Articles - Scenario analysis of climate related financial risks

 By Bob Tyley, Head of Credit Risk and Sarah Clare, Senior Consultant at Hymans Robertson

 It is becoming gradually clearer that many scenarios do not adequately capture the downside risks of climate change. Therefore these scenarios cannot be used effectively to control the risks of climate change or optimise portfolios and investment decisions to support positive change.

 Article from the Bank of England
 On 17 April 2024, the BoE released a paper exploring the use of scenario analysis for measuring firms’ climate-related financial risks. The context was the increasing focus on climate-related factors by financial institutions and the BoE considered the application of scenario analysis to the financial risks to which it is exposed. We believe the conclusions, if not the specific examples, are relevant to all financial institutions considering these risks.

 Our key takeaways from this bulletin are that the BoE believes that current mainstream scenario analysis:

 provides a useful starting point for assessing climate-related financial risk exposures but they do not generally provide the level of detail firms require
 only captures a subset of chronic and acute physical risks, rather than all relevant climate risks faced by a firm and that climate risks may be underestimated as these scenarios don’t allow for tipping-points or the possible non-linearity of risks
 doesn’t account for the heterogeneity of assets within a portfolio whereas risks and opportunities will differ between companies within the same sector or sub-sector
 doesn’t include projections of all variables needed for granular asset-level analysis, so firms will need to construct or acquire additional variables.

 The paper focuses on the asset classes the BoE is most exposed to, ie sovereign bonds, corporate bonds, and residential mortgages, and includes examples of how they have approached extending the NGFS macro-scenarios to undertake asset-level analysis.

 Corporate Bonds

 The BoE noted that key challenges in applying climate scenario analysis to bond-level assessments included the level of granularity needed and capturing intra-sectoral variability. It is noted that this data is often developed by third party providers rather than in-house due to the data intensive approach required.

 The BoE suggests that scenario analysis for corporate bonds should incorporate:

 the impact of carbon pricing on the issuer
 the impact of other transition risks and opportunities on the issuer
 the impact of physical risks, including to the issuer’s office location and supply chain
 the economy-wide interdependencies between different corporates, recognising that the scale of costs and benefits will be a function of impacts across the issuer’s supply chain.

 Having calculated these factors' impact on relevant financial metrics, the BoE expects financial institutions will be able to integrate them into existing financial modelling toolkits, albeit evaluating credit changes may require further assumptions. The biggest impact was seen on the electricity, industrial and transport, and energy sectors, while the BoE found the most striking result to be the significant variability between firms within the same sector, demonstrating the critical need to incorporate firm-specific considerations.

 Residential Mortgages

 Similar challenges were noted for residential mortgages, particularly the need to extend macro scenarios to capture impacts at a sufficiently granular level. For example, incorporating Energy Performance Certificate (EPC) ratings is required to assess the impact of changes in energy costs on specific households, and possible costs to improve the energy efficiency of properties. The estimated impacts vary by EPC rating, from a 14% increase in the proportion of household income used to meet mortgage payments for F-rated properties to 4% for B-rated properties.

 Similarly, incorporating flood data can improve assessments on changes in the cost and availability of insurance for specific properties following the run-off of FloodRe. FloodRe ensures flood insurance is widely available and that premiums are capped for many properties in flood prone areas. However, this guarantee will end in 2039. The BoE’s scenario analysis estimates changes in insurance availability and cost could lead to a fall in house prices for the 10% of areas that are most vulnerable to flood risk that is 6.5 times larger than that for an area with the median level of flood risk.

 Discussion paper from the Basel Committee on Banking Supervision
 In the same week as the BoE published their paper, the BCBS issued a discussion paper seeking feedback on the use of climate scenario analysis to strenghten the monitoring and management of climate-related financial risks. The BCBS’s focus is on banks and their supervisors, however there is a clear read-across to the use of climate-related financial analysis by insurers in both the key features and the usage-specific considerations that they are discussing. Similar to the BoE, the BCBS recognises there are challenges with the application of climate scenario analysis and have requested feedback in a number of areas. However, the paper also notes the objectives and benefits of effective use of climate scenarios, such as helping firms identify risk exposures, informing risk management processes, and assessing the resilience of their business model to climate risks. The closing date to provide feedback on the discussion paper is 15 July 2024.

 What are we doing at Hymans Robertson?
 Hymans Robertson has been carrying out climate scenario analysis for our clients for a number of years. Our in-house climate scenario model assesses investment portfolios under three climate scenarios and has been used by a range of clients to assess their climate strategies, and for inclusion in their Task Force on Climate-Related Financial Disclosure (TCFD)-reports. We’ve long been vocal about the importance of interpreting climate scenario modelling with care, recognising that it’s an area where both understanding and methodologies will develop through time. We recognise the need to evolve.

 In 2023, we developed our approach to climate scenario modelling to include more detailed narrative scenarios – ‘stories’ that help explore the complex interactions that traditional modelling cannot capture. With the help of these narratives, we are helping to educate our clients on limitations in current modelling approaches and to develop their own scenario analysis approach. We published details of our approach in September 2023, inviting feedback from the industry.

 We see many benefits to firms in developing narrative-based scenarios, including gaining insights into the broad drivers of risk, the behaviour and interconnectedness of risks, and more granular risk management.

 Conclusion
 It’s clear that climate scenarios are firmly on the regulatory agenda, and we can expect further guidance on their use over coming months.

 While we recognise the development of asset-level climate scenarios is challenging and resource-intensive, we believe the benefits far outweigh the challenges.