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Climate risk takes scenario analysis and stress-testing to the next level

Climate risk takes scenario analysis and stress-testing to the next level

Financial institutions are facing several challenges as they prepare for the transition risk journey that will see them evaluating their existing risk and finance solutions. SAS discusses what this means for scenario analysis and stress-testing in steering towards the net-zero emissions ambition

Ludwig Dickens, SAS
Ludwig Dickens, SAS

The focus of this article is the ‘environmental’ pillar of ESG and climate transition risk. We consider the challenges financial institutions are facing, how past Basel Committee on Banking Supervision and International Financial Reporting Standards (IFRS) global and local experiences can provide valuable lessons, and what this means for scenario analysis and stress-testing in steering towards the ambition of net-zero emissions.

In doing so, this analysis foregoes but recognises the dependencies between physical and transition risk, as well as the impact that actions on the environment have on the other ESG pillars, and vice versa.

Challenges

In determining the transition risk of a bank’s portfolio (assets and liabilities) there are many aspects to consider. For example:

  • Regulatory framework – currently it is unclear how far regulators will become prescriptive, rather than giving financial institutions the freedom to show when and how to get to a net-zero portfolio that matches their situation from geographic and business perspectives.
  • Geographic differences – the various regions worldwide have either different carbon reduction ambitions, different focus areas or different timelines. This makes developing a coherent strategy a challenge for organisations with a global presence.
  • Taxonomy – there is no single truth on green versus brown, nor on how green a funding is. Partly because of a lack of reference data on carbon dioxide (CO2) emissions, but also because of differences in how to classify assets and investments.
  • Granularity of geospatial data – assessing the carbon footprint of both scope 2 and 3 emissions requires detailed knowledge about suppliers and customers, processes and assets or, alternatively, the availability of industry emissions statistics with sufficient relevance.
  • Multilayered assets – the repackaging nature of complex financial instruments requires a multilayered analysis to get to the carbon emissions of the underlying assets, but there is not an obvious choice as to what to consider and what not to.

History has shown that the solution to complex problems requires several iterations

Climate risk has many unknowns and approximations for carbon emission calculations and translating them into financial impact, so it will likely take several iterations before getting to a desired agreed maturity.

Assessment should be made to evaluate candidate solutions on their ability to:

  • Integrate various calculation methods (internal or publicly available, such as the Paris Agreement Capital Transition Assessment).
  • Integrate additional data sources (climate, taxonomies, emissions, and so on).
  • Handle models for various combinations of industry segments and geographies.1
  • Increasingly disclose details to address the requirement for transparency.
  • Compare period-to-period evolutions, and identify and interpret outliers, which may lead to complementary steering actions.

With this comes the need for strong version management and process governance.

Do not simply reuse and extend what is already there

Many financial institutions have already started on their journeys by:

  • Controlling the influx of new carbon-intensive investments – additional data about the underlying assets themselves will need to be gathered to assess the financial impact of physical and transition risk.2
  • Assessing the carbon footprint of the current portfolio – this is new ground and will be especially challenging for calculating scope 3 emissions for upstream and downstream processes. Small and medium-sized enterprises typically do not know the CO2 footprint on the services they offer so one can, at best, rely on published averages.
  • Exploring how the carbon footprint will evolve towards an intended target – banks participating in early regulatory climate stress-testing exercises experienced difficulties due to:
    • Long time horizons
    • Poor data quality
    • High data volumes
    • Granular geospatial forecasting data
    • Mature scenario analysis capability
  • Implementing strategy and governance – a net-zero ambition needs to set the objectives at the level of individual portfolios and the asset manager. The next step is to regularly measure decarbonisation progress and integrate metrics into a management dashboard to be able to actively monitor, steer and adjust.

There is more to scenario analysis than just scenario analysis

While scenario analysis is exploratory by nature compared with stress-testing, both can easily be achieved within a single solution. Nowadays regulators worldwide are requesting that financial institutions conduct stress tests for various scenarios. Climate risk will add to the complexity, warranting a sophisticated and industrialised approach that goes beyond manual processes and spreadsheets.

Tight deadlines, multiple and complex scenarios, increasing frequency of requests, traceability, explainability and governance throughout the steps of the process will all require banks to further improve or replace their solutions for stress-testing and scenario analysis.

Conclusion

Basel and IFRS regulations were fine-tuned through several iterations, pushing many financial institutions to rebuild their risk and compliance solutions. Transition risk is a less well-defined journey, so a solution for scenario analysis (and stress-testing) will require adaptability.

The initial steps on the transition risk journey will see firms evaluating their existing risk and finance solutions – recently put to the test by Covid-19 stress-testing. This will be important and timely, as banks prepare for what lies ahead, considering the speed at which regulators are gearing up for mandatory disclosures, and stakeholders look to understand how the bank will support a transition to net-zero carbon emissions.

 

ESG strategies – Special report 2021
Read more

 

Notes

1. Already today this can be seen with, for example, syndicated loans or large corporations as counterparties for which a lot of information is available compared with retail counterparties.

2. As insurers traditionally do for assessing the insurance risk.

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