Chapter 6 Flashcards
Credit Risk Metrics
- Probability of Default (PD)
- Loss Given Default (LGD)
- Exposure at Default (EAD)
Probability of Default
Likelihood of someone/something not being able to meet their Financial obligations (repaying loans/debts)
Loss Given Default
Amount of money lender is likely to lose if a borrower defaults on a loan or debt
Exposure at Default
Total amount of money or credit lender is exposed to when a borrower defaults on a loan or debt
Credit Risk - Macro level risks
Significant - sector wide asset stranding or change in demand can impact sector revenues and increase sector level PD - posing financial stability risks in important sectors and for exposed Financial Insitutions
Credit Risk - Micro level risks
Transition Risks: Asset stranding could worse a firm’s Financial position (higher PD and LGD for a lender given decrease in asset valuations)
Physical Risks: lead to loss of revenue and profits - worsening firm’s Financial position and increasing PD
Operational Risk Metrics
- Proportion of facilities in risky areas
- Level of company preparedness
Operational Risk - Micro level
Transition Risk: abrupt policy change leading to facility shutdown
Physical Risk: more frequent and severe extreme weather will cause property damage and business interruption
Operational Risk - Macro level
Limited - only under specific set of circumstances (sector has high geographic concentration_; potential for climate to cause system/Financial stability risk
Liquidity Risk Metrics
- Load to deposit ratio (banks)
- Liquidity Ratios
- Bid-ask spread (markets)
Liquidity Ratios
Helps assess a company’s ability to meet its short-term financial obligations
Liquidity ratio = (current assets) / (current liabilities)
Bid-ask spread
Difference between highest price a buyer is willing to pay for an asset (bid price) and lowest price a seller is willing to accept for that same asset (offer/ask price)
ex: trading stocks, bonds, currencies
Climate Minsky Moment
Sudden and sever market or financial crisis caused by abrupt recognition of risks associated with climate change
ex: high number of asset stranding leading to financial crisis
liquidity risk - micro level
Both TR and PR can prompt sharp repricing and sudden market re-evaluation of firm’s viability, leading to liquidity shock therefore leading to widening of bid-ask spreads
ex: abrupt climate event can prompt large demand for deposit withdrawals at banks, leading to increase in load-to-deposit reatios
Liquidity risk - macro level
Significant - climate minsky moment could cause abrupt and wide enough repricing and dislocation to constitute a market liquidity shock
Underwriting Risk metrics
- Change in insurance premiums
- Availability of Insurance
Underwriting risks - micro level
TR: lead to decrease in insurance availability, as some insurers refuse to underwrite certain kinds of activities and facilities
PR: lead to increase in insurance premiums for corporations or certain facilities in vulnerable areas to become uninsurable
Underwriting risk - macro level
Significant - if number of insurers withdraw or refuse coverage, leaves firms completely without coverage therefore amplifying risks to financial stability
Market risks metrics
- Weighted Average Carbon Intensity
- Climate Value at Risk
- Portfolio Risk scores
Climate Value at Risk (Cl. VaR)
Risk assessment tool that quantifies potential financial losses a company or portfolio could incur due to climate change
Market Risk - micro level
Both PR and TR can become more widely incorporated in asset prices (through abrupt pricing and more gradual changes)
Large scale shifts in input and product markets affect non financial corporations.
Shifts in asset price increases risk of FI portfolios
Market Risk - macro level
Significant - climate risk is expected to produce sector and market wide repricing of many assets and commodities therefore causing dislocation and system risk
Sovereign risk metrics
- proportion of budget revenues from fossil fuels
- vulnerability to physical climate risks
Sovereign risks - micro level
PR: can cause countries that are particularly vulnerable to have higher costs of damage and lower GDP growth
TR: heavily affect countries reliant on fossil fuel production for a substantial proportion of GDP and government tax revenue
Sovereign risk - macro level
Many countries have diversified economies and geographies, but some countries are heavily exposed to PR and TR and likely to be severely affected
Operational Risk
Risk in doing business
Credit Risk
Ability borrower has to pay back a loan
Liquidity Risk
Ability to easily convert assets into cash
Underwriting Risk
Ability for insurers to insure
Important transmission channel that leads to credit risk
operational risk
climate change - leads to operational risk - leads to credit risk
ex: climate risk causes raw materials to become more expensive, makes products decrease in value
To properly assess Transition Risk
a. multiple types of data
b. appropriate analytical tools to understand application to user’s needs
c. accurate asset level and company level data on GHG emission
d. data on policy landscapes, technological changes and consumer preferences
To properly assess Physical Risk
a. data on current and future physical hazards (historical data + climate models)
b. topographical data
c. locational data of assets
d. info on vulnerabilites and adaptive capacities
Weighted average carbon intensity
tons of CO2 equivalent / million USD
where “tons of Co2 equivalent” is = money invested; and /mill USD is mill USD of revenue
ERM approach
- Governance and Culture
- Strategy and Objective setting
- Performance
- Review and revision
- Info, communication and reporting
Governance and culture
Board and senior executives - understanding and diffusion of climate knowledge
Strategy and objective setting
high level decisions on organization’s prioritization and missions
- SWOT Strength, weakness, opportunities, threats)
- impact and dependency mapping (stock and flow in terms of capital)
- materiality assessment (SASB framework)
Performance
- risk identification - examine transmission channels of climate risk drivers in f risk (what are most relevant for particular orgs)
- risk assessment and prioritization (gather data on scope of these risks - i.e. portfolio level analysis ; rank risks based on what will be most impacted and what is most important (profit, revenue, asset valuation)
- implementation of risk response (1.acceptance (accepting impact and not taking action); 2.avoidance (removing risk completely and anythin related to it (ex: refusal to invest in FF); 3. pursuit (converting risks into opportunities); 4.reduction (improvement in processes, systems, strategies); 5.sharing (collaboration as risk mitigation strategy))
Review and revision
reassess risks in light of changes and analyze effectiveness of ERM processes
info, communication and reporting
communication to board, senior managers, external stakeholders (investors, suppliers, employees, regulators, public)
Which risk has only limited potential for systemic impact on F stability
operational risk
what is not an important climate risk transmission channel
physical risk leads to damage and supply chain disruption, increasing market wide liquidity risk
what are key shortcomings of physical risk scores
- incorporate multiple hazards, but methods that they are calculated are in black box
- normalization of raw data means physical risk scores are only relative, not absolute
Transition risks
- policy regulation
- technology development
- consumer preferences
Physical risks
- Chronic (temperature, precipitation, sea levels)
- Acute (heatwaves, floods, wildfires)
SASB
Sustainability Accounting Standards Board -
- materiality
- indsutry specific
- Quantitative and Qualitative Disclosure:
- Integration with Financial Reporting:
- Stakeholder Engagement
- Transparency:
