Climate Risk Types & Classification

Climate risks, as they could filter through to affect a bank, are classified into three groups, namely, physical risks, liability and disclosure risks and transition risks [1]. This article will look at transition risks as they relate to financial institutions. 

Transition risks arise from changes in technology due to new technological requirements that will be required for a low-carbon economy. Furthermore, changes in consumer sentiment, investor sentiment and Government policies that are necessitated by climate change will have carry risks of making the goods and services produced by some sectors of the economy to decline in demand.  

Transmission Channels

There exist two transmission channels through which transition climate risks filter into banks. These are (i) the microeconomic channel and (ii) the macroeconomic channel [2]:

1. The microeconomic channel analyses the ways in which climate risks affect counterparties of a bank and the extent to which this poses climate-related financial risk to the bank and the whole financial system.
2. Macroeconomic channels describe climate risk drivers that affect macroeconomic indicators such as economic growth and productivity. In turn these indicators may require that macroeconomic variables such as interest rates, exchange rates and commodity prices be adjusted, and this affects the macroeconomic environment within which a bank operates. 

Microeconomic Channels 

Transition Risk

Consumers, investors, and Governments have become more cognisant of transition risks, but banks are yet to be materially affected by the transition to a low-carbon economy. The extent to which banks will be affected in the future is dependent on the path that economies take in carbon reduction. 

Transition related changes could lead to abrupt changes in asset prices and changes in borrowing costs. Investors in financial markets will reward borrowers who will be resilient or be likely to benefit from the transition to a low-carbon economy. Borrowers in sectors that are carbon-intensive are likely to face higher borrowing costs.

A large portion of the transition risks that are to be manifest in the future will be driven by global economic factors in aggregate rather than the specific policies of one state and hence cannot be prevented by a single Government of a sovereign state [1]. Estimated transition risks for the South African are in the order of R2 trillion (60% have been incurred) and infrastructure investments in the order of R362 billion that are under consideration may not be economically viable in a low carbon economy [3].

South Africa is the 14th largest emitter of CO2 and the 10th largest emitter of CO2 on a per capita basis. This is driven by exposure to exports of thermal coal to countries such as India [4],  power generation and production of synthetic fuel through the Fischer-Tropsch process. In November 2016, the parliament of South Africa ratified the Paris Agreement on Climate Change and the country set a goal of reducing carbon emissions to 42% below the business-as-usual scenario by 2025 [1].

Credit Risk

Credit risk drivers impact household, corporate and sovereign income, and wealth. Transition risks affect the credit risk of a bank as the risks will reduce the ability of certain borrowers to repay loans or affect the value of the collateral that a borrower had placed for the loan.

Market Risk

Climate risks may have a significant impact on the valuation of financial assets. Transition risks will reveal information about real or financial assets which cause asset prices to reduce and market volatility for traded assets to increase. This results in changes in asset correlations and thus reduce the effectiveness of some hedges and portfolio diversification strategies. If climate risk is already priced in the markets, then the potential for such disruptions is lower and thus there is less transition risk. The uncertainty that accompanies transition risks will likely amplify market volatility caused by the risks, however over time this risk is expected to wear out once there is more certainty on the path the economy is likely to take.

Liquidity Risk

Climate drivers may affect the liquidity of a bank directly, through their ability to raise funds or liquidate assets, or indirectly through demands for liquidity by clients. Transition risk is likely to affect the liquidity position of banks as certain instruments that banks hold may become harder to sell to institutional investors. Bonds of coal producing electricity utilities are an example of bond markets whose liquidity is likely to decrease with time. Currently, coal mines and other stocks of coal producing assets are facing discounts due to activist investors and this can be thought of as a transition and liquidity risk premium.

Operational and Reputational Risk

Corporates and banks may be exposed to legal and regulatory compliance risk and liability costs associated with climate-sensitive investments and businesses. The current tension between energy requirements in South Africa and the need to transition to clean energy creates not so well-defined transition risks within the set of operational and reputational risks in the South African context.

Pricing and management of climate risks in markets

In some developed economies, there is limited evidence that transition risks are priced into municipal bonds, corporate bonds, and some equities. Thus, these financial assets will be less affected by the transition to a low-carbon economy. However, this pricing is affected by absence of consistent methodologies in pricing of climate risks. This is the space where Riskworx can make a difference through our quantitative skillset.

Banks manage and market risk and limit exposure to systemic shocks based on historical data. The absence of historical data with respect to climate shocks makes the hedging and pricing process of assets difficult for banks. It makes it difficult to analyse the extent to which pricing methodologies used by banks and seen in the market consider climate change, broadly speaking. 

Macroeconomic Transmission Channels

Physical Risk Drivers

Increases in temperature negatively affect mortality, agricultural yields, energy demand, labour supply, and productivity. In the context of Africa, with high unemployment and poverty rates the effect on agricultural yields and mortality may have social consequences. Despite having the lowest contribution to CO2 emissions, Africa is the most vulnerable continent to the physical effects of climate change. Sub-Saharan Africa has 95% of rain-fed agriculture due to poor irrigation infrastructure [5] and hence has the least capacity to offset extreme heat events and their impact on food-security. Furthermore, close to 65% of the African population depend on subsistence farming, with women consisting of most of the labour [6]. Without agricultural financing to create resilience in the form of irrigation systems and other such measures, these populations would be vulnerable and an acceleration of rural to urban migration would be expected. 

While some of the physical risks such as in agriculture are unfolding gradually, some of the physical risks are already manifest. Cyclone Idai that struck Mozambique in 2019 destroyed over 90% of the infrastructure in the port city of Beira and had casualties that stretched all the way to the eastern regions of Zimbabwe [5]. Due to the extent of the catastrophe the World Food Program (WFP) declared the floods a level-3 emergency, the same level as war-stricken states such as Yemen and Syria [5]. It should be noted that more floods of such nature are to be expected more regularly due to climate change. 

The cost of natural disasters is likely to be higher for poorer cities and countries. Evidence suggests that exposure to climate change increases borrowing costs for countries and municipalities that are prone to extreme weather events [7]. This effect is also expected for sovereign states. Higher sovereign yields affect borrowing costs of firms and banks within these countries. As such it is to be expected that during the transition, before the effects of climate change are visible, markets may price these effects into the market during the transition.

Credit Risk 

Oil and coal reserves are likely to be devalued during the transition to a low-carbon future. This will result in climate-related income effects on sovereigns that depend on oil exports, which will affect their abilities to service debts, in turn impacting the value of their bonds and interest rates, their credit ratings and the credit ratings of institutions associated with the sovereign. In turn, this is expected to increase the credit risk of banks facing these counterparties.

The transition risk drivers noted in the microeconomic transmission channels could, in aggregate, have macroeconomic effects.

Conclusion

It is important for banks to attempt to be ahead of the curve in terms of pricing the impacts of climate change on products in their trading and banking books. While the path of the future global economy is uncertain, what is certain is that the status quo is unsustainable, and banks will be at the forefront of allocating capital to shape the future economy.

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