Journal of Risk

Risk.net

A framework to analyze the financial effects of climate change

Stuart M Turnbull and Lawrence Habahbeh

  • We describe a general framework to calculate the risk management implications of climate change.
  • Our framework can be used to identify the vulnerability of a company’s up-stream and down-stream firms to different climate events.
  • We derive an easy to compute expression for the probability of default that incorporates the impact of climate events.
  • We show how to incorporate scenario analysis into our framework to assess the financial and risk implications of different regulatory and climate regimes.

Starting with an expert assessment of the climate risk factors over a specified horizon, then moving to a description of the expected number of climate events and the severity of the losses if an event occurs, we describe a framework to analyze the financial impact of climate events. Standard risk metrics can be computed. We derive an easy-to-compute expression for the probability of default that incorporates the impact of climate events. The analysis is extended to a multiperiod framework that can be used to assess the financial and risk management consequences of transitory risk, as discussed in an April 2019 Prudential Regulation Authority (PRA) Consultation Paper published by the Bank of England. We show how to construct a time profile of risk exposures to different types of climate events. This information can be reported to senior management, directors, shareholders and regulators. We extend our analysis to incorporate scenario analysis over multiple periods, allowing for the refinement of tactical and strategic decision making, fulfilling PRA requirements for corporate governance.

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