Over the past few years, we’ve got used to managing disruption in financial markets, with unexpected shocks like the pandemic and Russia’s invasion of Ukraine posing unique challenges. Now we need to make sure we’re ready for another type of disruption event that could affect trading businesses – climate change. Severe weather events, such as wildfires in Australia, California and Europe, are occurring with increasing frequency, but there has been relatively limited understanding of the possible impact of natural disasters on traded assets. That’s beginning to change as ISDA pushes forward with the development of short-term climate risk scenarios for the trading book.

Future climate shocks are likely to fall into two distinct categories – a physical event, such as a flood or an earthquake, or a transition event, such as a change in climate policy or the introduction of a carbon tax. In either scenario, there would be knock-on implications for financial markets, which could be severe depending on the scale of the shock. Scenarios have previously been developed to model the impact on long-term assets, such as loans, but determining the impact on traded assets is more complex as it requires a short time horizon – running to days and weeks rather than years. It also involves modelling specific market risk parameters rather than just considering the macroeconomic impact.

ISDA has been working with a group of banks to get a firmer grip on this issue. Last year, we developed a conceptual framework for climate scenario analysis in the trading book and we recently completed the second phase of the project. This included the design and modelling of three specific climate scenarios: a physical risk scenario involving a sudden increase in temperature; a transition risk scenario comprising a sharp increase in carbon taxes; and a combined scenario in which both physical and transition shocks take place at the same time.

These scenarios break new ground, using the conceptual framework as a foundation to demonstrate how the trading book impact of climate shocks can be modelled. Having set out the narrative for the three scenarios, which was designed to be severe but plausible, the analysis projects the 12-month impact on a set of macroeconomic indicators across regions. The scenarios build on this to project the one-day, 10-day, three-month and one-year market risk shocks across equities, credit, interest rates, commodities and mortgage-backed securities. The results broadly showed all three scenarios would drive a fall in equity prices and a rise in credit spreads, while yield curves would rise in the transition risk scenario but fall in the physical risk scenario.

In developing the scenarios, ISDA engaged closely with both market participants and public-sector entities, including the Network of Central Banks and Supervisors for Greening the Financial System, which is closely focused on this area. We found strong interest and support for the project, as the need to improve readiness for climate disruption is widely recognized.

It’s still early days, but the scenarios represent a valuable starting point. We’re now thinking about the next stage of this work, which could involve the expansion of the scenarios to include more regions and sectors. There’s little doubt that further climate disruption lies ahead, so now is the time to get involved in this vital work.

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