In our earlier post Climate change: why balance sheets need to be green, we introduced how banks will need to apply climate-related factors in their balance sheets alongside traditional approaches for managing risk-weighted assets and credit risks. Here, we look in more depth at the steps needed to ‘green’ the balance sheet.
The start point is to recognize that modeling the impact of climate change is complex. To include it in credit risk means separating out the costs of compliance with the physical impacts of climate change on the business itself. Modeling needs to incorporate industry and geographic correlations, take into account both compliance and physical disruptions, work with globally accepted scenario data and be able to reflect individual mitigation efforts from businesses. If we can estimate the overall economic (GDP) impact from climate change, we can assess the sectors most likely to be impacted by policy changes through the following steps:
- applying climate-specific impacts to the forward loss curve for each geographic region;
- correlating industrial sectors to climate-related impacts; and
- adjusting specific borrower correlations to reflect known and specific adaptation actions.
This provides a framework to create robust estimates of likely future credit costs for each scenario, and the origins of the costs on the balance sheet – and it becomes the start of a robust plan to ‘green’ the balance sheet. It is also more robust and comprehensive than current Scope 3 disclosures. These don’t capture the risks banks assume by financing entities such as energy trading firms that have an indirect climate impact.
Looking at the issue of greening the balance sheet from the perspectives of economic and capital rather than CO2 means we can see the whole picture of the climate transition. By estimating the correlation by industry and individual obligor to the financial impact, we can directly estimate the excess capital needed for the applicable pathway or scenario. This also makes it possible to project the funding/opportunity cost of being on the wrong side of a downgrade to ‘brown’ industry.
In essence, we can define a metric that represents balance sheet resiliency to climate risk and mitigation policies and use it to:
- Create a baseline scenario that can be reported within the risk management framework.
- Set targets that meaningfully and prudently move the bank towards the center of a sustainable economy.
- Monitor progress towards sustainability.
- Enable the bank to make economically viable loans/investments.
Read about this issue in more detail, including use cases for policymakers, CROs and credit officers, and potential technology solutions in our white paper Climate change: the new risk variable
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