Climate change is prompting investors to consider plausible climate-related scenarios and evaluate the potential impact on their portfolios. Dr Giorgio Baldassarri, Global Head of the Analytic Development Group (ADG) talks about the considerations for building climate change into scenario analysis. The following questions have been addressed from our webinar hosted on May 05, 2020^[1].

1. 1) Why is it important for banks and specifically their risk management teams to manage climate risks?

Climate change induced by greenhouse gas emissions poses a serious threat to life on earth. Over the past few years, it has become one of the top topics of debate among governments, central banks, and regulators due to its potential to slow-down countries’ economic output, reduce employment, and undermine the stability of financial markets. Since the 2015 Paris Agreement, 180+^[2] countries have committed to accelerate the transition to a low-carbon economy by enacting a variety of policies to facilitate the process.

Major central banks and financial regulators across the world are planning to test banks’ preparedness for major physical and transition risks.

2. 2) What are some of the risks and opportunities in banks’ lending activities?

The site of a commercial borrower used as collateral can depreciate due to natural disasters (floods, etc.), thus increasing the expected loss for the bank. Also a firm’s earnings could be influenced by increased costs of chosen investments into new/green technologies. These investments, in turn, could decrease its liquidity and, therefore, the ability to repay a loan.

Moreover, the need for additional capital to invest in green technologies could result in a decrease of the capital/debt ratio, which, in turn, would lead to an increase in credit risk. The potential introduction/increase of a carbon tax will penalize companies with high greenhouse gas emissions, thus affecting their debt service capacity. 

However, the opportunities include resource efficiency and cost savings due to innovative technologies which can help maximize a borrower’s profits and liquidity; moreover, companies with lower costs may reduce prices and compete more effectively to gain market share and increase earnings. These have a positive impact on firms’ creditworthiness.

3. 3) What challenges will banks face when conducting climate risk scenario analysis?

Scenario analysis is routinely employed at risk management departments, but the analysis of climate risk and transition risk in particular poses new challenges such as:

• What data should be included? The geographic location of the organizations value chain (both upstream and downstream).
• What scenarios in each country/industry sector? How many scenarios? How far away in time?
• What methodology should we use to connect transition risks to credit risk? How to capture risks and opportunities?

4. 4) What is S&P Global Market Intelligence doing to help customers estimate the impact of climate transition risks on credit risk?

We have developed two models to help our clients assess the credit risk of climate-related carbon policy issues. One of the main policy tools considered by governments to facilitate the transition to a low-carbon economy is the introduction of a carbon tax that penalizes firms with greenhouse gas (GHG) emissions. With our Climate Credit Analytics models you can evaluate how a future carbon tax may affect each item reported within company financial statements over the next 30 years with a fundamentals-driven model, developed in consultation with Oliver Wyman™ ; this is currently available for 1,200 large-revenue public and private companies in the upstream Oil & Gas sector, and we are further working with our partners to expand it to a selection of other carbon-intensive sectors; our company has officially announced the kick-off of this project that will enable analysis of the climate transition reference scenarios published by the Network for Greening the Financial System, a group of over 60 central banks and supervisors representing 60% of the global greenhouse gas emissions. The adjusted financials can be then fed into our Credit Analytics’ statistical models or into fundamentals-driven internal models used by our clients.

Additionally, you can evaluate how costs, revenues, earnings and creditworthiness of public and private companies across any sector may change over the next three decades with a market-valuation approach that leverages Trucost, part of S&P Global, carbon emission data. This approach was employed to carry out a detailed research on public firms, recently published in a Risk.Net journal^[3], including Trucost’s methodology to estimate carbon earnings at risk by quantifying current carbon pricing schemes in over 130 regions together with potential future carbon pricing scenarios required to limit global warning to well below 2°C.

Understanding climate transition (and physical) risks is an important component of the Task Force on Climate-related Financial Disclosures (the “TCFD”). Trucost also works with companies and investors to help them understand their exposure to climate-related risks and opportunities and report in line with TCFD recommendations.  

5. 5) What about climate-related physical risks?

We are closely following work completed by our colleagues at Trucost and are looking to embed their rich physical risk assessments into our credit risk models, to provide our users with a fully integrated, scalable and automated climate-linked credit risk tool. Trucost’s Climate Change Physical Risk dataset assesses company exposure to physical risks (including heatwaves, water stress, wildfires and sea level rise) at the asset-level based on a database of over 500,000 assets mapped to 15,000+ listed companies in the S&P Global Market Intelligence database. The dataset helps companies and investors understand their exposure to climate change physical risks under different future climate change scenarios to inform TCFD-aligned reporting, risk management and investment strategies.

6. 6) What other caveats should banks consider when conducting Scenario Analysis?

Regulators are starting to include climate change risks in their stress testing exercises, notably, Bank of England-Prudential Regulatory Authority for Banks and Insurers

In the context of scenario analysis, it is important to highlight that:

• Scenarios represent plausible future pathways under uncertainty
• Scenarios are not associated with probabilities, nor do they represent a collectively exhaustive set of potential outcomes
• Further work needs to be done by lenders/investors to embed scenario analysis as a key exercise in managing forward-looking climate risks in credit analysis and other investment analysis

Dr Giorgio Baldassarri

Giorgio is Global Head of the Analytic Development Group (ADG). His team is responsible for the analytical development, maintenance and on-going validation of all credit risk quantitative models and products across Credit Risk Solutions, which are used by financial institutions and corporate companies to measure and manage credit risk, including within regulatory frameworks such as Basel II/III or Solvency II.

Prior to joining S&P Global Market Intelligence in 2011, Giorgio worked at Barclays in Group Risk, with exposure to Operational and Credit Risk.

Giorgio holds a PhD in Quantum Mechanics and Semiconductor Physics from the University of Rome “La Sapienza”.