Journal of Risk

Estimating the impact of climate change on credit risk

Stuart M Turnbull

  • With climate change the frequency and severity of extreme weather events are increasing.
  • To address the increasing concerns about climate physical risks, many countries are changing extant regulations and introducing new forms of regulation, giving rise to transition risks.
  • We extend a Bank of England analysis to a portfolio of credit risky obligors and show how to incorporate the effects of physical and transition risks employing a multi period Monte Carlo simulation.

With climate change, physical and transition climate risks are increasing and affecting the credit risk characteristics of individual obligors and portfolios of credit obligations, such as credit cards, mortgages and loans. To accommodate the effects of physical climate risks, we first estimate the frequency of extreme weather events for different US states by using state-specific meteorological data. Using these estimates, the probability of default is calculated for an obligor in a particular state. For a pair of obligors, a closed-form expression (up to a summation) is derived for the probability of default of two companies. A recent Bank of England conference addressed the importance of scenario analysis. This paper shows how to incorporate the effects of physical and transition risks using a multiperiod scenario analysis. This facilitates the estimation of different risk measures. Physical and transition risks can significantly increase the probability of default, value-at-risk and expected shortfall. The magnitude of these changes depends on the nature of the different risk parameters and the initial creditworthiness of a company.

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