The journey to a more sustainable tomorrow: credit risk and climate change

Apr 13, 2021

Chris Wood headshot photo Chris Wood
Partner, Accounting Advisory Services, Toronto, PwC Canada

In my last blog, I wrote about new and emerging risks to consider when measuring expected credit losses (ECLs) and the reminder from John Maynard Keynes that ‘it’s better to be roughly right than precisely wrong’. As this month marks a half decade since the signing of the Paris Accord, I thought it’d be worthwhile to dig a bit deeper on one of those areas that’s been getting a lot of attention lately – ESG (Environmental, Social and Corporate Governance). In many cases, quantification remains in its infancy and my objective here isn’t to plead for immediate and exhaustive modelling of all things ESG. Having said that, regulators and investors are becoming more and more interested and change is happening fast, so it’ll be wise to think things through now even if we can’t measure them precisely yet. When it comes to credit risk, here are some ways to do that:

  • Start by focusing on climate change (where the most information is available) and corporate exposures (which are most likely to be affected).
  • Think separately about physical risk (such as destruction or temporary disruption of physical assets from increased incidence of severe weather events) and transition risk (advancement or displacement as a result of moving to a ‘greener’ and more sustainable economy).
  • Consider independently how each risk, and forward-looking change therein, might affect ‘significant increase in credit risk’ assessments, ECL measurements and related disclosures.
  • Be mindful of duration – while change is happening fast, longer-term exposures are likely to be more affected than short-term ones.
  • Explore approaches that go both top-down (portfolio and industry / segment heatmapping) and bottom-up (borrower / segment correlation or other analysis).
  • Be aware of the resources and tools already out there, like the UN Environment Programme Finance Initiative publication Navigating a New Climate and its New Tools and Frameworks for Transition Risk.
  • Recognise that ‘one size’ doesn’t fit all – different portfolios will have different risk exposures depending on duration, industry, geography etc and, in many cases, only top-down assessments of vulnerable geographies and industries will be possible.
  • Examine beyond immediate transactions and structures to understand the full impacts (including those that are indirect).
  • Avoid double counting risks, by considering the extent to which they might already be captured directly or indirectly through model inputs like market credit spreads, expected default frequency and other factors.
  • Acknowledge that, while all risks need to be considered, that doesn’t necessarily mean that they can all be modelled and, in some cases, limitations of data (such as geo-spatial, hazard and technology impact pathways) will make granular analysis difficult and require judgement instead (remember the Keynes quote).
  • Consider other arrangements like insurance, guarantees, government subsidies (or other payments and policies) and other sources of recoveries, including how they’re structured and how their providers are thinking about (and responding to) evolving ESG risks.
  • And remember what Ralph Waldo Emerson said – it’s about the journey, not the destination, so scenario analysis will likely be key too.

Whatever approach you take, expect it to receive increased attention as focus on climate risks by government, regulators, investors and other stakeholders continues to increase. The good news is that the past year has helped to advance thinking when it comes to measuring uncertainty, and today’s task isn’t to precisely predict which changes and events will happen and when, but to consider the possibilities and significant effects that they could have. While we can’t presume that forward-looking risks will manifest later than a portfolio’s maturity, by doing thoughtful analysis we might find that, in some cases, that’s true. Either way, thinking through things now will help prepare for questions that are sure to come. More importantly, for banks whose profits hinge on the measurement, management and monetisation of risk, it might also help to avoid surprises down the road and to identify market opportunities.

All views expressed are the authors

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