Climate Risk Concentration
Climate Risk Concentration denotes the excess concentration (measured in absolute or relative terms) to the risks related to the transition to a lower-carbon economy or the physical impacts of climate change. Climate risk concentration is a form of Concentration Risk.
The impact of Climate-Related Risk on an organization depends on its nature ( business models, typical assets and liabilities) and its existing exposure to major risk types. The climate-related risks captured by the Climate-Related Risk Taxonomy are not a new form of Risk, they are rather new (and more sharply defined) risk factors.
Risk Identification in this context entails identifying how climate risk factors potentially aggravate the existing risk profile of the firm. This is schematically achieved via a mapping exercise that aims to explicitly identify underlying linkages between underlying climate risk factors (broadly classified as impact and transition risks) and the risks a firm is exposed to (from credit risk to reputation risk).
Measurement of climate risk concentration can be based (broadly) on the tools and approaches for Concentration measurement, with specific challenges linked to the evolving understanding and quantification of Climate-Related Risk.
Defining Climate Risk Exposure
The concept of climate risk Exposure (and thus exposure based Concentration Measurement) is opportune for those business models where risk measurement is already able to create meaningful exposure metrics. This is happens primarily in bussiness models built around credit products, insurance and other business generating or revolving around explicit financial contracts (this includes also trading of financial products). It is less relevant for those hard to quantify risks, such as Reputation Risk and many Operational Risk types where an a-priory numerical estimate of what is at risk is either not possible or possibly very imprecise.
In line with the discussion above of the nature of climate risk being a factor rather than a managed risk type, climate risk exposure is best understood as the incremental impact on existing risk types and exposures. For example, the normal assesment of Credit Risk may be augmented with the potential physical impact or transition risks (in cases where that impact is already included, it may be separated as standalone contribution). This leads to potential metrics such as
In turn such metrics can be combined with normally used exposure metrics to develop a Climate-Risk Adjusted Concentration Index
Defining Climate Risk Sensitivity
In some cases where adjusted exposure metrics are difficult to define , it may be possible to define instead climate risk sensitivities. This will be primarily the case where some type of quantitive measure is available as a proxy (e.g. earnings, investment, expenditure etc.) For example the climate transitions risks faced by clients may have impact on a firm's Business Model Risk as factors to its Revenue Risk. In this context future expected revenues can be tagged as to the degree to which they are sensitive to transition risks.
Absolute versus Relative Concentration
As with other concentration risk considerations, climate risk concentration can be measured on a standalone basis, in which case absolute concentration thresholds must be set, or a relative basis, i.e., ranking different the concentration of different portfolios, firms, sectors etc.
The management of climate risk concentration is done using (among others) tools from Risk Mitigation:
- Modifying (where possible) the firm's Risk Profile (changing the conditions or factors that contribute to climate-related risk), e.g. by adapting the Business Model pursued (client segments, products etc.)
- Obtain insurance (with the possible limitation that some climate-related risks might be uninsurable)
While low level (granular) metrics and concentrations indexes help built an objective basis to support risk management, the long term implications of climate change suggest that firms should adopt a Holistic risk management approach that will help avoid missing the forest for the tree.