Climate change risk classification methodology by Tamara Close

climate change risk classification methodology

by Tamara Close

climate change as an unpriced systemic risk

climate change risk assessment classification methodology

During the 2008/09 Financial Crisis, some market participants blamed Fair Value Accounting and Fair Market Valuations (FMV) for a worsening of the financial crisis, since assets and loans that were still performing were required to be marked-to-market to what were then extremely low values, sometimes even to a zero value. This caused, in some cases, extreme decreases in NAVs and even caused some financial firms to become insolvent. Opponents of the fair value approach argued that the market was pricing in a risk that had already happened and was not likely to reoccur. Today we find ourselves in the opposite situation with a risk – climate change - that is known and will occur and yet it is not being priced into the market.

Climate change is increasingly being viewed as a systemic risk, and the valuation of climate change risks (both physical and transition risks) represents a complex and multi-dimensional process for which there is currently no agreed-upon industry standard. Due to the inherent complexities of climate change risk, many investors are not factoring these risks into their investment valuations, or they are doing so at a broader sector or industry level, leaving investment / company level climate change risk as a largely unknown, unpriced, and yet very material risk in their portfolios. If there was a sudden repricing of climate change risk, we could see the same impact that we witnessed during the financial crisis.

During the 2008/09 financial crisis, the valuation of complex OTC derivatives became increasingly unclear due to their dependence on certain underlying assumptions that no longer held as markets became dislocated. The FAS 157 classification methodology was developed to give investors and regulators a clearer view into the amount of complex OTC derivatives (classified as Level 3) in an investment portfolio. This required asset managers and asset owners to re-classify their financial assets into 3 risk levels. Investment firms were not required to change their valuation methodologies, but rather were required to classify their assets based on the valuation methodologies and inherent / perceived liquidity.

The theoretical foundations and practical implementation of XVAs have been a matter of debate and controversy over the past years, due to misalignment between market, accounting, and regulatory practices. Banks have been accused of boosting their profits by recording gains on the fall in value of their debt through DVA, while hedging of DVA is problematic and monetization of own default is almost impossible. Similarly, inclusion of FVA in derivatives pricing has raised concerns between market participants about the potential for double counting with DVA, or the violation of the law of one price.

The same concept could be applied to the assessment of climate change risks in an investment portfolio. For instance, one could classify securities based on whether a climate change assessment was performed or not, and if so, the robustness of the assessment. This implies a reverse burden of proof on investment managers: If they have not performed a climate change risk assessment, then the security is categorized as Level 3. The manager would need to prove that they have performed a climate change risk assessment to be able to categorize it in Level 2 or 1.

For example:

• Level 1 securities included liquid securities that were tradable at observable market prices (e.g. listed securities). • Level 2 securities included mark to model instruments but that used inputs that were observable in the market (e.g. interest rate swaps). • Level 3 securities included instruments that required a model to value the instrument but that also included material assumptions within the valuation methodology (e.g. the recovery rate for credit default swaps).

• Securities that have not been assessed for climate change risks would be automatically classified as

Level 3

• Securities that have been assessed for climate change risks but at a sector or industry level would be classified as Level 2

• Finally, securities that have been assessed for climate change risks at the investment / company level could be classified as Level 1

Proposed classification methodology for climate change risk assessments for a portfolio of securities

Benefits of a classification methodology such as this include:

• Increased transparency into the current and future expected risks of an investment portfolio • Ease of comparability between portfolios and asset classes • Straightforward and universal application as the methodology is strategy and asset class agnostic • Expanded use of the classification model for broader ESG risk assessments within a portfolio of securities

While this is not a substitute for risk management practices, given the complex and multi-dimensional nature of climate change risks, a classification methodology can create a foundation for fostering essential conversations around climate change risks and impacts on valuations, and can be a critical first step to bring further transparency to stakeholders into the potential risks of a portfolio.

authors

Tamara Close, CFA

Founder and Managing Partner, Close Group Consulting

Tamara is the Founder of Close Group Consulting, which is a boutique ESG strategy advisory firm that uses capital markets and ESG expertise to implement ESG integration best practices at asset managers, asset owners and corporates. She was previously the Head of ESG Integration for KKS Advisors, a global ESG Advisory firm and has over 20 years of combined experience in capital markets and ESG strategy. Tamara has held various investment management, risk and leadership positions in the global capital markets and spent 10 years in senior management roles within the risk and public markets investment groups of PSP Investments.