Chapter 6. Climate Risk Measurement and Management Flashcards
What is Risk Management?
It is a structured approach to monitoring, measuring, and managing exposures to reduce the potential impacts of uncertain occurrences.
How can climate risk management help when proactively practiced?
To mitigate the impacts of climate change, both physical and transition, on a financial institution’s portfolio or corporation’s operations.
What types of financial risk does climate risk affect?
- Operational
- Credit
- Liquidity
- Underwriting / Insurance
- Sovereign
What is required to understand physical risk?
- Forward-looking climate models and historical weather data
- Information on physical geography
- Adaptive infrastructure
- Market responses
- Cross-correlations and distributions
What are the economic risk transmission channel categories?
- Microeconomic, affecting small businesses and households
- Macroeconomic, aggregate impacts on the Macroeconomy
What is the operational risk?
It is the risk inherent in doing business. It reflects potential losses from inadequate or failed internal processes, systems, human error, or outside events such as extreme weather or terrorist attacks.
Which are the operational risk metrics?
- The proportion of facilities in risky areas
- Level of company preparedness
Which are the operational risks subcategories?
- External risk (from outside events)
- Systems risk
- People risk (from human error)
- Internal process risk
- Legal
- Strategic
- Reputational
What is the credit risk?
The creditworthiness, or ability a borrower has to pay back a loan.
Which are the credit risk metrics?
- Probability of default (PD)
- Loss given default (LGD)
- Exposure at default (EAD)
Which are the transmission channels from climate to credit risk?
- Operational risk (physical and transition)
- Valuation effects (asset stranding)
- Pricing effects (on raw materials and products)
What is the liquidity risk?
It’s about losing access to liquidity—the ability to quickly and easily convert assets into cash.
Which are the liquidity risk metrics?
- Loan-to-deposit ratios (specifically for banks)
- Bid-ask spreads (specifically for markets)
What is the underwriting risk?
The risk is that an insurance company will suffer losses because the economic situation or the occurring rate of incidents has changed contrary to the forecast made when a premium rate was set. As a result, the insurer’s costs may significantly exceed earned premiums.
Which are the underwriting risk metrics?
- Changes in insurance premiums
- Availability of insurance.
How can climate transition risk affect underwriting risk?
Through general liability or “directors and officers” (D&O) policies through which, insurance takes on (at least part of) the financial risks of a firm being sued due to a lack of ability to meet policy, operational, and technological changes required for a transition to a net-zero economy.
What does the operational risk require to have a systemic effect?
- To manifest across various companies, having ripple effects across supply chains and through to markets, customers, and financial counterparties.
- Geographic concentration and pinch points in supply chains.
What does the credit risk require to have a systemic effect?
Changing demand and cost structures resulting from climate-related pressures can impact a sector’s revenues and profits, as can physical climate impacts leading to business interruption, both of which can lead to widespread increases in credit risk.
What does the liquidity risk require to have a systemic effect?
- If enough households, corporations, and financial firms sharply increase their demand for precautionary liquidity after a severe natural disaster, this can be at a systemic enough scale to necessitate intervention by the central bank.
- A climate Minsky moment could provoke a market-wide liquidity crunch, not unlike the shock of the global financial crisis of 2008, perhaps even more significant.
What does the underwriting risk require to have a systemic effect?
- In cases where insurers deem climate risks too significant to underwrite, the specter of uninsurability can have systemic effects.
- Insurers collectively reducing their exposure to climate-related risks (by significantly increasing premiums or withdrawing their coverage of certain climate-related risks) could have negative consequences for the financial system.
What does the market risk require to have a systemic effect?
At the systemic level, climate risk translates into market risk through repricing, dislocation effects, and asset stranding. The repricing effect is an important channel through which physical or transition risks anticipated but not yet realized can more quickly and tangibly impact asset prices, whether they are physical assets such as housing or financial assets such as shares and bonds.
Which are the market risk metrics?
- Value at Risk (VaR)
- Climate VaR (CVaR)
- Weighted average carbon intensity [of a portfolio]
What is VaR?
Value at Risk. It’s a metric for quantifying the level of financial risk in a firm, a portfolio, or a given investment, and it is meant to estimate a lousy outcome.
What is CVaR?
Climate Value at Risk, like standard VaR, is meant to capture a rough estimate of climate-related financial losses; it includes both transition and physical risk as well as economic data and company-level data.
What is IPR?
The Inevitable Policy Response (IPR) is a climate transition forecasting consortium commissioned by the PRI which aims to prepare institutional investors for the portfolio risks and opportunities associated with accelerating policy responses to climate change.
What is the IPR assumption?
The realities of climate change become increasingly apparent and urgent, and governments, firms, and others will be forced to act more decisively, potentially quickly, abruptly, and disorderly.
What is Sovereign Risk?
Sovereign risk is the chance that a national government’s treasury or central bank will default on its sovereign debt or implement foreign exchange rules or restrictions that significantly reduce or negate the worth of its forex (foreign and exchange) contracts.
What is required to evaluate a country’s physical sovereign risk?
- Geographical exposures
- Size and sectoral composition of its economy
- Capacity to create adaptive policies and responses to climate change
- Debt accessibility and affordability
- Specific policy decisions
What is required to evaluate a country’s transition sovereign risk?
Country’s reliance on fossil fuel and other carbon-intensive exports.
What data is required to gauge company transition risk accurately?
- Asset-level and company-level data on greenhouse gas emissions
- Data on policy landscapes, technological changes, and consumer preferences
What data is required to gauge a company’s physical risk accurately?
- Data on current and future physical hazards (derived from a combination of historical data and climate models)
- Topographical data and locational data of assets
- Information on vulnerability and adaptive capacity
How does The Greenhouse Gas (GHG) Protocol categorize company carbon emissions (corporate carbon footprints)?
- Scope 1. Emissions resulting directly from a company’s operations
- Scope 2. Upstream emissions from purchased electricity, heating, and cooling
- Scope 3. All other upstream emissions from supply chains and downstream emissions result from the company’s use or disposal of products and services.
What is Corporate Carbon Footprint (CCF)?
CCF is the total amount of GHG emissions directly or indirectly caused by a company’s activities.
Besides CCF disclosure, what else is expected of a Company to disclose?
Corporate alignment and plans for addressing both transition and physical climate risk
Besides emissions and emissions trajectories, what else is required to gauge a company transition risk?
An understanding of the drivers of transition risk, such as:
- Policies
- Changing technologies
- Shifts in consumer preferences
- Market sentiment
What is CMIP?
Coupled Model Intercomparison Project (CMIP)
The CMIP objective is to better understand past, present, and future climate changes arising from natural, unforced variability or in response to changes in radiative forcing in a multi-model context.
Which are the gauging standard metrics for portfolio-level transition risk?
- Carbon intensity, or greenhouse gas emissions normalized by portfolio market value (tons of CO2 equivalent/million USD invested)
- Weighted average carbon intensity (tons of CO2e/million USD of revenues)
What is ERM?
Enterprise Risk Management (ERM).
It’s a comprehensive approach to managing risk across and within an organization, such as a large corporation.
What is COSO?
Committee of Sponsoring Organizations of the Treadway Commission.
COSO is a committee of five sponsoring organizations whose representatives come together periodically to help organizations improve performance by developing thought leadership that enhances internal control, risk management, governance, and fraud deterrence.
Which are the COSO’s ERM framework areas that group responsibilities and actions?
- Governance and Culture
- Strategy and objective-setting
- Performance
- Review and Revision
- Information, Communication & Reporting
Within the COSO EAR framework, which actions are part of the Governance and Culture?
- Exercises Board Risk Oversight
- Establishes Operating Structures
- Defines Desired Culture
- Demonstrates Commitment to Core Values
- Attracts, Develops, and Retains Capable Individuals
Within the COSO EAR framework, which actions are part of Strategy & Objective-setting?
- Analyzes Business Context
- Defines Risk Appetite
- Evaluates Alternative Strategies
- Formulates Business Objectives
Within the COSO EAR framework, which actions are part of Performance?
- Identifies Risk
- Assesses Severity of Risk
- Prioritizes Risks
- Implements Risk Responses
- Develops Portfolio View
Which actions are part of the Review & Revision within the COSO EAR framework?
- Assesses Substantial Change
- Reviews Risk and Performance
- Pursues Improvement in Enterprise Risk Management
Within the COSO EAR framework, which actions are part of Information, Communication & Reporting?
- Leverages Information and Technology
- Communicates Risk Information
- Reports on Risk, Culture, and Performance
What does characterize successful risk governance?
- Multiple employee layers involved, including Board and senior executives
- Climate risk built into internal processes, such as legal and compliance
