Modeling Climate Transition Risk: A Network Approach
Executive Summary
Climate transition risks pose a significant threat to financial stability, particularly those related to the shift towards a lower-carbon economy. These risks can arise from policy implementations, technological advancements, or market behavior shifts. For instance, transitioning to a 1.5°C target instead of a 2°C target can lead to higher markdowns in the value of fossil fuel-exposed assets. Investors need to understand these risks, their exposure in investment and loan portfolios, and the systemic implications in an interconnected financial system.
Various institutions, such as banks and insurance firms, consider climate transition risks when determining risk premiums and aligning loan books with sustainability targets. Policymakers, including central banks and regulatory authorities, should account for these risks to ensure financial stability.
One method to assess climate transition risks is through a scenario-based approach. This involves incorporating changes in firms' expected future returns into present valuations using forward-based transition scenarios, rather than relying solely on historical data. Scenarios based on different climate transition narratives and physical climate targets can better reflect potential losses.
Case Study: Developing Countries in Asia
The study focuses on developing countries in Asia, a region with significant climate transition risks. It models the cascade of losses between financial firms under different transition scenarios using a systems-thinking approach. The analysis reveals the interconnected nature of transition risks within the financial system.
Three layers are defined to compartmentalize key parts of the system:
- Scenario Layer: Represents transition risk scenarios associated with energy firms' physical assets, such as coal, oil, and gas. Losses in energy firms' physical assets translate into economic scenarios affecting future revenues.
- Economy Layer: Accounts for the differential in energy firms' revenue trajectories across future years under a discounted cash flow model. This reduces the net present value of physical assets, impacting profits and equity.
- Financial Layer: Divided into:
- Energy to Financial: Losses from energy firms under the transition scenario are incurred by financial firms providing loans. Financial firms face credit valuation adjustments (CVAs) due to decreased creditworthiness, leading to a decrease in the initial value of loans held as assets.
- Financial to Financial: Losses from financially impacted firms spread to other financial institutions through counterparty asset holdings, triggering further losses and contagion effects.
Key Findings
- Equity Losses: The average equity losses for financial firms in smaller economies are comparable to those in larger economies due to spillover effects. For example, Chinese financial firms, representing the largest market, face average expected equity losses of around $11 million, while financial firms in Thailand and Vietnam incur around $6 million.
- Contagion Effects: Contagion losses from the financial network contribute more than 40% to equity losses, despite financial counterparty asset holdings comprising only 4.5% of total asset holdings. This indicates that losses between financial firms can be larger than direct losses under the transition scenario, highlighting the importance of network methodologies.
- Network Density: Higher interdependencies between financial firms reduce the range of equity losses. The number of links between financial firms decreases the quantity of counterparty assets held, potentially leading to increased network density.
Recommendations
- Regulators should consider financial firms' transition risk exposures in their jurisdiction by understanding network contagion and the potential losses from third-country exposures.
- Further research is needed to refine the modeling and address uncertainties in the transition scenario and financial network.
This framework provides valuable insights into the complexities of climate transition risks and their impacts on financial systems.