CLIMATE STRESS TESTING FOR

CREDIT AND EQUITY:

Dr Svetlana Borovkova

CASE STUDIES AND EMERGING METHODOLOGIES

Climate risk in FIsFinancial Risk in Banking
The problem:
The economic impacts of climate change can pose
significant risks for financial institutions.

The issue:
The financial risks are traditional, but the risk drivers are
different: larger magnitude, longer term and potentially
irreversible consequences.

The Scope:
Measuring, managing, and mitigating these unique
challenges.

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Climate risk

Physical risk Transition risk

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Key Challenges in Modelling Climate-Related Risks
Non-linear and Systemic Incorporating Physical and
Nature of Climate Impacts Transition Risks into Models

Limited availability and Policy and Regulatory Changes Interdependencies between Climate
relevance of historical data Risks and Other Financial Risks

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Additional challenges

• High exposure granularity

• Longer term horizon: (short term: 3 years, long term: 10 years)

• Solution: scenario analysis and stress testing

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Modelling approaches for credit and equity portfolios

• Top-down: on the level of macroeconomy and ecosystem as a whole

• Bottom-up: on the level of individual assets
• Meso-approach: on the level of sectors and geographical regions. Equity or credit portfolios are
then mapped into sector/region matrix. Mortgage portfolios – into region matrix.

Corporate credit vs retail mortgages:

• Creditworthiness of corporates (PD and LGD) is the function of transitional risk (and less of
physical risk, except specific industries/regions)​
• ​Value of mortgages (PD and LGD) is the function of both physical risk and transitional risk​
• SME loans are somewhere in between the two​ (credit: as corporate, collateral: as mortgages)

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Climate Risk Scenarios: NGFS

• NGFS (Network for Greening the

Financial System):
 six climate scenarios
 forecasts of macroeconomic variables,
emissions, carbon prices and others
 on global and regional levels

• https://www.ngfs.net/ngfs-scenarios-
portal/explore

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Examples of scenarios

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Carbon reduction costs according to scenarios

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 CASE STUDY 1: MORTGAGE PORTFOLIOS

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Mortgage portfolio climate risk - I
• Physical risk drivers:

 Deterioration of property value as a function of flood/SLR/pole rot or other climate

events/risk (LGD)

 Increase of value as a function of structural interventions (LGD)

 Cost (and as a result financial stress on borrowers) of repairs due to climate risk
events and of improvement interventions (PD)

 Except for indirect effect above, climate events have no effect on individual PDs
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What do we know?

• IR on mortgages in areas prone to SLR (US) is higher

than on other mortgages (Ohana et al (RF 2022))

• But this difference (in IR and in implied PD) is very small (4 bp)

• This pricing difference is also observed

 in NL for areas more prone to flood

 in US for areas more prone to hurricanes

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How to model?
Mapping of mortgage portfolio into weather/climate risk maps by zip
code

Essential: geographic risk data (e.g., US: NOAA). Risks are correlated

Dynamic approach by using scenarios and physical risk projections

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Climate stress testing – physical risk region-specific
Risk of pole rot and foundation
Risk of floods
degradation
In the Netherlands 26% of the wate
surface is below sea level and Pole rot is the result of
29% is susceptible for river prolonged exposure of
flooding. This combines with foundation to low ground r
the expected increase of level.
extreme weather events.

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Probability of flood (>50cm) and pole rot (CAS)

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Left: flood risk heatmap 2022, right: 2050

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Challenge:

Estimations/assumptions about monetary value of damages in a certain risk

category (% of property value?) and repairs (possible to find in open national
sources)

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Mortgage portfolio climate risk: II

• Traditionally, it was thought that physical risk is the main risk for
mortgage lenders

• In fact, more severe, short-term risk (in financial terms) is transitional

risk arising from harsh and sudden regulations regarding “greening” of
residential real estate

• Heat pumps, isolation, “green” gas or no gas for heating/cooking etc.

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Mortgage portfolio climate risk: II

• Transitional risk drivers:

 Value of property as a static function of

energy label. Risk: lower value of
“brown” dwellings vs “green” ones

 Challenges: energy label imputation,

transition dynamic

 Regulation and associated costs of

house refitting

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House value vs energy label

• UK: value of “brown” dwellings GBP 5000 to 9000 less than “greener” counterparts

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Energy label transition and regional analysis
• Roberto Benenato, Maurits Bakker (SAS)

• Dynamic Markov model for energy label transition

• Missing energy labels: imputation by ML methods

• Market (mid) scenario: convert low-class energy label (E-F-G) towards “green” rating at the end of
2030.
• Net-zero scenario: All energy label shift to A by 2050.
• For both such scenarios, required rates of energy label changes can be “back-engineered”
• Current rate of change: “catastrophic” scenario
• https://www.youtube.com/watch?v=EyuYQb1rL_w

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TR Regulation for residential dwellings
• Short-term risk: obligation for house owners to refit their houses

• Types of interventions: severe, medium and low

• Examples: low <-> green gas

medium <-> collective heating systems
severe <-> individual heating systems (heat pumps)

• Germany: mortgage portfolio losses up almost 300% for stricter policies

• Belgium: similar numbers
• NL: large-scale FS study
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Average required investment per house (in thousands of Euros)

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Risk consequences: % of owners with insufficient funds

• Retrofitting: substantial cost, so it affects financial position of borrowers

 higher credit risk, higher LTV and LTI

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Effect on LTV, LTI, PD and LGD

• These are average numbers

• For most credit-constrained

borrowers, PD goes up by
7% in the most costly
scenario

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 CORPORATE CREDIT PORTFOLIOS

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Climate risk modelling approaches for corporates

 Transition risk: stressed PDs via e.g.,

leverage and profitability

 Using carbon cost pass through rate &

stressed financial variables to arrive at
stressed PDs

 For six NGFS scenarios, on

microeconomic or sector/industry level

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Typical elements of modelling
• Carbon price scenarios (NGFS)
• Carbon price pass-through rate for different industries (0.5 to 1.3)
• Price elasticity of demand

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Typical elements of modelling
• Scope I, II and III emissions data per company: scarce data, approx. 80% missing

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Putting it together…

• Firm-specific financial variables are

needed (financial ratios etc)

• PDs: logistic regression estimates

• Major challenge: quantifying carbon

price impact on company’s financials

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Climate-stressed PDs

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Climate-stressed PDs

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 EQUITY PORTFOLIOS

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Climate risk modelling approaches

 NGFS forecasts of carbon tax and

carbon reduction costs

 Using price elasticity of demand and

emissions data, quantify increase in
costs (and possibly revenues)

 Stressed NPV via DCF model  impact

on equity value

 For six NGFS scenarios, on company or

sector level

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Carbon reduction costs

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Transition risk
• Outgoing cashflows related to CO2 reduction & carbon tax

• Benefits of reduction in terms of e.g., lower carbon tax

• Way of assessing:
 Identify sectors particularly sensitive to carbon transition risks
 Use Scope I & II emissions directly, Scope III proxy by % of revenues

• Sector- (and region-) dependent

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Impact on sectors

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NPV impact: mining (B), manufacturing (C) & electricity supply (D)

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Impact per region

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Future earnings averaged over sectors

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Main takeaways

• Climate risk and stress testing will become more important as regulatory burden in
this area grows

• No established methodologies yet, but these are slowly emerging

• The main problem is the data: lack of , difficulty of getting, total absence

• For mortgages, transitional and short-term risks are the highest

• For corporate credit, the effect of climate stress on PDs is significant but not huge
• For equities, there is a huge variability between industries and sectors

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Thank you!

Dr. Svetlana Borovkova

svetlana.borovkova@probability.nl
s.a.borovkova@vu.nl

Acknowledgements: Roberto Benenato, Tessa Savelkoul, Stijn Kolenbrander (VU)

See my papers on SSRN, Refinitiv, Financial Investigator:

SSRN Electronic Library
Svetlana Borovkova | Financial Investigator

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