1. Defining climate scenarios: the estimation of the impact of climate change and of the transition to a low-carbon economy on credit risk relies first on the definition of physical scenarios for climate change and for the transition. These scenarios define how climate change will impact the variables that are relevant for economic activities, how a transition will mitigate these impacts and which measures are taken to steer the transition.
2. Estimating economic and financial impacts: once the impact of climate change on the variables relevant for economic activities has been estimated, its consequences must be translated into economic terms though macro and microeconomic simulations. This step basically assesses the direct and indirect repercussions of climate change and the transition to a low-carbon economy in economic terms and identifies which actors are affected by them and by how much. Once the economic effects on actors have been identified, the next step is to estimate the impact of these effects on both their cash flows and their balance sheets.
3. Translating financial impacts into credit risk measures: based on this assessment of financial impacts on firms and households, the next step is to compute how changes in cash flows and balance sheets will affect their credit worthiness in terms of probability of default and loss given default – and thus also in their credit ratings.
The report then identifies 5 main methodological challenges that market participants are facing while implementing these building blocks:
1) addressing the limitations of historical data,
2) expanding the horizon of credit risk models,
3) finding the right level of data granularity,
4) identifying the relevant climate risk exposure metrics and
5) translating economic impact into financial risk metrics.