Lawrence Habahbeh looks at climate change from a traded risk perspective
There is compelling evidence that climate change is happening, and the impacts are observable daily at many locations across the planet. According to the latest Sigma study from the Swiss Re Institute, total global economic losses from natural and manmade disasters in 2017 were $337bn - almost double the losses in 2016, and the second-highest figure on record. Climate-related risks and their impacts are expected to become more severe as the climate changes and becomes more chaotic in the near future.
According to the Task Force on Climate-Related Financial Disclosures, climate-related risks fall into two major categories: risks related to the transition to a lower-carbon economy, and risks related to the physical impacts of climate change. A major challenge for actuaries and risk managers at financial institutions is understanding how the projected evolution of climate-related risks, their interactions and impacts will occur, as well as where they will occur and in what form.
This task is complicated by a number of factors - particularly the empirical relationships and dependencies between changes in climatic variables (for example, changes in precipitation), impacts (increased flooding) and financial system response (adaptive capacity), which are far from clear. A further complication is the dynamic nature of vulnerability and its direct or indirect links to a range of environmental, social, economic, political and geopolitical risk factors. This makes the financial risk assessment process in a changing climate more challenging.
Evaluating the impact
According to the Bank of England Prudential Regulation Authority Consultation Paper 23/18, issued in October 2018, financial firms are required to embed climate-related risks into their governance, strategy and risk management frameworks. Firms are required to have a comprehensive risk management framework that takes climate-related events into account and measures their impact on financial risks.
The paper falls short on providing details regarding the methodology to be applied in order to identify the scope of climate-related risks, and the risk and capital models to be used in order to quantify the financial losses that arise due to climate-related weather events. UK banks' current practice is to assess and measure financial risks from climate change based on quantifying the resulting impact that short-term and long-term climate processes have on financial risk. They do this by measuring, for example, the impact of flood risk on mortgage portfolios based on a range of flood scenarios, and quantifying the impacts on credit risk underlying assumptions such as loss given default, probability of default, and exposure at default.
In addition, UK banks are evaluating the impact of extreme weather events on their sovereign risk exposures. However, the industry is lacking a uniform working definition of what defines and constitutes climate risk. There is no general view defining the scope of climate-related risk factors that are relevant in assessing and measuring financial risks arising from normal and extreme weather events. Moreover, there exists no view on how the underlying dependency structure of climate risk factors evolve and manifest into a wide spectrum of climate-related weather events, such as floods, heatwaves, wildfires, storms and mudslides, which are all consequences of a number of underlying, interacting and randomly evolving climate risk factors, manifesting as short-term and long-term weather-related events.
As actuaries and risk practitioners, we measure risks to a single financial transaction or to portfolios of financial transactions, using various approximation techniques and assumptions about both the statistical properties of the underlying risk factors driving the risk processes, and the sensitivity of changes in the value of financial transactions to small moves in the underlying risk factors. Therefore, it is necessary to have an industry consensus and breakdown of the essential climate risk factors that drive potential expected and unexpected losses on financial transactions covering a range of possible scenarios. This consensus must take into account the linear and non-linear behaviour of the underlying risks that drive climate events and consequently impact the value of assets and liabilities alike.
Certainly, climate risk has a wide range of financial and non-financial impacts. From a traded risk perspective, in order to measure climate risk, we should have a broad industry consensus and clear definitions for several questions. First, what is the definition of climate risk - and is it going to be defined in the same way as we define the market, credit, counter-party and liquidity risks that we quantify and hedge on daily basis? Second, what is the scope of short-term and long-term climate risk factors driving weather events such as tornadoes, hurricanes, storms, droughts and floods? Third, how is climate risk going to be treated? Is it to be treated as an independent risk class similar to interest rates, equity, commodity, credit spreads and foreign exchange, or as a threat amplifier to existing risks? Fourth, how can we incorporate numerical weather prediction models - methods of weather forecasting, mathematical modelling and computing used to predict atmospheric variables such as temperature, pressure, wind and rainfall - into banks' internal risk and regulatory capital models?
Finally, how is climate risk going to be hedged and mitigated? For example, is climate risk going to be passed to the insurance sector, or will more innovative structures such as collateralised weather obligation be utilised to pass the risk to the market?
Within the confines of traded risk, many questions remain unanswered. For this reason, the industry must begin in earnest to imagine the unimaginable when it comes to managing climate risk, in order to meet the strategic future while operating in a changing climate. Furthermore, we must seriously begin to build capacity by hiring in-house climatologists, computer scientists and actuaries in order to upgrade risk models and develop a more robust assessment of the impacts of a wide spectrum of plausible and possible climate weather events on financial risks.
There is substantial evidence to indicate that significant global climate change is no longer a faraway threat, but an existential risk whose effects are obvious and require immediate action.
Lawrence Habahbeh is a traded risk specialist