The journey so far
Firms have come a long way in quantifying climate-related financial risks, since Supervisory expectations were set out in SS3/19. The BoE’s 2021 Climate Biennial Exploratory Scenario (CBES) provided the first major test of firms’ climate risk modelling capabilities and highlighted several challenges. In this article we look at the modelling related challenges firms are faced with, how we expect the regulatory landscape to change, and highlight why firms need to think beyond risk modelling.
The current state of play
By the end of 2021, most firms have built tactical solutions. In response to the CBES or to comply with SS3/19 they have tried to leverage existing stress testing tools, and where necessary developed additional modelling capabilities. Firms are now looking more holistically at how to make improvements to their climate risk modelling capabilities. They are also working on extending modelling capabilities to the estimation of IFRS9 impairment add-ons, and preparing themselves for the additional guidance on climate related capital requirements that the PRA is expected to provide in Q4 2022.
Key modelling related challenges
In our discussions with firms about integrating climate risk into credit risk modelling, there are three key challenges that appear; data, data and data. The core data and modelling related issues are presented below, together with some of the insights that we have gained.
1. Portfolio level data - The CBES exercise highlighted several gaps in firms’ data relating to missing fields on underlying exposures. For example, for mortgages, missing post codes, EPC ratings and insurance flags are some examples of pain points and have required firms to use extrapolation techniques in order to fill the gaps. For corporate and SME portfolios, obtaining an accurate sector assignment (e.g. a NACE code) has also proved to be cumbersome for many.
2. Climate related data - Undoubtedly modelling climate risk requires a wealth of additional data. Additional physical risk data is required to capture the risk (i.e. the severity and the likelihood) of an event for a given scenario. Damage curves are typically used to translate these metrics into financial losses on assets. Most firms source the hazard risk metrics from a third party and then use damage curves to estimate the impact on credit risk parameters. For corporate portfolios, additional data on carbon emissions, carbon intensity, carbon reduction costs, mitigation and adaptation plans need to be sourced, either from third party vendors or from the counterparties themselves. SME portfolios are particularly challenging given that third party data vendors do not provide coverage for smaller businesses and the counterparties themselves do not have the required data.
3. Modelling capabilities - Due to the nature and expected impact of climate risk, and particularly the length of the period over which many of the risks have to be assessed, firms are investing in building specific modelling capabilities for retail and non-retail portfolios, as discussed below.
i. Retail mortgages - Modelling the impact of climate risk for retail mortgages can be done largely by leveraging existing IFRS9 and stress testing models, provided that the additional data required (such as physical hazard risk data, cost of EPC upgrades, etc.) is available. However, the key distinguishing feature compared to a macro economic stress test, is the more detailed granularity of the assessment. Whilst macro economic impacts tend to be at a higher level (such as region or country level), physical risk impacts are much more localised. For mortgages in particular, firms should perform property-level modelling. This is one of the areas that has required firms to enhance their existing models.
ii. Corporate and commercial portfolios - Climate risk drivers are very different to the typical risk drivers that exists within an ordinary stress test or modelling framework. Therefore firms need to develop new methodologies. For example changing carbon prices, improvements in low carbon technology and changes in consumer preferences can drive the impact of transition risk on counterparties’ financials and subsequent default risk.
Firms have taken different approaches to quantifying this risk. The range covers qualitative, quantitative and hybrid approaches. Qualitative approaches typically use a climate questionnaire and require firms to establish robust outreach programmes to collect the required data from their counterparties. The output from the questionnaire is used to derive a climate risk score that is subsequently used to adjust the PD rating produced by existing rating systems.
A quantitative approach aims to model the impact on counterparties’ balance sheet and income statement considering the sector and firm specific dynamics of transition risk. The climate-adjusted financial KPIs (e.g. revenue, profits, capex, etc.) are then plugged into traditional rating models or other frameworks (such as the Merton-Vasicek or KMV-Merton model) to determine the impact on PD.
Finally, a hybrid approach contains both qualitative and quantitative elements. For example, a basic qualitative scorecard can be used to identify customers whose financial position is vulnerable to transition risk. For these vulnerable customers, more detailed cashflow modelling and/or sensitivity analysis is performed to assess the potential impact on rating grade assignment.
Forward looking regulatory landscape
The BoE is due to publish the results of the CBES this month. This will highlight their views on the strengths and weaknesses of firms’ climate risk modelling approaches and the progress that has been made in embedding climate risk into risk management frameworks.
Although the CBES will not be used to set capital requirements, the PRA is intensifying its supervisory approach to firms’ climate-related financial risk management. In addition to the strategic and competitive gains, firms who get on the front foot and clearly demonstrate greater progress in integrating climate risk compared to peers should benefit from being at a lower risk of action from the PRA.
On the qualitative side, the PRA have clearly set out their intention to assess firms more closely against the expectations set out in SS3/19. On capital, they have undertaken an assessment of the current framework and acknowledge a number of gaps and limitations, particularly in relation to time horizons, the reliance of existing models on historical data, and the consistent use of ‘severe but plausible’ scenarios.
The EBA also recently published a discussion paper on how environmental risks might be integrated into the Pillar 1 framework. The key takeaway from the paper is that the EBA is in favour of taking a strictly risk-based approach to incorporating climate risks – the EBA is not aiming to directly incentivise firms to direct capital flows to green assets, or away from brown assets. This paper is an important milestone in the development of capital rules and will be keenly read – not least by the PRA, which is due to set out its own approach later in 2022.
Whilst any changes on the Pillar 1 side are likely to take longer to implement (due to the need for international standards), the PRA reserves its right to use the Pillar 2 framework to address any observed deficiencies. We expect to see refinements to the risk assessment process and methodology, as well as the way in which climate risk is captured in the ICAAP. We also expect to see capital add-ons for firms with climate risk management weaknesses.
Beyond risk modelling
Firms should view climate risk as an opportunity to diversify their portfolios and align with their client’s changing preferences by developing new products. Ultimately this will deliver better risk adjusted returns – and will not just be another lens through which to mitigate risk or reduce cost. Ideally, climate-related considerations should be incorporated into each stage of the credit risk lifecycle, which we have discussed in more detail in a previous article.
Firms should also be linking risk modelling with their efforts on Net Zero. There are several touchpoints between climate risk modelling and Net Zero implementation where Risk, Finance (Strategy) and Sustainability teams should work together. Engaging with clients, selecting scenarios, and adjusting counterparty ratings will become key features of firms’ climate modelling and Net Zero actions.
- Client questionnaires can inform both credit assessments as well as help inform Net Zero targets at the sectoral level.
- Scenarios should be selected to be relevant for both Net Zero target-setting and sector pathways as well as climate risk modelling.
- Assessing a counterparty’s transition plan is important to meet a firm’s own Net Zero target but should also be used in risk assessment as a strong (weak) transition plan can reduce (increase) transition risk.
Finally, given the recent development on TNFD (Task Force for Nature-related Financial Disclosures) firms are starting to think about how to leverage climate risk models to quantify the risk associated with nature related losses.
The banking sector in the UK has started to make some advances in quantifying climate risk impacts on credit risk. Regulators are expected to provide more guidance in the near term which will help shape firms’ approach to quantifying the impact. In the meantime, firms that want to create a competitive advantage are forging ahead, looking for ways to overcome the industries' data and modelling challenges.