Climate-related risk management is an evolving field with the banking industry currently in the process of understanding and developing novel risk capabilities. Transition risk, encompassing potential shifts in market dynamics, regulatory frameworks, and technological advancements as economies move towards sustainable alternatives, has emerged as a new dimension to credit risk modelling. This brings with it significant complexities and unknowns.
At one of our large banking clients, Monocle assisted in establishing and expanding its transition risk modelling capabilities. This included fundamental climate risk modelling research through to the development and testing of a transition risk adjustment model to be integrated into the bank’s formal Probability of Default (PD) corporate credit risk model.
Initially, Monocle was tasked with researching transition risk drivers and the pathways which these factors impact financial performance amongst companies in high energy sectors and sub-sectors. Transition risk drivers include changes to market-related risk, policy- based risk and technological risk due to transitioning.
Following this, Monocle worked closely with various data stakeholders in the bank to obtain counterparty level financial data that would be adjusted for transition risk drivers within the existing transition risk framework.
Monocle conducted detailed research and analysis across long-term climate scenarios to forecast climate transition impacts using various growth rate proxies. The existing PD model was adjusted for three distinct macro-economic policy scenarios across the spectrum of transition outcomes. Monocle also delivered additional research regarding the measurement of financed emissions.
Finally, Monocle was extensively involved in developing and integrating the adjustment model to output a PD score that is adjusted for climate transition risk at a counterparty, sector, and sub-sector level across the three distinct policy scenarios. The model shows how conventional financial statement items can be affected by transition risk drivers. More specifically, these financial variables are underlying drivers of counterparty performance and affect PD scores.
The client also requested an MI dashboard that Monocle then designed and developed to report results and support the distribution of insights to senior management and various stakeholders across the business.
By adapting credit risk modelling to account for climate transition risk, Monocle aided the client to understand and respond to the emergent challenges posed by climate change risk in the banking portfolio, while underscoring the critical need to enhance the resilience of financial institutions in the face of evolving environmental pressures.
