Climate risk has caused significant challenges for life insurance financial risk modelers. There is a lot of noise in the market, with emphasis on either very precise or very complex modelling. However, it is important to also look at the broader, systematic impacts on financial markets exposures; such as yield curves, inflation, credit spreads, risk premia, and asset class returns.
How do you find the balance and a sufficient level of granularity in your modeling? How do you select and assess the impact of different climate models? Are there risks we are missing? We have created a series of short articles to help those responsible for climate modeling in the actuarial, risk, and strategic asset allocation functions of a life insurance company. These articles begin to address and simplify the complexities of climate change in processes such as the ORSA, stress testing, and strategic asset allocation.
In the second of the series of six articles, we explore balancing bottom-up and top-down analysis for Strategic Asset Allocation work, own risk and solvency assessment (ORSA) and Task Force on Climate-related Financial Disclosures (TCFD) reporting.
Achieving a Balanced View of Climate Risk
As providers of climate data and risk analytics, we are often asked: which is more appropriate, a ‘bottom-up’ or a ‘top-down’ analysis of climate risk? Over the past three years, it is fair to say that the bottom-up approach has dominated. Regulators such as the UK’s Prudential Regulation Authority (PRA) have been pushing firms to demonstrate that they can produce ever more granular holdings or activity level analytics.
This article discusses how to achieve a balanced view of climate risk by balancing bottom-up and top-down analysis. Our view is that you need both. And we believe that the economic experience of the past two years, offers a timely reminder of why ignoring the global nature of climate change and the carbon transition, might lead to risk assessments which prove overly precise and systematically skewed. The recommendations hold for Strategic Asset Allocation work, own risk and solvency assessment (ORSA) and Task Force on Climate-related Financial Disclosures (TCFD) reporting.
Most bottom-up financial analysis focuses on the dynamics of cashflows. For example, analyzing how increases in the shadow price of carbon, or the geolocation of production and facilities, might impact earnings generated. Most of the climate data being produced is granular in nature–for example, detailed, firm-level scope 1, 2 and 3 emissions, and facility location and supply chain structure. By making some simple assumptions about where increased costs will fall, it is possible to calculate the deltas on cashflows generated by firms. If this is done consistently across your portfolio of holdings, then aggregating up to a systematic analysis is often straight forward, and at the appropriate level for sharing with senior management.
So, what could this typical method of granular bottom-up modeling be missing, and how might it be systematically skewed? To answer this question, it is important to remember that:
• In the real world economy, incurred costs are usually passed on when they can be.
• Any valuation problem has two sides–understanding the expected cashflows generated, and the prevailing discount rates applied.
For those involved in carbon emissions foot printing, the first point leads them to emphasize the importance of scope 3 data (emissions occurring in the supply chain both upstream and downstream). For risk modelers, there is an important lesson to be learned from the way emissions data is collated and presented. There is deliberate double counting of emissions (direct versus indirect), precisely because there is uncertainty around how demand for goods and services will hold up, and where costs will fall.
For modelers to produce a rounded view on climate risks, we believe it is also necessary to complement bottom-up analysis of cashflows with a top-down analysis of market and price dynamics. Recent real-world experience has taught all investors some hard lessons about the systematic impacts of an energy- and supply-constrained economy. If demand holds up, costs are passed on to the end consumer creating persistent inflation, increases in yield curves and drops in asset market values.
Strategic Asset Allocators have long recognized that 90% of portfolio risks can be attributed to asset allocation, with stock selection driving only 10%. As the financial industry faces up to the challenges of climate change and net zero commitments, it would do well to remember that adage; and ensure they analyze the risks and opportunities from both a bottom-up and top-down perspective.
For more insights on this topic, listen to our podcast series.
Speak to our Experts about how we can help with your climate-related modeling needs.
