Frameworks for Assessing Climate Risk in Investment Portfolios

# Quantifying climate change risk


# Quantifying climate change risk












I am looking for resources on applicable and practical solutions for estimation and quantifying climate change risk from asset owners perspective (for example, a portfolio of equity, fixed income, and their derivatives). BIS published several papers/reports on this but they are largely related to banking sector.

In particular, I am interested in stress testing, scenario analysis, VaR, and other metrics that could be useful in estimating climate change risk.

As I was not able to find anything practical, I am willing to look at both asset class specific approaches as well as integrated cross asset methodologies. For example, pertinent to equities, we could potentially create a benchmark index that represents the "climate change" factor and look at the relationship between this factor and equity holdings in the portfolio.

## Answer by Dimitri Vulis (score 20)

https://quant.stackexchange.com/a/66070

Here are some resources that I found useful when learning about this subject, in which I'm very interested. (Some may be more general ESG than just just climate.)

- Citigroup. Environmental and Social Policy Framework (March 2021)

- UBS. Suni Harford. Investing in an ESG world - A practitioner’s guide (2020)

- AQR. Clearing the Air: Responsible Investment (2019)

- Jefferies. Reinventing “Value”. An Advanced ESG Primer

- KPMG. Frontiers in Finance. Issue # 62 (May 2020)

- The United Nations Principles for Responsible Investment (PRI). Climate change for asset owners

- Recommendation from the Investor-as-Owner Subcommittee of the SEC Investor Advisory Committee Relating to ESG Disclosure (May 2020)

- Basel Committee on Banking Supervision. Climate-related risk drivers and their transmission channels (April 2021)

- Basel Committee on Banking Supervision. Climate-related financial risks: a survey on current initiatives. April 2020

- Basel Committee on Banking Supervision. Climate-related financial risks – measurement methodologies (April 2021)

- Basel Committee on Banking Supervision. Principles for the effective management and supervision of climate-related financial risks (June 2022)

- Patrick Bolton, Morgan Despres, Luiz Awazu Pereira da Silva, Frédéric Samama, Romain Svartzman. The green swan: Central banking and financial stability in the age of climate change (January 2020)

- “Honey, I Shrunk the ESG Alpha”: Risk-Adjusting ESG Portfolio Returns, Scientific Beta white paper, April 2021

- Aneesh Raghunandan, Shivaram Rajgopal. Do Socially Responsible Firms Walk the Talk?

- CFA Institute. Future of Sustainability in Investment Management: From Ideas to Reality

- CFA Institute. Global ESG Disclosure Standards for Investment Products (June 2022)

- Task Force on Climate-related Financial Disclosures 2020 Status Report

- Value Reporting Foundation (formerly Sustainability Accounting Standards Board (SASB) + International Integrated Reporting Council (IIRC)

- HM Treasury. A Roadmap towards mandatory climate-related disclosures (November 2020)

- Global Sustainability Standards Board (GSSB). Global Reporting Initiative (GRI) Sustainability Reporting Standards

- IFRS Foundation. Consultation Paper on Sustainability Reporting

- Bob Litterman et al. Managing Climate Risk in the U.S. Financial System. Report of the Climate-Related Market Risk Subcommittee, Market Risk Advisory Committee of the U.S. Commodity Futures Trading Commission.

- Federal Reserve Bank of San Francisco. Glenn D. Rudebusch. Climate Change Is a Source of Financial Risk (February 2021)

- Federal Reserve Bank of Chicago. Nahiomy Alvarez, Alessandro Cocco, Ketan B. Patel. A New Framework for Assessing Climate Change Risk in Financial Markets (November 2020)

- ISDA. Overview of ESG-related Derivatives Products and Transactions (January 2021)

- CEPS & ECMI. Derivatives in Sustainable Finance. Enabling the Green Transition.

- Central Banks and Supervisors Network for Greening the Financial System (NGFS). Guide for Supervisors: Integrating climate-related and environmental risks into prudential supervision. Technical document (May 2020)

- Central Banks and Supervisors Network for Greening the Financial System (NGFS). Guide to climate scenario analysis for central banks and supervisors. Technical Document (June 2020)

- Central Banks and Supervisors Network for Greening the Financial System (NGFS). NGFS Climate Scenarios for central banks and supervisors (June 2020)

- Intergovernmental Panel on Climate Change (IPCC). Climate Change 2014: Mitigation of Climate Change. Working Group III Contribution to the Fifth Assessment Report of the Intergovernmental Panel on Climate Change

- Intergovernmental Panel on Climate Change (IPCC). Global Warming of 1.5°C. Special Report, October 2018

- Erik Landry, C. Adam Schlosser, Y.-H. Henry Chen, John Reilly and Andrei Sokolov. MIT Scenarios for Assessing Climate-Related Financial Risk. Report 339 (December 2019)

- Bank of England Prudential Regulation Authority (PRA). Enhancing banks’ and insurers’ approaches to managing the financial risks from climate change. Supervisory Statement SS3/19 (April 2019)

- Climate Financial Risk Forum. Guide to climate-related financial risk management (June 2020)

- EU technical Expert Group (TEG) on Sustainable Finance. Taxonomy: Final report of the Technical Expert Group on Sustainable Finance. Technical Report, March 2020

- European Central Bank. Guide on climate-related and environmental risks: Supervisory expectations relating to risk management and disclosure (November 2020)

- BIS Consultative Document. Principles for the effective management and supervision of climate-related financial risks (2021)

- APRA Prudential Practice Guide CPG 229 Climate Change Financial Risks (2021)

- Office of the Superintendent of Financial Institutions Canada (OSFI). Navigating Uncertainty in Climate Change: Promoting Preparedness and Resilience to Climate-Related Risks (January 2021)

- Sustainable Stock Exchanges. Model Guidance on Climate Disclosure

- Bill Hare, Robert Brecha, Michiel Schaeffer. Integrated Assessment Models (IAMs): what are they and how do they arrive at their conclusions? (October 2018)

- International Organization Of Securities Commissions (IOSCO). Environmental, Social and Governance (ESG) Ratings and Data Products Providers. Consultation Report (July 2021)

Edit: @nick012000 suggested I copy to the answer some additional color that I had in comments.

- A good non-quant book explaining various climate change claims is Joseph J. Romm. Climate change - What Everyone Needs to Know. 2nd Edition (2018). (Joe Romm is blogger.)

- Bob Litterman has written/co-authored a few papers on pricing climate risk, example, example, example. His book Climate Risk: Tail Risk and the Price of Carbon Emissions-Answers to the Risk Management Puzzle is forthcoming.

8 The book Shmatov, Castelli. Quantitative Methods for ESG Finance is also forthcoming.

- People usually try to quantify 3 kinds of ESG-related risks:

Physical Risk - how will the company be affected if sea levels and/or mean temperatures go up or down (as they did historically, e.g. Little Ice Age or Younger Dryas. (Note that you don't need to assume that any climate change is "anthropogenic" for this.)

Transition Risk - the exposure to legacy assets such as petroleum reserves, coal mines, or natural gas pipelines that will lose value if we are mandated to reduce greenhouse gas emissions (again, you don't need to believe that such a mandate would be a good thing - just what its impact would be).

Legal or Liability Risk - not limited to climate change. Suppose, for example, that IBM sells its punch card machines to Nazi Germany who uses IBM products to keep track of Jews to gas. In addition to reputational risk, can IBM get sued for lots of money? Likewise, what if a bank lends money to a corporation engaged in child labor / environment destrucrtion / some other bad behavior - can the bank get sued?

There are, of course, lots of debates on how these risks should be quantified and reported, e.g. which scenarios should be considered for physical risk, and how can their impact be assessed. Everyone thinks that it would be better if reports from different companies in different jurisdictions were comparable. The Financial Stability Board (FSB) created a task force (TCFD) which created some documents. Now accounting and regulatory bodies (IFRS in EU, FASB & SEC in the U.S., etc) are working on reporting standards that already are or are soon likely to be obligatory for lots of firms.

In addition to single company reporting/accounting, there's been lots of work on using ESG data for portfolio analysis and investments decisions. E.g. Pedersen, Fitzgibbons, Pomorski. Responsible investing: The ESG-efficient frontier (2021). E.g. MSCI. Climate Value-at-Risk E.g. Blackrock's Aladdin Climate combines data from Refinitiv&c with analytics from Rhodium Group, Baringa Partners,&c to produce a "CAV" Climate Adjusted Value, an adjusted market price at which an asset "should" be valued based on embedded climate risk. One can then optimize a portfolio to minimize climate risks and to maximize the "climate adjusted" P&L rather than regular P&L. Some of the links in my answer discuss that the unadjusted P&L from such portfolios is generally meh.

Edit: E.g. Moody's paper connects climate risk with their (former KMV) model for physical probability of default. E.g. Chris Kenyon, Mourad Berrahoui. Climate Change Valuation Adjustment (CCVA). E.g. Michael Barnett, William Brock, Lars Peter Hansen. Pricing Uncertainty Induced by Climate Change.