A suite of Climate Change Risk Management models for Banks and Asset Managers
In December 2015 in Paris, 196 national governments agreed to work to keep the global average temperature below 2°C above the preindustrial revolution mean and targeted under 1.5°C above that level. It has since become clear that even this would not be enough to avoid some of the more severe impacts of climate change. Huge transition and physical risks are faced which include:
- Transition Risks – Adapting to climate change will require individuals, companies, and governments to change behaviours at an unprecedented pace. The ability of companies to adapt to improve the sustainability of their products will require both clear management strategies but also considerable capital investment. Companies with large emissions or damaging products could well face huge reductions in cash flows and limited access to capital.
- Physical Risks – The planet is facing a set of natural catastrophes the likes of which have not been witnessed in historical times. We are anticipating unprecedent shocks, driven by increasingly frequent and powerful storms, droughts, and erratic weather patterns.
These are the four key themes that need to be considered by any financial institution to ensure that it can adapt and operate successfully through the changes that are likely to be coming.
- Governance – Organizations need to align accountability and incentivisation with their proposed client solutions and have a clear framework of leadership to effect and manage the change.
- Strategy – Decisions on the objectives of the firm, meeting the needs for disclosure, risk assessment, product innovation, portfolio solutions; then defining how to go about building solutions.
- Management – Defining the systems and processes to meet the needs, from low-cost top-down approaches to bottom-up integrated solutions that identify and enhance investment strategies and business decisions.
- Disclosure – Meeting the needs for voluntary and regulatory disclosure. Outward demonstration of the firm’s capabilities around governance, strategy, and capabilities.
Climate change poses a range of threats to millions of lives and is not currently reflected in the pricing of financial instruments. Understanding the financial impact of these threats needs a new, appropriately calibrated, level of modelling that reflects the implications of these long-term risks on the horizon that will affect both current and future investments and exposures over the coming decades (30 to 50 years).
Ensuring that organisations have the right framework in place to measure, report and manage these risks “and opportunities” is changing from being voluntary into a regulatory requirement – for Banks, Insurance Companies and Asset Managers. The challenge is to build an understanding of these risks and embed them within the firm’s current systems and processes.
The team at our partner, Quant Foundry, has researched and developed a suite of solutions to address these challenges. In addition to insight on governance and strategy, this includes a risk engine that can deal with transition and physical impacts.
These solutions provide an organisation with the means to leverage our partnership’s expertise and insight into climate risk management on a consultancy basis, so they can build the requisite infrastructure, adopt the necessary principles, and grow their expertise.
Our models can be utilised to accelerate and enhance the firm’s risk capabilities and integrate across the enterprise, covering Counterparty Credit, Credit Risk, Operational Risk and Economic capital. We have developed a coherent quantitative risk engine that can be applied to build scenarios to investigate different climate outcomes, greenhouse gas emissions target that can provide results at a “security level” (equities, bonds etc).
In essence, our suite of solutions is flexible and can be leveraged by our clients to the degree that they want. This could be in the early stages of their climate change effort, to build a framework and define strategy, or to start a disclosure and reporting process – all the way to integrating a full risk solution to improve the use of capital across the business.
The QF4CM Model Suite
Quant Foundry created the QF4CM to provide a transparent bottom-up scenario engine that can be applied to generate multiple scenarios from changes in greenhouse gas emission targets. The solution simulates the climate and industry sector outcomes and integrates them at a company level, giving an unambiguous causal link for each outcome.
Ongoing research and investment into modelling and assessing the impacts of climate change helps us to address the myriad of risks concentrated in this arena. This includes the impact to Sovereign bonds, Real Estate, Mortgages etc. Additionally, Quant Foundry has combined forces with a world class provider of physical risk solutions to deliver detailed best in class physical risk assessment for real estate portfolios down to the individual property level.
The model suite is categorised as follows:
- Integrated Climate Model
Solution uses an integrated climate and transition model, capturing the impact of technology change, and land use for a whole earth system.
- Multiple Scenario Generating Capability
Ability to define detailed technology costs and commodity usage for each major market. Define trade, CO2 taxes and limits. Detailed sector level modelling.
- Corporation Level Evolution Over Time
Ability to capture the diversity of revenue generation units around the world. Possible to customize and define current and future investments model capital structure constraints.
- Financial Markets
Model can provide detailed financial instrument pricing, credit ratings, credit spread estimates, commodity prices, equity prices. Market volatilities.
Application & Approach
Our approach brings together physical and transition risk scenario impacts within a framework that incorporates sector and then company level analyses which can then be used to derive financial impacts at an instrument / security level.
There is a dearth of models in the commercial environment that enable statements at a company level and focus on a corporation’s forward looking carbon footprint. Those that have come to prominence tend not to factor in the rational management of companies going forward in time, which gives rise to unrealistic company exposures over the wrong timescales.
The QF4CM solution amalgamates and customises a best-in-class integrated assessment model (that has been academically validated in hind-casting studies and used as part of IPCC studies) with a detailed model of the revenue generation capability for a company’s optimal transition path. Accordingly, it measures the impact to its market capitalisation and credit rating. It also provides non-financial insight, such as technology mix.
The diagram above demonstrates how the amalgamated model provides estimates (pathways / scenarios) of macro and micro-economic measures annually (macro and micro-economic pathways) to meet CO2 emittance targets. This can be between 2020 and 2050 (or beyond to 2100 if required). Inputs include macro-economic information such as level of the carbon tax, energy demand, generation mix, as well as micro-economic corporate financial information such as revenue, EBIT, credit spread/rating, market cap, outstanding debt.
The macroeconomic pathways project what the future economy is likely to look like and can be configured to provide views on GDP (or deliver updated views on GDP) – whilst the microeconomic pathways provide insight into the performance of companies based on their ability to complete the necessary transition path, a critical requirement on the sell side.
Essentially, the model comprises of two principal components. The first being an overall CO2 emission allowance, set at a country / nation state level. The second being a specific company allocation of that emission allowance. To survive and prosper, a company will need to at least meet, but ideally fall short of its allocation.
For Asset Managers
With its detailed risk modelling and revenue forecasting capability, QF4CM delivers insights into portfolio construction and can be used for optimisation across equity and bond portfolios. As understanding evolves about the impacts on climate change of policy choices made by national and regional governments, companies with the help of QF4CM will be better able to comprehend the impact to them and how to adapt and evolve.
The QF4CM model delivers the insight to highlight those companies that can adapt efficiently versus those that will not. This provides a powerful means to build and explain offerings to clients, ranging from pure renewables to fast adapters. The solution provides a way to accelerate an Asset Manager in terms of expertise and capability, to be competitive in an evolving marketplace.
In a nutshell, they will gain the means to build and justify portfolios to address client requests and provide a clear motivation for their investment choices.
Armed with a view of climate risk exposures across the organisation, banks get the means to address and manage their exposures and develop business strategies to identify opportunities, data, and capability gaps across the enterprise.
The business end of a bank (front office) will now be able to structure new client solutions and advice, client management plans, new funding / loan structures and initiate the journey for their clients in the market (corporations, financial institutions, and sovereigns) to mitigate their exposure to climate risks.
Pressured by regulators and client demand in the market, QF4CM delivers to the risk management function a clear roadmap on how climate stress testing can be implemented within the organisation. Most banks will probably initially adopt a top-down approach to stress scenario construction because that is how they have dealt with their current regulatory stress testing programs (e.g., CCAR, ECB, BoE etc). Whether or not this is the case, QF4CM delivers a transparent causal explanation for each stress scenario, which is critical where historical data is missing.
Risk Management use cases will include:
- Measuring and managing exposure to climate risk across the enterprise
- Measuring and managing retail exposure to climate risk
- Measuring and managing climate risk across counterparties
- Climate risk stress testing for retail and wholesale portfolios respectively
Holley Holland works closely with its partner, Quant Foundry Limited. QF has been at the forefront of climate risk research for nearly two years. Dr Chris Cormack and the QF team has designed and built an innovative risk model to address transition and climate risks from counterparties, real estate portfolios and more. Their research has been published in peer reviewed journals and used commercially.
QF has also developed an advisory service, to help companies develop their understanding of climate risks and build the risk infrastructure to meet the stress test objectives and then embed the capability across their business model. Their solution for banks was developed to accelerate climate change capabilities; capturing transition and physical risks and how they manifest into credit, operational, and market risks – ultimately to assimilate them into their Pillar 2 and ICAAP disclosures for climate risks.
More details on the modelling framework and QF’s ability to assess asset level physical risks and the impact on financial instruments can be found at https://quantfoundry.com/climate-change/.
The Quant Foundry Climate Modelling overview can be found at https://quantfoundry.com/climate-change-model-challenges/.