Gaurav Ganguly, Head, Group Risk Economics, HSBC
“Environment-related risks account for three of the top five risks by likelihood and four by impact”, the World Economic Forum’s Global Risk Report 2019 said. The severity of the impact is clear but how financial institutions might put that into a model is less clear. In this article, Gaurav Ganguly, Head, Group Risk Economics, HSBC, outlines what banks should expect from climate financial scenario analysis, what such analysis should be able to tell you, and why it’s important to start building it now.
Banks are increasingly turning to scenario analysis to gauge climate risks in their portfolios and to deepen their understanding of the impact of climate change on the financial system. Climate financial scenario analysis in banks is a relatively new and fast-growing discipline and while it seeks to rely on existing risk management frameworks, understanding the impact of climate change and associated policies on the financial system creates several new challenges. These challenges are significant and are related to the unprecedented nature of climate change, the uncertainty associated with making climate related predictions, and their transmission through the financial system.
We expect scenarios to measure the economic and financial consequences of climate risks in order to help banks take risk-based decisions and aid their disclosure, while at the same time, close gaps in data and knowledge. This is a hefty ask, so what should we reasonably expect from climate financial scenario analysis?
Scenarios of emissions or of weather are not constructed to directly enable financial risk assessment and significant further work is necessary to extend the analysis. Climate financial scenario analysis is typically split between transition and physical risk. The financial system faces the former as a result of policy measures that accelerate the shift to a low emissions economy while the latter arise from damages due to changes in the climate system. Scenarios need to start by mapping these two climate related risks to their corresponding economic and financial effects. Transition scenarios will need to translate policy action and emissions reductions into economic drivers that can help measure standard risk factors such as credit or market risk i.e. the risk of default and/or the risk of abrupt re-pricing. Physical scenarios will need to work in a similar way by linking weather events to economic and hence financial loss. This may seem obvious but the complexity of linking climate models and the economic effects to standard drivers of financial risk should not be underestimated.
Mitigation, adaptation, and climate change will affect the allocation of capital within and across sectors and will alter returns to certain types of economic activity across locations. Despite our best efforts to capture such re-configuration through models, economic changes may occur in unanticipated ways and there may be risks and opportunities that current models and assumptions are unable to fully recognise. As our knowledge of financial transmission improves, we are likely to find ourselves revisiting our models and our scenarios. In this context, helpful scenarios are those that make the appropriate macro-financial linkages based on current understanding, while at the same time, are transparent on the challenges that remain. At this stage of development, good climate financial scenarios are those that lead to more questions rather than answers!
Scenarios should serve as an exploratory tool for tackling the uncertainty embedded in climate financial decision-making. Banks will find it helpful to consider a range of outcomes rather than rely on a single scenario and possibly even over different time horizons. To examine a full range of outcomes, including the more extreme, banks will need to create scenarios that probe very different types of economic consequences of climate. These might include scenarios that examine the consequences of political and social change, changes in economic management mechanisms or changes in financial expectations. This suggests the need for a very engaged approach whereby banks bring the insights of different models, assumptions and even different disciplines into scenario analysis.
Climate scenarios, if they are to make useful predictions of future changes, need to start with an understanding of the current shape of the global economy and its vulnerabilities. In addition, historical economic analysis is likely to be useful when examining financial tail risks related to climate. Banks frequently use scenario analysis to model tails i.e. to probe the impact of fundamental changes in economic structures and/or market disruption and negative spillovers. Banks are guided in such analysis through examination of past events e.g. institutional changes such as trade agreements or exchange rate regimes, build-up of speculative bubbles and their subsequent correction, episodes of sovereign default, high vs low-inflation regimes and so on. While climate scenarios require making predictions outside the range of historical experience, this still needs to be based in an understanding of the economy today and, in the case of more extreme tail scenarios, may be usefully informed by past analysis of financial disruption.
Scenarios we build today will take large steps forward despite limitations in data and understanding. Models will improve as understanding of the financial transmission mechanism of climate change increases and as data gaps are closed. Financial institutions need to consider a road-map that acknowledges the improvements required and create an appropriate programme for scenario development that can enable financial decision making and aid disclosure.