Understanding the potential impact of climate risk on the financial system is of increasing importance, but the uncertainty associated with climate change makes it very difficult to build this understanding. Climate risk scenario analysis is a core tool that is being developed and used by financial institutions and regulators to navigate the uncertainty associated with future climate outcomes and ensure the wider financial system can withstand possible climate events in the future.
To date, such analysis has been primarily focused on measuring the long-term effects of climate risk on the banking book. Those exercises have helped to identify gaps and progress has been made in building the industry’s capabilities to assess the effects of long-term climate risk scenarios on the banking book. A survey of ISDA members in 2022 highlighted that trading book scenario analysis is now seen as a priority for many banks. While some have partial capabilities to assess the market risk or counterparty credit risk impact of defined climate risk scenarios, there is a lack of consensus on the methodology, as well as a scarcity of reliable data to support robust scenario analysis.
Regulators and financial institutions are now shifting their focus to the shorter-term effects of climate risk on the trading book. During the first half of 2023, to support the industry and regulators in these efforts, ISDA commissioned Deloitte to conduct research with more than 30 ISDA member banks and develop a conceptual framework together with a set of key considerations to support the design and implementation of climate risk scenarios for the trading book. The framework is novel because it includes explicit consideration of climate risk factors, with the aim of producing a set of corresponding market risk factors consistent with climate risk as an output. The conceptual framework and key considerations have been developed in consultation with the participating banks and are informed by their insights.
During the second half of 2023, ISDA plans to pilot the conceptual framework to test its usefulness as well as to generate some estimates of potential climate risk impacts on a set of hypothetical portfolios.