How to Map Climate Risk to the Open Risk Taxonomy

From Open Risk Manual

How to Map Climate Risk to the Open Risk Taxonomy

The impact of Climate-Related Risk on an organization depends on the nature (business models, assets and liabilities) of the organization and its existing exposure to major risk types. In the context of an overarching taxonomy of risk types, the climate-related risks captured by the Climate-Related Risk Taxonomy are not so much a new form of risk as they are new (or more sharply defined) risk factors.

A key design element of the open Risk Taxonomy used in this Manual is the segmentation into

  • Category:Contractual_Risks, that is, risks that are associated with explicit legal contracts in which the organization currently is involved and
  • Category:Business_Risk, namely risks that threaten a firm's business plan and/or objectives without being linked to any concrete current contractual relationship.

The following tables indicate an (approximate) mapping of climate-related risks to existing risk types. The mapping is decomposed into several tables to capture the relevant sub-categories. First, the high-level mapping approach:

Climate-Related Risk Category Mapping as a Risk Factor of
Acute Physical Risks Contractual Risks
Acute Physical Risks Business Risks
Chronic Physical Risks Contractual Risks
Chronic Physical Risks Business Risks
Transition Risks Contractual Risks
Transition Risks Business Risks

Mapping of Acute Physical Risks to Contractual Risks

Acute physical risks are regularly assessed by the insurance industry and are not new. The mapping stressed that in the context of climate-related risk, existing contracts (credit risk, market risk etc.) can be exacerbated by acute physical risks.

NB: It is worth noting that newly developed contracts / markets that explicitly reference / take climate-related risks into account may exhibit very different behavior than the mapping suggested below. For example there may potentially shifting (transformation) of risks from one entity to another.

Risk Type Mapping
Category:Credit Risk There is potentially 1) idiosyncratic impact on the creditworthiness of corporate clients exposed to acute events (e.g with operations in affected areas) and 2) potentially more systemic impact affecting large sectoral / regional portfolios (including retail)
Category:Market Risk Examples are sudden spikes in commodity prices, impact on stock markets affecting the value of existing holdings etc.
Category:Insurance The possibility that the likelihood or severity of underwriten risk is in excess of priced / capitalized models
Category:Pension Risk Impact on asset/liability balance (e.g., via a pension fund's asset portfolio)
Category:Optionality Risk Adverse behavioral changes of clients exposed to acute events (increased drawdowns, altered pre-payment patterns)
Category:Human_Resources_Risk Key persons affected by acute events

Mapping of Acute Physical Risks to Business Risks

Acute physical risks map potentially to the entire spectrum of Business Risks, both tangible operational risks and more intangible business risks

Risk Type Mapping
Category:Operational Risk Two standard subcategories of Operational Risk (Physical Damage, Business Execution) are direct reflections of acute risk events
Category:Franchise Risk Acute events may reveal vulnerabilities and affect the reputation of the firm for risk management or even the viability of its business models
Category:Revenue Risk Acute events may disrupt existing budgets and revenue streams
Category:Funding Risk Incidental to the realization of other risk factors (credit risk, operational risk etc.) the firm may experience difficulties obtaining funding to support operations
Category:Human_Resources_Risk Incidental to reputational loss, the firm may experience difficulty fullfiling required positions

Mapping of Chronic Physical Risks to Contractual Risks

Chronic risks can impact existing contracts when those are long-dated and/or where it is structurally difficult to mitigate risk on the face of increasing climate-related exposure

Risk Type Mapping
Category:Credit Risk Impact on the creditworthiness of (long-dated exposures) to client segments that are exposed to structural deterioration due to geography or business model that is affect by climate risk
Category:Market Risk Incidental to long-dated / exotic contracts
Category:Insurance Likelihood or severity of underwriten risk in excess of priced / capitalized models
Category:Pension Risk Incidental impact on asset/liability balance (via pension fund asset portfolio)
Category:Optionality Risk Incidental to long-dated contracts (e.g sensitive to prepayment rates)
Category:Human_Resources_Risk

Mapping of Chronic Physical Risks to Business Risks

Chronic physical risks map also potentially to the entire spectrum of Business Risks, in particular where management action is less able to reduce the exposure

Risk Type Mapping
Category:Operational Risk To the extend that the firm is unable to structurally mitigate its exposure to physical damage or disruption of operations
Category:Franchise Risk Chronic exposure may question the viability of the firm's business models
Category:Revenue Risk Revenue streams may become more fragile / volatile
Category:Funding Risk Long term funding may be not available at normal prices
Category:Human_Resources_Risk Incidental to reputational loss, the firm may experience difficulty fullfiling required positions

Mapping of Transition Risks to Contractual Risks

Transition Risks can impact existing contracts when those are long-dated and/or where it is structurally difficult to mitigate the risk created by the transition process

Risk Type Mapping
Category:Credit Risk Impact on the creditworthiness of (long-dated exposures) to client segments that are exposed to structural deterioration due to a business model that is becoming obsolete (Stranded Assets)
Category:Market Risk
Category:Insurance
Category:Pension Risk Impact on asset/liability balances (via pension fund asset portfolio)
Category:Optionality Risk
Category:Human_Resources_Risk

Mapping of Transition Risks to Business Risks

Transition Risks map also potentially to the entire spectrum of Business Risks, in particular where the business strategy is not aligned with the nature and pace of the transition process

Risk Type Mapping
Category:Operational Risk Legal Risk from litigation associated with entities affected by the transition process
Category:Franchise Risk The firm's business model may be incompatible with certain transition scenarios. Increased sensitivity to the nature of policy choices implemented (Political Risk)
Category:Revenue Risk Revenue streams may become more fragile / volatile or be eliminated under transition scenarios.
Category:Funding Risk Long term funding may be not available at any price
Category:Human_Resources_Risk The broader pool of talent may be diminishing under transition scenarios as people opt for future-proof sectors

References