By Thomas Lorans, analyst, Beyond Ratings
Climate physical risks correspond to the economic and financial losses caused by climate-related hazards. This concept regroups both acute (e.g. flood, storms or extreme temperature) and chronic (such as increasing temperature, sea level rise) hazards. Both risks are intrinsically linked, as frequency and intensity of acute hazards are expected to increase due to the global warming.
If Australia’s exposure to physical risks has been recently highlighted by giant fires having blighted an area larger than the size of Belgium, the biggest potential threat comes from the increasing temperature impact on the economy. Indeed, according to a study of Burke et al (2015[1]), temperature increase in the worst-case scenario could reduce Australia’s GDP per capita by 53% by 2100 (compared to a world without climate change).
Climate transition risks correspond to the risks of economic dislocation and financial losses associated with the unanticipated process of adjusting toward a low-carbon economy.
Here again, Australia is highly exposed to these risks. In order to be compliant to a 2°C warming, the country should decrease its GHG emissions 87% by 2030 according to the Beyond Ratings’ Climate Liabilities Assessment Integrated Methodology (CLAIM).
Climate risks will challenge the concept of “risk-free assets”
As of today, the Australian government is rated AAA by the most important credit rating agencies (S&P, Moody’s, Fitch). This rating highlights a very high credit quality profile and is associated to a probability of default close (but not equal) to 0. This kind of issuer is generally seen as a “risk-free asset,” used to diminish the overall exposure to any kind of risk in a portfolio.
However, as we’ve seen before, Australia is highly at risk for both climate risks, physical and transition. Given the huge potential impact of both risks on the economy, Australian government finances will probably suffer from it, as will its credit quality profile.
Indeed, Battiston et al (2019[2]) highlight the climate risks transmission channel from fiscal revenue to the value of sovereign bond: “a drop in fiscal revenue due to climate shock impact on the economy would cause an increase in the probability of default, and then a decrease in the bond expected payoff and value.”
Whereas physical risks should materialize mostly in emerging markets, transition risks are an important threat for most part of advanced economies. Then, climate risks will globally increase default risk exposure in sovereign fixed income assets class, even for the current higher quality issuers (AAA-rated). Taking into account climate risks will thus challenge the very concept of “risk-free assets.”
Hedging climate risks
In view of the above-mentioned potential implications of climate risks, investors needs to implement a financial assessment of their portfolio exposure to such risks, even if they do not necessarily have an explicit greening mandate.
However, as mentioned by Battiston et al (2019), “in this context, the standard approach to financial risk analysis, consisting of: identifying the most likely scenario, computing expected values, and estimating financial risk based on backward looking metrics and historical values of market prices, is not an adequate approach.” Thus, they propose a risk management strategy in order to hedge climate risks, based on a “Climate Value-at-Risk” (CVaR).
Value-at-Risk (VaR) on investor’s rate of return is the worst-case loss at a certain confidence level and can be used to minimize portfolio exposure to risk. Defining the Climate VaR as the Value-at-Risk of the index or of the investor’s portfolio—conditional to climate risks shock scenario—this Climate VaR will increase with the marginal default probability due to climate risks. An accurate risk management strategy could thus be conducted by minimizing climate risks in the portfolio through the Climate VaR. In practice for the sovereign bonds assets class, this approach implies to (i) define climate risks considered; (ii) model climate shocks impact on economy; (iii) assess the impact of climate shocks on probability of default; (iv) compute a Value-at-Risk adjusted for forward-looking climate risks scenarios.
Hedging climate risks is therefore a clarion call for further research. Watch this space…
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[1] Burke, M., Hsiang, S. M., & Miguel, E. (2015). Global non-linear effect of temperature on economic production. Nature, 527(7577), 235.
[2] Battiston, S., Mandel, A., & Monasterolo, I. (2019). CLIMAFIN handbook: pricing forward-looking climate risks under uncertainty. Available at SSRN.
Further reading:
Climate risk: Who are Europe's sovereign leaders and laggards
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