Understanding and Managing the Impact of Climate Risk

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

It has become clear that climate-related risks – including extreme weather events – have the potential to impact asset prices and even the creditworthiness of some companies, but what’s less clear is to what extent and under what circumstances. Banks are now upping their efforts to better understand the impact of climate change on their trading books, but it’s relatively early days and there’s little information on how different institutions are approaching this. In response, ISDA and EY recently published the findings from a survey that help to clarify the industry progress to date – and the work that still needs to be done.

Banks have so far spent much of their effort on assessing climate risk in their banking books, which include some longer-dated assets that could change over time due to the effects of climate change. That also reflects where regulators have focused most of their attention. But this is changing – most respondents have at least partial ability to assess climate scenario impacts for market risk and have prioritized further development of trading book scenario analysis for 2022/2023.

Climate-related risks may impact trading book assets in different ways. For example, initiatives to support the transition to net zero can drive shocks to carbon and commodity prices, while extreme weather events such as floods and hurricanes can destroy firms’ assets, leading to sudden losses.

So far, trading book scenarios have tended to focus on changes to carbon and commodity prices, with less attention given to the impact of acute physical risks. To some extent, this reflects scenarios developed by the European Central Bank and the Network of Central Banks and Supervisors for Greening the Financial System, which many firms have been using as the basis of their analysis. This is likely to change, as the survey finds most banks are planning to develop new scenarios to focus on firm-specific climate vulnerabilities and concentrations.

There are some issues that need to be addressed first, though. For one thing, there is a lack of consensus on the methodology and approach, as well as challenges in selecting and calibrating the parameters that should be used. Most respondents highlighted difficulties in identifying and defining climate risk shocks, along with mapping climate risk drivers to market risk factors. In response, banks want to engage with regulators to help define and run exploratory scenarios for the trading book. This would create the opportunity to compare outputs and identify emerging standards, as well as provide a constructive learning exercise.

Respondents also identified the availability and quality of data as a key challenge. Scenario analysis requires consistent, granular and reliable data, and there is demand for greater availability from data providers and firm disclosures. Respondents also see the benefits of increased standardization from regulators and international bodies like the Taskforce on Climate-related Financial Disclosures, which was established by the Financial Stability Board.

Banks have come a long way in developing their scenario analysis capabilities for the trading book, but there’s still room for further improvements. As with other areas of trading book risk, ISDA will work with banks, regulators and solution providers to identify gaps and develop standardized best practices. Given the severity of extreme weather events, the ability to quantify, manage and mitigate climate-related risks will be critical to maintaining safe and efficient markets.

Read the ISDA, EY report: Climate Risk Scenario Analysis for the Trading Book

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