BIS Paper Explores Pricing of Physical and Transition Climate Risks
The Basel Committee on Banking Supervision (BCBS) issued responses to frequently asked questions (FAQs) to clarify the way in which climate-related financial risks may be captured in the existing Pillar 1 standards of the Basel framework. Additionally, the Bank for International Settlements (BIS) published a paper that examines practices on the pricing of climate risks in financial markets.
The paper on climate risk pricing notes that physical and transition risks related to climate change are starting to be priced, though concerns are growing that current prices do not fully reflect the risks. The paper also notes that investors grapple with three major challenges when seeking to price climate risks adequately. First challenge is that the aggregate nature of climate risks limits the availability of risk-sharing arrangements and hedging instruments while the second challenge is around the high degree of uncertainty about climate risks and concrete policy actions to address them, which heightens modeling and measurement challenges. The third challenge is that the information available to investors about climate risks and their consequences is often incomplete or imperfect. Furthermore, investors seeking to extract information from environmental, social, and governance (ESG) ratings often face uncertainty about a true ESG profile of a firm. ESG rating providers appear to give a higher weight to the existence of corporate policies rather than forward-looking climate metrics such as reductions in greenhouse gas emissions and intensity. Thus, it becomes important to have effective tracking and verification processes to ensure that relevant information has been adequately incorporated into prices, so that market participants can verify and assess progress in line with a low-carbon transition and align company objectives with actions to mitigate climate risks.
The clarifications on the inclusion of climate risks in Basel framework cover aspects such as calculation of risk-weighted assets for credit, market, and operational risks, stress testing, and calculation of liquidity coverage ratio. The document intends to facilitate a globally consistent interpretation of the existing Pillar 1 standards, given the unique features of climate-related financial risks and should not be interpreted as changes to the standards. The responses to FAQs are consistent with the Principles for the effective management and supervision of climate-related financial risk, which the Basel Committee published in June 2022. With this, BCBS is examining the extent to which climate-related financial risks can be addressed within the Basel Framework, identifying potential gaps in the current framework, and considering possible measures to address these gaps. The current publication represents a set of responses to initial FAQs but should not be considered an exhaustive list of standards where the impact of climate risk drivers should be considered. BCBS will publish additional FAQs in future, as needed, to facilitate implementation of the existing Basel Framework, particularly as the availability of sufficiently granular data and consistent measurement methodologies for climate-related financial risks improves over time.
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Keywords: International, Banking, ESG, Climate Change Risk, Basel, Pillar 2, FAQ, Credit Risk, Regulatory Capital, Physical Risk, Transition Risk, Sustainable Finance, ESG Ratings, BCBS, BIS
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