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首页文档碳中和资料研究报告2021年气候风险特别报告（英）-Risk.net

2021年气候风险特别报告（英）-Risk.netVIP专享VIP免费

Climate risk
Risk.netSpecial report 2021
Sponsored by
Risk_Climate21_OFC.indd 99 22/11/2021 14:20
1risk.net
Stella Farrington, Head of Content, Energy Risk
stella.farrington@infopro-digital.com
Joanna Edwards
Global Director, Commercial Sales
joanna.edwards@infopro-digital.com
Stuart Willes
Commercial Editorial Manager
stuart.willes@infopro-digital.com
Alex Hurrell, Senior Commercial Subeditor
alex.hurrell@infopro-digital.com
Antony Chambers, Publisher, Risk.net
antony.chambers@infopro-digital.com
Philip Harding, Global Head of Commercial Content
philip.harding@infopro-digital.com
Baker Jaggwe, Account Director, Energy Risk
baker.jaggwe@infopro-digital.com
Todd Heligman, Business Development Manager
todd.heligman@infopro-digital.com
David Pagliaro, Group Managing Director
david.pagliaro@infopro-digital.com
Ben Wood, Managing Director, Risk.net
ben.wood@infopro-digital.com
Rachel White, Senior Production Executive
rachel.white@infopro-digital.com
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Published by Infopro Digital
© Infopro Digital Risk (IP) Limited, 2021
All rights reserved. No part of this publication may be
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transmitted, in any form or by any means, electronic, mechani-
cal, photocopying, recording or otherwise, without the prior
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Risk
is registered
as a trade mark at the US Patent Office
O
ne of the most promising news stories to come out of negotiations at the
2021UN Climate Change Conference, COP26, was the announcement
that the Glasgow Financial Alliance for Net Zero now has $130trillion committed
to combatting climate change. Additionally, its 450 members– which include
banks, insurers and investors– have pledged to become net zero by 2050 at
thelatest. Firms have agreed to report their progress and their financed
emissions annually.
This commitment means the private sector could deliver around 70% of total
investments needed to meet net-zero goals, according to analysis conducted for
the UN High Level Climate Action Champions.
As these financial firms begin to transfer lending and investment from carbon-
intensive to carbon-neutral firms and clean technologies, more sectors and
financial firms will begin to feel the effects. In a
Risk.net
crowd-sourced scenario-
generation exercise, it was revealed that people expect rising carbon prices to
have a big impact on just about every sector, financial index and investment(see
page3).
However, even though measuring and mitigating climate risk has become a
priority at many financial firms, the discipline is still nascent and poses huge
challenges. Modelling climate risk exposures within a portfolio is beset with hurdles.
These are discussed in Matthew Lightwood’s article,
Applying scenario
analysis to climate risk
(see page14).
While firms are working towards producing their own robust transition plans,
many want greater input and clarity from regulators. For example, some banks are
calling for regulation to define and set standards for transition lending– loans that
intend to aid the transition to a low-carbon economy(see page16).
As banks work on integrating climate risk into their risk management frameworks,
a debate is currently in full swing around whether climate risk can fit into existing
credit risk weights, and how it should be treated when it comes to capital rules.
This report explores the credit risk weighting(see page11) and capital rules
issues(see page27).
The report also includes a roundtable in Q&A format in which three experts
discuss a range of issues from disclosure to climate stress-testing, and from carbon
markets to climate metrics, providing insight into how they see these crucial issues
developing(see page20).
Of course, the price of carbon will play a pivotal role in driving green investment,
but currently gas and coal prices also jump to the tune of their own fundamental
influences, such as weather, supply and demand, and storage availability. This has
been very evident in Europe and the UK in recent months, where soaring gas prices
have made coal more economical. An analysis of this situation also features in this
report(see page8).
Finally, the 2021 Climate risk special report explores some important issues
facing investors, asking whether some environmental, social and governance-type
investments have inflated values(see page26) and whether European Union rules
could be encouraging greenwashing(see page30).
Stella Farrington
Head of content, Energy Risk
Integrating climate risk
into risk management
frameworks
OpinionOpinion
Risk_Climate21_Intro.indd 1 22/11/2021 11:58
2Climate risk Special report 2021
Contents Contents
Features
3
Crowd-sourced
climate scenarios
Carbon price shock sees
asset prices slump
by James Ryder
Crowd-sourced scenario analysis suggests very
few sectors are safe from a carbon price pop in
the wake of COP26
11
Credit risk
Weather, or not: is climate
risk just part of credit risk?
by Samuel Wilkes
Practitioners are divided on whether climate
risk can fi t into existing credit risk weights
16
Transition fi nancing standards
Banks seek regulatory guidance
on climate transition plans
by Sharon Thiruchelvam
Policy-makers struggle to agree on how to identify
whether borrowers are converging with net-zero targets
17
Carbon trading
Making the cut: EU eyes
Isda’s carbon trading proposals
by Samuel Wilkes
The EBA fears the suggested treatment of emissions
would be misaligned with rest of FRTB
23
Disclosure
TCFD backs carbon disclosure,
but not temperature scores
by Will Hadfi eld and Nell Mackenzie
The TFCD declares the implied temperature rise ‘not
ready’ for funds
24
Climate risk weights
Study fuels doubt over benefi ts
of climate risk weights
by Samuel Wilkes
Research by a Paris-based think-tank fi nds that both
a green supporting factor and a carbon penalising
factor have drawbacks
26
ESG investing
Stock-level ‘inelasticity’
explains ESG boom
by Rob Mannix
ESG investors’ reluctance to sell holdings is pushing
prices even higher
27
Capital rules
FSB debates how to fi t
climate risk into capital rules
by Sharon Thiruchelvam
Regulators ponder whether climate risk needs new
RWAs or recalibration of existing ones
28
Carbon cuts
Climate laggards need to
double their carbon cuts
by Will Hadfi eld
Asset managers that wait until 2025 will have to cut
emissions by 14% a year to limit global warming
30
Regulation
Why new EU rules are fuelling
greenwashing and how to stop it
by Samuel Wilkes
Reporting requirements for ESG funds may not solve
the problem of greenwashing, but a list of harmful
investments might
2420
17
11
83 27 28
30
8 ZE Power
The impact of European
gas prices on climate goals
As governments increase their focus on
climate change following the UN Climate
Change Conference, COP26, ZEPower asks
whether high gas prices in Europe could derail
decarbonisationefforts
Sponsored feature
14 Conning
Applying scenario
analysis to climate risk
Matthew Lightwood, director, risk solutions at
Conning, discusses the application of stochastic
modelling with scenario analysis to quantify
climate risk in a portfolio
Sponsored feature
20
Sendingthe rightsignals
Quantifyingand repricingrisk
Risk.net
convened a panel of three experts from
different fi elds to discuss some of the most
pressing and pertinent climate-risk related issues
Sponsored Q&A
Risk_Climate21_Contents.indd 2 22/11/2021 14:27
/34
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ClimateriskRisk.netSpecialreport2021Sponsoredby1risk.netStellaFarrington,HeadofContent,EnergyRiskstella.farrington@infopro-digital.comJoannaEdwardsGlobalDirector,CommercialSalesjoanna.edwards@infopro-digital.comStuartWillesCommercialEditorialManagerstuart.willes@infopro-digital.comAlexHurrell,SeniorCommercialSubeditoralex.hurrell@infopro-digital.comAntonyChambers,Publisher,Risk.netantony.chambers@infopro-digital.comPhilipHarding,GlobalHeadofCommercialContentphilip.harding@infopro-digital.comBakerJaggwe,AccountDirector,EnergyRiskbaker.jaggwe@infopro-digital.comToddHeligman,BusinessDevelopmentManagertodd.heligman@infopro-digital.comDavidPagliaro,GroupManagingDirectordavid.pagliaro@infopro-digital.comBenWood,ManagingDirector,Risk.netben.wood@infopro-digital.comRachelWhite,SeniorProductionExecutiverachel.white@infopro-digital.comInfoproDigital(UK)133HoundsditchLondonEC3A7BXTel:+44(0)2073169000InfoproDigital(US)55BroadStreet,22ndFloorNewYork,NY10004-2501Tel:+16467361888InfoproDigital(Asia-Pacific)1801-05,ShuOnCentre6–8HarbourRoad,WanchaiHongKong,SARChinaTel:+85234114888Coverimagesteveo73/GettyPublishedbyInfoproDigital©InfoproDigitalRisk(IP)Limited,2021Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinorintroducedintoanyretrievalsystem,ortransmitted,inanyformorbyanymeans,electronic,mechani-cal,photocopying,recordingorotherwise,withoutthepriorwrittenpermissionofthecopyrightowners.RiskisregisteredasatrademarkattheUSPatentOfficeOneofthemostpromisingnewsstoriestocomeoutofnegotiationsatthe2021UNClimateChangeConference,COP26,wastheannouncementthattheGlasgowFinancialAllianceforNetZeronowhas$130trillioncommittedtocombattingclimatechange.Additionally,its450members–whichincludebanks,insurersandinvestors–havepledgedtobecomenetzeroby2050atthelatest.Firmshaveagreedtoreporttheirprogressandtheirfinancedemissionsannually.Thiscommitmentmeanstheprivatesectorcoulddeliveraround70%oftotalinvestmentsneededtomeetnet-zerogoals,accordingtoanalysisconductedfortheUNHighLevelClimateActionChampions.Asthesefinancialfirmsbegintotransferlendingandinvestmentfromcarbon-intensivetocarbon-neutralfirmsandcleantechnologies,moresectorsandfinancialfirmswillbegintofeeltheeffects.InaRisk.netcrowd-sourcedscenario-generationexercise,itwasrevealedthatpeopleexpectrisingcarbonpricestohaveabigimpactonjustabouteverysector,financialindexandinvestment(seepage3).However,eventhoughmeasuringandmitigatingclimateriskhasbecomeapriorityatmanyfinancialfirms,thedisciplineisstillnascentandposeshugechallenges.Modellingclimateriskexposureswithinaportfolioisbesetwithhurdles.ThesearediscussedinMatthewLightwood’sarticle,Applyingscenarioanalysistoclimaterisk(seepage14).Whilefirmsareworkingtowardsproducingtheirownrobusttransitionplans,manywantgreaterinputandclarityfromregulators.Forexample,somebanksarecallingforregulationtodefineandsetstandardsfortransitionlending–loansthatintendtoaidthetransitiontoalow-carboneconomy(seepage16).Asbanksworkonintegratingclimateriskintotheirriskmanagementframeworks,adebateiscurrentlyinfullswingaroundwhetherclimateriskcanfitintoexistingcreditriskweights,andhowitshouldbetreatedwhenitcomestocapitalrules.Thisreportexploresthecreditriskweighting(seepage11)andcapitalrulesissues(seepage27).ThereportalsoincludesaroundtableinQ&Aformatinwhichthreeexpertsdiscussarangeofissuesfromdisclosuretoclimatestress-testing,andfromcarbonmarketstoclimatemetrics,providinginsightintohowtheyseethesecrucialissuesdeveloping(seepage20).Ofcourse,thepriceofcarbonwillplayapivotalroleindrivinggreeninvestment,butcurrentlygasandcoalpricesalsojumptothetuneoftheirownfundamentalinfluences,suchasweather,supplyanddemand,andstorageavailability.ThishasbeenveryevidentinEuropeandtheUKinrecentmonths,wheresoaringgaspriceshavemadecoalmoreeconomical.Ananalysisofthissituationalsofeaturesinthisreport(seepage8).Finally,the2021Climateriskspecialreportexploressomeimportantissuesfacinginvestors,askingwhethersomeenvironmental,socialandgovernance-typeinvestmentshaveinflatedvalues(seepage26)andwhetherEuropeanUnionrulescouldbeencouraginggreenwashing(seepage30).StellaFarringtonHeadofcontent,EnergyRiskIntegratingclimateriskintoriskmanagementframeworksOpinionOpinion2ClimateriskSpecialreport2021ContentsContentsFeatures3Crowd-sourcedclimatescenariosCarbonpriceshockseesassetpricesslumpbyJamesRyderCrowd-sourcedscenarioanalysissuggestsveryfewsectorsaresafefromacarbonpricepopinthewakeofCOP2611CreditriskWeather,ornot:isclimateriskjustpartofcreditrisk?bySamuelWilkesPractitionersaredividedonwhetherclimateriskcanfitintoexistingcreditriskweights16TransitionfinancingstandardsBanksseekregulatoryguidanceonclimatetransitionplansbySharonThiruchelvamPolicy-makersstruggletoagreeonhowtoidentifywhetherborrowersareconvergingwithnet-zerotargets17CarbontradingMakingthecut:EUeyesIsda’scarbontradingproposalsbySamuelWilkesTheEBAfearsthesuggestedtreatmentofemissionswouldbemisalignedwithrestofFRTB23DisclosureTCFDbackscarbondisclosure,butnottemperaturescoresbyWillHadfieldandNellMackenzieTheTFCDdeclarestheimpliedtemperaturerise‘notready’forfunds24ClimateriskweightsStudyfuelsdoubtoverbenefitsofclimateriskweightsbySamuelWilkesResearchbyaParis-basedthink-tankfindsthatbothagreensupportingfactorandacarbonpenalisingfactorhavedrawbacks26ESGinvestingStock-level‘inelasticity’explainsESGboombyRobMannixESGinvestors’reluctancetosellholdingsispushingpricesevenhigher27CapitalrulesFSBdebateshowtofitclimateriskintocapitalrulesbySharonThiruchelvamRegulatorsponderwhetherclimateriskneedsnewRWAsorrecalibrationofexistingones28CarboncutsClimatelaggardsneedtodoubletheircarboncutsbyWillHadfieldAssetmanagersthatwaituntil2025willhavetocutemissionsby14%ayeartolimitglobalwarming30RegulationWhynewEUrulesarefuellinggreenwashingandhowtostopitbySamuelWilkesReportingrequirementsforESGfundsmaynotsolvetheproblemofgreenwashing,butalistofharmfulinvestmentsmight24201711832728308ZEPowerTheimpactofEuropeangaspricesonclimategoalsAsgovernmentsincreasetheirfocusonclimatechangefollowingtheUNClimateChangeConference,COP26,ZEPoweraskswhetherhighgaspricesinEuropecouldderaildecarbonisationeffortsSponsoredfeature14ConningApplyingscenarioanalysistoclimateriskMatthewLightwood,director,risksolutionsatConning,discussestheapplicationofstochasticmodellingwithscenarioanalysistoquantifyclimateriskinaportfolioSponsoredfeature20SendingtherightsignalsQuantifyingandrepricingriskRisk.netconvenedapanelofthreeexpertsfromdifferentfieldstodiscusssomeofthemostpressingandpertinentclimate-riskrelatedissuesSponsoredQ&A3Crowd-sourcedclimatescenariosrisk.netDelegatesatthismonth’sUNclimateconferencehavefacedmanydifficultchallenges.Somemoreunusualthanothers.AstrikebyGlasgowbinmenhasledtorubbishpilinghighinthestreets,withgiantratsreportedlyrunningamok,terrifyingdiplomatsandlocalsalike.Intheapocalypticfuturesomeimaginethesummit’sfailureportending,thatcouldbetheleastofhumanity’sworries.TheConferenceofthePartiestotheUNFrameworkConventiononClimateChange–COP26forshort–isseenasperhapsthelastchancefornationstotakeco-ordinated,meaningfulactiontoavoidariseinglobaltemperaturesabove1.5°Celsius.Toagrowingnumberofdelegates,thatmeansfactoringinthecostofcarbonpollutiontoalleconomicactivity,globally.Asuddenspikeinthepriceofcarbon–byoneofseveralmeans(seebelow)–wouldconstituteasupply-sideshock,whichanalystswarncouldmakeoilcrisesofthepastpaleincomparison.Butperhapsthefarbiggerunknownishowmarketswouldreact:asCharlesDonovan,visitingprofessoroffinanceattheUniversityofWashington,putsitsimply:“Nobodyreallyknowswhattheeffectofaveryrapidriseinaglobalcarbonpricewouldbe”–becauseithasn’thappenedbefore.InRisk.net’slatestcrowd-sourcedscenariogenerationexercise,weasked50ofourreadersthatveryquestion.Theverdict:asudden,significantjumpinthepriceofcarbonwouldcauseturmoilinfinancialmarkets.Ahypotheticalportfolioholdingabroadrangeofassets(seefigure1)wouldbelikelytoplungeinvalue,withameanexpectationofanannualised14.4%decline.Thingslookfarworseatthetail,however:takingthethree-monthexpectedshortfallmeasurefortheportfolio,investorscouldfaceacollapseininvestmentvaluesofmorethanaquarter,withthebiggestcontributortothedropbeingafallofnearly10%inUSequities.EuropeanandAsia-Pacificequities,particularlyAustralia,alsoseefalls,andevenprivateequityassetsseemodestdeclines.Onlygovernmentbondsprovidesomemodestcushioning,indicatingalikelyflighttoquality,asobservedfollowingtheCovidshocklastyear(seefigure1).Risk.netreaderswereaskedtoofferestimatesonthemovementsofaseriesoffinancialindicatorsunderthreecarbonpriceregimes.Inthefirstregime,thepriceofcarbonremainssomewherebelow$60/totalcarbondioxide(tCO2)bytheendof2021,accordingtoIHSMarkit’scarbonindex,whichtracksatrade-weightedaverageofEuropeanandUScarbonemissionallowances.Inthesecond,theaveragepricelandssomewherebetween$60–120/tCO2;inthethirdregime,ahigherpriceofabove$120/tCO2.Theshort,sharpnatureoftheimpliedshock,Donovanadds,meansitisunlikelyinvestorsandothermarketparticipantswouldbeabletoavoidabsorbingsomelossesinthosescenarios.Butfirmsinterestedinexaminingthepotentialimpactsofapriceadjustmentshouldconsideradditionalfactorsbesidethespeedatwhichthepricecouldchange,hesays.CarbonpriceshockseesassetpricesslumpCrowd-sourcedscenarioanalysissuggestsveryfewsectorsaresafefromacarbonpricepopinthewakeofthe2021UNClimateChangeConference,COP26.ByJamesRyder•Asudden,dramaticincreaseinthecostofemittingatonneofcarbonwouldcausewidespreaddislocationsacrossfinancialmarkets,accordingtoRisk.net’smostrecentcrowd-sourcedscenariogenerationexercise.•Commoditiesandglobalequitieswouldtakeabatteringinscenarioswheretheaveragepriceofpollutionpermitsintradedmarketsleapsbyyear-end.•Risk.netreadersofferedprojectionsforaseriesoffinancialindicatorsacrossthreepriceregimes:littleornochange,amodestrise,andaspike.•Butaudienceprojectionsacrossallthreeregimesyieldedwidedistributions,indicatingsignificantuncertaintyamongfinanceprofessionals.•Thesurvey’sprojectionsareseenasextreme,butnotunlikely:avolatileanddisorderlycarbontransitionisemergingasthemostlikelypathway,accordingtoZurich’sJohnScott.NeedtoknowTHERESULTSDuringOctober2021,Risk.netaskedroughly50ofitsreaderswhattheythoughtwouldhappentoaseriesofleadingfinancialindicatorsduringthefinalquarterof2021,toDecember31,underthreedifferentcarbonpriceregimes,usingIHSMarkit’sGlobalCarbonIndexasabenchmark:littleornoincreaseinthepriceofemittingatonneofcarbon,withthepriceremainingunder$60;amoderaterise,upto$120;andasharpincrease,above$120.Thescenarios(seelinktoPDFbelow),builtbySapiat,weremodelledfromtheseanonymisedforecasts.TheindicatorsaretheS&P500,theEuroStoxx50;theMSCIEmergingMarketindex,BrentCrudeOilandtheUSDollarIndex,whichmeasuresthegreenback’svalueagainstaglobaltrade-weightedbasketofcurrencies.ThosepredictionswereaggregatedandusedtofeedSapiat’smodel,withtheimpactsoftheregimessimulatedonanillustrativeportfoliocontainingawiderangeofassetclassesincludingequities,bondsandcommodities,aswellassmallerallocationstoalternatives.USequitiesmakeup20%oftheportfolio;Europeex-UKequities,7%;USgovernmentbonds,10%;andglobalex-USgovernmentbonds,10%.Theremainingassetclasses,includingregionalequitiesandcorporatebonds,realestate,hedgefundallocationsandcommoditiesandinfrastructurefunds,haveweightingsofbetween3%and5%.Outofthetotalrespondents47%thoughtcarbonpriceswouldremainunder$60atyear-end;43%thoughttheywouldbebetween$60and$120;while10%saidpriceswouldleapabove$120.4Crowd-sourcedclimatescenariosClimateriskSpecialreport2021Perhapsmorestrikingthantheworst-casefallsisthesheerspreadofopinionbetweenparticipants:figure2showcasestherangeofexpectedportfolioimpactsforeachoftheregimes.Forecastsforregimeoneshowahugerange,betweenanear-25%declineandthelowerbound,anda6%return,foroptimistsinthesurvey(seefigure2).Thiswidedistributionofreturnsistobeexpected,saysDonovan–whopreviouslyledImperialCollegeBusinessSchool’sCentreforClimateFinanceandInvestment–thespreadisindicativeofagooddealofjustifieduncertaintyamongrespondents.“Thewidthofthatdistributionisnosurprise,becausenobodyknowswhattheeffectofaveryrapidriseinaglobalcarbonpricewouldbe,”Donovansays.“It’sindicativeofalotofguesses,someofwhicharegoingtobereallywell-formed,andsome[ofwhichare]justthrowingdarts.”Whilethe>$120regimeseesthesteepestdropsinthedummyportfolio’sassets,themoremoderate$60–120regimeseesitsownunappetisingdeclines;cashholdingstakeabeating,withonlyChinaequitiesmakingapositivereturn,andworldcommoditiessinkto-0.19%.Insuchascenario,Donovansays,youmightexpecttoseeinvestorsmakingcautiouscommoditybetsandlookingforwaysoutofsub-classesconsideredtobelesssubstitutable.“Youhavelotsofpotentialdispersionwithineachsector,”hesays.“Youcouldthinkaboutsteelandlumberbeingfungibleinsomeconstructionsettings;coalandfossilgasasalong-short;thereareanumberoflong-shortpairings.ThisisprobablywhyUSequitiesarehighlynegative[intheresults],”Donovanadds.“Investorsareabletounderstandwhenanentireeconomyoranentirebenchmarkisheavilyweightedtowardscarbon-intensiveactivities.Atamacrolevel,youselltheentirebenchmark”(seefigure3).Eventhemoremoderateriseincarbonpricesseenunderregimetwomightcausealarmforholdersofcertainassets.Insectoralanalysis1PortfoliocontributionsbyregimeandassetclassCarbonprice<$60Carbonprice$60–120Carbonprice>$120Carbonprice<$60Carbonprice$60–120Carbonprice>$120Carbonprice<$60Carbonprice$60–120Carbonprice>$120Analyticsas%Meanreturn(annualised)Volatility(annualised)ConditionalVAR(3-month,99%)Modelallocation6.88-0.89-14.387.157.0315.66-7.33-10.24-25.17ContributiontoreturnContributiontovolatilityContributiontoCVARUSequities2.27-0.70-6.093.022.956.08-3.08-4.18-9.26Japanequities0.20-0.05-0.390.230.220.44-0.24-0.33-0.55Chinaequities0.430.08-0.330.280.290.40-0.22-0.50-0.81UKequities0.14-0.17-0.730.280.290.80-0.35-0.47-1.34Europeex-UKequities0.73-0.36-2.060.720.721.63-0.74-1.20-2.64Canadaequities0.22-0.16-0.730.290.300.70-0.34-0.49-1.08Australiaequities0.24-0.21-0.810.340.340.74-0.37-0.55-1.44Advancedemergingequities0.32-0.06-0.700.250.260.63-0.24-0.42-0.97USgovernmentbonds0.120.320.47-0.05-0.06-0.060.090.230.35UScorporatebonds0.180.210.200.030.020.070.010.050.01Worldex-USgovernmentbonds0.160.270.38-0.01-0.02-0.030.060.150.22Worldex-UScorporatebonds0.020.230.460.020.000.16-0.060.14-0.67Worldprivateequity0.64-0.02-1.260.570.541.38-0.59-0.84-2.47Worldrealestate0.53-0.03-1.060.420.431.02-0.44-0.76-2.07Worldcommodities0.21-0.19-0.760.370.370.76-0.42-0.43-0.84Worldhedgefunds0.14-0.03-0.300.110.120.25-0.12-0.20-0.45Worldinfrastructure0.33-0.02-0.680.280.280.68-0.30-0.42-1.14§Source:Risk.net;analyticsprovidedbySapiatReturn10%-25%-20%-15%-10%-5%0%5%AggregateCarbonprice>$120Carbonprice$60–120Carbonprice<$602PortfolioexpectationbycarbonpriceSource:Risk.net;analyticsprovidedbySapiat5Crowd-sourcedclimatescenariosrisk.netprovidedbySapiat,anumberofinterestingdistributionsarevisible–themostdramatictailsbelongtothe>$120scenario,butthe$60–120regimeisn’twithoutitsshareofsignificantmovements.Hitstoequityinvarioussectorscouldresultinthemiddlescenario,theexercisesuggests,withthemostpronounceddipseen–unsurprisingly–inoilandgas,whichcouldwitnesscontributiontoportfolioreturnsaslowas-19%.Industrialequitycouldalsofallsharply,somerespondentssaid,ascouldfinancialsandtech.Conversely,however,somepredictmodestgainscouldawaitinvestorsinoilandgasequity,theanalysissuggests.Peakprojectedcontributiontoreturnsforthesectorinboththe$60–120and>$120scenariostayabove10%,suggestingthatsomerespondents,atleast,havehighconfidenceintheperformanceofcarbon-intensiveequityeveninaworldwherecarbonisexpensive.Sucharangeofviewscouldindicateturmoiltocomeacrossthecommoditiescomplex,saysJohnScott,headofsustainabilityriskatZurichInsuranceGroup.“Ithinkwhatweshouldexpecttosee–ifwegetthepoliciesthatdriveanincreaseincarbonprices,andsubstitutionandchangeinallthesedifferentsectorsandservices–isquitealotofenergypricevolatility,”hesays.“Astimegoeson,itbecomesclearerthatit’sunlikelythatwe’regoingtohaveamanaged,low-volatilitytransition,andIthinkthisiswhatyoursurveyisrevealing:we’renotgoingtogetaglobaltransitioninallthesesectorsinanythingotherthanadisorderlyfashion.It’sacompetitiveworld,differentmarketsaredoingdifferentthingsandit’sveryunlikelythateveryone’sgoingtodoitalltogether.”Return20%-50%-40%-30%-20%-10%0%10%HealthcareTelecomsConsumerservicesUtilitiesConsumergoodsIndustrialsFinancialsBasicmaterialsTechnologyOilandgasCarbonprice>$120Carbonprice$60–120Carbonprice<$603GlobalequitysectorsbycarbonregimeSource:Risk.net;analyticsprovidedbySapiatCarbonprice>$120Carbonprice$60–120Carbonprice<$60910.60.40.2023456782.Japanequities1.USequities4.Europeex-UKequities3.UKequities7.Advancedemergingequities6.Australiaequities5.Canadaequities10.Globalex-USgovernmentbonds9.UScorporatebonds8.USgovernmentbonds13.Globalrealestate12.Globalprivateequity11.Globalex-UScorporatebonds16.Globalinfrastructure15.Globalhedgefunds14.Globalcommodities161514131211104CorrelationtoChinacommoditiesSource:Risk.net;analyticsprovidedbySapiatCarbonprice>$120Carbonprice$60–120Carbonprice<$60910.60.40.2023456782.Chinaequities1.USequities4.UKequities3.Japanequities7.Australiaequities6.Canadaequities5.Europeex-UKequities10.UScorporatebonds9.USgovernmentbonds8.Advancedemergingequities13.Globalprivateequity12.Globalex-UScorporatebonds11.Globalex-USgovernmentbonds16.Globalinfrastructure15.Globalhedgefunds14.Globalrealestate161514131211105CorrelationtoworldcommoditiesSource:Risk.net;analyticsprovidedbySapiat6Crowd-sourcedclimatescenariosClimateriskSpecialreport2021Thevolatilityseeninthethirdregimeisasubstantial15.66,comparedwith7.03inthe$60–120regimeand7.15inthesub-$60regime.Inthehighlyvolatilethirdregime,thehealthcareandutilitiessectors,whilegivingnegativereturns,performtheleastbadly.Bondsfairmuchbetteracrossallscenariosthanequities,notesTimWilding,Sapiat’sheadofresearch.“Interestingly,thevolatilityofthemoderaterisescenarioislowerthantheothertwo,andthemeanhigherthanthe<$60carbonpricescenario,suggestingstrongconfidenceintheimprovedperformanceofbondsinthisscenario.”Sapiat’sanalysisalsorevealsinterestingcorrelationsbetweensomeassetclasses.TheChinaequitiesclass,forexample,exhibitsonlyaverylimitedrelationshipwiththeotherassetsheldintheportfoliounderregimesone–$60–andtwo,$60–120.Averymildpositivecorrelationisfoundbetweenitandtheotherequitytypes–spanningAustralia,Canada,Europeex-UK,Japan,UK,USandadvancedemerging–aswellasworldprivate,equity,realestate,commodities,hedgefundsandinfrastructure,acrossallthreescenarios(seefigure4).Chinaequitiesarenegativelycorrelatedwithsomebondclasses,butthesecorrelationsarestillslight.Averysmallnegativecorrelationisfoundbetweenit,USgovernmentbondsandworldex-USgovernmentbondsunderallregimes;inthethirdscenarioalone,apositivecorrelationemergesbetweenitandthecorporatebondstypes.Themostsignificantpositivecorrelationsarefoundinthethirdandmostextremeregime,wherecarbonpricesgoabove$120;there,Chinaequitieshavea0.38positivecorrelationwithadvancedemergingequities,and0.35withbothEuropeex-UKequities,worldprivateequityandworldrealestate.Similarcorrelationscanbeseentoworldcommodities.Theclassisnegativelycorrelatedtothreebondtypes–USgovernmentbonds,uscorporatebondsandworldex-USgovernmentbonds–inmostinstances.Inthe>$120regime,however,thecorrelationbetweenworldcommoditiesandUScorporatebondsturnsslightlypositive,reaching0.06.AswithChinaequities,worldcommodities’positivecorrelationstotherestoftheportfolioincreasewiththeextremityoftheregime.Itscorrelationtoadvancedemergingequities,forexample,is0.23underregimeone,0.24underregimetwoand0.51underregimethree.InRisk.net’slastcrowd-sourcedscenarioexercise,focusingoninflation,Chinaequitiestendedtoperformwellincaseswhereotherassetclassesbegantostruggle.Inthehighestinflationregime,forinstance,theclassexhibiteditsstrongestreturns,whiletherestoftheportfolio–exceptforworldcommodities–slumpedintothenegative(seefigure5).Sojusthowlikelyarecarbonpricingjumpsliketheonesseeninthescenarios?Whilecallsforhighercostsoncarbonemissionshaveintensifiedintherun-uptoCOP26,influentialvoicesinthefinancialcommunityhavebeenforecastingariseforsometime.InJuneoflastyear,theNetworkforGreeningtheFinancialSystem–aconsortiumoftheworld’scentralbanks–publishedscenariosindicatinganaverageuniversalcarbonpriceof$100/tCO2wouldneedtobesetby2030foradecentchanceoflimitingglobalwarming.1AndtheBankofEngland’sflagshipclimatestresstestcontainsan“earlyaction”scenariothatseesthepricereaching$900/tCO2intheUKby2050.Inthe“lateaction”scenario,itclimbsabove$1,000bythesamedate.Fewhavepredictedapriceofmorethan$100/tCO2bytheendof2021–butreal-lifemedium-termtrends,however,suggestsuchafigureisn’tthatfaroff:Ember’spricepertonne(EUR)wasaround€33atthebeginningoftheyear,andnowsitsatcloseto€59.IfthepricecontinuestoincreaseatthesameHOWTHERESULTSWERECOMPILEDDuringOctober,Risk.netaskedroughly50ofitsreaderswhattheythoughtwouldhappentoaseriesofleadingfinancialindicatorsduringthefinalquarterof2021,underthreedifferentcarbonpriceregimes:littleornoincreaseinthepriceofemittingatonneofcarbon,withIHSMarkit’sindexremainingunder$60;amoderaterise,upto$120;andasharpincrease,above$120.Thescenarios,builtbySapiat,weremodelledfromtheseanonymisedforecasts.Here,thefirmgivesabriefinsightintoitsmethodology.Commontoallcrowd-sourcedscenariosistheassumptionthatforecastsfromeachindividualrespondentcarrybiasanduncertainty,butthattheireffectscanberemovedwhenusingalargesetofresponses.Sapiatappliedthefollowingsettingsduringscenarioconstruction:•Meanreturn.Wherethemeanreturnisbeingforecast,eachforecastistreatedasindependent,implyingindividualforecasterrorsareassumedtobediversified.Thisreductionoferrorsisinlinewiththeso-called‘wisdomofcrowds’(FGalton,1907).•Variancematrix.Sincetherespondentsareassumedtohaveagoodunderstandingofthecontextofinflationregimesandtheimpactonallinflationvariables,weusetherangeofforecaststoestimateavariancematrixacrossrespondentswithineachregimescenario.•Scenariocombination.Finally,acombinedestimateofthemeanandthevarianceissetfromthecombinationofallthescenarios.Eachoftheforecastsforaparticularinflationscenarioareweightedbytherespondents’probabilityestimateforthatinflationscenario.Thesepredictionsarethenadjustedusingtheforecastmeansandvariancematrixfromeachinflationscenariobeforebeingweightedbytheaverageprobabilityofeachscenarioandaggregatedtogethertogetanoverallforecastoffutureconditions.Thescenariosarethensimulatedoverasingleperiodforecast,endingDecember31.Sapiatusedthefollowingproprietaryenginesinthesimulation:•Aregimemodel,whichidentifiesprobabilisticallywhichregimethemarketsarecurrentlyfollowing,andthelikelihoodoftransitioningtoanyoftheotherregimesoverthesimulationhorizon.•Asimulationmodel,inwhichreturnpathsaresimulatedbyrigorouslycombiningtheforecastscenariosandtheregimemodellingovertime.Theresultingscenariodistributionallowsthecalculationofscenarioriskmeasures(includingtypicalstress-testoutputsfordownsiderisk),butalsoplausibleestimatesforportfolioreturn.Wheretheforecastsincludestressscenarios(definedasscenarioswithlargeorunprecedentedshocks),theresultingdistributionsincludethesimulatedresultsofsuchshocks,andsothedownsideriskmetricsforanyportfoliomaybecalculateddirectlyfromthescenariodistribution.•Interpretation.Sapiatemploysexpertjudgementwhenturningaudienceviewsintofuturereturnscenarios.Sincescenariodistributionsaresimulatedforallassetclassesglobally,andnotjustforthoseforwhichforecastshavebeenprovided,theframeworkcanbeusefulinmodellingthereturnsofinvestmentportfoliosovermultipletimehorizons.6Crowd-sourcedclimatescenariosClimateriskSpecialreport20217Crowd-sourcedclimatescenariosrisk.netrate–thatis,byroughly78%aroundevery11months–wecouldexpectanapproximateEuropeancarbonpriceofmorethan€100byOctober2022.“AlotwoulddependonwhatdecisionsaretakeninthenexttwoweeksattheCOP,”saysZurich’sScott.Hesaysit’scertainlypossiblethatgovernmentsworkingintandemcouldraisethepriceofcarbontothelevelinthemostextremescenario:“Ifgovernmentseverywheresuddenlyagreetocreatesomeeconomicdriver–recognisingthattheInternationalEnergyAgencysaysyoudon’thaveamaterialimpactoneconomicdecisionsunlessyou’reintherangeof$80to$120–andpushtariffsorleviesalltogether,Ithinkthere’sachance.”Still,aspartoftheirCOP26negotiatingarsenal,Europeanlegislatorshaveproposedanaggressivecarbonbordertax,whichwouldslaptariffsongoodsenteringtheEUfromjurisdictionsthatdon’teffectivelytaxcarbon–which,accordingtotheIMF,accountforsome80%ofglobalemissions.2,3Auniformcarbonpricewouldapplyuniformlyforallemissions,globally.Itcouldtakeseveralforms:aglobally-agreedstraightforwardtaxoncarbonemissions;uniformtariffsongoodsimportedfromregionsthatdon’timposepollutionpermitsintothosethatdo;oraflooronthepriceofcarbonpermits,whicharealreadyinplaceinsomeregionsglobally.Withaphase-inproposedfromtheendofnextyear,shouldthebillpassinitscurrentambitiousform–ormorelikely,forcegovernmentsfromothernationstoshoreuptheirownemissionscaportaxregimesinresponse,forfeartheirexportsbecomeuncompetitiveinEurope–theglobalcostofemittingatonneofcarboncouldspikedramatically.Achievingthisaimwouldbenomeanfeat:accordingtoIMFestimates,some80%ofglobalemissionsareunpriced.AndasZurich’sScottpointsout,‘possible’doesn’tequateto‘likely’:afternearly30yearsofCOPssincetheKyotoAgreement,worldleadershaveyettocometoadecisionthatcouldyieldsuchanimpact.■PreviouslypublishedonRisk.netThisarticleformspartofRisk.net’sseriesofcrowd-sourcedscenario-generationexercises.DownloadaPDFofthefullresultsatwww.risk.net/media/download/10722011NGFS(June2020),NGFSclimatescenariosforcentralbanksandsupervisors,www.bit.ly/3odEwRq2EC(Jiuly2021),Carbonborderadjustmentmechanism:questionsandanswers,www.bit.ly/3DeAcYA3VGasparandIParry(June2021),Aproposaltoscaleupglobalcarbonpricing,IMFBlog,www.bit.ly/30pHpXgCOP26couldbethelastchanceforco-ordinatedactiontoavoidariseinglobaltemperaturesabove1.5°C,whichmeansfactoringthecostofcarbonpollutionintoglobaleconomicactivity7Crowd-sourcedclimatescenariosrisk.net8SponsoredfeatureClimateriskSpecialreport2021Record-highenergypriceshavetakentheirtollonindustriesthroughoutEurope–especiallyintheUK,wherearaftofsmallerpowerretailershavegoneoutofbusinessinrecentmonths.Thesteepincreaseingaspricesin2021hasalsolessenedtheincentiveformanypowerplantstomoveawayfromcoal,threateningEurope’sabilitytomeetitsclimatetargets.Inthisarticle,ZEPowerpresentsananalysisofthesituation,lookingatthecausesofhighgasprices,theoutlookforgas,coalandcarbonprices,andtheimpactoftheinterplaybetweentheseonclimategoalsgoingforward.EuropehasstruggledthisyeartoimportenoughnaturalgastorefillitsstoresandrunitspowerplantsamidaglobalrecoveryfromtheimpactoftheCovid-19pandemic.Gaspricesfornext-monthdeliveryattheDutchTitleTransferFacility(TTF),theregionalbenchmark,rosetorecordlevelsofmorethan€120permegawatthour(MWh)inearlyOctober,from€17.90atthestartof2021,asregionalsupplierssoughttoreplenishstoragesaheadofthecomingwinter.Soaringgaspricesarealsomakingelectricitymoreexpensive,particularlyasmoreandmorecoal-firedplantsarebeingshutdowntohelptheblocachieveitsclimatetargets.Germanbaseloadelectricityfordeliveryin2022alsoleapedtomorethan€180/MWhinearlyOctober,afterhavingstartedtheyearat€52/MWh.Thissuddenandsteepincreasecausedmayheminthemarketastradersfacedhugemargincallsonopenpositions,withmanyforcedtodumptheirpositionstoremainsolvent.TherallyreachedacrescendoinearlyOctober,whenpricesweremovingbyasmuchas30%withinasinglesession,beforeRussianpresidentVladimirPutinappearedtotriggerawidespreadsell-offwhenhepledgedthatRussiawouldhelpmoderateenergypricesbyraisinggassupplies.Howdiditstart?Anextendedwinterheatingseasonin2020–21leftstoragesinEuropeattheirlowestend-of-winterlevelssince2018,accordingtodatafromGasInfrastructureEurope(GIE),andstockshavenotbeenreplenishedasquicklyasnormal.InAugust,gasstoragesintheEuropeanUnionwereattheirlowestlevelforthattimeofyearsince2013,GIEdatashows.EvenbyearlyOctober,storageswerestill20%lowerthanatthesametimein2020and2019.Europe’sshortfallstemsfromacombinationofdeclininglocalproduction,asqueezeonimportsfromRussiaandstrongcompetitionforliquefiednaturalgas(LNG)fromotherregions.AccordingtotheEuropeanCommission(EC),regionalLNGproductiondeclined11%to13.8billioncubicmetresinthefirstquarterof2021,comparedwithayearearlier,asoutputfromNetherlands’giantGroningengasfielddeclinedaheadofitseventualdecommissioningin2022.ConsumptioninQ1rose7.6%year-on-yearto141.8billioncubicmetres,whilenetimportsdroppedby3%to78.5billioncubicmetres.LNGsuppliesfellby29%fromthesameperiodin2020,partiallyoffsetbya9%hikeinpipelinesuppliesfromRussiaandajumpof141%inflowsfromAlgeria.TheimpactofEuropeangaspricesonclimategoalsAsgovernmentsincreasetheirfocusonclimatechangefollowingtheUNClimateChangeConference,COP26,ZEPoweraskswhetherhighgaspricesinEuropecouldderaildecarbonisationefforts“Thegradualphase-outofover50gigawattsofnuclear-,coal-andlignite-firedpowergenerationcapacitycreatesadditionalmarketspaceforgas-firedpowerplants”InternationalEnergyAgency9Sponsoredfeaturerisk.netImportsdropThelargestsinglesupplierofgastoEuropeisRussia,whichshipsaroundhalftheEU’simports.Whilelong-termcontractedvolumesremainedbroadlystableintheearlypartofthisyear,shorter-termspotsalesdeclinedsharply,reflectingrisingmarketprices,accordingtotheEC.“GazprompreferredtorelyonwithdrawalsfromitsownstoragesinEUterritoriestosupplyitsclients,giventheaveragecostofinjectedgaswasmuchlowercomparedtohubpricesinQ12021,”theECreported.RussiangasisshippedtoEuropeviaanetworkofpipelinesacrosstheBalticSea,throughBelarus,Ukraine,theBlackSeaandTurkey.Russianstate-ownedproducerGazpromisalsoleadingaconsortiumofcompaniesthatrecentlycompletedNordStream2–asecondpipelineacrosstheBalticSea.Whilethenewpipelineisnowready,itcannotdelivergastocustomersuntilithasreceivedallrelevantapprovalsandcertificationsfromGerman,DanishandEUregulators–aprocesslikelytolasttherestoftheyear.TheEuropeanmarkethasbeencloselymonitoringtheprogressoftheNordStream2project,whichwasoriginallyscheduledtocompletein2020.ThepipelineisintendedtoboosttheEU’ssecurityofsupplybuthasencounteredstiffoppositionfromtheUSgovernment,aswellasUkrainianinterests,whoseeitasincreasingEurope’srelianceonRussia.EventhoughNordStream2’spromoterssaytheprojectwillcomplement,ratherthanreplace,muchofEurope’sexistingsupplies–includingvolumesthatRussiahassentthroughUkraine–theECreportedthevolumeofRussiangastransshippedthroughUkraineplungedby83%inQ1.TradingsourcesreportedthatGazpromdeclinedtobookadditionalpipelinecapacitybeyonditscontractedcommitmentsthroughoutQ2andQ3,andhasyettoagreeanewlong-termcontractwithUkrainianpipelineownerUkrtransgazforshipmentsafter2024.Accordingtosomeanalysts,Russia’sdomesticstockpilesarealsoatunseasonablylowlevels,meaningpotentialexportvolumesarebeingdivertedintoRussianstorages.AnalystsatIndependentCommodityIntelligenceServices(ICIS)estimatedthat,inApril2021“[Russian]stockswerejust19%full,ratherthantheaverageof39%aswitnessedintheAprilsof2017–19.”1TheEUalsoimportssignificantvolumesofgasthroughpipelinesfromAlgeria,butadisputebetweenAlgeriaanditsneighbourMoroccothreatenstoreducesupplyfromthesouth.GrowingtensionsbetweenAlgeriaandMoroccohaveledtodelaysinthetworenewinganagreementforAlgeriangastomovetoEuropethroughtheGazoducMaghreb–Europe(GME)pipeline,whichrunsthroughMoroccotoSpain.GMEpassedintoMoroccanownershiponNovember1,andtheexistingtransshipmentagreementexpiredonOctober31.Algeria’sstate-ownedproducerSonatrachisnowworkingtoboostcapacitythroughitsownMedgazpipelinetoEuropeby25%beforetheendofthisyear.However,expertswarnthateventhisincreasewillnotfullyreplacethevolumeslostthroughtheGMEpipeline.LNGswitchestoAsiaInadditiontopipelinegas,EuropehashistoricallyreceivedaconsiderablevolumeofLNGfromexportersintheUS,theMiddleEastandAfrica.However,thefast-growingmarketforLNGhasledtomoredynamicpricing,andEuropeanbuyersnowhavetocompetewithAsianconsumersforavailablesupply.LowstocksinAsiaafterlastwinter,coupledwithrapidincreasesindemand,haveledtospirallingpricecompetitionasbuyersscourthemarketforavailablecargoes.ShipmentsofLNGfromtheUSGulfCoast,theclosestsourceofthechilledgastoEurope,havebypassedtheEUformuchofthisyearinfavourofhigherreturnsinAsianmarkets.Asaresult,Europefacesthecomingwinterwithgasstocksattheirlowestforanumberofyears,whiledemandhasincreasedasmorepowerisgeneratedwiththefuel.German,DanishandEUregulatorsmustapprovetheNordStream2pipelinebeforeitcandelivergastocustomers10SponsoredfeatureClimateriskSpecialreport2021Whathappensifgasstaystight?Wearealreadyseeingtheresultofthegasshortage.Utilitiesareburningasmuchcoalaspossibletogeneratepowertodivertgasintostoragefordomesticheatingthroughthewinter.Coal’srenaissanceinthelatterhalfofthisyearhasalsotightenedthatmarket,andpriceshavebeguntojumpasEuropeanbuyerscompetewithotherbuyerssuchasChinaforavailablesupplies.OneGermanplantevenranoutofcoalsupplyandwasforcedtosuspendoperationsinearlyOctober.However,coalgenerationisshrinkingasEUmemberstatesfollowthroughonpledgestophaseoutuseofthepollutingfuel.AccordingtotheBeyondCoalcampaign,atleast13coal-firedplantswerescheduledtoclosethisyear,aswellasthreeGermanunitsthatwillshutinDecemberafterwinningcompensationinanAprilgovernmenttender.Fallingcoalgenerationmeanssomenaturalgaspowercapacityneedstooperateatthemargins,anditistheseplantsthataresettingthehighpricesfornaturalgasandelectricityinEuropeatthemoment.Thegascrunchcouldn’tcomeataworsetimefortheregion’sleadingeconomy,asthecountryalsopreparestoclosethreeofitssixremainingnuclearplantsattheendofthisyear.Previousclosureshaveledtobrownoutsandhighelectricityprices.Poorrenewablegenerationhasalsoaddedtotheproblem.DatafromtheFraunhoferInstituteshowsthatGermanwind,solar,hydroandbiomassgenerationintheninemonthstoSeptember2021hasfallenby7%from2020.Coaloutputhasgrown22%year-on-year,whilegasgenerationisdown8%.2Powerandgastradershaveallabsorbedthisandotherdata;pricesforwinterenergyareatrecordlevelsandarelikelytoremainhighthroughtospring.Carbon’sroleWhilegaspricesweresoaring,EUcarbonallowancesnearlydoubledin2021,reachingapeakof€65.77shortlybeforejoiningtheenergymarket’ssharpsell-off.Asaconsequenceofenergypricemoves,gas-firedelectricitygenerationisnowlessprofitablethancoal,evenaftertheincreaseincarbonprices.GastypicallygenerateshalfasmuchCO2ascoalperunitofpowergeneratedso,asthepriceofnaturalgasrosefarquickerthanthatofcoalthisyear,thepriceofcarbonkeptpacetomaintaingasprimacyinthegenerationmeritorder.However,thissummeritbecameclearEuropeneedsmoregasinstorageratherthanburningitforpower.Toensuregasflowedtostorageratherthanpower,gaspriceshadtorisesufficientlysocoalbecamecomparativelymoreprofitableasanelectricityfuel.IndexingthemarketpricesshowsthatcarbonandgaspricesbegantodivergeinJuly,asDutchhubTTFpricesbegantoriseveryquicklyandcarbonralliedmoremoderately.Incontrast,coalpricesonlybeganoutstrippingcarbontowardstheendofSeptember(seefigure1).Thepricemovesmeant,forpowergeneratednextyear,coalbecamemoreprofitablethangasattheendofSeptember–sincethentheso-calledcleandarkspreadhasjumpedtoasmuchas€42/MWh,whilethegasmargin,knownasthecleansparkspread,hasfallenintonegativeterritory(seefigure2).Whatcanthegasmarketdo?Intheshortterm,thelackofsupplymayonlybealleviatedwhenRussianshipmentsincrease,eitherbyhighertransshipmentsthroughUkraineandotherinterconnectors,orwhentheNordStream2pipelinebeginsoperation.AdditionalsupplycouldcomeintheformofLNG,butthiswouldrequireEuropeanpricestomatchorexceedthoseofAsia,whichiscurrentlyreceivingthelion’sshareofavailablecargoes.Andthelong-termbalanceislikelytoremaintightasconsumptioninEuropeisexpectedtocontinuetorise.TheInternationalEnergyAgency(IEA)predicted2021demandwouldincreaseby3%.3However,therapidgrowthofrenewablesissettoeatintogas’growthpotential,itadds.“Europeangasdemandisexpectedtoremainstablethroughtheperiod[2021–25],”theIEAsaidinaseparatereport.4“Thegradualphase-outofover50gigawattsofnuclear-,coal-andlignite-firedpowergenerationcapacitycreatesadditionalmarketspaceforgas-firedpowerplants.”Butgas’growth“islimitedbytherapidexpansionofrenewablepowergeneration,settoincreasebyalmost30%overthemediumterm”.Anditwon’tbejustrenewablesthatlimitgas’growth.SomeanalystsarepredictingcarbonpermitpricesinEuropetoexceed€90bytheendofthedecade,asthebloctightensthelimitongreenhousegasemissionsaspartofitsgoaltocutCO2by55%from1990levelsby2030.HigherCO2priceswillbringyetmorelow-orzero-carbonalternativesintoplayattheexpenseofgas,expertssay,includinghydrogenasaprocessfuelforsteel-,cement-makingandpetrochemicals.Long-rangeprojectionsenvisageaEuropeaneconomyinwhichnaturalgashasonlyamarginalrole,buttheexperienceofthepastfewmonthssuggeststhattherearemanymoretwistsandturnsbeforewegetthere.■1TMarzec-Manser(August2021),ICISanalystview:Gazprom’sinabilitytosupplyorunwillingnesstodeliver?,www.bit.ly/3H8rddu2EnergyCharts(September2021),NetpublicelectricitygenerationinGermanyinweek45,2021,www.bit.ly/2YxffJa3IEA(April2021),Gasmarketreport:Q22021,www.bit.ly/3wrScvM4IEA(June2020),Gas:2020,www.bit.ly/31DZDVf€50-€20-€10€0€10€20€30€402018201920202021Clean-sparkspreadClean-darkspread2Calendar2022Germancleandark,cleansparkspreads(38%coal,50%gas)50001002003004002021JanFebMarAprMayJunJulAugSepOctCal-22TTFDec-21CO2Cal-22German1Carbon,gasandcoalpriceindex202111Creditriskrisk.netWhenregulatorsfaceanewriskinthebankingsector,theirnaturalresponseistodecidehowmuchcapitalbanksneedtoholdagainstit.Thelargestemergingriskisfromclimatechange:eitherthephysicalrisksofextremeweathereventsandrisingsealevels,orthetransitionriskofpolicychangestoclampdownoncarbonemissions.Bothwillpotentiallycausedefaultstoflowthroughbankloanbooks.TheBaselCommitteeonBankingSupervisionhasalreadybegunworkonhowtoincorporateclimateriskintoprudentialrules,andtwosourcesbelieveBaselcouldproduceapaperonthisbeforetheendof2021.“I’llbefrankwithyou,wearedoingworkonthistopicandthinkingthroughaboutitandwehopefullyaregoingtobeabletosaysomethingaboutitwhenwehaveconcludedthisthinking,”VictoriaSaporta,theBankofEngland’sexecutivedirectorofprudentialpolicy,toldanonlinewebinarhostedbytheInstituteofInternationalFinanceonSeptember13.Butthere’soneobviouschallenge:theexistingframeworkforassessingcreditrisk–byfarthelargestpartofbanks’balancesheets–reliesheavilyonhistoricaldata.MichelvandenBerg,asustainabilityadviserwhohasworkedwithDutchbanksincludingRabobankandING,saystransitionriskhasbarelybeguntomaterialise.Physicalriskhasdevelopedfurther,butisstillatanearlystage.Thatmeanshistoricaldataisnotaparticularlyusefulguidetofuturerisks.“Wecanonlyrunhypotheticalscenariosthatlayouthowthiswillripplethroughtheeconomy,”saysvandenBerg.Expertsseetwodifferentresponsestothis,butneitheriscompletelyfreefromdrawbacks.Thefirstistoincorporateclimateriskintotheexistingcreditriskcapitalrules.Asdefaultsincrease,thedataforrecalibratingrisk-weightedassets(RWAs)willgraduallybecomeavailable.Inthemeantime,banksandregulatorswillneedtouseexpertjudgementtomakequalitativeadjustmentstoRWAsinanticipationoffuturelosses.“Ibelievethebankcapitalframeworkwehave–wherewehavepoliciestodetermineprobabilitiesofdefault[PD]andlossgivendefault[LGD]–shouldbemadetoaccommodateclimaterisk,eventhough[it]can’tbemodelledinthesamewaywemodeltraditionalcreditrisk,”saysvandenBerg.Butothersbelievemoredrasticalterationstothecapitalframeworkareneeded,especiallyasexistingRWAstendtofocusonshort-termrisks.Thisalternativecouldinvolveaseparatesetofspecificclimate-drivenfactors,add-onsordiscountsbeingusedtoincreaseordecreasebanks’totalRWAs.“Thequestiononecanaskis:shouldclimateriskbeinPDorLGDestimatesthemselvesfortheinternalapproaches,andcreditratingsinthestandardisedapproach[SA],orshoulditbeintheriskweightingsasafinal‘adjustmentatcheck-out’typefactor?”asksJudsonBerkey,headofsustainabilityregulatorystrategyatUBS.MarketparticipantsarehopingtheBaselCommitteewillultimatelytakeaviewonthischoice,andprovidemoredetailonhowtoimplementwhicheverpathitchooses.However,bothapproacheswouldstillfacethedatachallenge.RobertBegbie,chiefexecutiveofNatWestMarkets,warnedatapressbriefingonOctober4thatitwilltaketimetoamasstheappropriatedataandmethodology.“Historically,wherecapitalruleshavebeenchangedorcapitaladd-onsintroduced,itisnormallybasedonhavinggooddata,goodstress-testanalysesofbanks’balancesheets,andthatisveryevolutionary,”saidBegbie.“So[if]youaregoingtodocapitaladd-onsatsomepoint,itwillneedtobebasedonrigorousassessment,becauseotherwiseyoucouldhaveunintendedconsequencesifyouintroducethemtooearly.”Someclimateriskexperts,however,haveagreatersenseofurgency,andfearthatwaitingfordatawillonlydelaythebankingsector’snecessaryresponse,inhibitingthefinancingoftransitiontoalow-carboneconomy.Thatimpliestheneedforamakedoandmendapproachtoclimateriskcapitalchargesforthetimebeing.TrustyourjudgementBanksmustcalculatetheriskarisingfromborrowersdefaultingonloansorbondseitherthroughtheirownmodels,orthroughtheSAthatusesratingsfromcreditratingagenciesorregulator-setriskweights.Intheinternalratingsbasedapproach(IRB),PDandLGDarethekeymodelinputs.Threesourcesatbanksandconsultanciesbelieveregulatorsdon’tneedtodrasticallychangetheframeworktoreflectclimaterisk,asbankscanincorporatetherisksthroughtheIRBapproach.Butthere’sahitch:IRBmodelstypicallylookfordefaultrisksonlyovertheshortterm.Theywillstruggletocapturetherisksclimatechangecanposeforaborrower,sincethoseconsequencesmaytakedecadestomaterialisefully.PDmodels,forexample,onlyestimatethelikelihoodofdefaultoveraone-yearperiod.Thatwouldonlybeappropriateforcertainshort-termlendingthatbankscouldmanagedownrapidly–vandenBerggivestheexampleoftradefinance.Weather,ornotIsclimateriskjustpartofcreditrisk?Practitionersaredividedonwhetherclimateriskcanfitintoexistingcreditriskweights.BySamuelWilkes•Theseverityandfrequencyofclimate-relatedrisksareexpectedtoincreaseinthefuture.•Thecreditriskcapitalframeworkdoesn’tadequatelycapturetheserisksyet,butitwillneedtoifbanksaretobeprotectedagainstcarbon-intensiveclientsbecomingnon-viableduetopolicyresponses,ortheimpactofextremeweatherevents.•Regulatorscouldcreateaclimateriskfactorthatlowersrequirementsforgreenercompaniesorraisesthemforheavyemitters.•Alternatively,theycouldrequirequalitativemodificationstoexistingcreditriskcapitalrequirements,toincorporateclimateriskintocalculationsofprobabilityofdefaultandlossgivendefault.•Ineithercase,therearelimitsontheprecisionofthenumbersproducedbecauseoftheunprecedentednatureoftherisksthemselves.Needtoknow12CreditriskClimateriskSpecialreport2021ThewayaroundthisobstacleistoadjustIRBoutputswithqualitativejudgements.JamesBelmont,apartnerandclimateriskleadatconsultancyBaringa,saysthoseassessmentsgivebanksthechancetoscrutinisetransitionplansandaltertheinternalcreditscorestheygivetocounterparties,iftheyfeeltherawmodeloutputdoesnotreflecttheembeddedphysicalortransitionriskofthatborrower.“YoucancaptureclimateriskinyourPillar1RWAsthroughembeddingclimateriskswithintheannualcreditreviews,”saysBelmont.“Wherethisresultsinrevisionstotheinternalcreditratingthatthebankassignstothecounterparty,thiswouldnaturallyfeedthroughintoRWAs,sothatisamoreorganicwayofdoingit.”Ofcourse,supervisorswillwanttotakeaviewontheaccuracyoftheassessmentsbanksmakeforeachcounterparty.ThisiswheretheworkofregulatoryinitiativessuchastheNetworkforGreeningtheFinancialSystem(NGFS)cancomeintoplay.TheNGFShasalreadyproducedasetofclimatechangescenariosdesignedtochartmacrofinancialpathwaystodifferenttemperaturetargets.“There’senoughtoolsouttheretobeabletobuildupadecentopinionofthelevelofvulnerabilitytotheserisks,whichyoucanthenfactorintoyourdefaultestimates,”saystheheadofclimateriskataglobalinvestmentbank.Regulatorscanweighanindividualbank’squalitativeassessmentagainstinternationalbenchmarksliketheNGFSscenarios.Iftheyfinditwantingintermsofundervaluingtherisk,BelmontsuggeststhePillar2supervisoryadd-onsprocessalreadyinuseintheUKandEuropeanUnionistheobviouspathtocorrecttheproblem.Hesaysregulatorscouldapplyatop-downassumptionthatis“moredraconian”thanthebank’sownjudgement.“Regulatorshavetohavesomewayofenforcingthatminimumstandard,andanincentivemechanismfordoingthat,”saysBelmont.Don’ttrustyourjudgementHowever,theheadofclimateriskattheglobalinvestmentbanknotesthattheNGFSscenariosthemselvesmaynotalwaysbeasrigorousasnecessary,withsomeofthepredictedmedium-termeventsalreadyplayingouttoday.Forexample,underthebenignscenarioofanearlytransitionthatlimitstheultimatetemperatureriseto1.7degreesCelsius,carbonpricesareassumedtoriseto$70pertonnein2030and$100pertonnein2040.Inreality,end-of-dayfuturespricesforallowancescompaniesbasedintheEuropeanUnionmustpossessiftheywanttoreleaseemissionshavealmostdoubledinpricethisyear,tradingatmorethan€60($70)pertonnesinceSeptember2021,accordingtodatasourcedfromtheIntercontinentalExchange.UKallowancespeakedat£76($101)onSeptember29.12CreditriskClimateriskSpecialreport202113Creditriskrisk.netConsequently,regulator-setscenariosandPillar2capitaladd-onsdonotchangethefundamentaldifficultyofthisapproach.Supervisorsareusedtoheavilyscrutinisingtheaccuracyofbankriskmodels–andthereforetheirtotalcapitalrequirements.Twosourcessaythequalitativeadd-onstoIRBcouldbetoofuzzyforsupervisorstoswallow.OnebankerpointstothehugeeffortthatboththeregulatorandthebanksputintotheEuropeanCentralBank’stargetedreviewofinternalmodels(Trim).“ThereisaninherentcontradictionherebetweenontheonehandtheTrim-likeexercisesthatseektoestablishahighburdenofstatisticalvalidityforPDmodelling,andontheotherhandthepushtoincludemorequalitativeESG–notjustclimate–informationincapitalandpricing,whichishardlyevergoingtopassstatisticalscrutiny,”saysaheadofcapitalmanagementataUKbank.AheadofmodellingataEuropeaninvestmentbankalsowarnsthatanyattempttoincorporateclimateinformationintoPDmodelsthemselveswilldamagetheintegrityandexplainabilityofthemodels.“Ifyou’redoingthisforatime-horizonof25years,theamountoferrorwillbeabsolutelyridiculousandthevalidityofthesemodelswillbeputinquestion,”saystheheadofmodelling.“Mymodelshavetobeauditable,theyhavetobevalidandtheywillnot[be],sothatisaproblem.”StandardisedapproachIfregulatorsarenotinclinedtotrustbankstoincorporateclimateriskintotheirIRBmodels,thereisalwaystheSA.Forcorporatecreditrisk,bankscaneitherderivestandardisedRWAsfromtheratingsassignedbyacreditratingagencyaccordingtoaregulator-setmatrix,or–injurisdictionsthatdonotallowtheuseofexternalratings–theregulatorsetsgenericRWAsbytypeofexposure.Althoughthelargestbanksthataccountforthebulkoflendingrelyoninternalmodels,theamountofRWAsgeneratedbytheSAisstillrelevant,becauseanoutputfloorwilllimitthediscountbankscanderivefrominternalmodelsto72.5%oftheRWAsgeneratedbySAs.ExternalcreditratingsrunintosomeofthesameproblemsastheIRBapproach.Ratingsagenciestypicallyuseshort-termforecaststoproducearatingthatreflectstheabilityoftheissuertorepayitsdebtovertheshortterm,andrelyonreviewingthatratingonaregularbasis.However,analystssaytheydosometimesconsiderrisksthatarelikelytomaterialiseoverthelongterm.“It’smuchmoredifficulttopredictsomethingthat’sgoingtohappensofaraway,”saysJanineDow,seniordirectoratFitchRatings.“Thegreaterthedistance,themoredifficultitisforcreditanalyststoforecastthatandtoincludeitinourfinancialprojections,whichoftenonlygoouttwotothreeyears.”TheEuropeanSecuritiesandMarketsAuthority(Esma)iscurrentlylookingintohowenvironmental,socialandgovernance(ESG)risksaresystematicallycapturedincreditratings.AccordingtotheEU’srenewedsustainablefinancestrategy,EsmamustshareitsfindingswiththeEuropeanCommission,whichmaythentakeactiontoensuretheESGrisksaresystematicallycapturedincreditratings.ThesituationforstandardisedcreditRWAsnotderivedfromexternalcreditratingsismuchworse.Forexample,EUlawmakersaremullingriskweightsforunratedcorporateexposures–thosethatdon’ttapintosecuritymarketsandhavelittlepublicinformation–thatwouldsimplybestatic.ThesametechniqueisalreadyusedforallcorporateexposuresintheUScapitalframework.RetailexposuressuchasmortgagesarealsosimplysortedintofixedRWAbucketsundertheSA.Whenregulatorsoriginallysettheseriskweights,climatechangewasn’ttopoftheagenda,andsohasn’tbeenfactoredin.“Theriskweightsonunratedexposuresaren’tgranular,”saysMonsurHussain,headoffinancialinstitutionsresearchatFitchRatings.“TheirgranularitydoesimprovetosomedegreeinthefinalBaselIIIframework,buttheunratedcreditriskassessmentforbanksandcorporatesreliesonbackward-lookingcreditandgovernance-basedfactors.”AllchangeForthosewhoseetheseobstaclesasinsurmountable,theansweristobuildatotallyseparatecategoryofclimateriskweights,intheformofadd-onsordiscountstotheexistingframework.Acarbonpenalisingfactorhasbeensuggested,whichwouldhaveanoppositeeffecttotheEU’ssupportingfactorsforinfrastructureprojectsandsmallandmedium-sizedenterprises,whichgivecapitaldiscountstoloansgrantedtothoseborrowers.PierreMonin,aseniorfellowoftheCouncilofEconomicPolicies,specificallyfavoursincreasedRWAsonpollutingassets.Thiswouldprotecttheircapitaladequacyfromclimaterisk,anddiscourageinvestmentinpollutingassets,whichwouldinturnreducethefinancialsector’sexposuretoclimatechangetransitionrisks.“Centralbanksaresayingclimaterisksarenotreallytakenintoaccountbyfinancialmarkets,sothereisamissingriskinasense.Thesolutionformissingriskistoincreasethecapitalrequirementratherthandecreaseit,”saysMonin.“Bydoingthat,youthenalsoincentivisefirmstotransition,andaworldwhichhastransitionedtoalow-carboneconomyisthesafestscenarioforfinancialstability.”AttheNatWestpressbriefingonOctober4,thebank’sheadofclimateandESGcapitalmarketsCarolineHaassaidthereisalreadyevidenceofa‘greenium’–tighterpricingongreenbonds,loansandprojectfinance.Consequently,arisk-weightdiscountforgreenassetsmightriskcreatinganoutrightbubble,andapenalisingfactorforcarbon-emittingassetswouldavoidthatproblem.“Theintentwouldbetohaveahighercapitalrequirementthatthenevolvesdownascompaniesorassetstransition,versusjustsupportingthegreenefforts–butthatenhancesthecomplexityofallthis,”Haassaid.Moninsaysthereisenoughevidencetoidentifythecompaniesmostatriskoftransition,asclimatemetricprovidersalreadyoffersuchassessments.Thismeansarisk-weightdifferentialcouldbejustifiedfortransitionrisk,despitethelackofstatisticalevidenceshowingtheexactimpactitmayhaveondefaultrates.Forphysicalrisk,however,arecentstudyreleasedbytheUniversityofZurichfindssubstantialdivergenceamongmetricproviders’scores.1Asaresult,specificriskweightsforexposuretoclimateriskwouldn’tbeanymoreaccuratethanadjustmentstotheIRBoutputs.“Itisakindofcatch-22situation:youprobablycoulddoariskdifferential,butyoudon’thavetheunderlyingdataorforward-lookinganalysistosupportthat,”saysConstanceUsherwood,adirectoratindustrygrouptheAssociationforFinancialMarketsinEurope.“Ouroverarchingprincipleisrisksensitivityandensuringanytreatmentofagreenorbrownassetisconsistentwiththeunderlyingrisk.”Butthoseadvocatingaquickerresponsetoclimatechangesayregulatorsandbankswilljusthavetolivewithalowerlevelofaccuracy.“Ithinkitcouldbesimplerthantheverypreciseformulasthatarecurrentlyusedforriskweights,”saysMonin.“Ifaregulatorknowsthatafirmisveryexposedtoclimaterisk,thentheyshouldapplyanextraadd-ontotheRWA.”Someintheindustrysympathisewiththatimprovisedapproach,ifithelpsbankstostepuptheirresponsetothethreatofclimatechange.Theheadofclimateriskattheglobalinvestmentbankobserves:“Youdon’tneedtobetootiedintotryingtobepinpointaccurate–justlookatthingsfromanewdirectionoftravel.”■PreviouslypublishedonRisk.net1LHain,JKölbelandMLeippold(September2021),FinanceResearchLetters,Let’sgetphysical:comparingmetricsofphysicalclimaterisk,https://bit.ly/3jFGnNr13Creditriskrisk.net14SponsoredfeatureClimateriskSpecialreport2021Assessingthelevelofclimateriskinaportfolioisnowatoppriorityatawidevarietyofbusinesses–fromassetmanagersandbankstoinsurers,energyfirmsandtheindustrialsector.Thequestionisclear:whatimpactdoesclimatechangeandpossiblegovernmentalpolicyactionhaveonafirm’sassetrisk?Arrivingattheanswer,however,isachallengewithwhichriskmanagementisstillgrappling.Climateriskisunlikemanyothertypesoffinancialrisk.Thereislittletonousefulhistoricaldata,andmanyfuturedevelopmentsintheworld’sresponsetoclimatechangearebothunknownandunknowable.Additionally,climateimpactsonfinancialmarketsarelikelytomanifestassubtlechangesoverlongperiodsoftime.Thispointisnotlostonregulators,andtheideaofatermstructureofrisksisalreadyafeatureofthenextgenerationofclimatestresstests.Incaseswhereitisdifficulttoassignaprobabilitytooutcomes,scenarioanalysisisthetoolofchoiceandhasbeenadoptedbymanyorganisationsforanalysingclimaterisk.However,havingascenariotoconsiderandactuallyassessingitsimpactonaportfolioaretwodifferentthings.Thisfeatureconsiderstheuseofastochasticmodeloverlaidwithascenarioanalysisalgorithmtoquantifythepossibleriskimpactsofoneclimateriskscenario.ApplyingstochasticmodellingThisstudyusesaneconomicscenariogeneratortomodeltwoportfolios.Portfolio1consistsof70%globalfixedincomeinvestmentsand30%riskassets.Portfolio2issplit50/50betweenfixedincomeandriskassets.Astochasticprojectionoftheriskdistributionisproducedandanalysedusingthepowerofthecloud.Aclimatescenario,representinganorderlytransitiontoalow-carboneconomyovera30-yearfuturetimehorizon,isoverlaidusinganalgorithmthatallowstheimpacttobeconsideredthroughtimeaswellasonthewholeriskdistribution.Alsoconsideredistheimpactfrombothtransitionriskandphysicalrisk.ThisscenarioisaglobalscenariotakenfromthedefinitiongivenbytheUKPrudentialRegulatoryAuthorityinits2019exploratoryexerciseandrepresentstheimpactthatmightbeexpectedifgovernmentstookpolicyactionsthatbroadlyalignwiththeParisAgreementonclimatechangeattheendofthe30-yearperiod.Thisinvolvesamaximumtemperatureincreaseofbelow2degreesCelsiusrelativetopre-industriallevelsandfullgreenhouse-gasneutralitybeyondthe30-yearhorizonofthescenario.TheassumptionsofthisscenarioarebasedonthescenariosdescribedintheIntergovernmentalPanelonClimateChange’s(IPCC’s)specialreport,Globalwarmingof1.5°C.1Figure1considerstwopossiblethrough-timepathswithregardtothemagnitudeandtimingofthefuturetransitionriskimpactsorfinancialdamageofthescenario.Thesearealinearlyincreasingdamagescenarioandarapiddecarbonisationscenario.Inthelatterscenario,theimpactincreasesrapidlyinthenext10years,whichcanbeseenasthepeakstressofthebluelineinfigure1,beforefallingbackasmarketsreordertoabsorbthestructuralchangesthathavetakenplace.Forphysicalrisk,aWeitzman-likedamagefunctionisassumed,oneofthecommonlyusedfunctionsfromtheclimateliterature.ThesescenariosarethenappliedtotheoutputoftheGEMSEconomicScenarioGeneratorusinganalgorithmdevelopedbyConningandacloud-basedscenarioanalysistool,theConningClimateRiskAnalyzer.Figure2showstheeffectthroughtimeofthescenariosonthemeanmarketvalueofeachportfolioandthe1%annualvalue-at-risk(VAR).Theeffectisexpressedintermsofexcessclimaterisk(ECR)definedasthechangeinthestatisticrelativetothecurrentbestestimateofriskandreward.Avalueof-1%inthemean,forinstance,canbeinterpretedassayingthat,conditionalonthisApplyingscenarioanalysistoclimateriskMatthewLightwood,director,risksolutionsatConning,discussestheapplicationofstochasticmodellingwithscenarioanalysistoquantifyclimateriskinaportfolio1Transitionandphysicaldamagefunctionsforportfolio1and2undertwotransitionscenarios0%-1%-2%-3%-4%Financialdamage/returnstressFuturetimehorizon(years)301510152025Weitzman(physical)RapiddecarbonisationLineartransitionFuturetimehorizon(years)3015101520250%-1%-2%-3%-4%Financialdamage/returnstressWeitzman(physical)RapiddecarbonisationLineartransitionPortfolio1financialdamagefunctionsPortfolio2financialdamagefunctionsPreparedbyConning,Inc.15Sponsoredfeaturerisk.netscenarioplayingout,itwouldbeexpectedthattheportfoliomarketvalueis1%lowerthanourcurrentbestestimate.Figure2alsoillustratestheattributionoftheECRtotransitionrisk(middlerow)andphysicalrisk(bottomrow).Forbothportfoliositisobservedthattherapiddecarbonisationscenarioleadstolargerimpactsonriskandreturnattheshorterandmediumtimehorizons.Overthefull30-yearhorizonitcanbeseenthattheportfoliosarerelativelyinsensitivetothepaththeclimatescenariotakesthroughtime.Itisalsoobservedthatthescenariohasalargerimpactonriskthanonmeanreturn.Forportfolio1,themeanreturnis5%lowerundertherapiddecarbonisationscenariothanthecurrentbestestimate,whilethe1%VARhasincreasedbynearly6%.Forportfolio2,thedifferencesaregreater,withthemeanreturndecreasingbyapproximately7.5%whilethe1%VARincreasedby9%.Consideringthefive-yearhorizonthatmightbeusedforOwnRiskandSolvencyAssessmentreportingoranalysistoformpartoftheTaskForceonClimate-relatedFinancialDisclosuresorPrinciplesforResponsibleInvestmentdisclosures,increasesinriskofonly1.3%forportfolio1and1.9%forportfolio2areobservedundertherapiddecarbonisationscenario.■Thisfeaturecontainsforward-lookingstatements.Readersshouldnotplaceunduerelianceonforward-lookingstatements.Actualresultscoulddiffermateriallyfromthosereferencedinforward-lookingstatementsformanyreasons.Forward-lookingstatementsarenecessarilyspeculativeinnature,anditcanbeexpectedsomeoralloftheassumptionsunderlyinganyforward-lookingstatementswillnotmaterialiseorwillvarysignificantlyfromactualresults.Variationsofassumptionsandresultsmaybematerial.Withoutlimitingthegeneralityoftheforegoing,theinclusionofforward-lookingstatementshereinshouldnotberegardedasarepresentationbytheinvestmentmanageroranyoftheirrespectiveaffiliatesoranyotherpersonoftheresultsthatwillactuallybeachievedaspresented.Noneoftheforegoingpersonshasanyobligationtoupdateorotherwisereviseanyforward-lookingstatements,includinganyrevisiontoreflectchangesinanycircumstancesarisingafterthedatehereofrelatingtoanyassumptionsorotherwise.2ClimateriskanalysisusingtheConningClimateRiskAnalyzersoftware.TheeffectofscenarioBonthemeanmarketvalue(left)and1%annualVAR(right)oftheportfolioareshown0%-1%-2%-3%-4%Futuretimehorizon(years)301510152025ScenarioimpactonmarketvaluePF250/50rapiddecarbonisationPF250/50linearPF170/30rapiddecarbonisationPF170/30lineartransitionFuturetimehorizon(years)301510152025Scenarioimpacton1%annualVAR0%-1%-2%-3%-4%PF250/50rapiddecarbonisationPF250/50linearPF170/30rapiddecarbonisationPF170/30lineartransitionFuturetimehorizon(years)301510152025Scenarioimpacton1%annualVAR0%-1%-2%-3%-4%-5%-6%PF250/50rapiddecarbonisationPF250/50linearPF170/30rapiddecarbonisationPF170/30lineartransitionFuturetimehorizon(years)301510152025Scenarioimpacton1%annualVAR0%-2%-4%-6%-8%-10%PF250/50rapiddecarbonisationPF250/50linearPF170/30rapiddecarbonisationPF170/30lineartransition0%-1%-2%-3%-4%-5%-6%Futuretimehorizon(years)301510152025ScenarioimpactonmarketvaluePF250/50rapiddecarbonisationPF250/50linearPF170/30rapiddecarbonisationPF170/30lineartransition0%-2%-4%-6%-8%-10%Futuretimehorizon(years)301510152025PF250/50rapiddecarbonisationPF250/50linearPF170/30rapiddecarbonisationPF170/30lineartransitionScenarioimpactonmarketvalueChangeinmeanmarketvalueduetoclimatescenarioTransitionriskattribution(changeinmeanmarketvalue)Physicalriskattribution(changeinmeanmarketvalue)Changein1%annualVARduetoclimatescenarioTransitionriskattribution(changein1%annualVAR)Physicalriskattribution(changein1%annualVAR)1IPCC(2018),Globalwarmingof1.5ºC,www.bit.ly/3AdoPh0MatthewLightwoodisdirector,risksolutionsatConningPreparedbyConning,Inc.Source:ConningClimateRiskAnalyzer™16TransitionfinancingstandardsClimateriskSpecialreport2021Someoftheworld’slargestbankssaytheyneedglobalstandardstoclassifyandmeasurethefinancingoftransitiontoalow-carboneconomy.Whileinitiativesalreadyexistforindividualcompaniestodisclosecarbonemissions,thereisnoconsensusonhowtodefinelendingthathelpscarbonemitterstotransitiontoagreenerbusinessprofile.TraceyMcDermott,groupheadofconductandcomplianceatStandardCharteredandchairoftheNet-ZeroBankingAlliance(NZBA)saidtransitionfinancewillbeattheheartofachievingnet-zerocarbontargets.“Butthereisaquestionastowhatyoudefineastransitionfinance,thereisnotaxonomy.[TheNZBA]publishedourownframeworklastweek...butthatiswithoutanysortofregulatoryorotherauthority,”McDermottsaidataCOP26eventheldonNovember4.TheNZBAhas92memberbanksrepresenting43%ofglobalbankingassets($66trillion),andincludesthe10largestbanksbyassetsinbothNorthAmericaandEurope.Thesebankshavecommittedtousingtheirlendingpowertohaltglobalwarmingat1.5ºCelsiusabovepre-industriallevels.However,itsmemberssaypolicy-makersmustkickstartthetransitionbyagreeingataxonomyfortransitionactivities,intermediatedecarbonisationtargets,andeconomy-wideincentivestosupportthetransition.AnaBotin,executivechairoftheSantandergroup,anotherNZBAsignatory,saidgovernmentsneedtodeterminewhichactivitiesareconsideredgreenandwhatisanappropriate“pathwaytogreen”.“We’rehappytodoitasaprivatesector,butthat’snotourjob.Weneedclarityonwhatlanguagewespeak...andhowwemeasure,”saidBotin.“Itisreallyimportantthatgovernmentsettheintermediatetargets...[andthey]needtobeveryconsciouswhatarethetaxes,incentivesanddisincentives.”TheEuropeanUnionhasalreadyestablishedagreentaxonomydefiningassetsthatarenotconsideredmajorcontributorstoclimatechange.However,transitiontaxonomiesaremeanttobemoredynamic,providingcriteriaandmethodologiesthatassessthepathwayforcompaniesoperatingintraditionallyhigh-emissionsectorstoengageinclimatechangemitigation.“Isgasincluded?Whatdoyoudointermsofbreakthroughtechnologies?Andhowdoyouaccountforthat?”explainedMcDermott.“Because...whatreallymattersistheimpactthat’shavingintermsofreductionofemissionsandemissionintensityandthat,Ithink,isthechallengethatweneedtotackle.”AccordingtoresearchbyNatixisfromJuly2021,onlyJapanandCanadaareclosetodevelopingtransitiontaxonomies.TheEUisworkingthroughfeedbacktoapublicconsultationonextendingitsgreentaxonomytoinclude“transitionalactivities”andcriteriathroughatraffic-lightsystem.1Aredratingmeanstheactivitywillnothavethepotentialtobecompatiblewithatemperatureriseof2ºCabovepre-industriallevels,whileyellowindicatestheactivityistransitioningtowardsthattarget.ResidualcarbonfinancingWhiletheUnitedNationsEnvironmentProgramme,whichsponsorstheNZBA,hascalledforahalttofinancingnewfossilfuelprojects,theNZBAmemberssayexistingfossilfuelfinancingmustcontinueintheshortterm.Thequestionisforhowlong.AnneFinucane,vice-chairofBankofAmerica,toldthepanel:“Weneedhelpwiththesemoredifficultemittingindustries,becauseif80%oftheworldisstillfuelledbyfossilfuels,wecan’tjustshutthemoff,norcanweshutdownplantsandskyscrapersandhomes.”Botincalledforcompanies,banksandregulatorstoagreeviablestandardsoncounterpartytransitionplans.“Weneedtobereally,reallycarefulofhowwedefinethetransition,whatitisweneedtodoandtomakeitaffordableandsimpleforcustomers,”shesaid.“Someconsumergroupsbelieveweshouldstopfinancinggasaltogether–thatisnotrealistic.”NZBAbanksalsowantofficialsectorguidanceandalignmentonthetreatmentofdevelopingeconomies.Tothisend,McDermottsaidtheNZBAneedstoincreaseitsrepresentationbeyondthe39countriescurrentlyrepresented.“We’vegottomakesurethatthetransitionisajustone–bothintermsofhelpingthedevelopingmarketstocontinuetodevelop,butalsoinensuringwedon’tsetstandardswhichmeanmoneycanonlyflowintoEUorUScompanies,becausethey’retheonlyonesthatcanmeetthecriteria,”saidMcDermott.RegulatorsonthemoveTheBankofEngland’s(BoE’s)executivedirectorforfinancialstabilitystrategyandrisk,SarahBreeden,toldthepanelthattheBoEisalreadyworkingwithpolicy-makersandsecuritiesmarketregulators,includingtheUKFinancialConductAuthority,toensurereal-economyfirmsprovideadequateemissionsdataandtransitionplans.Thenextstepafterdisclosuremayincludeaggregating,assessingandprovidingfeedbackonplans.“Whatdoallyourtransitionplansaddupto?Arewedoingenoughgivenwewanttokeep1.5ºCalive?”saidBreeden.Sheaddedthatregulatorswerealsolookingtoconsolidatetheclimatescenarioanalysisthatseveraljurisdictionshavebeenpursuingseparately.InadditiontotheBoE,theBanquedeFrancehasundertakenaclimateriskstresstest,andtheEuropeanCentralBankisduetofollowsuitnextyear.“It’shealthythatwetriedavarietyofapproaches,butwedoneedtogettoapointwherethereisabestpractice,”saidBreeden.Withregardtocontinuedfinancingoffossilfuels,BreedensaidthiswasreflectedinthedifferencesbetweentheInternationalEnergyAgency(IEA)1.5ºCscenarioandthescenarioscreatedbythefinancialregulators’NetworkforGreeningtheFinancialSystem(NGFS).ShesaidtheBoE’sobjectiveis“asorderlyatransitionwithaslowcostaspossible”.“IfyoucomparetheNGFSscenarioswiththeIEAscenarios,there’smoreuseoffossilfuelsinoursthanintheIEA’snet-zeroscenario,preciselyforthisreason.”BreedensaidtheNGFSscenariosaredesignedtoensuretherateatwhichfossilfuelsareretiredisconsistentwiththebuildingofnewrenewablesources.“Whatwe’reseeingintheenergymarketnowisanimbalanceofsupplyanddemand,andpricesaregoingup,andthat’shavingarealimpactonpeople,”shesaid.RecentmonthshaveseensharpspikesingaspricesastheglobaleconomyrecoversfromCovid,resultinginsevereproblemsamongUKenergysuppliersinparticular.■PreviouslypublishedonRisk.netBanksseekregulatoryguidanceonclimatetransitionplansPolicy-makersstruggletoagreeonhowtoidentifywhetherborrowersareconvergingwithnet-zerotargets.BySharonThiruchelvam1PlatformonSustainableFinance(July2021),Publicconsultationreportontaxonomyextensionoptionslinkedtoenvironmentalobjectives,www.bit.ly/31SmfSd17Carbontradingrisk.netWhathappenswhenaprudentialframework,whichtookyearsofnegotiationtodesign,meetsplansforcombattingclimatechangethathavealsotakenyearsofdiplomaticwrangling?Thetradingofcarbonemissionsisseenasessentialtoestablishcarbonpricingasamarketmechanismtocuttotalemissions.That,inturn,isvitaltotheobjectiveofthehard-won2015Parisclimateagreementtolimittheriseinglobaltemperaturesto1.5oCelsiusabovepre-industriallevels.ButastudyearlierthisyearbytheInternationalSwapsandDerivativesAssociation(Isda)claimsthestandardisedapproaches(SAs)containedinsoon-to-be-implementedtradingbookcapitalrulesforbanksaresopenaltheymayinhibitthedevelopmentofcarbontrading.ThetroubleisthattheBaselCommitteeonBankingSupervision’sFundamentalReviewoftheTradingBook(FRTB)wasalsotheproductofalengthyprocessoftalksthatincludedmultipledrafts.Tryingtounpickonepartofthemarketriskcapitalrulescouldcreateinconsistencyacrosstheframework,andunderminethelevelofconservatismregulatorsdeliberatelyincorporatedintotheFRTB.TheEuropeanBankingAuthority(EBA)hasreservations,butisnotrulingoutchanges.“Werecognisethatelementslikecarbontradingwillprobablybeimportantinordertofacilitateatransitiontoamorecarbon-neutraleconomy,”saysLarsOverby,headofrisk-basedmetricsattheEBA.“ItshouldhoweverberecalledthattheSAissupposedtoberelativelysimple.Thatbeingsaid,ifcarbontradingbecomesmoreimportantinbankbalancesheets,especiallyintheEU,wewillneedtolookintothisinmoredetail,ifitturnsouttobeoverlypunitive.”TheFRTBrequiresbankstocalculatethelevelofrisk-weightedassets(RWAs)withintheirtradingbooksbyeitherusingtheirowninternalmodels–iftheypassaseriesofrigoroustests–orwiththeregulator-setSA.BanksmustthenholdaminimumpercentageofcapitalagainstaproportionoftheRWAs.TheSAissettobecomeevenmoreimportantasjurisdictionsimplementBasel’soutputfloor,whichpreventscapitalrequirementsbasedoninternalmodelsfallingbelow72.5%oftheresultsusingthestandardisedmethods.IsdareleasedareportinJulyrecommendingchangestotheSA,whichitsaysdoesnotreflecttheactualriskbanksfacewhenactingasintermediarieswithinemissionstradingscheme(ETS)markets.“ClearlythehighertheRWA,thefewerincentivestherewillbetokeep[emissionsallowances]inthebank’sbalancesheet,”saysaseniorriskmodellerataEuropeaninvestmentbank.However,thereislittleevidencethattheRWAsgeneratedundertheSAforcarbonemissionsaresomehowtoohighcomparedwithothermarketriskassets.Moreover,Isda’sproposaldoesnotusethesamehistoricalstressperiodthatmostoftherestofthecapitalframeworkisbasedon–the2008financialcrash.ThatmeansitwouldcreateinconsistencieswithintheFRTB,whereemissionsallowancesbasetheirriskweightsonadifferentobservationwindowfromotherformsofmarketrisk.Agreenexceptiontohelpachievenet-zeroemissionsby2050isn’tnecessarilyabadideaifitmeetstheobjectiveofcombattingclimatechange,anditmightbebettertimingtoadjusttheFRTBbeforeitentersintoforce.ThattouchesonawiderquestionregardingtheSA.Internalmodeloutputswilladjustasthemarketperformancedataevolves.Bycontrast,thedataunderpinningtheSAcanbecomestaleatsomepoint,andthecalibrationmaynolongerbeappropriate.ThreesourcestellRisk.nettheyhaveheardtheEuropeanCommission(EC)isconsideringmakingatargetedalterationontheirversionoftheFRTBwhentheyimplementit.Afirstdraftislikelytobepublishedthismonth.Butthatwouldraiseafurtherconcern.Thecarbonmarketisglobal,sotherewouldbeanunlevelplayingfieldiftheEUdilutesFRTBbutotherjurisdictionsdonot.“TherearesomeconcernsinaffectingthelevelplayingfieldifwechangeatEUlevelonly,”saysStephaneBoivin,aseniorpolicyexpertintheEBA’srisk-basedmetricsunit.“However,italsodependsontheimportanceofthistopicinotherjurisdictions–thisisclearlyakeytopicfortheEU.”TheECdidnotrespondtoRisk.net’srequestforcomment.MakingthecutEUeyesIsda’scarbontradingproposalsTheEuropeanBankingAuthorityfearsthesuggestedtreatmentofemissionswouldbemisalignedwithrestoftheBaselCommittee’sFundamentalReviewoftheTradingBook.BySamuelWilkes•TheInternationalSwapsandDerivativesAssociationdisputesparameterssetbyregulatorsinupcomingprudentialrulesforbankstocalculatethelevelofcapitaltheyneedtoholdagainstemissionsallowances.•AstudybytheindustryassociationrecommendsloweringtheriskweightforvolatilityandincreasingacorrelationparameterforemissionsallowancesbasedonevidencefromtheEuropeanUnion’smarket,tolightenthecapitaltreatmentforbanks’tradingallowances.•Buttherecommendationswouldremoveanelementofconservatismbakedintothecapitalforemissionsallowances,asIsda’sstudyexcludesperiodsofvolatilityusedtocalibrateriskweightsformostotherassets.•However,themovecouldservethepoliticalobjectiveofusingemissionstradingmarketstohelpestablisharisingcarbonpricetoincentivisetheshifttowardsalow-carboneconomy.Needtoknow“Onehastobehonest–notallthecapitalframeworkisdrivenbydata;alotofitisdrivenbypoliticalconcerns”JochenTheis,independentconsultant18CarbontradingClimateriskSpecialreport2021AdifferenttreatmentCompaniesmusthaveenoughemissionsallowancestomatchthequantityofcarbonemissionstheyproduce.Theideaisforgovernmentstosetandcaptheemissionstheireconomiesproduce.Bycappingandloweringtheamountofallowances,governmentscanencourageindustriestoreduceemissionsbymakingitcheapertocutemissionsthantobuyallowancestocoverthem.Allowancesareallocatedforfreeorareauctioned.Bankstypicallysellforwardcontractstodeliveremissionsallowancestoacompanyandhedgethetradebybuyingcertificatesfromtheauctions.TheIsdastudy–basedondatafromtheEUemissionsallowancemarket–pointedtotwoinputsintheSAasbeingdisproportionatetothelevelofriskbanksundertakeinETSmarkets:therisk-weightbucketrepresentingpricevolatilityandacorrelationparameterusedforaggregatingtradeswithdifferenttenors.Emissionsallowancessharearisk-weightbucketwithelectricity,whichslapsa60%riskweightonopenpositions.Isdaestimatesemissionsvolatilityshouldbeclosertoa40%bucketgiventometals.“Anycalibrationofanymodelisonlyasgoodasthehistoricaldatathatfeedintoit–ifthemarketisevolvingandchanging,thentherehastobeaprocesswherethisnewinformationistakenunderconsideration,”saysPanayiotisDionysopoulos,headofcapitalatIsda.“HowdoesthatreconcilewiththefactthatanychangesinthoseSAshavetogothroughthislengthylegislativeprocess?”TheEUemissionsstabilisationmechanismwasintroducedin2017,andallowsauthoritiestowithdrawallowancesinthemarketduringtimesofexcesssupply.Thismeasurehashelpedstabilisepricesinthemarket.“TheissueisalsothatthestressperiodusedforcalibratingFRTBriskweightsprecedestheapplicationoftheEUstabilisationmechanismoncarbontrading,”saystheEBA’sBoivin.Inaddition,thenettingabilityforcarbonemissionsisbasedontheriskbucketsforcommodities.Thatmeansacorrelationof0.99isassumedifthecommoditiesareinthesameriskbucket,butoneofthecommoditytype,tenorordeliverylocationisdifferent.Isdastatesthecorrelationiscloserto0.996foremissionsallowances.Althoughaseeminglysmallchange,itcanhavebigconsequencesforcapital.Forgetting2008Theinternalmodelsapproach(IMA)isintendedtogivebankstheflexibilitytotrackchangesinaproduct’sriskprofileovertime.Conversely,theSAismeanttobeasimplerfallbackthatisnotperfectlyrisk-sensitive.“Thestandardisedapproachlooksatsomeminimalsetofindicatorsandsays:‘Thisisenoughcapitalforthisproduct,’”saysRobertLitterman,afoundingpartneratNewYork-basedhedgefundKeposCapitalandchairmanoftheCommodityFuturesTradingCommission’sclimate-relatedmarketrisksubcommittee.“Thatiswhyitismoreconservative,becauseitdoesn’tdrilldownintothesecorrelationsandhowtheyarechangingovertime–andtheydochangeovertime.”ThatmeanstheconservatismintheSAforemissionsallowancesisn’tnecessarilyoutoflinewithothermarketrisks.Isdadoesgiveonecomparativeexampleinitsstudy–thevolatilityofcrudeoilfutures.Althoughtheriskweightforcrudeoilisaroundhalfofthatforcarboncertificates,volatilitybetweenthetwoproductssince2015hasbeenrelativelyclose–indeed,crudeoilhasbecomemorevolatilethanemissionsin2020and2021.TheproblemwiththeIsdarecommendation,though,isthatitrequiresemissionsallowancestoreceiveadifferenttreatmentfromotherproducts.Intheperiodbetween2012and2015,emissionsallowancesweremuchmorevolatilethanoil,peakingatalmost80%yearlyaveragevolatilityin2014.Crudeoilhasn’treachedsuchheightsofvolatilityatanytimebetween2009and2021,accordingtoIsda’spaper.SothelowervolatilitybucketandhighercorrelationassumptionforemissionsproposedinIsda’spaperarebasedonexcludingtheperiodbeforemid-2013.Butwhendesigningthepost-crisismarketriskcapitalrulesin2016,theBaselCommitteehadconsideredearlierpeakstressperiods.Formostproducts,thatwouldbethe2008financialcrash.ThismeansthatifIsda’sproposalwereimplemented,theSAforemissionswouldbebasedonareferenceperiodforvolatilityandcorrelationthatisinconsistentwithotherproducts.“Soitmeansthattherewouldbeamismatch,forexampleinthecorrelationbetweenriskfactors,ifweweretoconsideramorerecentstressperiodforthisparticularbucket–thatisoneofthedifficultiesinreconsideringtheframeworkrightnow,”saysBoivin.IMAversusSAAsimilarinconsistencywouldemergebetweenbanksusingtheIMAandthoseusingtheSAforcarbonemissions.BankswithIMAapprovalmustuseanexpectedshortfallmeasuretocalculatetheirRWAs.Expectedshortfalliscalculatedbyaveragingallofthereturnsinthedistributionthatareworsethantheportfolio’svalue-at-risk–along-establishedmeasureforestimatingfinancialrisk–atagivenlevelofconfidence.Itmustincludetheworstyearforabank’sportfoliosince2007.Formostbanks,onceagain,thisisthe2008financialcrisis.“Ifwechangethe[emissions]risk-weight[toreference]morerecentvolatilityunderthestandardisedapproach,wewouldriskcreatingadiscrepancybetweenIMAandstandardisedapproachbanks,”saysBoivin.“ManyIMAbanks,despiteCovid-19,arestillusingaone-yearperiodaround2008astheirstressperiod,sotheywouldbecapturinghighervolatilitythanstandardisedapproachbanks.”Fundamentally,theproblemwithnarrowingthehistoricalobservationtoexcludetheperiodwiththemostseverestressisthat,ifasimilarworst-caseshockappearsinthefuture,thecapitalrequirementsaresuddenlytoolenient.“Thosecorrelations[intheIsdastudy]weresuperhigh,buthowdoIknowtheyaren’tgoingtocomedown?Whenyougetashockinthemarket,whoknowswhatwillhappentovolatilitiesandcorrelations?”asksLitterman.“Thewholeideaofthestandardisedapproachisthatitisnotsofinelytunedthatachangeinthemarketwillcause[capitalrequirements]tobetoolow.”NoworneverOneargumentinfavourofmovingnowisthatboththeEUandtheUSarepreparingforsubstantialregulatorypackagestoimplementthefinalpiecesofBaselIII.IntheUS,theFederalReservewillneedseveralroundsofconsultationontheFRTB.IntheEU,theprocesswillbeevenmoredifficult,asthefinalFRTBcapitalrequirementsarelikelytobecontainedinahugepackageknownasthethirdcapitalrequirementsregulation(CRRIII)thatwillneedtobeagreedbetweentheEC,CounciloftheEUandEuropeanParliament.“Idon’tthinktheyaregoingtorevisethatcapitalframeworkagainanytimesoonafterCRRIII,soitisprobablyagoodchancetogetthat[changeforcarbonemissions]in,”saysJochenTheis,anindependentconsultantandformerheadofmarketriskmodellingatanumberofglobalbanks.“ClearlythehighertheRWA,thefewerincentivestherewillbetokeep[emissionsallowances]inthebank’sbalancesheet”SeniorriskmodellerataEuropeaninvestmentbank18CarbontradingClimateriskSpecialreport202119Carbontradingrisk.netHeaddsthatthereisplentyofprecedentfortweakingriskweightstosuitapolicyobjective,ratherthantoproduceanexactrisk-basedcalibration.“Onehastobehonest–notallthecapitalframeworkisdrivenbydata;alotofitisdrivenbypoliticalconcerns,likethetreatmentofmortgagesandotherassets,”saysTheis.“Therearecertainlybitsandpiecesofthestandardisedframeworkthatgiveaslightlybettertreatmenttocertainkindsofriskthantoothers.”IfachangetothetreatmentofcarbonemissionsisnotincludedinCRRIII,theEUmightstillhaveanotheropportunityshortlythereafter.ByJune23,theEBAisduetodeliveradvicetotheEConadedicatedprudentialtreatmentdesignedtoincentiviseexposuresthatsupportenvironmentalandsocialobjectives.Followingthatreview,theEChasthepowertoproposechangestothecapitalrulesdependingontheoutcomeoftheEBA’sreport.WhiletheEUmovingalonewouldraiselevelplayingfieldissues,itisunclearwhethertheUSshouldfollowsuitfromapurelyrisk-basedperspective.OneofthedifficultieswithIsda’sproposalisthattheBasel60%riskweightwasdesignedtoapplyglobally,andsoitscalibrationwasbasedoncarbonmarketsbeyondjusttheEU.“Ingeneral,severaljurisdictionswereconsidered,butatthesametime,datawascompoundedtomakeitrelevantatgloballevel,”saysMarcoCrotti,apolicyexpertintherisk-basedmetricsunitattheEBA.Bycontrast,Isda’sstudywasprimarilybasedonthebehaviouroftheEUemissionstradingscheme.OtherjurisdictionsdonotsharethesamepricestabilitymechanismsastheEU’smarket,andnoraremostothercarbonmarketsasliquidincomparison.Asaresult,Isda’sproposedrecalibrationcouldbeunsuitableforotherjurisdictions.Thatmaywellbegintochange,especiallygiventhefocusofPresidentJoeBiden’sUSadministrationontacklingclimaterisk.Butfornow,nobodyknowswhatpolicyinitiativestheUSwilltake,orindeedwhethertherewillbefurtherstepsintheEU.Andthat’sexactlythereasonwhytheSAforcarbonemissionsneedstoremainconservative,accordingtoLitterman.“Intermsofvolatilityandintermsofanychangesinvolatility,governmentpolicycouldchange–youneverknow,”hesays.“Thatisabigpartoftheuncertaintyintheallowancemarket:itisgovernmentpolicythatcreatesthemarket,soitisgovernmentpolicythatdominatesuncertainty.”■PreviouslypublishedonRisk.net19Carbontradingrisk.net20SponsoredQ&AClimateriskSpecialreport2021Avertingcatastrophicclimatechangeisabigaskforanascentdiscipline,yeteffectiveclimateriskmanagementcoulddoexactlythat.Onlybyquantifyingandrepricingriskwillthecorrectpricesignalsbesentoutacrosstheeconomytochannelinvestmentsawayfrompollutingactivitiesandintotherequiredcleanenergyandgreentechnologies.Themyriadwaysinwhichdecarbonisationcouldbeachieved,andthecountlessunknownsthatwillpopupalongthejourney,makeclimateriskmanagementexceedinglychallenging.Thisiswhydiscussionandexchangeofideasonthefinancialrisksandopportunitiesofclimatechangeissoimportant.InthisQ&A,threeexpertsanswersomeofthemajorquestionsbeingaskedaboutthedisciplinetoday,eachbringingadifferentangletothedebate.Whatcanbedonetoimprovethelevelofclimateriskdisclosurefromcapitalmarketsparticipantsandmid-sizedtolargecorporations?HowimportantisitthatfirmsfollowtheguidelinesoftheTaskForceonClimate-relatedFinancialDisclosures(TCFD)?MatthewLightwood,Conning:Itisessentialthatgovernmentsadoptaconsistentglobalreportingstandardforclimatedisclosuresandwritetheseintolaw.Theyneedtobesufficientlydetailedsoinvestorscanunambiguouslydifferentiatefirmsfromoneanother.Also,Iseealotofclaimsaroundnet-zeroambitionsandaneedformorerigoroustestingoftheassumptionsaroundthemagnitudeofthenettingeffectofsomeinitiatives.Thereisagreatdegreeofscepticismamongthegeneralpubliconthisissue,andwewon’tgetasecondchancetogetitright.NickStansbury,Legal&GeneralInvestmentManagement(LGIM):Therearetwomainroutestoimprovingdisclosure:investorpressureandregulatorychange.Disclosureshouldbeakeyelementofinvestorengagementwithinvesteecompanies.Withoutcarbondata,itisdifficultforinvestorstounderstandtheirinvestments’climateriskexposureandevaluatetheirclimateimpact.TheTCFDprovidesbest-practiceguidanceonclimatereportingfordifferentsectors,andcanbeusedasachecklistwhenevaluatinginvesteecompanies’disclosure.Investorscansettheirownminimumstandardsbasedonthischecklist–a‘must-have’list–andimposevotingordivestmentsanctionswherethesearenotmet.Policy-makersmustenshrinetheirownminimumstandardsintorelevantregulation.Thisisalreadyhappening,withsignificantregulatorymomentumobservedacrosstheworld.Inmanyjurisdictions,suchastheUK,mandatorydisclosureswillbedirectlybasedontheTCFDguidelines.Companiesmustfollowtheseguidelinesassoonaspossibleiftheyaretoavoidacostlycrunchwhenrecommendationsbecomerequirements.Whatrolewillvoluntarycarbonmarketsplayintheenergytransitionoverthenextfewyears,andhowwilltheydevelop?MatthewLightwood:WhileIthinkvoluntarycarbonmarketsareadmirable,thereisariskofthembeingusedbytheworstemitterstodolessthantheycouldonreduction.Thescaleofemissionsissomuchgreaterthanourabilitytoscalecarbon-reductiontechnologiesthatIworryweareoverestimatingtheimpacttheseschemescanhaveontheproblemathand.Ithinkacompulsorycap-and-tradesystemwouldhavealargerimpact.Thiswashighlyeffectiveatcombattingacidraininthe1980sandcouldcontributeheretoo.RobertLitterman,CommodityFuturesTradingCommission:Manyclimatescientistsandconservationexpertsbelieveprotectingexistingforestsandregeneratingdegradedforestlandsaretheleastexpensiveapproachestoincreasingtheearth’sabilitytopullcarbondioxideoutoftheatmosphere.Thesecriticallyimportantactivitieshavenotscaledupinrecentdecades,however,becausetheyrequireinvestmentsthathave,todate,beenvoluntary,withnopromiseofreturn.Fewinvestorsparticipateinthevoluntarymarketbecause,whileitmaymakethemfeelbetter,itprovidesnoopportunityforfinancialreturns.Fortheforestcarboncreditmarketstoscale,theymustprovidepositiveexpectedreturnstoinvestors.Thiscanbeachievedbyusingremotesensingtechnologytocreatereal,measurable,auditableandhigh-qualitycarbonfluxestowhichcarboncreditscanattachownershiprights.Bymeasuringcarboncontentandfluxoflandscapes,aswellaspoliticaljurisdictions,suchtechnologycanaddressthekeyissuesofpermanence,additionalityandleakage.Justasfinancialmarketscreatelarge,liquidmarketsformortgages–whicharepackagesofriskycashflowsbackedbyidiosyncraticproperties–thosemarketscancreateliquidityandscaleforforestcarboncredits.Todoso,however,thesecreditscannotbevoluntary,butmustbeinvestablesecuritiesrepresentinginsuredclaimsonfuturecarbonfluxesthatareexpectedtohavecompliancevalue,andthusgeneratepositiveexpectedreturnsforinvestors.SendingtherightsignalsQuantifyingandrepricingriskRisk.netconvenedapanelofthreeexpertsfromdifferentfieldstodiscusssomeofthemostpressingandpertinentclimate-riskrelatedissues,eachofferingdifferentinsighttothediscussionfromtheirrespectivebackgrounds,providinganexchangeofideasontheimportanceofthefinancialrisksandopportunitiesofclimatechangeMatthewLightwoodDirector,RiskSolutionswww.conning.com®21SponsoredQ&Arisk.netDoyouexpectanindustry-standardclimateriskstresstesttoemerge?NickStansbury:Therehavebeencallsformorestandardisationinclimateriskanalysis.Itisimportanttodistinguishbetweenthreeimportantdimensionsalongwhichthiscouldtakeplace:scenarios,methodologiesandoutputs.Thefirstelementthatcouldbestandardisedarethescenarioscompaniesconsider.Thisis,ineffect,the‘input’ofthestresstest.Forexample,theNetworkforGreeningtheFinancialSystem(NGFS)providesastandardsetofscenarionarratives,whichitsaysprovidesapointofreferenceforclimateriskanalysis.Thesemaycomeclosetorepresentinganindustrystandard.Standardisingscenarioscouldensuresomedegreeofcomparabilityacrossanalysesfromdifferentcompanies.Itcouldensurecompaniesdon’tonlystress-testagainstscenariosdesignedtobelessdisruptivefortheirbusinessmodel.However,giventhedegreeofuncertaintyaroundfutureclimateoutcomesandthepathwaysofgettingthere,completestandardisationwoulddomoreharmthangood.Thesecondelementwouldbethemethodologywithwhichcompaniesanalysetheirexposure.Thesamescenariocouldrepresentdifferentlevelsofriskdependingonthemethodofquantification.Giventhecomplexityoftheseanalyses,numerousassumptionsareneededtoarriveataclimaterisknumber.Ascompaniesoftendiscloseonlyalimitednumberoftheseassumptions,comparisonsacrossdifferentclimaterisknumberscanbechallengingforthirdparties.Especiallyifthethirdelement–outputs–alsodiffersacrossanalyses.Thebestoutcomecouldbeamixtureofstandardisationandfreedom:ensuringcompaniesstresstestagainstasetofstandardscenarios,givenaspecificmethodology,andproducingaspecificsetofoutputsandallowingthemtoexploretheirownspecificationsinadditiontothis.MatthewLightwood:Yesandno.IthinksomestandardisationislikelybecausemostofwhatwehaveseensofarhasbeenbasedontheNGFSframeworkinsomeway.However,whatweareseeingmoreandmoreisamoveawayfromhighlyprescriptivestresstestsandtowardsamoreinterpretativeapproach.Forexample,theBankofEngland’s(BoE’s)ClimateBiennialExploratoryScenario(CBES)definesaverywiderangeoffinancial,economic,transitionalandphysicalclimateriskscenarios,anditisverymuchuptotheinsurerorbanktomakeuseofthoseandthinkaboutwhatitmeanstotheirbusiness.Thisisverydeliberate;regulatorswantriskdepartmentsandboardstoputsomeeffortintounderstandingtheirparticularexposurestotherisk.Howshouldfirmsincorporateclimateriskwithintheirstrategicandriskmanagementframeworks?MatthewLightwood:Thisisthethirdpillarofclimateriskreportingfromaregulatoryperspective.First,insurershavetosizetherisk,understandtheimpactontheirfirm’sbusinessmodeland,finally,managementneedstodecidehowtousethisinformationtoinformfuturestrategicdecisions.Thisthirdstepisextremelychallenginginpracticebecause,untilthereisfirmactionfromgovernmentsonthecostofcarbon,itisdifficulttoseewhatmanagementactionsmightbeappropriatetodaythatwouldalsoalignwiththeirbasicfiduciaryduties.Thereareperhapssomeexceptionstothisontheliabilitysideandalsowhenwestarttoconsiderreputationalrisk,butIdon’tseemarketsrealigningthemselveswithoutsomepolicyactionasatrigger.Whathavebeenthemostimportantdevelopmentsinthefieldoffinancialclimateriskmodellinginrecentyears?Whatarethekeychallengestomodellingclimateriskexposureinaportfolio?NickStansbury:Climateriskmodellingisarelativelynewdiscipline,butithasevolvedconsiderablysince2017whentheTCFDfirstrecommendedclimatescenarioanalysisforriskmanagementpurposes.First,thediversityofclimatescenarioshasgrownsignificantly.Therearenowmanymoreorganisationsandcompaniesprovidingpossiblepathwaystoagivenclimateoutcome,notleasttheNGFS.Therearealsomoredestinationsbeingconsidered–especiallyaroundthe1.5°Celsiusoutcome,whichrosetoprominencefollowingaspecialreportfromtheIntergovernmentalPanelonClimateChange(IPCC)in2018.Second,climatesciencehasevolved.Climatechangeandassociatedriskscanbemodelledwithgreatercertaintythanbefore.NewcarbonbudgetsindicatingtheamountofcarbonhumanitycanemitbeforereachingacertaintemperatureoutcomebytheendofthecenturyhavebeenprovidedbytheIPCC,mostrecentlyinAugust2021.Third,companieshavedevelopedtheirmodellingcapacities.Takingclimatescenariosandtranslatingthemintofinancialimpacts–orindeedquantifyingtheimpactsofcompaniesontheclimate–werenotcommonpracticepriorto2017outsideoftheenergysector.Now,manycompanies–especiallyinvestors–haveinternalmodellingcapabilitiesspecialisingintheirindividualinterests.Thekeychallengeforinvestorswhenmodellingportfolioriskexposureistocapturetheindividualinvestmentcontextwhileenablingbig-pictureconclusions.Thetransitionwillnotaffectallcompaniesinasectorinthesameway:acompany’sfinancialsituation,carbonperformance,assetlocationsandmanymorefactorsplayimportantrolesindeterminingrisk.Yettheamountofdatarequiredtoevaluatecompany-specificriskisverylarge,andcanbepatchy,especiallyaroundissueslikeScope3emissionsandphysicalassets.Collectingallavailabledataonanentityandfillinganygapsistime-intensive,butasmuchofaportfolioaspossiblemustbecapturedtoarriveatameaningfulhigh-levelconclusion.Therefore,thekeychallengeisthebalancingactofcapturinginvestment-leveldetailandprovidingmeaningfulhigh-levelresults.NickStansburyHeadofClimateSolutionsLegal&GeneralInvestmentManagementwww.lgim.com22SponsoredQ&AClimateriskSpecialreport2021RobertLitterman:Itisimportanttoseparatethegrowingspecificclimaterisksthatthreatenindividuals,companies,citiesandregionsfromthelonger-termaggregatesystemicriskthatfaceshumanityglobally.Theformeraremostlylocal,measurableimpactsofextremeweathereventsorsea-levelrise,andcanbeadaptedto,mitigatedandinsuredagainst,whereasthelatteraredifficulttoquantifyandcanbeaddressedonlythroughurgentaggregatecollectiveactiontoreduceglobalemissions.Theexplosionintheavailabilityofpublicdata,analyticapproachesandexperienceinaddressingspecificextremeweatherimpactsmeanscorporationsaremuchbetterabletoaddress,measureanddisclosespecificclimaterisks.Publicandprivateclimateriskanalysisandunderstandinghasincreasedgreatlyinrecentyears.Whilethesespecificimpactswillgrow,theywilldifferbylocationandbusinesssector,andaggregateportfolioclimateriskexposurewilllikelyemergemoreslowlyovertimeasindividualspecificimpactsincreaseinsizeandfrequency.Aggregateriskwillincreasetotheextentthatspecificclimateimpactsdepleteaggregatefinancialresources.Thoughlessunderstood–andperhapslesslikely–themostdangerouslong-termclimaterisksmaywellbecausedbynon-linearresponsestoimpactsthatemergesuddenlyandhadnotevenbeenrecognisedaheadoftime.MatthewLightwood:Theavailabilityofdataandthedevelopmentofsomefreelyavailabledetailedscenariosetshavemadethetaskofdefiningclimatestresstestsmuchsimpler.Thentherehasbeenthedevelopmentofsoftwaresolutionsthathelpmakethosescenariosimplementableandtoturnthemintoanalytics.Thishasbeenkey–seeingsystemsbecomingavailabletomaketheprocesspracticable.Oneofthemainchallengesiscentredaroundthefactthereisnoreallyrobustwayofpinningeconomicandfinancialmarketeffectsonaparticularclimatescenario.Tryingtounderstandthedistributionofpossibleoutcomesiskey.Atransitiontoalow-carboneconomy,forinstance,mayhavethepotentialforupsideaswellasdownside–spurringinnovationandfiscalstimulus,perhaps.Adeterministicstresstestdoesn’treallytellyouanythingaboutthat,sowe’vebeendevelopingtechniquesthatmodeltherangeofoutcomesusingthestochasticmodellingtechniquesinwhichwealreadyhaveexpertise.Thisreallyhelpstocapturetheuncertaintyinthefuturemarketimpactsofclimateriskandavoidthepitfallsoffalseprecision.Howaredevelopmentsintechnologyandanalyticshelpingwithclimateriskmanagement?RobertLitterman:Climateriskisanemergingscientificfieldwithanexplosionofdatagatheredthroughremotesensingandsatelliteimagery,large-scalemodellingandforecastingabilities.Asasimpleexample,thescienceofrapidattributionofextremeweathereventstoclimatechange,basedonclimatesimulationswithandwithoutchangesinatmosphericgreenhousegases,hasemergedinthepastdecade,allowingthepublictomaketheconnectionbetweenlocalimpactsandclimatechange.Thisincreasedpublicunderstandingsupportsappropriategovernmentpolicyaswellasprivateadaptationandmitigationstrategies.Anotherexampleistheabilitytoprojectsea-levelriseatveryfinegranularity,whichallowshomeownersandbusinessestogaugetheadequacyoftheirmitigationefforts.MatthewLightwood:Wehaveseenabigspikeincompanieslookingfortechnologicalsolutionstohelpthemmakesenseoftheemergingregulatoryrequirementsaroundclimaterisk.WithininsurancethishascentredaroundtheOwnRiskandSolvencyAssessmentandthetypeofscenarioanalysisrequirementstheBoEandtheUK’sPrudentialRegulatoryAuthorityreleasedaspartofitsCBESexerciseearlierthisyear.Wehavebeenworkingwithanumberofclientstodevelopacloud-basedstochasticscenarioanalysistool,whichenablesthemtoassesstheimpactofclimatescenariosontheassetsideofthebalancesheetinamorequantitativeway.Havingapre-packagedandimplementablesolutiontothesestandardisedstresstestsisprovingverypopular,particularlyformid-sizedinsurersthatmaybedon’thavetheresourcestohaveadedicatedclimateorenvironment,socialandgovernance(ESG)riskperson.Whatarethemostimportantmetricsformeasuringclimaterisk?Canitbequantifiedinasimilarwaytomarketriskordofactorssuchassentimentandreputationmakeita‘soft’ratherthan‘hard’discipline?MatthewLightwood:Ithinkitisboth.Weareseeingthetypesofquantitativeanalysiswearedoingwithclientsisbeingusedtofeedintothosesofterqualitativediscussions.Climateisdefinitelyabranchofmarketrisk,whereasESGismoreagovernanceissuewithclimateasarelatedtopic.NickStansbury:LGIMbelievesitimportanttoconsiderclimateriskfromtwoangles:first,theriskthatclimatechangeandanypolicyresponserepresenttocompanies;andsecond,theriskthatcompaniesrepresenttoclimatechange.Weseeassetvaluationriskascapturingthefirstdynamic,andtemperaturealignmentascapturingthesecond.Climateriskcanandshouldbequantifiedinasimilarwaytomarketrisk.Thatistheonlywaytheresultsofclimateriskstress-testingwillbetakenseriouslybymarketparticipants.Ofcourse,thereareweaknessesinthisapproach:notallelementsofclimateriskcanbemeaningfullyquantified,andeventhosewecanquantifycarryanunusuallyhighlevelofuncertainty.Areaswithpotentialclimate-relatedrisksthataredifficulttoquantifyinameaningfulwayarereputationandlitigationrisk.Astheimpactsofclimatechangeworsen,firmsthatdonotalignwithalow-carbontransitioncouldlosetheirsociallicencetooperateandseeconsumersshiftdemandelsewhere.Forhighemitters,thereisanadditionalquestion:willtheyonedaybeheldtoaccountfortheclimaterisktheycontributedtothroughhistoricalemissions?Thesciencearoundattributionofindividualclimate-relatedeventssuchashurricanesandfloodingtospecificemittersprovidesinsufficientgroundsforsuchlawsuits–butthiscouldchangeinthefuture,withsignificantfinancialconsequences.Evenelementsthatcanbequantifiedarelikelytocarryamuchhigheramountofuncertaintythantypicalmarketriskmetrics.Therearemanyreasonsforthis,includingtheunprecedentednatureoftherisksandtheunusuallylengthytimehorizonsconsidered.Yettheyprovideinvaluableinsightsintothesignificanceofclimateriskandmustbequantified,despiteshortcomings.Overtimewecanworkonaddingcapacitytoquantifythe‘softer’partsofclimateriskpreviouslymentioned,asthescienceandsentimentaroundclimatechangeareconstantlyevolving.n>>Thepanellists’responsestoourquestionnairearemadeinapersonalcapacity,andtheviewsexpressedhereindonotnecessarilyreflectorrepresenttheviewsoftheiremployinginstitutionsRobertLittermanChairman,Climate-relatedMarketRiskSub-CommitteeCommodityFuturesTradingCommissionwww.cftc.gov23Disclosurerisk.netThemostwidelyusedstandard-setterforclimatedisclosureshasomittedtemperaturescores,whichrevealhowmuchglobalwarmingacompanyisontracktocause,fromalistofmetricsthatitisrecommending.TheTaskForceonClimate-relatedFinancialDisclosures(TCFD),whichwassetupbytheFinancialStabilityBoard,urgedcompaniestopublishclimatemetricsinsevenareasasitunveileditsannualreviewofcompliancewithitsrecommendations.1TheTCFD,whichischairedbyMichaelBloomberg,askedallorganisationstodisclosetheirgreenhousegasemissionsforthefirsttime,regardlessoftheirsize.Italsocalledforbusinessestorevealtheirindirectemissions,includingforassetmanagerstodisclosethecarbonemittedbytheirinvestmentportfolios.However,theTCFDstoppedshortofpushingfinancefirmstopublishtheimpliedtemperatureriseofthestocksandbondsintheirportfolios.“Impliedtemperaturerise,althoughimportant,justisnotreadytoday,”saidMaraChildressoftheTCFD’ssecretariat.“Wedidaconsultationonforward-lookingmetricsforthefinancialsector.Andwereceivedover200responsestothat.We’veheard,essentially,thattheseforward-lookingmetricsforthefinancialsectorareimportant.Butthey’restillnew.Sotherearestillsomedatachallenges.Thereisstillvariationinmethodologies.Andtherearestillthingsthatfinancialinstitutionsareworkingoninternally.”TheTCFDrecommendedthatfirmscalculatetheiremissionsintensity–thecarbontheyemitforevery$1millionofrevenueorevery$1millioninvested.Assetmanagersneedtoknowboththegreenhousegasemissionsofthefirmstheyinvestinandtheemissionsintensityofthosefirmsbeforetheycancalculateanimpliedtemperaturerisefortheirportfolios.Assetmanagerscanmarktheirprogressincuttingthecarbonemittedbytheirportfoliobymonitoringemissionsintensity.Ifemissionsintensitydeclines,theassetmanager’scontributiontoglobalwarmingisfallingevenifitsassetsundermanagement,andthereforeitsabsolutegreenhousegasemissions,significantlyincrease.Emissionsintensity,howeveritiscalculated,isbasedonacompany’scurrentbehaviour,nothowmuchitwillpolluteinfuture.Nomeasureofemissionsintensityisforwardlooking,saysToddBridges,globalheadofsustainableinvestingatArabesque,whichrunsanimpliedtemperaturerisemethodology.“Youcandoallyouwanttodecarbonise,buttheminuteyouwantprojections,youneedanimpliedtemperaturerisetool,”hesays.Assetmanagersthatcalculatethetemperatureratingofindividualsecuritiescaneithersellthemorpressuremanagementtochangetheirbusinesspractices.“Understandingwhichcompanieswithinhigh-emittingsectorsareemergingasclimateleaders,ratherthanclimatelaggards,isacriticalpartofthetransition,”saysHubertKeller,seniormanagingpartneratLombardOdier,whichalsosuppliesanimpliedtemperaturerisescore.“Implementingforward-lookingapproachessuchasimpliedtemperaturerisemetricsisfundamentaltoourabilitytosuccessfullynavigatetheclimatetransition.”TheTCFDcommissionedareportonforward-lookingclimatemetrics,includingimpliedtemperaturerisescores,whichwasalsopublishedonOctober14.2ThereportbythePortfolioAlignmentTeam–agroupsetupbyMarkCarney–recommendedthreewaystoimprovetoolsthatshowwhetheraportfolioisontracktodelivertheParisAgreement’stargetof“wellbelow2ºCelsius”ofglobalwarming.Thereportsaidthatmorecompaniesneedtodisclosetheiremissions,thereneedstobemoreresearchintoclimatescenarios,andthefirmsthatoperatemethodologiesneedtodisclosemoreinformationabouthowtheycalculatetheirratings.TheTCFDreviewofcompliancewithitsstandardsrevealedthatfewinstitutionalinvestorshavecalculatedtheircontributiontoglobalwarming.Just3.3%ofinstitutionalinvestorsdisclosedanimpliedtemperaturerisescore.Just3%ofassetownersand1.5%ofassetmanagershavealignedtheirgroup-wideportfolioswithagoaltoreducecarbonemissionstonetzero.TheseresultscamefromtheUN-affiliatedmembergroup,PrinciplesforResponsibleInvestment(PRI),becausetherangeofpublicreportingmethodsfortheinvestmentindustrymeantitwaslargelyexcludedfromthemainresultsoftheTCFDreport.AssetmanagersandownerspaytobelongtoPRI.Thiswasthefirstyearthatthe2,720assetmanagersandownerswhicharesignatoriestothePRI,includingpensionfundsandinsurancecompaniesfrom60differentcountries,publishedaportionoftheirresultspublicly.Three-quartersoftheseinvestorssaidtherewasastrategyfortherisksandopportunitiesthatclimatechangepresentedtheirfirmandmorethanhalfspokeabouthowglobalwarmingwouldimpacttheirorganisation.Whileafifthofinvestorsusedsomekindofclimate-relatedmetrics,8%ofassetmanagersand12%ofassetownerssharedinformationonhowmanygreenhousegasemissionstheywereresponsibleforasacompany(Scopes1and2)andtheirinvestmentsandsupplychain(Scope3).Evenfewersettargetsforreducingthese–7%ofassetmanagersand10%ofassetowners.ThenumberofPRIsignatoryinvestorsrepresentatenthoftheindustryintheUS,accordingtonumbersbydataproviderPreqinincludedintheTCFDreport.■PreviouslypublishedonRisk.netTCFDbackscarbondisclosure,butnottemperaturescoresTheinfluentialstandard-setter,theTaskForceonClimate-relatedFinancialDisclosures,declarestheimpliedtemperaturerise‘notready’forfunds.ByWillHadfieldandNellMackenzie“Implementingforward-lookingapproachessuchasimpliedtemperaturerisemetricsisfundamentaltoourabilitytosuccessfullynavigatetheclimatetransition”HubertKeller,LombardOdier1TCFD(October2021),FourthTCFDstatusreporthighlightsgreatestprogresstodateonTCFDadoption,www.bit.ly/2ZcmTce2PortfolioAlignmentTeam(September2021),Measuringportfolioalignment:technicalconsiderations,www.bit.ly/2Xu1b2u24ClimateriskweightsClimateriskSpecialreport2021Cuttingbankcapitalrequirementsforgreenassetsmaynotprovideenoughfinancialincentivetochangeconsumerbehaviour,aParis-basedthink-tankhasfound,inastudypublishedinSeptember.“Theimpactisquiteweak,especiallyforrenovationsandelectriccars,”saysJulieEvain,aresearchfellowattheInstituteforClimateEconomics(I4CE)andoneofthestudy’sauthors.Thestudyalsowarnsthatsettingriskweightstopenalisedirtyassetscouldhamperthetransitiontonet-zerocarbonemissions.Giventhatpricesforelectriccarsarecomingdown,Evainsaysthefinancialbenefitofagreensupportingfactor(GSF)forapurchaserwouldbeworthnomorethansimplywaitingtwomonthstobuythecar.ThisisthecaseevenassumingahighGSFthathalvescurrentriskweightsonbankloansforelectriccars.“Soweseeitisaverysmallpartoftheequation,anditisreallynotstrongenoughtopushpeopletobuyanelectriccar,”saysEvain.TheEuropeanUnionisconsideringprovidingpreferentialcapitaltreatmenttoassetsthatcomplywithEUenvironmentalandsocialpolicyobjectives,includingtheParisAgreementtargetsforcarbonemissionreductions.Aspartofitsstrategyforswitchingtoasustainableeconomy,unveiledinJuly2021,theEuropeanCommissionsaysitwillbringforwardthedeadlinebywhichtheEuropeanBankingAuthority(EBA)mustdeliveranassessmentofwhethertoprovidepreferentialcapitaltreatmentforactivitiesthathaveenvironmentalandsocialobjectives.ThisreportmustnowbedeliveredinJune2023,twoyearsearlierthanpreviouslyplanned.TheI4CE’sstudypourscoldwaterontherationaleforadjustingriskweightstoencouragetheeconomytotransitiontonetzero.MuchsmallerthansubsidiesThethink-tankbuiltamodelthatsimulatesthechangeinloanratesofferedtocustomersdependingonthesettingofaGSF.Themodeldeterminestheratelevelbanksmustsettogenerateareturnontheregulatorycapitalrequiredafterthedeductionofothercosts,suchastaxes,costsofborrowingandsalaries.TheseassumptionsarederivedfromthesixlargestFrenchbankinggroups’annualreports.Themodelensuresbanks’returnoncapitalfromloansissetat6.3%–avaluetheFrenchPrudentialSupervisionandResolutionAuthority(ACPR)statesinareportreleasedin2020asthereturnoncapitalfortheFrenchbankingsector.Resultsfromthemodelhavealsobeencross-referencedwithseveralstudiesthatlookintotheelasticitybetweencapitalrequirementsandloanprices,whichcorroboratethemodel’sfindings.TheI4CEstudyexploredGSFsthatgrant15%,25%and50%discountsinriskweights,andassumedbankspassedthewholediscountontocustomers–meaningthemaximumpossibledeductioninloanrateswasassumed.Currentsupportingfactorsforloanstosmallandmedium-sizedenterprisesandtoinfrastructureprojectscontainedinexistingEUcapitalrulesaresetat25%.Themodelfoundannualloanratessawreductionsof10%foraGSFsetat50%and5%foronesetat25%.Forshorter-datedloansofonetotwoyears,thatwouldmeanthecostofthetotalpurchasedecreasesbyjust0.2%to0.5%.Forexample,acarloantotalling€30,000wouldonlyreceivea€200discount.“Almostnothing,”saysEvain,especiallywhencomparedwithstatesubsidies,whichinFrancecanrangebetween€5,000and€7,000forelectricvehicles.StudyfuelsdoubtoverbenefitsofclimateriskweightsResearchbyaParis-basedthink-tankfindsthatbothagreensupportingfactorandacarbonpenalisingfactorhavedrawbacks.BySamuelWilkesFOCUSONEXISTINGSUPPORTINGFACTORSForlonger-datedloans–ofatleast10years–thereductionintotalfundingcostsfromaGSFishigherthanforshort-termloanssuchascarfinancing.Thisisbecausethelowerinterestpaidatthebeginningoftheloanallowsfasterrepaymentofprincipal,pushingdownsubsequentinterestcosts.Accordingtothestudy,thiscanreducethetotalborrowingcostsofprojectswithlonger-datedloansby1%to3%.AhighGSFcouldthereforehavea“considerableimpact”onthecostofrenewableenergyprojects,Evainsays.However,thestudywarnsagainstgrantingthefactorforrenewablesprojects,becausetheydonotcurrentlystrugglewithaccesstofinancingunlesstheyhavenotreceivedplanningpermission–inwhichcasetheywouldpresentaregulatoryrisktothebank.Infact,thereisalreadyanoversupplyofcredittotherenewablessector.Instead,theI4CEadvocatesadjustingtheEU’sexisting25%infrastructuresupportingfactorsothatitisonlyavailableforexposurestorenewableenergyprojects,ratherthantoall.25Climateriskweightsrisk.netMoreambitionThestudyalsolookedatwhetherthepresenceofaGSFwouldencouragebankstoaltertheirlendingstrategiestofunnelmorecredittogreenprojects,evenifitdoesnothaveasubstantialimpactoncustomerborrowingcosts.However,Evainisunconvinceditwouldpushbankstoadoptmoreambitiousinvestmentstrategiesforfinancingthetransition,becausethecapitalfreedupcanonlybeallocatedtotheshareofavailablegreenprojects,whichestimatesputat1%to5%oftotalloans.ThestudyonlyappliedtheGSFtonewloansbankswouldmake.UndertheassumptionbanksincreasetheirstockofgreeninvestmentsaccordingtoFrance’sroadmaptofightclimatechange–aimingata20%increaseyearonyear–itwouldtakeuntil2028forthestockofgreenloanstobecomemateriallydifferentunderaGSFthanitwouldundercurrentlendingstrategies.“Wethoughtitwouldhaveaninterestingeffect,becauseitwouldpushbankstohaveamoreambitiousgreenstrategy,”saysEvain.“Butwefoundthatbecausethegreenpocketofloansisnotsuperwideatthemomentandyoucan’trenewallyourloansatthesamepoint,youreallyhavetowaitfivetoeightyearstoseeastrongdifferencebetweenbanksthatarebusiness-as-usualandbanksthatreallyadoptambitiousstrategies.”ThecapitaldiscountfromaGSFmaynotbeusedtopursueanaggressiveincreaseingreenloans,warnsthestudy,butcouldbedistributedtoshareholders–between€1billionand€2billionfrom2022to2028.LawofunintendedconsequencesThisstudyconfirmstheviewofthosewhohavecriticisedtheideaofaGSF,includingPierreMonnin,aseniorfellowoftheCouncilonEconomicPolicies.HefearstheGSFwouldserveonlytodecreasetheoverallcapitalisationofthebankingsystematatimewhenclimatechangeposesapotentiallyseverebutnotyetcapitalisedrisk.Instead,he’dliketoseeapenalisingfactor(PF)thatincreasesbankcapitalrequirementsforcarbon-intensiveassets.“Ithinkfromafinancialsupervisor’sperspective,itmakesmoresensetohaveapenalisingfactorbecausethatincreasestheresilienceofthebankingsystem,”saysMonnin.ButtheI4CEstudysoundsanoteofcautiononthePFaswell.TheresearchusedthreehypothesestostudytheeffectsofaPFsetatthreedifferentlevels–10%,25%and250%increasesincapital–andlookedatdifferentrangesofassetscaughtwithinitsgrasp.APFsetsoitresultsinsmallincreasesincapitalfacesthesameproblemastheGSF:itwillhavelittleimpactontherateschargedonloanstocarbonemitters.“Tohavearealimpactonthetransition,youhavetogoforastrongpenalisingfactor,otherwisetheimpactaPFhasonratesisnotstrongenoughtoreallycreateadistortion,”saysEvain.OneregulatoryexpertataEuropeanbanksaysiflegislatorsdowanttousecapitalrequirementstoencourageatransition,thena1,250%riskweightondirtyassetswouldbethemosteffectiveatshiftingthoseassetsoffbanks’balancesheets.EvainoftheI4CE,however,saysaheavyPFshouldonlycaptureasmallproportionofdirtyassets.Thereasonisthatiftheperimeterissettoowide,thenthedepletionincapitalratiosresultingfromexistingloanbookswouldsignificantlyreducebanks’abilitytoextendcreditforeconomictransitionornewgreenborrowers.“Youwouldhavetobeverycautiouswiththepenalisingfactor,”saysEvain.“Itcanhaveacontractioneffect–notonlyonthecredityouaretargetingbutalsoontherestoftheeconomy,becauseiftheperimeteriswide,thenthebankhastoholdmuchmoreinreserveanditcanonlygiveoutmuchlesscredit.”APFthatcapturesalargernumberofloanswouldalsoincreasetheamountoftimebankswillneedtoexitthepenalisedpositions,causingalongerdelayuntiltheycanstartincreasinglendingtothegreeneconomy.Evainsaystheirstudysuggestsregulatorswillneedtoviewtheproblemnotjustasamatterofcapitalisingclimaterisk.“Sometimes,byintegratingtherisk[intocapitalrequirements],youcancreatemoreriskbecauseyouhaveanegativeimpactonthetransition.Wethinkitwouldbemoreinterestingtolookatsupervisorymechanismstolinktransitionplanswithstresstests,”saysEvain.Thatwouldpotentiallyinvolvemovingtoadynamicbalancesheetapproachtostress-testing,astheACPRdidinitsinauguralclimatestresstestthisyear.Ambitioustransitionplansatindividualbankswouldthereforeimprovestress-testresults.Atpresent,theEBAusesastaticbalancesheetapproachthatsimplystressesabank’sexistingexposures,soitwouldbehardtodemonstratethebenefitsofabank’stransitionplan.■PreviouslypublishedonRisk.net“Sometimes,byintegratingtherisk[intocapitalrequirements],youcancreatemoreriskbecauseyouhaveanegativeimpactonthetransition”JulieEvain,I4CE26ESGinvestingClimateriskSpecialreport2021ThepricesofESGstocksarebeingdrivenuplargelybecausemanyoftheinvestorsthatholdthemsimplyrefusetosell,newresearchfinds.Stocksthatmeetenvironmental,socialandgovernance(ESG)criteriahavebeatenthewidermarketbyaround1.5%perannumoverthepastfiveyears.Butintheabsenceofsurgingdemand,thesestockswouldhaveunderperformedthemarketby2.1%ayear,accordingtoPhilippevanderBeck,aresearcheratÉcolePolytechniqueFédéraledeLausanneandtheSwissFinanceInstitute,whocarriedoutthestudy.1WhileESGinvestmentsstillrepresentonlyasmallportionofoverallfundassets,theyhavegrownexponentiallyinpopularity.Thefirstquarterof2021sawover$180billionininflowstosustainablefundsglobally,accordingtodatafromMorningstar.Butevenwithvaluationsrisingrapidlyinresponsetoincreasingdemand,existingholdersofESGstocksareunwillingtoselltheirpositions.Thisunresponsivenesstopricechanges–knownasinelasticityinacademicparlance–means“flowsareartificiallypushinguprealisedreturns”,saysVanderBeck.HeestimatesthateverydollarinvestedinESGstocksoverthepastfiveyearspusheduppricesby$2–2.50onaverage.VanderBeck’sfindingsalsosuggestthatsomespecialistESGfunds–becauseoftheinelasticityofthestockstheyinvestin–haveagreaterimpactonthecostofcapitalforgreenfirmsthanothersuchfunds.UsingdatafromquarterlyUSmutualfundfilings,VanderBeckexaminedhowinvestorsadjustedtheirportfoliosinresponsetobuyingpressureinESGstocks.Heestimateda“priceelasticitymatrix”foreveryinvestortogaugehowquicklytheywouldselldifferentstockswhenpricesrose.Hethencalculateda‘multiplier’forindividualstocks–ameasureofhowfardemandcanmovetheprice–basedontheownership-weightedsumofelasticities.BysimulatingdifferentlevelsofflowsintoESGfundsandthenapplyingthemultiplier,VanderBeckwasabletoestimatethereturnsattributabletothegrowthininvestordemand.“Thesearereturnsnotbecauseofanyfundamentals,butduejusttoflow-drivenpricepressure,”heexplains.Afterdeductingtheflow-drivenreturns,hefoundtheperformanceofESGstockstobe“stronglynegative”.Thelatestresearchbuildsonrecenthigh-profileworkbyXavierGabaixatHarvardandRalphKoijenatChicagoBoothonhowflowsaffectprices.Economistsandquantshavelongarguedoverwhetherflowsinfluenceprices,orviceversa.Conventionaltheorysaysflowshavelittlepriceimpactbecauseinvestorswillquicklyselloutofstocksinresponsetogrowingdemand.Byexaminingfundholdingsdata,GabaixandKoijenshowedthatmanyinvestorsareinfactpriceinsensitive.Thisinelasticityinsupplymeansdemandspikescancauseoutsizedandpermanentchangestostockprices.“Classicalfinancialmarkettheorytellsyouinvestorsareveryelastic,”VanderBecksays.“Themultipliermatrixwouldhaveallzeros.Buteverybodyintheindustryknowsthatlargeflowscreatepricepressure.Andthat’swhatwe’reestimating.”TheresearchsuggestsESGstockswilloutperformaslongasflowsintothesectorremainelevated.“Therealisedreturnongreenfirmswillbeevenstrongerinfutureifflowscontinuetorise,andthatmaybeforyearstocome,”VanderBecksays.SpilloversVanderBeckalsotrackedthespillovereffectsthatoccurwhenESGsellersreallocatecapitaltootherinvestments.“IfyoubuyApple,notonlywillyouhaveanimpactonthepriceofApplebutyouwillalsohaveanimpactonthepriceofAmazonandMicrosoftandGoogleandallotherstocks,”hesays.“PeoplewillrebalancetheirportfoliosinordertosellAppletoyou.”Thesespillovereffectscanbesurprisingandcanevenextendtounrelatedstocks.Forexample,ifBlackRockhadsolditsentire6.8%stakeinExxonMobilduringthethirdquarterof2020,theresultingflowswouldhavecauseditsstockpricetofallby62%,VanderBecksays.Atthesametime,sharesofrenewablenaturalgascompanyCleanEnergyFuelsandretailerWalmartwouldriseby9%and2%respectively,themodelsays.VanderBeck’sresearchsuggeststhatsomespecialistfundscandriveupthepriceofESGstockssharply,loweringthecostofcapitalforthecompaniestheyinvestin.ButESGfundsthathugthemarketbenchmarktoocloselyandinvestinhighlyelasticstockscanhavelittleeffectonprices.“Anextremelygreeninvestormightinvestonlyinthegreenestfirmsbutifthosegreenfirmsareheldbyelasticinvestorsthey’lljustselltoyouandthepriceremainsunchanged,”VanderBecksays.Heclaimstheresearchcanhelpinvestorscutthrough“floweryfundprospectuses”andidentifyESGfundsthathavea“true”impactonthecostofcapitalforgreenfirms.EverydollarinvestedintheiSharesMSCIUSASRIfundpushesupthepriceofESGstocksby$5andlowersthevaluationofminingstocksbyfivecents,VanderBeckestimates.Bycontrast,adollarinvestedintheDFAUSSustainabilityCoreEquityPortfoliowouldcausethevalueofESGstockstoincreasebyjust28cents.Successfulimpactinvesting,VanderBeckargues,reliesoninvestingingreenfirmsheldbyinelastic,oftenpassive,investors.“Thenyoureallydriveupthepriceofthosestocksandyoucanhavealargepermanentimpactonvaluation,resultinginalowercostofcapital[forthecompany].”ValentinHaddad,associateprofessoroffinanceattheUniversityofCalifornia,LosAngeles,saystheresearchcouldhelpexplainhowflowscaninflateESGstockprices,despitewhatconventionaltheorysays.Haddad’sownresearchshowsthatevenifsomehedgefundsbetagainstheavilyboughtESGstocks,theyareunlikelytoreversetheeffect.■PreviouslypublishedonRisk.netStock-level‘inelasticity’explainsESGboomEnvironmental,socialandgovernanceinvestors’reluctancetosellholdingsispushingpricesevenhigher.ByRobMannix1PVanderBeck(September2021),Flow-drivenESGreturns,www.bit.ly/3AYPf6D“Therealisedreturnongreenfirmswillbeevenstrongerinfutureifflowscontinuetorise,andthatmaybeforyearstocome”PhilippevanderBeck,ÉcolePolytechniqueFédéraledeLausanne27Capitalrulesrisk.netRegulatorsarestillundecidedonwhethertherisksassociatedwithclimatechangecanbehandledwithintheexistingbankprudentialframework,orwillneedseparateriskweightsandcapitaladd-ons,anofficialattheFinancialStabilityBoard(FSB)hassaid.JosephNoss,headofvulnerabilitiesassessmentattheFSB,toldaneventorganisedbytheInstituteforInternationalFinance(IIF)onSeptember16thatclimaterisksarebroadandnon-linear,andthatpastdatawasa“poorguide”tothefuturecrystallisationoftheserisks.“Doesthatmeanweneednewpolicies,orarethesejustexistingriskfactors–marketrisk,creditrisk,liabilityrisk,allsortsofriskthatcolleaguesonthispanelareusedtodealingwith–onsteroids?”saidNoss.“Ifthelatter,thenhowbigarethosesteroids,andwhatdoesthatmeanforthecalibrationofcapitalbuffers?”TheBaselCommitteeonBankingSupervisioniscontinuingtoexplorewhetherclimateriskdriverscanneatlymapontothestandardriskcategories,orwhetherthatwouldstillleavegapssuchthat“climate-relatedfinancialrisksmaynotbesufficientlyaddressed”.TheEuropeanBankingAuthority(EBA)isthemostadvancedamongglobalregulatorsintermsofexamininghowtointegrateclimateriskintotheprudentialrulebook.TheEuropeanCommissionoriginallyaskedittoproducerecommendationsbyJune2025onwhethertoaltertherisk-weightedasset(RWA)frameworktoincludeclimaterisk,andhasnowmovedthisdeadlineforwardbytwoyears.Asaresult,EBAexecutivedirectorFrançois-LouisMichaudtoldtheIIFpanel,theregulatorwillpublishaninitialdiscussionpaperonthesubjectinlate2021orearly2022.Speakingonthesamepanel,JudsonBerkey,headofsustainabilityregulatorystrategyatUBSandchairoftheIIF’ssustainablefinanceworkinggroup,urgedglobalregulatorstoco-ordinatetheirworkcarefully.Inparticular,hesuggestedsupervisorycollegescouldcementknowledgesharingandalignment,andhelpsupervisorsbettermanagebankswithsignificantcross-borderbusiness.“Collegescanbeaveryeffectivetooltosharetheresultsacrosssupervisorswhomayhaveabroaderinterestinagivenfirm,”Berkeysaid.TheIIFhasproposedthattheBaselCommitteecanplayakeyroleinco-ordinatingthesecolleges,whichcouldhelpfocusresourcesandresearch.1TheEBA’sMichaudassuredtheaudience:“WeworkhandinhandatthegloballevelwithmycolleaguesinthecontextoftheBaselCommitteetotrytocomeupwithsomethingmeaningful.”ClimatestresstestsInadditiontochangingtheRWAframework,regulatorscoulddevisecapitaladd-onsbasedonclimateriskstresstesting.AccordingtotheIIF,18supervisorsworldwidehavebeendeployingstressscenariosaroundclimaterisk.TheFrenchregulatorcarriedoutaclimatestresstestearlierthisyear,andtheEuropeanCentralBankplanssomethingsimilarduring2022fortheeurozonebanksitsupervises.MichaudsaidthiswouldfeedintoongoingdiscussionsaboutwhethertointroduceaclimatestresstestprogrammeacrosstheEuropeanUnion.TheEBAisduetorunitsnextEU-widestresstestin2023.“Theextenttowhichtherewillbeaclimatedimensionisnotcompletelydecidedyet.Wewillbeworkingonthat,andthatwillalsodependonthelessonslearnedbytheECBnextyear,andalsoonthelessonslearnedbyothersupervisorsinwhatthey’vedonerecently,”saidMichaud.TheFSB’sNossacknowledgedthattherearesignificantdifficultiesdecidinghowtoconvertclimatestress-testresultsintomacroprudentialcapitalbufferstoprotectagainstthesystemicriskposedbyclimatechange.“It’simpossibletoanswerthesequestionsofcalibrationpreciselygiventhelackofdata,but…thatshouldn’tstopushavingacrackattryingtoanswerthem,becausetheseissuesareurgentandclearlyveryimportant,”saidNoss.Atpresent,theEBAandECBdovetailtheirconventionalstressteststhattakeplaceinalternateyears,sobanksintheeurozonewillrunatesteachyeareitherfortheEBAorfortheECB.However,Berkeywarnedagainsttryingtorunclimatestresstestseveryyear,giventhatdatacollectionandscenariodesignarestillatanearlystage.“Ittakesawhiletogetmodelsapprovedthroughourinternalprocesses,[and]aswe’veseenwithcorefinancialstresstests,Ithinkeveryonewouldbenefitfrombeingabletoreallytakeonboardthelearnings,dothatnextroundofinvestmentintermsofcapabilities,thenpotentiallycomebacktothem…later,”saidBerkey.■PreviouslypublishedonRisk.netFSBdebateshowtofitclimateriskintocapitalrulesRegulatorsponderwhetherclimateriskneedsnewrisk-weightedassetsorrecalibrationofexistingones.BySharonThiruchelvam1IIF(September2021),Navigatingclimateheadwinds:referenceapproachesforscenario-basedclimateriskmeasurementbybanksandsupervisors,www.bit.ly/3pmnGCc“It’simpossibletoanswerthesequestionsofcalibrationpreciselygiventhelackofdata”JosephNoss,FSB27risk.net27risk.net28CarboncutsClimateriskSpecialreport202128ClimateriskSpecialreport2021ClimateriskSpecialreport2021ClimateriskWhenanassetmanagerstartscuttingportfolioemissionscanmakeahugedifferencetohowmuchdisruptionitfacesonthepathtomeetingitsnet-zerocommitments,accordingtoanalysisconductedonbehalfofRisk.netbyMSCI,theindexcompiler.Fundgroupsthatputoffemissioncutsuntil2025willneedtoreducethecarbonfootprintsoftheirportfoliosby14%everyyeartoreachnetzeroby2050.Assetmanagersthatbegancuttingemissionslastyear,however,needonlyreducetheiremissionsby7%ayeartoachievethesameoutcome.AmajorreportpublishedinAugustbytheIntergovernmentalPanelonClimateChange,agroupofscientistsconvenedbytheUN,concludedthat“limitinghuman-inducedglobalwarmingtoaspecificlevelrequireslimitingcumulativecarbondioxideemissions,reachingatleastnetzero”.1ResearchbyAndreasHoepner,afinancialdatascientistatUniversityCollegeDublin,suggeststhatcutsof7%peryearareneededtoachievenet-zeroemissionsby2050andlimitglobalwarmingto1.5degreesCelsiusabovepre-industrialtemperatures.TheEuropeanUnionusedHoepner’sworkwhenitdraftedclimateregulationsthatonlyallowindexcompilerstocalltheirproducts“climatetransitionbenchmarks”or“Paris-alignedbenchmarks”ifthecarbonemissionsoftheirconstituentsdropbyatleast7%ayear.ThomasHaehl,aconsultantatMSCI,calculatedhowmuchcarbonwouldbereleasedintotheatmosphereby2050ifcompaniesreducedemissionsby7%peryear,startingin2020.Hethencalculatedthelevelofcutsnecessarytoachievethesameresultiftheywaiteduntil2025.Delayingbyfiveyearsdoublesthesizeoftheannualcuts.RegulatorsintheEUandUKwillrequireassetmanagerstodisclosetheirScope3emissions–thecarbonemittedbythecompaniestheyinvestin–from2024,meaningthatthefirstyear-on-yearcomparisonsneednotbepublisheduntil2025.TheUSandbigAsiancountrieshaveyettomandateanyclimatedisclosuresforcompanies.Atotalof128fundgroupsthatcollectivelymanage$43trillion–almosthalftheworld’stotalassetsundermanagement–havecommittedtoachievingnet-zeroemissionsby2050.Butonlyahandfulhavealreadystartedcuttingemissions.Legal&Generalreducedtheemissionsfromevery£1millionitinvestsby2.5%lastyear,whileAxaloweredtheemissionsfromevery€1millioninitsportfoliosby4.3%.Bothcompaniesareaheadoftheirpeers,butbehindwherethesciencesaystheyneedtobe.“Wehavecommittedtodecarbonisationof18.5%by2025,”saysAdrianChapman,headofgroupclimateassetliabilitymanagementatLegal&General.“Becauseofthenatureofthatportfolio,wearenotabletocommittoalinearreduction.It’screditandbondheavy.Alotofourportfolioisinlong-datedbond-typeinvestments.”ClimatelaggardsneedtodoubletheircarboncutsAssetmanagersthatwaituntil2025willhavetocutemissionsby14%ayeartolimitglobalwarming.ByWillHadfieldClimateriskSpecialreport20212829Carboncutsrisk.net29risk.netTheUKinsurerwantsthecompaniesitinvestsintochangetheirways.Ithasspentthepastfewyearstryingtoconvincethemtoemitlesscarbon.Ifthateffortprovestobesuccessful,ChapmansaystheemissionsfromL&G’sportfolioswilldropatafasterpace,enablingthefirmtomeetitstargets.“Wewanttouseengagementfirstasourkeyportfolio-managementtoolandseekdivestmentasoneofthelastthingswedo,”Chapmansays.“Wearelookingforthecompaniesweinvestintodecarbonisethemselveswithouttakingawayourfinancingtosupportthetransition.Overtime,weexpectthatdecreasetoincrease.”Legal&Generalhascommittedtohalveitsemissionsby2030,whileAxasaysitwillloweritscarbonby45%.Bothinsurancecompaniesdeclinedtosaybyhowmuchtheywillcuttheiremissionsduringeachyearofthisdecade.Therivalinsurersarelookingforinvestmentsthatwillprofitfromthetransitiontoalow-carboneconomy.Theyalsowanttorootoutpotentiallosers.“It’sreducingtherisksthatweholdunderperformingcompaniesinthetransition,”Chapmansays.“Itincreasesthechancethatweholdoutperformingcompanies.Ofcourse,wearelookingtofindoutperformance.”Otherbigassetmanagershavemadenet-zeropledges,buthaveyettomaketheirfirstcuts.BlackRockandVanguard,thetwolargestassetmanagers,havesignedtheNetZeroAssetManagersInitiative,whichrequiresthemtohalvetheiremissionsby2030andreachnetzeroby2050.2BlackRock’schiefexecutiveLarryFinksaidinJanuarythatthefirmwillpublishScope3emissionsforitsclients’portfoliosbytheendofthisyear.ABlackRockspokesmandeclinedtocommentonMSCI’sresearchforRisk.net.VanguardsaysitwillpublishitsfirstannualreportbasedontheTaskForceforClimate-relatedFinancialDisclosures,abodybackedbytheFinancialStabilityBoard,in2022.ATCFDreportisanobviousplacetopublishanassetmanager’stargetsforcuttingemissions.“Wewillbesharingourtargetinduecourse,”aVanguardspokeswomansays.■PreviouslypublishedonRisk.net1IPCC(August2021),Climatechange2021:thephysicalsciencebasis,www.bit.ly/3C5R6aY2NetZeroAssetManagersinitiative(2021),www.bit.ly/3jnjIVS10090807060504030201002050202020252030203520402045AxaLegal&GeneralDelayedcutsImmediatecuts1Absoluteannualdecarbonisation,normalisedto100Emissionscutsneededtolimitglobalwarmingto1.5ºCelsiusabovepre-industrialaveragesSource:MSCI,companies29risk.net30RegulationClimateriskSpecialreport2021Europe’snewrulesonsustainablefinanceweremeanttohelpinvestorshuntouttrulyethicalfunds.Instead,theyhavegiftedsheep’sclothingtothewolves:assetmanagerssaymanyundeservingfundsnowdeclarethemselvesgreen.Admittedly,thegranularreportingrequirementsthatcomewithanethicallabelarenotyetinforce.Butevenwhentheydokickin,thereisscepticismthefully-fledgedSustainableFinanceDisclosureRegulation(SFDR)willcombatgreenwashing.Anotherfixmaybenecessary–suchasatooltoidentifyenvironmentallyharmfulinvestments.Thegloomovertheregulationispalpable.“TheSFDRiscreatingthegreenwashingitwastryingtoavoid,”saysaregulatoryexpertatalargeassetmanager.Anothersource–EoinFahy,headofresponsibleinvestingatKBIGlobalInvestors–makesanequallydownbeatprediction:“ThedisclosurerequirementsaresodetailedandcoversomanyfactorsthatIsuspectnotmanyinvestorswillactuallypayagreatdealofattentiontothem,unfortunately.”ThecurrentmislabellingoffundsisattributedtothevaguewordingoftheSFDR’sArticle8.AfundcanbeclassedasanArticle8financialproductifitpromotes“environmentalorsocialcharacteristics”,providedthefundjustifiesthisclaimandthecompaniesitinvestsinfollowgoodgovernancepractices.JuliaLinares,aseniorsustainablefinancepolicyofficeratconservationcharityWWF,considerstheArticle8definition“extremelywide”,saying:“TheslightestthingthatismoresustainablethanaverageactuallyqualifiesandcanbecalledArticle8.”Article8fundshavebecomeknownas‘light-green’,reflectingtheindustry’spresentfocusonenvironmentalratherthansocialcredentialsandcontrastingwithArticle9funds,dubbed‘dark-green’.Astricterandlesscontroversialdefinitionofsustainabilityappliestothesefunds:theymusthavesustainableinvestmentastheirobjective.FundsthatdonotfallundereitherarticleareknownasArticle6products.Article6requiresallfundstodisclosehowtheytakeaccountofsustainabilityrisksandhowthesearelikelytoimpacttheirreturns.Intheory,moredetailedinformationaboutself-proclaimedArticle8fundsshouldhelpretailinvestorsdecideforthemselveswhetherthefundsaregreeninpractice.Buttherearedoubtssuchdisclosureswillactuallyweedoutproductswithdubiousenvironmentalcredentials–forreasonsthathavetodobothwithinvestorbehaviourandthespecificdisclosurerequirements.AssetmanagerssaythereareseveralpossiblewaystostopthegreenwashinginadvertentlymadeeasierbytheSFDR.Potentiallythesimplestoneistocreateataxonomyforcompaniesthatdamagetheenvironment.Iffundsdisclosedwhatshareoftheirinvestmentsisinsuchcompanies,investorsshouldfinditeasiertoseparatethewheatfromthechaff.GoodmarketingWithoutregulatorychanges,identifyinggreenfundsthatdeservethelabelwillbecomeevenharderastheuniverseofArticle8fundsislikelytoexpand.Andnotbecausemoretrulysustainablefundswillspringup,butbecausemoreplainvanillafundswillstartdescribingthemselvesaslight-greentofallinlinewiththedominantinterpretationofArticle8.TheregulatoryexpertatthelargeassetmanagerexplainswhyhisfirmcurrentlyhasfewerArticle8fundscomparedwithcompetitors:“Wethoughtwewerebeinghonestbutinhindsightwewonderifwewerefoolish.Ifthewholemarketshiftslikethis[toArticle8],thenwemaygetforcedtodosotoo.Butwedon’tthinkthatreallyhelpsanyone.”AnotherassetmanagersaysitisconsideringreclassifyingmoreofitsArticle6fundsasArticle8,forthesamereason.Butthereisamorequestionablemotiveforshoe-horningfundsintoArticle8:thelabelprovidesgoodmarketing.Forexample,somefunddistributorsandassetmanagersallowuserstofilterthroughproductsbasedonwhichSFDRarticletheyfallunder.AndsomedistributorshavetoldassetmanagersthatonlytheirArticle8and9productswillbemadeavailabletoclients.So,manyassetmanagershaveaclearmotiveforgreenwashing.Unwittingly,withthemurkyArticle8,lawmakershavealsogiventhemthemeanstodeclarefundsgreen,whetherornotthatisstrictlytrue.“Thepolicy-makershavedonethistotryandmakeiteasierforretailinvestorstoinvestsustainably,”saysFahyofKBIGlobalInvestors.“Infact–onthecurrentwordingandthewayit’sbeingimplemented–itappearstomethatthereisariskthatitmayhavemadethesituationworse.”LinaresofWWFismoreemphatic:“SFDRwassupposedtobekindofananti-greenwashingtoolbutnow,unfortunately,Article8isbecomingagreenwashinglabel.”Risk.nethasidentifiedagroupoffundslabelledArticle8thatareheavilyinvestedinoilandgasproducers,withoneholdingasmuchas91%ofitsportfolioinsuchcompanies.WhynewEUrulesarefuellinggreenwashingandhowtostopitReportingrequirementsforenvironmental,socialandgovernancefundsmaynotsolvetheproblemofgreenwashing,butalistofharmfulinvestmentsmight.BySamuelWilkes•AssetmanagerssaytheSustainableFinanceDisclosureRegulationhasbeenwidelyusedtostickagreenlabelonfundswithquestionableenvironmentalcredentials.•Themassofself-proclaimedsustainableproductsislikelytogrowasmorefundsadoptthedominantinterpretationofthevagueArticle8.Sospottingtrulyresponsiblefundswillbecomeevenharder.•SomehopedisclosurerequirementsforESGproductswillexposeundeservingfundsoncetheycomeintoeffect.Othersaresceptical,pointingtoquirksininvestorbehaviourandthedesignoftherules.•Managerssuggesttweakingtherulestomakefirmsreportnegativesustainabilityimpactsforeachfund.•Twootherpotentialsolutionsareintheworks:minimumsustainabilitycriteriaforArticle8funds,dubbed‘light-green’,andan‘eco-label’forthemostenvironmentallyfriendlyretailproducts.•Thesimplestwaytostopgreenwashingmaybetosetoutcriteriaforidentifyingcompaniesthatcauseparticularharmtotheenvironment–aso-called‘redtaxonomy’.Needtoknow31Regulationrisk.netManagersofsomeofthefundshavedefendedtheirlight-greenstatusbysayingtheinvesteecompaniesdonotengageinthemostenvironmentallydamagingextractionpractices,suchasfracking.ThatisthecasewithtwofundsrunbyBNPParibasAssetManagement,forexample.NNInvestmentPartnershasalsobeenabletojustifytheArticle8classificationforoneofitsfundsthatinvestsinoilandgasproducersbecauseitisunderweightfossilfuelsversusitsbenchmark.Thefundalsoexcludescompaniesinvolvedinoilsandsandthermalcoal–particularlyharmfulactivities–asdoallArticle8fundsmanagedbythefirm,accordingtoitswebsite.“Crazy”flexibilityAccordingtothreesources,theArticle8definitionhasbeenmadeevenmoreflexiblebyaQ&AontheSFDRpublishedbytheEuropeanCommission(EC)inJulyasitlistsawiderangeofactivitiesthatcanmean“promotion”ofenvironmental,socialandgovernance(ESG)principles.1TheQ&Astates:“Theterm‘promotion’withinthemeaningofArticle8…encompasses,bywayofexample,directorindirectclaims,information,reporting,disclosuresaswellasanimpressionthatinvestmentspursuedbythegivenfinancialproductalsoconsiderenvironmentalorsocialcharacteristicsintermsofinvestmentpolicies,goals,targetsorobjectivesorageneralambition.”BrunnoMaradei,globalheadofresponsibleinvestmentatAegonAssetManagement,comments:“Thecommissionhasmadethesituationevenworsebysayingpromotioncanmeananything,includingjustissuingareport.Tomethatiscrazy.“YoucouldhaveafundthatinvestsintobaccoandoilstocksandyouproduceanESGreportforthisfund–whichsaysthefundisterribleonESG–andbydoingthatyouhavepromotedanESGcharacteristic,sothereforeyoumightclassifyitasArticle8.”KristianHåkansson,headofproductandmarketingatSPP,aSwedishsubsidiaryofNorwegianfundmanagerStorebrand,believesmostfundswillbecategorisedasArticle8inthefuture.“Sowearebasicallybacktowherewebegan,”hesays.“YoustillhavethousandsofUcits[retail]fundstochoosefromandtheywillallbeArticle8andyouwillbenonethewiser.”TheproliferationoffundslabelledasArticle8sincetheSFDRcameintoforceinMarchgoesagainsttheEC’sexpectationsfortheregulation,accordingtoFahyofKBIGlobalInvestors.“They’rethinkingaboutitasbeingasetofregulationsthatforceextradisclosures.Theirthinkingcertainlywas–andmaybestillis–thatfundswon’twanttoofferArticle8fundsbecauseiftheydo,they’llhaveallthoseextrasetsofdisclosures,”hesays.Indeed,therewereprotestationsfromfundmanagerswhendetaileddisclosurerequirementswereputoutforconsultationlastyear.Theseregulatorytechnicalstandards(RTS)werethenpublishedonFebruary2thisyear,reflectingresponsestotheconsultation.2Thelatestrequirements,stilltobeadoptedbytheEC,havebeenrelaxedcomparedwiththe2020version.31Regulationrisk.net32RegulationClimateriskSpecialreport2021Disclosurestotherescue?Regulatorswillstillbehopingthatthedisclosurerulesarecomprehensiveenoughtohelpinvestorsfilteroutpseudo-Article8funds.“TheproposalofSFDRregulatorytechnicalstandardsrequiresArticle8andArticle9SFDRfinancialproductstodiscloseonanannualbasisitslargestinvesteecompaniesandsectors,aswellastheproportiontheyrepresentoutofthetotalinvestment,”saysaspokespersonforLuxembourgregulatorCSSF.“OncetheRTSwillbeadoptedandmandatory,suchtypeofdisclosureswillspeakforthemselvesinthecontextofthefundexamplespresented,”thespokespersonadds,referringtoArticle8fundsthatinvestheavilyinfossilfuelproducers.TheECplanstoimplementthedisclosurerulesonJuly1,2022,accordingtoaletteritwrotetotheEuropeanParliamentlastJuly.3NoteveryoneisascertainastheCSSFthattheywillhavetheintendedeffect.Themainproblemisinvestorsmaynotlookatthereporteddata–somethingassetmanagerssayiscommonwithfinancialandlegalinformationtheyalreadypublish.“Alotofretailinvestorsarenotveryuptodateonthisatall,butiftheyareusinganything,theywillbeusingfiltersprovidedbydistributorsandexecution-onlyplatformsthatfilterthroughSFDRArticle8fundsandArticle9funds,”saysHåkanssonofSPP.“Idon’tthinktheywilleverlookintotheannualreportsandthepre-contractualinformationinawaythatismeaningfulforthem.”Butlooktheyshould,evenforthesimplereasonthat,eco-consciousinvestorscan’totherwisebesurethattheArticle8fundtheyhavetheireyeoncarriesthelabelonenvironmentalratherthansocialgrounds.Particularlydiligentinvestorswillalsowanttoknowwhetherthefundisalignedwiththeirspecificconcerns–say,promotingbiodiversityasopposedtoreducingcarbonemissions.Investorsusingtheservicesofaninvestmentfirmorafinancialadviserwill,inaway,beforcedtoconsidertheSFDRdisclosuresastheserviceproviderwillbeobligedtoaskabouttheirsustainabilitypreferences.Sustainabilitypreferencescovertheinvestor’sviewonaproduct’s“principleadverseimpacts”,amongotherconsiderations.4However,informationonthesenegativesustainabilityimpactswillnotbereadilyavailableforeachfund.TheincomingSFDRdisclosureruleswillforceassetmanagementfirmstoreporttheindicatorsforalloftheirproductsinaggregate,meaninginvestorswon’tbeabletocompareindividualArticle8funds.Whatwouldhelp,accordingtothreesources,istoimposethisrequirementonindividualproducts.GavinHaran,headofpolicyforassetmanagementatlawfirmMacfarlanes,isoneofthepeopleinfavourofthechange.“Ifyoulookattheproductlevel,thenyoucanreallymeasureifthisisactuallysomethingthat’sgoodorbadfortheenvironment?IsthismandateorthisproductdoinggoodESGthingsorbadESGthings?”hesays.“Ithinkthat’salotmoreusefuloftenthanlookingacrossacompany’sentireportfolio.”MaradeiofAegonAssetManagementmakesasimilarpoint,pointingtoanSFDRrequirementthathethinksshouldgofurther.ManagersofArticle8fundswillhavetodisclosewhetherthefundtakesintoaccountprincipaladverseimpacts,butitisayes/noquestionthatdoesn’trequireanyevidencetobackupa‘yes’answer.“Whatismissingisthisnextleveldown:atthefundlevel,[whatareyour]adverseimpactindicatorsandwhatisthefunddoingaboutthem?Thesupervisors…needtoconnectthedotsabitmorebeforethelegislationcanhavetherightbitethattheywantittohave.”NaughtyorniceThereisanotherpossiblefixtothegreenwashingconundrum–theEU’sTaxonomyRegulation–butthesuccessofthissolutiondependsonanumberoffactors.Fromnextyear,theregulationwillintroducearequirementtodisclosewhatproportionofinvestmentsaresustainableaccordingtoasetofenvironmentalcriteria–thatis,thetaxonomy.Thefirstproblemisthat–basedonEUregulators’latestinterpretationoftheTaxonomyRegulation–onlyasubsetofenvironmentalArticle8fundswillbesubjecttotherequirement,inadditiontoallArticle9productsthatpursueanenvironmentalobjective.5EvenforthoseArticle8fundsthatwillpublishtheirso-calledtaxonomyalignmentscore,thescorewillrarelybeanaccuratereflectionofrealitybecausesofar,theTaxonomyRegulationrequiresonlysomeEUinvesteecompaniestodisclosetheirshareofsustainableactivities.6Ontopofthat,non-EUcorporationsreleaselittlesustainabilityinformation.SocompaniesnotsubjecttotheEUTaxonomyRegulationwillmostlyreceivea0%score.Untilmorecompaniesarebroughtintoscopeorstartpublishingsustainabilityinformationvoluntarily,enablingfundmanagerstoestimatetheirscores,trulygreenfundswillstruggletostandoutfromthecrowd.“Ifaverydark-greenfundonlyhas5%or10%ofitsinvestmentscomplyingwiththetaxonomy,thenafundwithnogreeninvestmentsatallhaving0%doesn’treallymarkitoutasverydifferent,”saysFahyofKBIGlobalInvestors.“Whenthatextrainformationispublishedbycompanies,thepercentagesmightwellgoupto15%,20%,25%,or30%.Sothatcouldbequiteagame-changerifthathappens.”Lastly,aswithalldisclosures,thereisnoguaranteeretailinvestorswillpayattentiontothetaxonomyalignmentscoresofArticle8funds.Butthatcouldchange.Somefundmanagershaveheldupanewtaxonomy,dubbed‘red’,asthebestremedyagainstgreenwashing.Suchataxonomywouldsetoutstandardsforidentifyingcompaniesthatarecausingsignificantharmtotheenvironment.“ThatcouldhavequiteanimpactontheArticle8fundsthatareinvestedinoil.ItwouldthenbecomeastretchtocharacteriseoilfundsasArticle8,”Fahysays.AnexpertadvisorybodysetupbytheEChasrecentlyconsultedondevelopingsuchataxonomy.7Twofurtherpotentialsolutionsdon’trelyoninvestors’workingtheirwaythroughfunddisclosures.OneisestablishingminimumsustainabilitycriteriaforArticle8funds.ThisissomethingtheECsaidinJulythatitwouldconsider,withoutelaborating.8ThecommissiondidnotrespondtoaRisk.netrequestformoredetails.Choosingthecriteriaisunlikelytobeaspeedyprocess.“Itisafraughtdiscussionthatisgoingtotakealotofconsensus-buildingbecausethenyougetintoadebateaboutwhatisausefulESGcharacteristic,”saysMaradeiofAegonAssetManagement.Theotherfixiscreatinganentirelynew‘EUEco-label’forthemostenvironmentallyfriendlyretailfinancialproducts,asproposedbyanECresearchcentre.9However,assetmanagershavecriticisedthelatestiterationoftheproposalforsettingexcessivelyhighthresholdsforqualifyingforthelabel.Forexample,retailequityfundsmustinvestatleast50%oftheirportfolioinenvironmentallysustainableeconomicactivities.“Mostlikelytherewill[even]beArticle9fundsthatwon’tmaketheeco-labelbecauseyouneedaconcentratedportfoliotoobtain50%,”saysHåkanssonofSPP.Whatshouldresponsibleinvestorsdointhemeantime?LinaresoftheWWFoffersasimpleanswer:“IwouldjusttrytofindArticle9fundsthat,althoughnotperfect,shouldn’tallowunsustainableexposurestobeincluded.”■PreviouslypublishedonRisk.net1Esma(July2021),QuestionrelatedtoRegulation(EU)2019/2088oftheEuropeanParliamentandoftheCouncilof27November2019onsustainability-relateddisclosuresinthefinancialservicessector,www.bit.ly/3poWFy02eJointCommitteeoftheEuropeanSupervisoryAuthorities(February2021),Finalreportondraftregulatorytechnicalstandards,www.bit.ly/3GbhOBM3EC(July2021),InformationregardingregulatorytechnicalstandardsundertheSustainableFinanceDisclosureRegulation2019/2088,www.bit.ly/3aVdw314EC(April2021),AmendingDelegatedRegulation(EU)2017/565asregardstheintegrationofsustainabilityfactors,risksandpreferencesintocertainorganisationalrequirementsandoperatingconditionsforinvestmentfirms,www.bit.ly/3E2k2l25eJointCommitteeoftheEuropeanSupervisoryAuthorities(March2021),Taxonomy-relatedsustainabilitydisclosures,www.bit.ly/3B4mYeV6EC(April2021),FAQ:WhatistheEUTaxonomyandhowwillitworkinpractice?,www.bit.ly/3aYGbE87EC(July2021),CallforfeedbackonthedraftreportsbythePlatformonSustainableFinanceonasocialtaxonomyandonanextendedtaxonomytosupporteconomictransition,www.bit.ly/3DYvXQE8EC(July2021),Strategyforfinancingthetransitiontoasustainableeconomy,www.bit.ly/3G52k1X9EC(March2021),DevelopmentofEUecolabelcriteriaforretailfinancialproducts,www.bit.ly/30R8rad1000MarketDataProvidersWeaggregatekeyinformationwithmanagementtoolsthatmakeiteasytoaccessyouressentialfeeds.13,000RapidReportsWithintegratedanalysisanddatatransformation.DeepIntegrationWith3rdPartysystems.SupportforFront,Middle&BackOfficeRolesWithautomatedworkflowsandprocessestailoredforeach.GlobalLeaderWesupportkeyindustries.Energy,RenewableEnergy,Commodity/Trading,Shipping&SupplyChain,Reinsurance,Mining&Metals,Finance&Banking,Agriculture,Electric&Utilities,RetailGasandmore.ZEMAgoesbeyondwhatothersofferbyleveragingindustryexpertise,powerfulinnovation,andourproprietarytenacitytocreatethesolutionsyouneedtogetthejobdone.HeadOffice:+1-866-944-1469UKOffice:+44-(0)800-520-0193Website:www.ze.comDataistherenewablepowersourcefuelingyourenterprise,butyouneedtherighttoolstomakeitworkforyou.ZEMAmakesitpossiblewithbest-in-classfeaturesthatputitaheadofthecompetition.EMPOWERINGYOURANALYSISFROMATO
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