A climate stress test model for credit spreads

In Short

Stress tests are a key tool for assessing the risk of climate change and mitigation measures to the economy and financial markets. They were initially developed for regulatory purpose and are proving useful also to individual intermediaries willing to fine tune their asset allocation and risk management.

Highlights:

 

  • Climate mitigation policies have varying impacts across sectors, which may not be fully accounted for in top-down scenarios. This limitation hinders the comprehensive assessment of their effects on a credit portfolio.
  • In order to analyse the influence of climate scenarios on sectoral credit performance, we have developed an econometric model that establishes a link between a set of macroeconomic variables, financial market metrics, sector-specific expected and actual default probabilities, and finally credit spreads (by industry and rating class)
  • This model enables us to evaluate the impact of both standard and climate-related economic scenarios on a wide range of credit spreads. The results can then be incorporated into Strategic Asset Allocation (SAA) and/or Asset and Liability management (ALM) tools. Additionally, risk management teams can leverage these findings to integrate climate stress testing capabilities. 
  • To illustrate the effectiveness of our approach, we simulated three macro climate scenarios using the same methodology employed by various central banks and the Network for the Greening of the Financial System (NGFS). Our findings reveal that delayed or uncoordinated climate risk mitigation policies could lead to increases of over 100 basis points in high yield (HY) spreads compared to baseline.
  • The modelling approach, which follows the logic of the widely used NGFS scenarios developed by a group of central banks, is based mostly on the historical relationships between variables. It has come under criticism as it may deliver too smooth, muted and in the end too reassuring responses of financial prices to the structural shift implied by climate change. We acknowledge this criticism and will tackle it in the development of our climate scenarios.
  • In a companion paper, we will analyse in more detail the modelling of equities.

 

Read the full publication below

CM_CreditModel_07_2023.pdf

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