This report synthesizes the efforts of a Working Group of sixteen international banks (ANZ, Barclays, BBVA, BNP Paribas, Bradesco, Citi, DNB, Itaú Unibanco, National Australia Bank, Rabobank, Royal Bank of Canada, Santander, Société Générale, Standard Chartered, TD Bank Group and UBS) convened by the UN Environment Finance Initiative (UNEP FI) and supported by Oliver Wyman to develop a methodology for assessing the risks and opportunities associated with the transition to a low-carbon economy (the “transition-related” impacts associated with climate change).
The proposed methodology aims to be extensible to multiple sectors, a variety of scenario sources, different risk factors, and timeframes.
It was framed to face the 6 following challenges:
- “Limited empirical data exists to measure the strength of the climate-credit risk relationship.
- Long time horizons for transition impacts challenge the way banks usually manage risk.
- Transition risks vary across sectors, both in terms of how, and how much, they impact specific industries.
- The methodology needs to be systematic, repeatable, and consistent in order to be useful for disclosure.
- Banks need to tailor transition risk assessments to their own organizations.
- Conducting quality scenario analysis requires major coordination across the organization.”
General overview of the risk assessment methodology
The proposed transition risk assessment methodology encompasses three integrated modules:
- “Transition scenarios: Transition scenarios describe an evolving economic environment in a consistent manner across time, sectors, and geographies. Each transition scenario provides detailed outputs which help assess the economic impact on sectors. Variables from transition scenario models are used to determine how risk evolves over time at sector and geographic levels. Scenarios provide a consistent reference point, and common parameters, that experts use to assess the impact of transition across institutions, geographies, and sectors during the borrower-level calibration. The scenario variables are also summarized into “risk factor pathways”, representing corporate credit risk drivers: direct and indirect emissions costs, changes in revenue, and required low-carbon investment. “Risk factor pathways” are differentiated across economic sectors in scenario model outputs, and further differentiated into more granular segments through customized sensitivities. In the portfolio impact assessment, these “risk factor pathways” allow extrapolation from calibrated borrower-level impacts to the whole of the portfolio.
- Borrower-level calibration: Borrower-level calibration addresses the lack of empirical data on corporate exposure to transition risk by using industry experts and tailored assessment to estimate the scenario’s impact on individual borrowers. Calibration specifies the relationship between climate scenarios and credit outcomes. The borrower-level calibration builds on scenario variables, bridging information gaps using expert judgment and in-house credit risk tools to assess the changes to the probability of default of particular borrowers. This assessment provides the primary basis for identifying the magnitude of the scenario’s impact on the creditworthiness of borrowers, incorporating quantitative and qualitative considerations. This analysis is only conducted on a subset of cases, allowing for manageable workload.
- Portfolio impact assessment: The portfolio impact assessment uses a systematic and repeatable approach to extrapolate the risk assessed by other modules to the remainder of the portfolio. Portfolio impact assessment provides a structured quantitative method for combining bottom-up expert judgment from calibration with top-down parameters provided by scenario models. Changes in creditworthiness from a handful of borrowers are extrapolated to the overall portfolio using a “climate credit quality index”, derived from the risk factor pathways and the calibration points, and a Merton-type framework.”
“The proposed transition risk methodology is a blend between sector-level and borrower-level modelling. The bottom-up, borrower-level calibration captures borrower-specific nuances. Top-down portfolio impact assessment extrapolates the borrower-level information to segments, which are homogenous in their sensitivity to transition risk. In practice, only a sample of “manual” borrower-level analyses is necessary to determine sector exposure, reducing both required time and resources, while maintaining the integrity and accuracy of the analysis. Furthermore, limited manual intervention is required when running a different climate transition scenario from the same source or adding a new borrower to the portfolio.”
Guidance provided on risk assessment based on the pilot outcomes
During the pilot, banks used the following assessment guide for defining segment sensitivities to risk factor pathways.
Developing the segmentation scheme across banks yielded two conclusions:
- The final segmentation scheme may differ by institution/region
- The segmentation process is iterative
In completing early calibration exercises, Working Group experts quickly identified two key factors to achieving success:
- “Considering the effort required, experts must be set up with the right resources and processes for calibration, including experienced team members, scenario information, and process guidelines. Throughout, experts must be empowered to experiment with evaluation methods to obtain results; setting ground-rules is important, but changes to the evaluation methodology will arise throughout the assessment process.
- The calibration exercise should be iterative and feed back into the rest of the transition risk assessment process, including the segmentation process. Since this is the first time banks have undertaken the calibration exercise, methods and results should be discussed and challenged amongst industry and credit experts within each bank to refine the calibration process.”
The report includes three case studies:
- BARCLAYS CASE STUDY: UTILITIES IN EUROPE AND THE US
- BANK #2 CASE STUDY: METALS & MINING
- BANK #3 CASE STUDY: OIL & GAS IN THE UNITED STATES
Guidance provided on the assessment of opportunities
The proposed approach aims to compare the assessment of the market with the strengths and capabilities of an institution, based on two scorecards:
- Market opportunities assessment
The report recommends to use a scorecard approach to assess the attractiveness of each segment by considering two key drivers: the segment’s response to policy, and technology considerations within a given target geography.
- Banks capabilities assessment
To gain a deeper understanding of which segments are actually within an institution’s grasp, the report recommends banks to conduct an individualized assessment of their own capabilities by assessing three major drivers of their potential market share: the competitive landscape, their risk appetite, and their operational capacity.
