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      Introducing a stress-test based approach to integrating climate-change risk into structured finance
      WEDNESDAY, 21/09/2022 - Scope Ratings GmbH
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      Introducing a stress-test based approach to integrating climate-change risk into structured finance

      Integrating ESG factors into credit assessments is far from being standardised and market participants appear uncertain about best practices. Climate change is a key area of focus, as it strongly affects business activities across different geographies.

      “The quantitative stress-testing solution we have introduced in this research helps to assess climate-change risk in structured-finance transactions in a consistent, transparent and flexible manner,” said Benoit Vasseur, executive director in Scope’s structured finance team. “By quantifying the variation in selected credit risk drivers, climate-change risks can be incorporated into credit analysis.”

      Scope has identified three main types of climate-change scenarios: orderly, disorderly and hot house world, as developed by the ECB, BoE and the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). Combined, these scenarios offer a wide range of outcomes for the crystallisation of transition and physical risks.

      “Assessing the potential impact of climate risks on financial markets starts with risk identification,” explained Benjamin Bouchet, director, structured finance. “We have identified scenarios for a range of outcomes regarding climate-change risks. The stress-test approach presented captures the transmission of transition and physical risks into the credit risk of structured-finance transactions.”

      Stress tests are used to assess the resilience of transactions to shocks on economic aggregates. With regard to climate risks, Scope’s climate-risk solution seeks to understand how, in a particular climate-change scenario, key economic variables stress over time. The analysis then derives how key credit-risk drivers change as a result of the stressed environment.

      In a given climate-change scenario, the intensity of shocks to economic aggregates is derived via established models, including ECB and BoE models as well as the Macroeconomic Climate Stress Test (MCST) developed by Scope ESG Analysis.

      On the basis of the three NGFS scenarios, the MCST models the flows of intermediate and final goods and their associated GHG emissions in a global country-sector-based value chain model and provides two risk-associated KPIs (physical and transition risks for country-sector combinations in terms of output gap) and two climate-associated KPIs (implied temperature and GHG in CO2-equivalent).

      Structured finance transactions backed by corporate debt:
      Sensitivity of default rate to climate-change risk under various scenarios

      Source: Scope Ratings’ calculations, assuming a B rated corporate loan from an obligor located in France in the ‘manufacture of coke and refined petroleum products’ business sector (without exposure to acute climate risk)

      “The set of economic aggregates to stress and the method of transmission to credit-risk drivers depends on the structured-finance transaction. We can distinguish two main types of approaches: top-down and bottom-up,” said Olivier Toutain, executive director, structured finance.

      The top-down approach is similar to macro stress tests performed by central banks to assess bank solvency. “Via scenarios, the impact of shocks on macroeconomic aggregates is observed over time. The impact on individual obligors is inferred and allows stresses on their credit-risk metrics to be derived,” Toutain added. This approach is appropriate when assessing climate risk for a transaction backed by corporate loans. Each scenario leads to an output gap at the level of country-sector, which translates into a revised probability of default at the level of each obligor.

      The bottom-up approach starts with the details of individual obligors. “Here, scenario modelling allows an assessment of how shocks to the global economy impact each household. The overall effect can then be inferred on a portfolio basis,” said Vasseur. This approach is pertinent when assessing climate risk for transactions backed by residential mortgages or consumer loans. Each scenario leads to a shock to household finances (income and wealth) based on geographical location, affecting the credit-risk metrics.

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