Climate Risk Measurement and Management Flashcards
What is a transmission channel?
The causal chains that explain how cliamte risk drivers impact banks directly or indirectly through their counterparties, assets, and teh economy that they operate in
What is the definition of risk management?
The approach to monitoring, measuring and managing exposures to reduce the potential impacts of an uncertain occurence
What are some microeconomic effects that can result from cliamte risk transmission channels?
1. Changes in Productivity
2. Business interruptions
3. Shifts in prices
4. All of the above
(2) Business interruptions
`
True or false
The potential for climate risks to cause systemic/financial operational risk is significant
False
The potential for climate risks to cause macroeconomic operational risks is limited and will increase if the sector has a high geographic concentration
True or false
The potential for climate risks to cause systemic/financial credit risk is significant
True
Sector-wide asset stranding or changes in demand can affect the sector’s revenue and overall probability of default, causing financial stability risks for the sectors and the exposed FIs
True or false
The potential for climate risks to cause systemic/financial liquidity risks is insignificant
False
The risk for climate risks to affect macroeconomic liquidity is extremely significant as a climate Minsky moment could cause abrupt and wide enough repricing and dislocation to recover from the market liquidity shock.
Remember that a climate Minsky moment refers to when there is a disorderly transition, caused by a rapid adjustment of assets, which has signficant financial impacts
True or false
The potential for climate risks to cause systemic/financial market risk is significant
True
Climate risk is exepcted to produce sectoral and market-wide repricing, causing dislocation and potential systemic risks
Why is the potential for climate risks to cause systemic/financial insurance risk significant?
Firms are left without sufficient coverage from insurance, thus amplifying risks to financial stability
Give 4 examples
What instruments are needed to understand physical hazards?
Think about the different models
- Weather and climate models
- Topographical maps
- Geolocation data
- Existing adaptive measures
2, 3 - measures exposure
4 - measures vulnerability
What is needed to understand transition risks better?
1. GHG emissions data for a particular asset, evolving climate policy landscape, broader societal preferences, technological changes
2. Existing adaptive measures, understanding of peers’ measures, market trends, socioeconomic preferences
3. State of financial stability, portfolio operations, market trends, evolving climate policy landscape
4. Market responses, cross-correlations and distributions, adaptive infrastructure
(1) GHG emissions data for a particular asset, evolving climate policy landscape, broader societal preferences, technological changes
Which of these are economic transmission channels that are NOT micro-economic in scale?
1. Property damange and business disruption from severe weather
2. Stranded assets and new capital expenditure due to transition
3. Productivity changes
4. Legal liability
(3) Productivity changes
Productivity changes are macroeconomic in scale. It can arise from the extreme heat, diversion of investment to mitigation and adaptation or even from higher risk aversion
Which of these are economic transmission channels can have macroeconomic risks?
1. Capital depreciation and increased investment
2. Property damage
3. Shifts in prices
4. Changing demand and costs
5. Socioeconomic changes
6. 1,2,5
7. 2,3,4
8. 1,3,5
9. 1,2,4
10. 2,3,5
(8) 1,3,5
Other economic transmission channels include:
* Labour market frictions (from the physical and transition risk)
* Impact on international trade, government revenue, fiscal space, interest rates and exchange rates
Which of these are ways in which climate risks can manifest as financial risk at the microeconomic company-level?
1. Operational risk
2. Credit risk
3. Liquidity risk
4. insurance risk
5. All of the above
6. None of the above
(5) All of the above
What is the definition for operational risks?
Risks inherent in doing business and reflects the potential losses from inadequate or failed internal processes, systems, human error, or outside events
Give 2 examples
What are the main metrics used to determine operational risk?
You prepared enough?
- Proportion of facilities in risky areas
- Level of company preparedness against external risks
True or false
Operational risk can be defined as the loss resulting from inadequate or failed internal processes, people, systems, external events, legal risk, strategic risk and reputational risk
False
Although operational risk is indeed the loss resulting from inadequate or failed internal processes, people and systems, external events, and legal risk, it excludes strategic and reputational risk
True or false
One of the strongest effects of climate risk on operational risk is through its effect on legal, strategic, and reputational risks
False
The strongest effect of climate risk on operational risk is through external risk. Acute and chronic physical risks can destroy factories, supply lines, warehouses, data centres, or branches of an FI.
Give 2 examples
How can climate risk transmit operational risks into people risk?
Staff and managers
- Inadequate staff training
- Management’s lack of attention towards physical and transition climate effects
This would result in these issues being ignored or underplayed within the institution’s operations, which can cause losses
True or false
So long as a company’s other risks have been dealt with, it doesn’t matter if a company’s internal procedures and processes aren’t as well developed
False
If a company’s intenral processes and procedures don’t take sufficient account of climate risk, this can negatively impact portfolios and facilities far deeper than anticipated
Which of these are ways in which FIs and non-FIs can be exposed to legal risk?
1. Failing to align their business practices with the net-zero transition
2. Neglecting to manage climate risks
3. Lack of adaptative measures
4. Associating with “dirty” industries
5. Failing to adequately disclose their exposures to such risks
6. 2, 5
7. 1,4
8. 3,5
9. 3,4
10. 1,2
(6) 2, 5
1) Is a strategic risk
2) Answer
3) Is a strategic risk
4) Is a reputational risk
5) Answer
ANother legal risk is if the company has signficantly contributed towards climate change
What is “credit risk”?
The ability of a borrower to pay back on their loan
Give 3 examples
What are the key metrics used to gauge credit risk?
they’re not ratios
- Probability of default
- Loss given default
- Exposure at default
PTN: PD is the most general measure of credit risk and can be used by institutions that aren’t just banks like bond markets
PTN2: LGD is expected to be highly sector specific and requires high degree of customisation
Remember: Loss given default refers to the proportion of value that can be recovered after a default
What is a key transmission channel from climate to credit risk?
1. Operational risk
2. Legal risk
3. Liquidity risk
4. Market risk
(1) Operational risk
When assets and the supply chain is vulnerable to extreme weather impacts or abrupt policy changes
* there is greater business interruption that can result in loss of revenue and profits
* weakens ability to repay loans vs. not exposed
True or false
Climate risk can affect companies’ credit risk through its counterparties
`
True
Which of these are NOT microeconomic transmission channels?
1. Climate risk drivers can affect a bank’s market risk through the value of their financial assets
2. Climate risk drivers can affect liquidity risk through its deposits, funding costs and drawdowns of credit
3. Climate risk drivers can affect credit risk through government debt, labour changes and socioeconomic changes
3. Climate risk drivers can affect credit risk through the companies’ counterparties
(3) Climate risk drivers can affect credit risk through government debt, labour changes and socioeconomic changes
Although transition risks such as government debt, labour changes, and socioeconomic changes can result in increased credit risk, this is a macroeconomic transmission channel
True or false
Credit risk can be reduced by pricing effects
True
Although it is easy to see how climate risks can cause materials to become more expensive/ less valuable :. increase credit risk, pricing effects can also have the opposite effect and reduce the company’s credit risk
Eg: companies in the mining sector that extract minerals for mass electrification will benefit from the higher prices of these commodities and will be able to earn more profits :. becoming more creditworthy
What is the definition of liquidity risk?
The risk incurred from the inability to obtain sufficient funding to meet its financial short-term obligations
What are the key metrics used to gauge liquidity risk?
1. Loan-to-deposit ratios
2. Bid-ask spreads
3. Quick ratio
4. Exposure at default
5. 1,4
6. 2,3
7. 1,2
8. 3,4
(7) 1, 2
Loan-to-deposit ratios are specific for banks whilst bid-ask spreads are specific for markets
True or false
Climate risk drivers can prompt depositers to draw down less deposits as debtors draw down credit lines at the same time, affecting the loan-to-deposit ratio
False
Climate risk drivers can prompt depositers to draw down more deposits as there is a precuationary dmand for more liquidtiy by financial institutions and households. Because debtors are also drawing down credit lines at the same time, the loan-to-depsit ratio increases
Give 2 examples
What ar the key metrics to gauge underwriting risk?
- Changes in insurance premiums
- Availability of insurance
The insurance industry also uses a variety of metrics and models to estimate how risky the company that it being ensured
True or false
Companies are more likely to be gradually exposed to increased credit risk rather than abruptly through liquidity risk
True
True or false
A non-FI is only affected liquidity risk that manifests as a consequence of cliamte risks under very specific circumstances
True
It typically happens after an acute physical risk, like a natural disaster, and they need access to more liquidty to finance their recovery and other cash flow needs, resulting in the crystallised liquidity risks for the bank
Why are climate risks particularly challenging for the insurance sector?
Because the concentration of assets can result in underwriting losses to facilities in areas that are no longer economically viable, like buildings in low-lying coastal regions
Additionally, there is likely a shorter return period than is expected :. insurance companies may need to dish out more insurance to people who have suffered loss more regularly
What is the definition of underwriting risk?
The risk incurred due to the inability to access sufficient insurance coverage
In what way can climate transition risk affect underwriting risk?
1. The highly concentrated nature of facilities and infrastructure can result in more underwriting damages
2. The increasing frequency of climate-related events means that the insurance companies requires very high premiums
3. The changing policy, operational and technological landscape required could cause litigation against emissions-intensive industries
4. Firms are more likely to refuse renewals to homeowners in hard-hit areas that have been exposed to climate-exacerbated disasters
(3) The changing policy, operational and technological landscape required could cause litigation against emissions-intensive industries
True or false
Underwriting risk can increase other types of risk. An example of this would be that a company is no longer able to obtain insurance coerage for physical damage, business interruption, or director’s liability. This means that they can’t use insurance as one of the buffer mechanisms, which exposes the company to operational risk, and in turn credit risk for the lender
True
True or flase
The various risks (eg: credit, liquidity, operational, insurance) do not pose a systemic risk or pose a threat to financial stability
False
Generally they mostly have microeconomic effects, but if they occur widely enough, whole sectors can be affected, causing a systemic isues.
Give 2 examples
Which risks primarily opeate at the macroeconomic level?
- Market risk
- Sovereign risk
Give 2 things
In what ways can operational risks have macroeconomic effects?
geography can come in a real pinch sometimes
- Geographic concentration
- Pinch points in supply chains
What is the definition of a “climate Minsky moment”?
A sudden, major collapse of asset values caused by the sudden and disorderly transition
Results in the massive repricing of assets and the procyclical crystallisation of losses, causing a liquidity crunch
Which of these would cause insurance risk on a macroeconomic level?
1. Significantly increasing premiums
2. Completely withdrawing coverage of certain climate-related risks
3. Revaluing assets in vulnerable regions
4. Changing cost and demand structures
5. 2,4
6. 3,4
7. 1,2
8. 2,3
(7) 1,2
Which of these channels are NOT ways that climate risk translates into macroeconomic market risks?
1. Repricing of assets
2. Dislocation effects
3. Changing societal sentiments
4. Asset stranding
(3) Changing societal sentiments
Changing societal sentiments would largely be a transition risk.
* Repricing effect can make physical and transition risks move more quickly to impact asset prices
What is a key metric to gauge macroeconomic market risk?
Really complicated equation
Climate Value at Risk
REMEMBER VaR refers to the extent of potential financial losses within a firm, portfolio, or position, giving an estimate of the bad outcome
What other metric can be used by individual institutions to gauge their own exposure to climate-related market risk?
Your beloathed equation
Weighted Average Carbon Intensity (WACI) of a portfolio
REMEMBER this looks at the level of exposure that the portfolio is at risk of due to carbon-intensive companies
True or false
Climate risk has not been priced into many asset classes
True
Basel Committee on Banking Supervision reported that there is empirical evidence to show that climate risks haven’t been priced into mnay asset classes, even if the evidence is slightly mixed
True or false
By incorporating climate risk into asset prices, it may also still increase the threat to financial stability
True
This is because it might demonstrate that risks are concentrated in certain parts of the economy, and may end up triggering amplifying behaviours from other FIs
What was the PRI’s “Inevitable Policy Response” and how does it result in market risk?
The assumption that governments and firms will have to transition in a more rapid, abrupt and disorderly way as the realities of climate change become more apparent. This could trigger repricing on a much larger scale
Give 5 examples
How do you gauge the transmission of physical risk into sovereign risk on a macroeconomic scale?
- Geographical exposure
- Size and sectoral composition of their economy
- Capacity to create adapative policies and responses to climate change
- Debt accessibility and affordability
- Specific policy decisions
What transition risk affects sovereign risk on a macroeconomic scale?
1. The presence of policies and regulations which hinder transition
2. The overall sentiment of the local market
3. The changes in the supply and demand of goods that foster the transition
4. The countries’ reliance on fossil fuels and other carbon-intensive exports
Ties back to “stranded nations”
(4) Countries’ reliance on fossil fuel and other carbon-intensive exports
As tighter climate policies and technologies emerge, this may resul tin a reduced demand of fossil fuels, leaving countries that had once relied heavily on fossil fuel exports as “stranded nations”
What is a shortcoming of using company-level carbon emissions data to gauge transition risk?
Taking it at face value
Most of data comes from self reports and are not audited, meaning that they can vary in breadth and detail
Give 2
What are other ways that transition risk can be gauged at a company level, without needing to rely on self-reporting?
Alignment, scores
- Corporate alignment with opt-in initiatives
- Temperature scores
- opt-in initiatives such as SBTi or external parties like the Transition Pathway Initiative
- Temperature scores to indicate what level of warming the company is most aligned with
True or false
Company or asset-level physical risk data and scores are the most interpretable
True
PTN: Although they are the most interpretable, only some of the free datasets offer a high level of geographic precision and its output is fairly unrefiend. This can make it harder to have facility-level informationi
What is a downside of using company-level scores to gauge physical risk at a company level?
1. By combining different proprietary methodologies of downscaling with climate model data, it gives an overall sense of the physical risk but not in sufficient detail
2. The methods used to calculate these company-level scores are kept from investors who purchase the scores
3. It is hard to disseminate and communicate to others, due to the technicality of the model
4. It has a low accuracy
(2) The methods used to calculate these company-level scores are kept from investors who purchase the scores
Other drawbacks include:
* Different scores will include different hazards, different methodologies, compiled internally by different financial firms :. may not be comparable with each other
Which of these analysis are most relevant for investors and lendors?
1. Asset level
2. Firm level
3. Portfolio level
(3) Portfolio level
Give two examples
Which metrics can be used to gauge the transition risks for portfolios?
Your beloathed equation + intensity
- Carbon intensity
- Weighted Average Carbon Intensity
- expressed in tonnes Co2e/USD mil revenue
- Expressed in tons CO2e/USD mil revenue
True or false
Aggregating and evaluating portfolio level physical risk is relatively easy for equity and bond portfolios
False
This is because exposure could impact the entire company, their facilities, and even their supply chains
Which companies have been instrumental in developing a comprehensive approach for ERM within an organisation?
1. WRI
2. Committee of Sponsoring Organisations
3. MSCI
4. Moody’s
(2) Committee of Sponsoring Organisations
Other regulatory bodies that have also impacted ERM include:
* TCFD
* NGFS
* Climate Financial Risk Forum
True or false
Risk management is the identification of relevant risks to the organisation, listing pertinent risks.
False
Although it does look at identifying relevant risks to the organisation, risk identification also involves articulating the potential impact on business operations and stategy
What sort of information and data is NOT used during a risk assessment?
1. Scores on physical and transition risk exposure
2. Portfolio level analysis
3. SWOT analysis
4. Company data
5. External data
(3) SWOT analysis
Give 3 examples
In the ERM context, how can risks be prioritised and ranked?
- Likelihood of occurence
- Adaptability and complexity
- Severity
When looking at the ranking of severity, can look at things such as whether the risks has the potential to impact core business fundamentals like revenue, profits and asset values
Give 5 examples
What are the risk responses established in COSO’s ERM Framework?
A, A, P, R, S
- Acceptance
- Avoidance
- Pursuit
- Reduction
- Sharing
Acceptance - Accepting that the risk will have an impact and do nothing about it
Avoidance - Refers to removing the risk entirely and anything related to it (eg: asset managers declining to invest in or businesses that generate revenue from thermal coal)
Pursuit - Converting risks into opportunities
Reduction - improvements in processes, systems or strategies
Sharing - collaboration with supply chain, regulators, professional associations, peers as risk mitigation strategy
How can companies establish whether or not they have properly implemented the ERM framework?
1. Periodic internal audit
2. Impact analysis and mapping
3. SWOT analysis
4. 3rd party review
(1) Periodic internal audit
What does enterprise risk management comprise of?
Culture, capabilities, and practices that organisations integrate with strategy-setting
Who are the first people to make allocation decisions and are integral in risk governance?
1. The senior Board members
2. The portfolio managers
3. The credit officers
4. The internal audit
(2) The portfolio managers
Portfolio managers are the first to make the judgements on the environmental and climate risks of the transactions
Give 3 examples
What can be used to analyse the company’s strategy?
Think about the impact, strengths and extent
- SWOT analysis
- Impact and dependencies mapping
- Materiality assessment
Give 3 things
What are the sub-components stated in COSO’s ERM framework to track performance?
Look, Manage, Act
- Risk Identification
- Risk Assessment
- Implementation of Risk Responses
What is the TCFD’s emphasis on strategy with regards to climate change?
1. Time horizons and outcome variance by scenario
2. Corporate social responsibility and societal norms
3. Carbon negative commitments
4. Short-term, medium-term, and long-term climate-related risks and opportunities
(1) Time horizons and outcome variance by scenario
Can both be addressed in scenario analysis
What are corporate carbon footprints?
1. Emissions resulting directly from a company’s operations
2. Upstream emissions from purchased electricity, heating and cooling
3. All other upstream emissions from supply chains
4. Carbon emissions data
(4) Carbon emissions data
What is the main focus of portfolio-level analmysis when it comes to transition risks?
1. Total Absolute emissions
2. Proportional amount invested or corporate revenues
3. Impacts of risks on a particular firm
4. Stress testing of the portfolio
(2) proportional amount invested or corporate revenues
What sort of data is required to gauge transition risk?
1. Physical hazards data
2. GHG emisisons data
3. Policy landscapes, technological changes, and consumer preferences
4. All of the above
(4) All of the above
To assess transition risk, you need toi have an accurate asset-level and compnay-level data on GHG emissions, policy landscapes, technological changes, and consumer preferences to capture the various drivers of transition risk
What is the purpose of physical climate risk scores?
1. To provide information about the physical risk of investing in companies
2. To provide information about the carbon footprint of companies
3. To provide information about the environmental sustainability of companies
4. To provide information about the climate change impact of companies
(1) To provide information about the physical risk of investing in companies
What is the repricing effect in regards to climate risk?
1. It has no impact on asset prices
2. It is a positive impact on asset prices
3. It is an important channel through which physical or transition risks can have an impact to asset prices
4. It is a negative impact on asset prices
(3) It is an important channel thorugh which phsyical or transition risks can have an impact to asset prices
What type of data provides more granular information for investments or lending decisions?
1. Portfolio-level data
2. Corporate-level data
3. Asset-level data
4. Climate scenario data
(3) Asset-level data
What is the purpose of tracking performance for ESG and climate risks according to eht COSO ERM framework?
1. To identify potential risks and their impact on business operations
2. To determine the lieklihood of occurence of risks
3. To prioritise risks by severity
4. To monitor the implementation of risk management processes
(1) To identify potential risks and their impact on business operations
What is the purpose of integrating climate risk into legal and compliance processes?
1. To reduce the likelihood of legal action
2. To support formalised internal risk management procedures
3. To ensure compliance with regulations
4. To minimise the impact of cliamte change on the organisation
(2) To support formalised internal risk management procedures
True or false
Risk management that is practiced fully in private is not successful risk management.
True
Shareholders, investors and lenders need to know that the company has a solid ERM to ensure continuied value creation and the public disclosure of best practices can result in systemic effects
Which of these is NOT an advantage of using WACI?
1. Metrics can be more easily applied across asset classes
2. Simple to calculate
3. Easy to conduct portfolio decomposition and attribution analysis
4. It is relatively stable and isn’t affected by outlying data points
(4) It is relatively stable and isn’t affected by outlying data points
This is actually one of its disadvantages alognside the fact that the use of revenue rather than physical metrics can normalise companies that have a higher pricing level
True or false
One benefit of using total carbon emissions as a metric is that it can be used to track changes in GHG emissions within a portfolio
True
Give 2 examples
What are some of the disadvantages of using total carbon emissions as a metric?
- Not used for cross-comparability
- Changes in market capitalisation can be misinterpreted
Which of these metrics is NOT good to compare against other portfolios?
1. Total carbon emissions
2. Carbon intensity
3. Carbon Footprint
4. WACI
(1) Total carbon emissions
This is because the data is not normalised
What is the carbon footprint metric?
1. Total carbon emissions for a firm
2. Total carbon emissions for a portfolio
3. Total physical risk exposure for a firm
4. Total sustainability score for a portfolio
(2) Total carbon emissions for a portfolio
True or false
One disadvantage of using the carbon footprint metric is that it doesn’t account for the size of different companies
True
What is a downside of using carbon intensity as a metric?
1. It can’t be used for comparing portfolios because the data is not normalised
2. It is sensitive to outliers
3. The calculation is complex
4. It doesn’t take into account the different sizes of companies
(3) The calculation is complex
1) This is a downside of total carbon emissions
2) This is a downside of WACI
3) answer
4) This is a downside of carbon footprint
