Are you factoring climate change into credit risk?

Gen10 have recently been exploring commodities credit risk and why the current market conditions suggest this is likely to be an area of heightened interest soon. Today, we consider the impact of environmental concerns on counterparty credit risk; why climate change is already a risk for organisations and for counterparty credit, and how this risk can be mitigated.

The climate change risk

Climate change risks are well-documented, but their impact on counterparty credit is less well-explored. These climate risks can be generally broken down into two distinct categories: transition and physical risks.

Transition risks

Transition risks arise from the steps taken by governments and other organisations in response to climate change. These transition risks can introduce a wide range of new costs for businesses. For example, making large-scale investments in R&D or adopting newer low-carbon technologies can increase borrowing or reduce the organisation’s overall wealth over several years during the transition.

Other transition risks could include potentially facing reduced demand for carbon-intensive products, or higher ongoing operating costs from new taxes or carbon offsetting, which can again impact on cashflow and wealth. As these are two of the key determinants of credit worthiness, climate transition risks have a direct impact on credit risk and need to be assessed accordingly.

Physical risks

Physical risks are the risks of material changes in the real world because of climate change. They include acute hazards, arising from extreme climate events such as droughts, floods, or storms, as well as chronic hazards, which arise from progressive shifts in climate patterns such as increasing temperatures, sea-level rises, or changes in precipitation. Physical events are expected to rise in number and severity. In 2019 alone, 40 weather-related disasters caused damage exceeding $1 billion each.

Organisations may be aware of their own physical risks, but awareness of your counterparties’ physical risk is also important; agricultural commodities grown in areas more susceptible to chronic hazards will create greater risks of increased operating costs and reduced harvests, leading to an inability to meet financial obligations. And counterparties at risk of acute physical hazards may also represent an additional challenge as these risks can severely impact their operations at short notice.

Mitigating these risks efficiently without limiting other opportunities is a new challenge, one which organisations are still experimenting with ways to address. Potential credit risk solutions include grouping similarly affected counterparties, such as those in the same high-risk region, and applying a credit limit to this group.

Technology can help to manage these risks, from early warnings of potentially disruptive weather events to mapping software used by Gen10 clients that allows you to group all warehouses or other significant locations within a selected area, such as the path of a storm or a flood plain.

Integrating climate and credit risk is a challenge

The main difficulty organisations face when attempting to integrate climate risk into their existing credit risk framework is that climate risk scoring is still in its early stages, with no rigorous models yet available. Climate risks should be incorporated into existing models like probability of default (PD) and loss given default (LGD), but without historical data and forward-looking scenarios, it is difficult to know how accurate estimates are.

Credit markets do not currently reflect climate credit risks because climate costs are not captured by the asset valuation models that market participants use. And there are challenges in the methodology of estimating the impact on credit risk too; addressing the limitations of historical data, finding the right level of data granularity, identifying the relevant metrics and translating the economic impact into financial risk metrics all add to the difficulty.

On top of the shortage of data and climate-related corporate information that would make it easier to assess counterparties’ exposure to climate change risk, there are several other unknowns, including the potential carbon prices levied by any future taxes or carbon markets, and the extent to which corporate carbon footprints will be measured; whether direct emissions, transportation or the wider supply chain will be considered.

The industry is changing

Despite the challenges, change is already well underway. The Bank of England and the ECB actively require climate-related stress tests in financial institutions’ annual stress-testing, meaning lenders will soon be looking at all aspects of climate and credit risk if they are not already.

With banks increasingly judged on their green credentials by a range of stakeholders, they face a commercial imperative to incorporate climate factors into capital allocations, loan approvals and portfolio monitoring. Traders will begin to feel similar pressure from their funding providers soon, or may be feeling that already, but can also adopt more effective ways to manage risk and improve margins by learning from banks’ changing climate credit risk approaches.

And as companies with high carbon footprints are perceived by the market to be more likely to default (the distance-to-default is negatively associated with the amount of a firm’s carbon emissions), climate change risk should already be an important factor in assessing credit worthiness.

It is important for organisations that have not already aligned their risk processes to do so now. Some organisations already assess climate risk at the level of individual counterparties, taking their industry, geography, and reliance on fossil fuels into account. This in-depth analysis becomes more important as more businesses incorporate climate risk into their credit risk strategies as it enables a better insight into a counterparty’s true risk profile and can expand beyond current carbon footprints to consider their mitigation measures, investment plans and future climate strategies.

Climate risk should already play a role in your organisation’s understanding of counterparty credit risk. In the coming years, we will continue to gather better data on climate risk and create better models for understanding its impact on counterparties and their credit worthiness. Getting a handle on climate credit risk is not simply a compliance issue for regulatory disclosure, but a key credit risk metric, and organisations need to be proactive in determining its impact to protect against losses and increase profitable trading.

 

At Gen10, we have a range of solutions that can help organisations put their counterparty credit data to better use; from auditing tools, to completely flexible reporting and mapping, to complete commodity management software. Get in touch today to find out more about what we can offer you.