmission channels for systemic risk stemming from overlapping portfolios, lending between financial market participants, and the interaction between the financial system and the real economy.
While there is an extensive literature on systemic risk, the literature on systemic risk in relation to a lowcarbon transition is still in early stages of development. Since the financial crisis, there has been a growing emphasisin the literature on assessing the systemic financial risk triggered by unexpected shocks, such as the bursting of the subprime mortgage bubble in the US. Approaches include the development of marketbased indicators that capture the build-up and materialisation of systemic risk, general equilibrium models and stress testing frameworks. Whilethe literature focussing on transition risk in particular is more limited,
there are studies which have employed networks approaches to estimating systemic risk in the context of a low-carbon transition.
We identify the main gaps in existing methodologies for estimating the systemic risk posed by a low-carbon transition and recommend areas for future research. First, further data collection is required to better assess
the exposure of assets to transition risk. In addition, policymakersshould work to develop more comprehensive climate-related stress testing exercises, with more of a focus on second round impacts.
Where possible, these exercises could draw on historical events with similar characteristics, such as a large swing in energy prices. Further, the development of more comprehensive approaches such as multi-layered
models of financial and production networks, and frameworks that include both the impact of rising and declining industries have the potential to improve the assessment of systemic risk.