Climate-Related Risk Drivers

• Risks resulting from climate change are referred to as climate-related risks. Due to global warming, which has increased the frequency of extreme weather occurrences, these hazards have increased dramatically. Since 1900, the Earth’s surface temperature has risen by 0.87°C on average globally. It is anticipated that the global warming will continue to increase gradually, bringing about changes that will influence all economies.
• Two categories can be used to classify climate risk drivers- (i). Physical risks (ii). Transition risks

Physical and Transition Risk Drivers

Physical risks-The risks that affect the economy physically are those that are related to weather and climatic fluctuations. They can be further differentiated into –

a) Acute risks – These are brought on by severe weather. Wildfires, heatwaves, floods, storms, hurricanes, typhoons, and cyclones are examples of acute physical risks. Acute risks frequently compound, and in some economies, one occurrence leads to another. These occurrences have the potential to seriously harm local economies, which results in large financial losses.

b)  Chronic risks – These are linked to long-term progressive climatic shifts. Increasing temperatures, desertification ocean acidification, and sea level rise all pose chronic physical risks. Additionally, they might encourage large-scale population shifts within a nation. Additionally, it has been warned that warmer temperatures will increase the melting of ice sheets and glaciers, which will result in higher sea levels. This could result in endemic (or perhaps permanent) inundations of coastal cities, islands, and low-lying regions, as well as their degradation.

Physical climate risks could manifest after a long delay. Additionally, severity varies from one incident to another. The location, timing, and size of individual physical events cannot be controlled, even though human activities and daily decisions influence exposure to physical risks to some amount.

Transition Risks – The societal changes brought on by a shift to a low-carbon economy are transition risk drivers. They may result from modifications to public sector regulations, technological advancements, investor and consumer attitude, or any number of other factors. Although the precise nature of the risk driver will differ by economy, transition risk factors are universal.

The following list gives examples of transition risk factors –

1. Climate Policies -The parties to the Paris Agreement agreed to implement steps to reduce GHG emissions through policies for the transition to clean energy, regulation of pollution, resource conservation, and public subsidies. Many governments have tied to boost energy efficiency standards. Some have reduced or eliminated fossil fuel subsidies. Some have introduced subsidies to encourage the use of electric vehicles. These actions are intended to promote the economy’s shift toward activities that generate less GHG emissions in general and lower carbon emissions.
2. Technology–Technological advancements in the areas of energy -efficient, low-carbon transportation, and other technologies that aid in the reduction of GHG emissions are required. However, the current business models of corporations may lead to increase in cost because of these (such as the adoption of carbon taxes or greater efficiency standards). But they must change as a result to lessen the negative effects and maintain their competitiveness. Also, technical advancements like improvements in battery technology for energy storage and climate-resilient infrastructure will increase economic climate change resistance.
3. Investor Sentiment – Investors are increasingly taking climate risk into account when making investment decisions, possibly in response to increasing pressure from environmental and non-governmental organizations. Some of the biggest asset managers in the world have made it known that they either already take climate change into account when making investment decisions or plan to do so in the future. Investors’ sentiment will definitely have an impact on the risk profile and valuation of debt and equity investments of corporates exposed to climate change.
4. Consumer Sentiment – To move to an economy with lower carbon emissions, human behavior must change. For instance, a change in behavior toward climate-friendly consumption would lead to changes in transportation, industry, and energy use. There are indications that these shifts in consumer behavior have already begun. Retail customers in the banking industry may request that their savings or investments be made in organizations with more environmentally friendly policies or initiatives. Regardless of future regulations, the rising demand for and knowledge of climate-friendly financial goods and investments may prompt banks and corporates to modify their business strategies, which could have an impact on the value of assets.

Microeconomic and Macroeconomic Drivers

• The causal paths that connect climate risk factors to the financial hazards that face banks and the banking industry are known as transmission channels. They can also be seen as a potential pathway for the emergence of climate change as a source of financial risk. Both macroeconomic and microeconomic factors can be used as these transmission routes.

• Microeconomic transmission channels comprise the causal links by which the individual counterparties of banks are impacted by climate risk drivers, potentially leading to a climate change related financial risks for banks and the financial system. This includes any direct consequences on banks that result from modifications to their daily operations or reductions in their capacity to raise capital. Additionally, the indirect effects on name-specific financial assets held by banks are captured by microeconomic transmission channels (e.g., bonds, single-name CDS and equities).
• Macroeconomic transmission channels are the means through which climate risk drivers have an impact on macroeconomic variables (such as economic growth, labor productivity, risk-free interest rates, inflation, commodities, and foreign exchange prices) and how these variables, in turn, may have an impact on banks by way of their effects on the economy in which banks operate.

Microeconomic Channels

Various microeconomic transmission channels and the financial risk they pose are as follows –

• CREDIT RISK – Physical and transition risk drivers raise a bank’s credit risk. They can have an adverse impact on a borrower’s capacity to repay and service debt (the income effect). They can also affect a bank’s ability to fully recover the value of a loan in case of default because the value of any pledged collateral or recoverable value might be diminished (the wealth effect).

Physical risks have the potential to harm or destroy the physical capital (housing, inventory, property, equipment, or infrastructure) of households, corporations, and sovereigns.

• Households – Bank-financed real estate may be harmed by acute or chronic physical risks. If residential real estate is damaged by bad weather or rising sea levels, banks utilising that property as mortgage collateral will witness an increase in credit risk.

• Corporates – Severe weather occurrences pose acute physical threats to businesses, reducing their profitability and possibly raising their credit risk to lenders. Physical risks have a greater chance of affecting the counterparties of banks due to global supply chains. According to several bank and industry scenario evaluations, gradual climate change – including rising temperatures, drought risk, and flood risk – could endanger borrowers’ financial well-being more than climate-related natural calamities. The agriculture industry is expected to be negatively impacted by rising temperatures and changing precipitation, according to studies.

• Sovereigns and subnational institutions – Physical risk occurrences may have an impact on sovereigns’ income largely through tax and spending channels. Reduced household income, damaged corporations, and a drop in overall output might all lead to lower tax receipts. The chance of default and the loss-given-default may thus increase, and sovereigns, including subnational organisations, may experience higher borrowing costs or restricted access to debt markets. In turn, this can result in increased credit risk for exposures to sovereign and municipal debt held by banks. According to analysis, sovereign bond rates and spreads are greater for countries that are more susceptible to climate change than for nations that are more resilient.

Since banks traditionally have not suffered significant losses because of a transition to a low-carbon economy, transition risk drivers have a more limited impact on a bank’s credit risk. Therefore, scenario analysis of governmental policy, technical advancement, and sentiment is mostly used to assess credit risk.

1. Government policy –
   Government policy changes like highertaxes on GHG emissions canaffectprofitability of businesses, which lowers their creditworthiness. and may result in limited access to capital, higher funding costs, and a decreased ability to meet debt commitments. As a result, the credit risk for banks lending to these corporations rises. Extraction of a significant fraction of fossil fuel deposits may become uneconomical during transitions to lower-carbon economies, leading to the creation of so-called “stranded assets” that are no longer able to generate an economic return due to changes brought about by the transition. The amount of credit risk mitigation offered by the fossil fuel reserve assets as collateral for loans could be significantly reduced if such values of such assets drop.
2. Technological change –
   Businesses that rely on carbon-intensive technologies risk losing their competitive edge in the face of newer technology. For instance, in carbon-neutral economies, automobile producers who are unable to create electric automobiles effectively may experience lower profitability. Banks exposed to businesses that struggle to transition to carbon-neutral economies may suffer more credit-related losses.
3. Sentiment –
   The transition to low-carbon economies may also result in changes in market and consumer sentiment toward investments or products with lower carbon footprints. People may become more aware of climate change when predictions of harmful future climatic occurrences rise. As a result, they might take actions that help mitigate the effects of climate change. Consumers may favour vehicles with lower GHG emissions, for example. Due to this, traditional automakers who continue to use less eco-friendly production methods risk having their brand recognition suffer and encountering unfavourable funding conditions. This will may have an impact on investment decisions and a bank’s credit risk as well.

LIQUIDITY RISK – Climate risk factors can directly impact a bank’s liquidity risk through funding and asset liquidation, or indirectly through its customers’ liquidity needs. Natural catastrophes might increase the danger of bank liquidity. These consequences could affect a bank’s capacity to fund asset growth and pay obligations as they become due without suffering intolerable losses. Liquidity buffers are significantly and negatively impacted by post-disaster lending. In order to finance recovery and other cash flow demands, households and corporations exposed to physical risks may withdraw funds from their accounts or draw on their credit lines. These withdrawals may put pressure on the bank’s own liquidity. The central bank may need to step in to maintain financial stability after severe natural disasters since the demand for liquidity by financial institutions, individuals, and businesses can spike sharply.

OPERATIONAL AND REPUTATIONAL RISK– Physical hazards can affect banks directly as operational risks. For example, banks’ capacity to function may be compromised if physical dangers affect telecommunications and transportation infrastructure.
Increasing legal and regulatory compliance risk, as well as litigation and liability costs related to climate-sensitive investments and businesses, may also be a risk that corporations and banks face. Furthermore, litigation relating to climate change may target companies, including banks, for past environmental behaviours while attempting to influence present behaviours.

Macroeconomic Channels

With respect to macroeconomic factors, climate risk is anticipated to have the biggest influence on credit risk and market risk.

CREDIT RISK – Physical and transition risk drivers raise a bank’s credit risk.

1. Physical Risk –

• It is expected that the two main factors contributing to output drops will be rises in human mortality and decreases in labour productivity.
• Recovery costs after a natural disaster can be high, especially for towns with lower incomes. In emerging nations, the impact of climate change on economic growth seems to be more evident. According to empirical data, exposure to climate risk has increased the average cost of debt in a sample of developing nations by 117 basis points, adding an extra $40 billion in interest payments to government debt over the past ten years. Higher taxes, less spending by the government, and decreased economic activity could result from higher borrowing costs, which could indirectly affect the credit risk for banks.
• Although it is particularly challenging to estimate their magnitude, there is evidence that socioeconomic changes brought on by climate change have the potential to have an impact on economic growth. By influencing changes in macroeconomic conditions and economic growth, these socioeconomic changes may indirectly have an impact on banks by affecting the creditworthiness of borrowers.

2. Transition Risk –

• To reach the goals of the Paris Climate Accords, it is expected that a global shift away from fossil fuels will cause the bulk of fossil fuel reserves (about 80%) to become stranded resources, including up to 90% of Africa’s coal deposits, resulting in material losses for many countries. In some of the world’s poorest nations that depend on fossil fuel earnings, such a transition might have a huge impact on government revenue and spending. The ability of sovereigns to fulfil their debts could be hampered by climate-related income consequences, which would lower the value of their bonds, lower their credit ratings, and lower the credit ratings of the institutions that the sovereign is linked to. This will consequently raise the credit risk that banks take when dealing with these counterparties.
• The income of banks’ counterparties may be impacted by transition risk drivers. Taxes on carbon emissions, price increases in carbon-intensive supply chains, or alterations in consumer preferences could all have an impact on income. Higher manufacturing costs make businesses less profitable, which drives down the value of investments and stocks. GDP is decreased because of decreased consumption and investment. Households may experience reduced income. A decrease in household wealth and income may result in a decline in their capacity to pay off debt, raising the credit risk to their banks.

MARKET RISK–The relationship between macro economic factors and banks’ climate-related market risk has not completely clear. There is some research suggesting that sovereigns exposed to physical risk factors may find their access to the debt markets limited or that their borrowing prices have gone up. Physical risk factors may influence a nation’s budget and even lead to sovereign defaults. Increases in sovereign risk and perceived declines in the sovereign’s creditworthiness may have an impact on home banks through losses on government debt holdings, a decline in the value of collateral that banks can use to secure funding and access liquidity, or rating downgrades that raise the cost of wholesale funding for banks.

A summary of the potential effects of climate risk drivers on different types of financial risks are given below

Risk	Potential effects of climate risk drivers (Physical and transition risks)
Credit Risk	Credit risk increases if climate risk drivers reduce borrowers’ ability to repay and service debt or banks’ ability to recover loans in the event of default.
Market Risk	Reduction in financial asset values could lead to sudden price adjustments where climate risk is not incorporated into prices, causing asset liquidity issues.
Liquidity Risk	Banks’ access to stable funding could be reduced due to market conditions. Climate risks may cause counterparties to withdraw deposits and credit lines.
Operational Risk	Increasing legal and regulatory compliance risks associated with climate-sensitive investments and businesses.
Reputational Risk	Increasing reputational risk based on changing market or consumer sentiment.

Factors That Amplify Climate Related Risks

The effects of climate-related risks can be amplified by the following factors:

1. Risk drivers interactions –

Risk factors for both physical and transitional risk drivers interact with one another. Such interactions have been observed, for example, in the simultaneous introduction of laws aimed at reducing global warming (such transport policies) and technological advancements.

2.  Financial amplifiers –
   By altering financial system behaviour and interacting with the real economy, climate-related risks may become more tangible on bank balance sheets. Losses in the financial system could go up because of these amplifying effects.
   Potential sources of financial amplification include interactions between the creditworthiness of financial institutions and sovereigns as well as the potential for market participants’ actions to reinforce negative effects, such as through self-reinforcing reductions in bank lending or in the provision of insurance. Insurance cancellation or unaffordability can act as a significant financial amplifier. Future insurance affordability and availability may be impacted by climate change, which amplifies the effects of less insurance availability.
3. Transmission through multiple channels –
   A particular risk driver may have several transmission channels that affect a bank, magnifying the impact of financial risks associated with climate change. There is a chance that the macroeconomic and microeconomic transmission channels will interact. An illustration of this would be where a macroeconomic channel had a more dispersed impact that led to an unfavourable economic environment while a microeconomic channel had a direct impact on the creditworthiness of a bank’s customers. In the context of climate change, conventional feedback loops between macroeconomic and financial shocks can also lead to amplification. As an illustration, physical risk factors like property damage can have a detrimental impact on an individual’s household wealth and, ultimately, the credit risk of banks. Physical risk factors may intensify macro-financial hazards for a nation, creating a vicious cycle. This could thus reduce the country’s ability to execute sensible transition risk strategies.

Mitigants

Through both proactive and reactive actions, financial mitigants can reduce or offset banks’ exposure to climate-related financial risks.

• Proactive actions include those that banks take to pre-emptively reduce their vulnerability to climate- related financial risks. Examples include diversification and strategic asset allocation.
• Reactive actions include those that are adopted in response to climate hazards that are already present in exposures on the balance sheet. They may consist of using financial products that transfer climate risk to other financial system components (e.g., hedging). Markets for insurance and reinsurance are essential for reducing the effects of climate change on enterprises, consumers, and banks. Also, asset sales and securitization enable banks to lower their exposure to risky assets.

The main financial risk mitigants which have been analysed in detail are –

• Bank behaviour and business models –Investment strategies may allow a bank to manage its portfolio against some aspects of climate risk, as shown in recent research. Diversification tactics might become less successful as increasingly frequent and correlated extreme weather occurrences are brought on by rising global temperatures. If investors have enough information to act on, asset allocation strategies may offer potential mitigation, such as increasing investment in sustainable companies. The extent of potential losses linked to extreme weather conditions or a sudden shift to a lower-carbon economy could be decreased by a steady reduction in climate-sensitive assets. As an alternative, banks can try to boost their financial capacity to maintain business as usual in a high-risk environment. Evidence suggests that banks that experience frequent natural disasters restrict their lending to the most vulnerable areas to strengthen their capital positions. A few indicators point to banks beginning to reduce their exposure to transition risk factors. As cap- and-trade laws pass through the legislative process, for instance, banks change the amount of loans they extend to US businesses. They find that corporations affected by these policies have shorter loan maturities, less access to long-term bank financing, and more shadow banks participating in their lending syndicates. Banks also contribute significantly to the stability of the economy, which may help to mitigate the financial effects of calamities. There are also instances where banks increase lending in disaster-affected areas.

• Availability and pricing of insurance – Insurance functions as a mitigant and enhances the financial resilience of banks to physical dangers. A bank may insure itself against physical hazard losses (such as losses from a borrower’s failure or operational outages) or a bank’s counterparty may insure itself against such losses (e.g., flooding damage to a house). However, insurance coverage is limited, and historical evidence indicates that only a portion of economic losses caused by natural disasters are compensated. Catastrophe bonds and insurance-linked securities (ILS) have been established as alternate sources of finance to cover possible losses. Through international financial markets, these shift the risks related to natural disasters to investors.
• Depth and maturity of capital markets and opportunities for securitisation -Banks having exposure to weak industries or regions may be able to lower on-balance sheet risk when securitization prospects exist. Evidence demonstrates that lenders may transfer risk by originating and securitizing loans in climate-vulnerable regions. Because of the significantly increased risk of default and payment defaults associated with these loans and mortgages, they are frequently securitized below the conforming loan limit, which is the dollar level for purchasing mortgages by GSEs (government-sponsored enterprises).
• Hedging opportunities – Banks and their counter parties, most frequently the agricultural, entertainment, tourist, energy, and insurance industries, employ weather derivatives to manage localised risk related to unforeseen weather and seasonal swings. While these items may be useful for controlling localised weather exposure, their capacity to offer protection against larger climatic risks may be more constrained. In recent years, there has been innovation in climate-related derivative products, such as ESG futures, carbon derivatives based on stock indexes, and water derivatives, to create more market hedging opportunities.